Economics of Money, Banking, and Financial Markets, The, Canadian Edition, 8th edition Solution Manu

INSTRUCTOR’S SOLUTIONS MANUAL for

THE ECONOMICS OF MONEY, BANKING, AND FINANCIAL MARKETS Eighth Canadian Edition Frederic S. Mishkin Columbia University

Apostolos Serletis University of Calgary

Contents Chapter 1: Why Study Money, Banking, and Financial Markets? ................................................................

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Chapter 2: An Overview of the Financial System .........................................................................................

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Chapter 3: What Is Money? ...........................................................................................................................

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Chapter 4: Understanding Interest Rates .......................................................................................................

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Chapter 5: The Behaviour of Interest Rates ...................................................................................................

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Chapter 6: The Risk and Term Structure of Interest Rates ............................................................................

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Chapter 7: The Stock Market, the Theory of Rational Expectations, and Efficient Market Hypothesis .......

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Chapter 8: An Economic Analysis of Financial Structure .............................................................................

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Chapter 9: Economic Analysis of Financial Regulation ................................................................................

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Chapter 10: Banking Industry: Structure and Competition ........................................................................... 10-1 Chapter 11: Financial Crises .......................................................................................................................... 11-1 Chapter 12: Banking and the Management of Financial Institutions ............................................................. 12-1 Chapter 13: Risk Management with Financial Derivatives ........................................................................... 13-1 Chapter 14: Central Banks and the Bank of Canada ...................................................................................... 14-1 Chapter 15: The Money Supply Process........................................................................................................ 15-1 Chapter 16: Tools of Monetary Policy .......................................................................................................... 16-1 Chapter 17: The Conduct of Monetary Policy: Strategy and Tactics ............................................................ 17-1 Chapter 18: The Foreign Exchange Market ................................................................................................... 18-1 Chapter 19: The International Financial System ........................................................................................... 19-1 Chapter 20: Quantity Theory, Inflation, and the Demand for Money ........................................................... 20-1 Chapter 21: The IS Curve .............................................................................................................................. 21-1 Chapter 22: The Monetary Policy and Aggregate Demand Curves ............................................................... 22-1 Chapter 23: Aggregate Demand and Supply Analysis................................................................................... 23-1 Chapter 24: Monetary Policy Theory ............................................................................................................ 24-1 Chapter 25: The Role of Expectations in Monetary Policy ........................................................................... 25-1 Chapter 26: Transmission Mechanisms of Monetary Policy ......................................................................... 26-1 Appendix: Alternative Course Outlines ......................................................................................................... ii .

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Preface To help instructors cope with the many demands of teaching, The Economics of Money, Banking, and Financial Markets, Eighth Canadian Edition, includes a comprehensive package of supplementary materials, including lecture slides and a computerized test bank. This Instructor’s Solutions Manual will help save time preparing class materials, such as class outlines, lecture notes, and solutions to homework.

This manual includes four key elements: • Chapter Overviews and Teaching Tips • Answers to End of Chapter Questions and Problems • Solutions to Mini-Cases • Appendix of Alternative Course Outlines There are many different ways to teach a course on money, banking, and financial markets. For this reason, the material in The Economics of Money, Banking, and Financial Markets, Eighth Canadian Edition, has been arranged with flexibility in mind, so that many teaching styles can be accommodated. The Appendix includes sample outlines for four main approaches to teaching money, banking, and financial markets, showing how the text can be adapted to each approach, as well as to quarter and semester teaching schedules. Note, however, that many variations on these outlines are possible.

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

Each chapter of the Instructor’s Solutions Manual also contains the answers to the end-of-chapter problems. Some of these questions require students to look up current data, and in these cases no answers are given; however, for the rest of the questions, the answers are quite complete. Many instructors will use the end-of-chapter questions for homework assignments, as we do. We have found it useful to hand out answers to the questions to the students as solutions sets after they have completed their assignments; they find them to be an invaluable study aid. You can prepare the solution sets for reproduction by cutting and pasting from the chapters. Note that most of the end-of-chapter questions and problems are also included in the MyLab Economics, where students will get instant feedback on the problems, as well as step-by-step tutorials for some questions.

Chapters 4, 5, 6, 7, 10, 12, 13, 16, and 18 include solutions to the mini-cases that are available to students on MyLab Economics.

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

Chapter Overview and Teaching Tips Before embarking on a study of money, banking, and financial markets, the student must be convinced that this subject is worth studying. Chapter 1 pursues this goal in two ways. First, it shows the student that money and banking is an exciting field because it focuses on economic phenomena that affect everyday life. Second, using eight figures, this chapter encourages the student to look at data that bear on the central issues in this field. An additional purpose of Chapter 1 is to provide an overview for the entire book, previewing the topics that will be covered in later chapters, and to indicate how the book will be taught.

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

The appendix to this chapter reviews concepts regarding the definitions of aggregate output, income, and the price level that the student already has seen in an economic principles course.

Since these concepts are extremely important, it might be worthwhile to have your students read this appendix outside of class to jog their memories.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What is the typical relationship among interest rates on three-month Treasury bills, longterm Canada bonds, and corporate bonds?

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

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

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

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

A bond is a debt instrument, which entitles the owner to receive periodic amounts of money (predetermined by the characteristics of the bond) until its maturity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In

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addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state that stockholders are residual claimants (i.e., the corporation has to pay all bondholders before paying stockholders).

4. Explain the link between well-performing financial markets and economic growth. Name one channel through which financial markets might affect economic growth and poverty.

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

5. What was the main cause of the global financial crisis that began in 2007?

The United States’ economy was hit by the worst financial crisis since the Great Depression.

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

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

In general, people do not lend large amounts of money to one another because of several information problems. In particular, people do not know about the capacity of other people to repay their debts or the effort they will make to repay their debts. Financial intermediaries, in particular commercial banks, tend to solve these problems by acquiring information about potential borrowers and writing and enforcing contracts that encourage lenders to repay their debt and/or maintain the value of the collateral.

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

Other important financial intermediaries are Trust and loan companies, credit unions, caisses populaires, insurance companies, mutual funds, pension funds, and finance companies.

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

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

From 1968 to 2020, the price level has increased more than sevenfold. In the late 1970’s interest rates rose, but they have decreased since then and have remained low.

10. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to a. Real output? b. The inflation rate? c. Interest rates?

The data in Figures 1-3, 1-4, and 1-6 suggest that real output, the inflation rate, and interest rates would all fall.

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

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

12. Is everybody worse off when interest rates rise?

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

13. Why do managers of financial institutions care so much about the activities of the Bank of Canada?

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

14. How does the current size of the Canadian budget deficit compare to the historical budget deficit or surplus for the time period since 1960?

The deficit as a percentage of GDP expanded dramatically in 2007; in 2010, the deficit to GDP ratio was over 4%, well above the historical average of around 1.3% since 1960. In the most recent year, 2017, the deficit turned out to be less than what was expected by over $5 billion.

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

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

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

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

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

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

18. According to Figure 1-8, in which years would you have chosen to visit the Canadian Rockies rather than Grand Canyon in Arizona?

In the mid-1980s and in the late 1990s, the value of the Canadian dollar was low, making travel abroad relatively more expensive; thus, it was a good time to vacation in Canada and see the Canadian Rockies. With the rise in the Canadian dollar’s value in the 2000s, travel abroad became relatively cheaper, making it a good time to visit the Grand Canyon. This was also true, to a lesser extent, in the early 2020s.

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

When the dollar increases in value, foreign goods become less expensive relative to Canadian goods; thus, you are more likely to buy American-made jeans than Canadian-made jeans.

The resulting drop in demand for Canadian-made jeans because of the strong dollar hurts Canadian jeans manufacturers. On the other hand, the Canadian company that imports jeans into Canada now finds that the demand for its product has risen, so it is better off when the dollar is strong.

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

As the dollar becomes stronger (worth more) relative to a foreign currency, one dollar is equivalent to (can be exchanged for) more foreign currency. Thus, for a given face value of bond holdings, a stronger dollar will yield more home currency to foreigners, so the asset will be worth more to foreign investors. Likewise, a weak dollar will lead to foreign bond holdings worth less to foreigners.

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

05-01 05-04

1.2509 1.2430

05-18 05-19

1.2211 1.2255

05-05

1.2449

05-20

1.2257

05-06

1.2347

05-21

1.2227

05-07

1.2349

05-22

1.2178

05-08

1.2436

05-25

NA

05-11

1.2330

05-26

1.2337

05-12

1.2299

05-27

1.2231

05-13

1.2225

05-28

1.2325

05-14 05-15

1.2194 1.2129

05-29

1.2320

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

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Statistics Canada CANSIM database, and find data on the M2++ (gross) money supply and the 10-year Canada bond rate from January 2000 to November 2000. Add the two series into a single graph. Transform the M2++ money supply variable into the M2++ growth rate by adjusting the units for the M2++ money supply to “Percent Change from Year Ago.” a. In general, how have the growth rate of the M2++ money supply and the 10-year Canada bond rate behaved during recessions and during expansionary periods since the year 2000?

Since the year 2000, during both recessions and expansions, the 10-year Canada bond rate shows an overall declining trend. The M2++ money supply growth rate, on the other hand, shows a cyclical pattern. The growth rate of M2++ is positive throughout the years, but it does not show any consistent pattern in recessions and expansions, as can be seen in the following figure (in which shaded areas represent recessions based on the FRED recession indicator, CANRECM).

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10-year Canada bond rate and the M2++ growth rate 14

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Series1

10 year bond rate

10

8

6

4

2

0 2000

2004

2008

2012

2016

2020

b. In general, is there an obvious, stable relationship between money growth and the 10year interest rate since the year 2000?

No. The 10-year Canada bond rate shows an overall declining trend irrespective of the growth rate of M2++. c. Compare the money growth rate and the 10-year interest rate for the most recent month available to the rates for January 2000. How do the rates compare?

The money growth rate and the 10-year interest rate for the most recent month (November 2020) is 13.2% and 0.7%, respectively. The values of these variables were 7.76% and 5.39%, respectively, in January 2001. So, the money growth rate increased by 5.5 percentage points, but the 10-year interest rate declined by 4.69 percentage points.

2. Go to the St. Louis Federal Reserve FRED database and find data on the three-month Treasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate (CPN3M), the 30-year Treasury bond rate (GS30), the 30-year fixed rate mortgage average (MORTGAGE30US), and the NBER recession indicators (USREC). For the mortgage rate indicator, set the frequency setting to ‟monthly.”

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a. In general, how do these interest rates behave during expansionary periods?

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

In nearly all instances, the 30-year rates are significantly higher than the three-month rates. Likewise, in most cases, the 30-year mortgage rate is higher than the 30-year Treasury rate, and the three-month commercial paper rate is higher than the three-month Treasury rate. c. For the most recent available month of data, take the average of each of the three-month rates and compare it to the average of the three-month rates from January 2000. How do the averages compare? d. For the most recent available month of data, take the average of each of the 30-year rates and compare it to the average of the 30-year rates from January 2000. How do the averages compare?

June 2020

January 2000

Three-month rate avg.

0.17

5.53

30-year rate avg.

2.33

7.42

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

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Chapter 2: An Overview of the Financial System Chapter Overview and Teaching Tips Chapter 2 is an introductory chapter that contains the background information on the structure and operation of financial markets that is needed in later chapters of the book. This chapter allows the instructor to branch out to various choices of later chapters, thus allowing different degrees of coverage of financial markets and institutions.

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

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. If I can buy a car today for $5000 and it is worth $10 000 in extra income to me next year because it enables me to get a job as a travelling salesperson, should I take out a loan from Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a result of taking out this loan? Can you make a case for legalizing loan sharking?

Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4500 (90% of $5000), but as a result, I will earn an additional $10 000, so I will be ahead of the game by $5500. Since Larry’s loan-sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.)

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

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

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

Examples of how financial markets allow consumers to better time their purchases include: ● The purchase of a durable good, like a car or furniture ● Paying for tuition ● Paying the cost of repairing a flooded basement In all three cases, consumers were able to pay for a good or service (education or the reparation of a flooded basement) without having to wait to save enough and only then being able to afford such goods and services.

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

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

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

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

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

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

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

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

9. A significant number of European banks held large amounts of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Financial firms that provide multiple types of financial services can be more efficient through economies of scope—that is, by lowering the cost of information production. However, this can be problematic since it can also lead to conflicts of interest, in which the financial firm provides false or misleading information to protect its own interests. This can lead to a worsening of the asymmetric information problem, making financial markets less efficient.

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

You would likely use a credit union if you were a member, since their primary business is consumer loans. In some cases, it is possible to borrow directly from pension funds, but it can come with high borrowing costs and tax implications. Investment banks do not provide loans to the general public.

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

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

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

How would this help stabilize the financial system?

During the financial panic, regulators were concerned that depositors worried their banks would fail and that depositors (especially with accounts over $100 000) would pull money from banks, leaving cash-starved banks with even less cash to satisfy customer demands and day-to-day operations. This could create a contagious bank panic in which otherwise healthy banks would fail. Raising the insurance limit would reassure depositors that their money was safe in banks and prevent a bank panic, helping to stabilize the financial system.

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23. Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss why it might be desirable—or undesirable—to have the same financial regulation across industrialized countries.

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

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

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

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

Option 4: Hold the money in cash and earn zero return. a. If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event.) b. Suppose Option 3 and Option 4 are your only choices. If you could pay your friend $100 to find out extra information about Mike that would indicate with certainty whether he will leave town without paying, would you pay the $100? What does this say about the value of better information regarding risk? a. With Option 1, since deposits are insured, it can be assumed that this is a riskless investment. Thus, the expected total payoff would be $10 000 × 1.02 = $10 200. With Option 2, a bond return of 5% implies a potential payoff of $10 000 × 1.05 = $10 500, and there is a 90% chance that this outcome will occur, thus the expected payoff is $10 500 × 0.9 = $9450. Under Option 3, the expected payoff is $10 000 × 1.08 × 0.93 = $10 044. Option 4 is riskless, so the expected total payoff is $10 000. Given these choices and the assumption that you don’t care about risk, Option 1 is the best investment.

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b. Option 3 implies the very real possibility of either receiving nothing (if he actually leaves town) or $10 800 (if he indeed pays as promised). If you don’t pay your friend to learn about Mike, you have an expected return of $10 044 as shown previously. If you paid your friend the $100 and learned that Mike would leave without paying, then obviously you wouldn’t loan Mike the money, and you would be left with $9900. However, if you paid your friend $100 and learned that Mike would pay, you would have $10 700 (= $10 000 × 1.08 − $100). After paying your friend to learn about Mike, but before knowing the true outcome, your expected return would be $10 644 ($9900 × 0.07 + $10 700 × 0.93). Under Option 3, paying your friend the $100 is definitely worth it because it increases your expected return and in addition dramatically reduces the downside risk that you make a bad loan, and it increases the certainty of the payoff amount. That is, with asymmetric information (not paying your friend), you have a range of payoffs of $0 to $10 800 versus $9900 to $10 700 without asymmetric information. Thus, paying a small amount to improve risk assessment under Option 3 can be very beneficial, a task for which financial intermediaries are well suited. Option 4 is riskless, so the expected total payoff is $10 000. If you are more risk-averse, Option 4 is likely the better option. However, if you are more risk-neutral, then paying your friend the $100 to have a minimum $9900 payment and possibly as much as $10 700 is the better scenario.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and find data on the total Canadian dollar assets held by chartered banks in Canada (series V36852). What is the percent increase in growth of assets, from January 2000 to November 2020?

It is 394.9%.

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

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

2020:Q1

2000:Q1

Commercial Banks

$18249.5 Bil.

$5645.1 Bil.

Money Market Mutual Funds

$4338.0 Bil.

$1696.1 Bil.

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Chapter 3: What Is Money?

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

Once the student understands what money is, the most important point to get across to him or her is that economists are not exactly sure how to measure money. This presents to policymakers a serious problem: Although they might want to control the money supply to affect the economy, they are not sure which measure of money is the right one to control. In many situations, knowing which measure of money is the right one is not crucial because different measures (such as Ml+, M2+, and M2++) move together. But, as Figure 3-2 illustrates, this is sometimes not the case, presenting the policymaker with a dilemma.

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Why is simply counting currency an inadequate measure of money?

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

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

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

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

Producer

Apples

Orchard Owner

Bananas

Banana Grower

Chocolate

Chocolatier

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

Because the orchard owner likes only bananas but the banana grower doesn’t like apples, the banana grower will not want apples in exchange for his bananas, and they will not trade.

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

4. Why did cavemen and women not need money?

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

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

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

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

Maria is contemplating the store-of-value function of money. As a medium of exchange and unit of account, measures of money known as M1+ or M2+ have no important rivals.

With respect to the store-of-value function, however, there are many assets that can preserve value better than a chequing account. Maria’s choice to preserve the purchasing power of her income by increasing her savings account balance is fine for a short period of time. For a period of 20 years, however, you might choose to buy a Canada bond that matures in 20 years (as many grandparents have done as a way to pay for their grandchildren’s educations).

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

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

Because money was losing value at a slower rate (the inflation rate was lower) in the 1950s than in the 1970s, it was a better store of value then, and you would have been willing to hold more of it.

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

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

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

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

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

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

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

Explain.

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

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

13. Which of the Bank of Canada’s measures of the monetary aggregates—M2+ or M2—is composed of the most liquid assets? Which is the larger measure?

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

14. It is not unusual to find a business that displays a sign saying “no personal cheques, please.”

On the basis of this observation, comment on the relative degree of liquidity of a chequing account versus currency.

The degree of liquidity of an asset is measured by considering how much time and effort (i.e., transaction costs) are needed to convert that asset into currency. Currency is by definition the most liquid type of money. Different types of money have different degrees of liquidity. A cheque, which represents a balance on a chequing account, is a quite liquid type of money. After all, all that is needed to pay for a good or service using a cheque is the two minutes it takes to include the date and amount and sign the cheque. However, the above example shows that some merchants refuse to accept cheques as a means of payment. (They

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cannot refuse to accept dollars, as dollars are legal tender in Canada.) This can result in significant transaction costs in trying to find a bank or an ATM. It is even possible that the transaction never takes place. This example illustrates the point that even inside the same monetary aggregate, different types of money do not have the same degree of liquidity.

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

Your actions will reduce your chequing account balance and increase your holdings of money market mutual fund shares. Considering this transaction only, M1+ and M2+ will decline.

17. In April 2009, the growth rate of M1 in the United States fell to 6.1%, while the growth rate of M2 rose to 10.3%. In September 2013, the year-over-year growth rate of the M1 money supply was 6.5%, while the growth rate of the M2 money supply was about 8.3%. How should Federal Reserve policymakers interpret these changes in the growth rates of M1 and M2?

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

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

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Not necessarily. Although the total amount of debt has predicted inflation and the business cycle better than M1+ or M2+, it may not be a better predictor in the future. Without some theoretical reason for believing that the total amount of debt will continue to predict well in the future, we may not want to define money as the total amount of debt.

ANSWERS TO APPLIED PROBLEMS 19. Look up the M1+, M1++, M2, M2+, M2++, and M3 numbers in the Bank of Canada’s Banking and Financial Statistics for the most recent one-year period. Have their growth rates been similar? What implications do their growth rates have for the conduct of monetary policy?

The growth rates of M1+, M1++, M2, M2+, M2++, and M3 are different, although they tend to move together over time. However, it does make a difference which monetary aggregate the Bank of Canada is using for monetary policy purposes.

20. Which of the Bank of Canada’s measures of the monetary aggregates, M1+, M1++, M2, M2+, M2++, or M3, is composed of the most liquid assets? Which is the largest measure?

M1+ is composed of the most liquid assets. M2++ is the largest measure.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download monthly data from January 1970 to November 2020 on the M2 (gross) monetary aggregate (series V41552796). a. What is the average monthly monetary growth rate over the entire period?

It is 0.69%. b. Calculate the average monthly monetary growth rate and its standard deviation over each of the last five decades.

1970 Jan – 1979 Dec average = 1.15%; stdev = 0.61 1980 Jan – 1989 Dec average = 0.85%; stdev = 0.54 1990 Jan – 1999 Dec average = 0.28%; stdev = 0.36 2001 Jan – 2009 Dec average = 0.60%; stdev = 0.38 2010 Jan – 2020 Nov average = 0.60%; stdev = 0.48

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c. Which decade had the lowest money growth rate? The highest?

Lowest: 1990 Jan – 1999 Dec; Highest: 1970 Jan – 1979 Dec d. Which decade had the lowest money growth volatility? The highest?

Lowest : 1990 Jan – 1999 Dec; Highest: 1970 Jan – 1979 Dec 2. Go to the CANSIM database, and find data on M1++ for Canada (series V37152). Calculate the annual growth rate, as 1200*ln(Mt/Mt-1) from January 2000 to November 2020. What is the average annual monetary growth rate? Its standard deviation?

Average = 9.48%; stdev = 7.06.

3. Go to the St. Louis Federal Reserve FRED database and find data on currency (CURRSL), demand deposits (DEMDEPSL), and other checkable deposits (OCDSL). Calculate the M1 money supply, and calculate the percentage change in M1 and in each of the three components of M1 from the most recent month of data available to the same time one year prior. Which component has the highest growth rate? The lowest growth rate?

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

Currency Demand Deposits Other Checkable Deposits M1

May 2019 $1650.8 Bil. $1493.8 Bil.

May 2020 $1818.7 Bil. $2166.7 Bil.

$647.9 Bil. $3792.5 Bil.

$1077.3 Bil. $5062.7 Bil.

May 2019 to May 2020 Currency

10.2%

Demand Deposits Other Checkable Deposits

45.0%

M1

33.5%

66.3%

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

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

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

An appendix to the chapter, which can be found in MyLab Economics, provides more detail on how interest-rate risk can be measured with the concept of McCauley’s duration. This is a basic financial tool that is used by practitioners and so will be of great interest to students who plan careers in the financial industry.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%?

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

2. Explain which information you would need to take into consideration when deciding to receive $5000 today or $5500 one year from today.

When comparing amounts of money that are disbursed at different dates, one has to take into consideration the concept of present value of money. To calculate the present value of the $5500 promised one year from today, one needs to know the annual interest rate. In this case, for an interest rate larger than 10%, one would prefer to accept the $5000 today (since one can deposit that amount and receive more than $5500 one year from today).

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3. To help pay for university, you have just taken out a $1000 government loan that makes you pay $126 per year for 25 years. However, you don’t have to start making these payments until you graduate from university two years from now. Why is the yield to maturity necessarily less than 12%? (This is the yield to maturity on a normal $1000 fixed-payment loan on which you pay $126 per year for 25 years.)

If the interest rate were 12%, the present discounted value of the payments on the government loan are necessarily less than the $1000 loan amount because they do not start for two years. Thus the yield to maturity must be lower than 12% in order for the present discounted value of these payments to add up to $1000.

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

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

Note: Check Equations 7 and 8 in this chapter.

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

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

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

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

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

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

The near-term costs to maintaining a given size loan are much smaller for a perpetuity than for a similar fixed-payment loan, discount, or coupon bond. For instance, assuming a 5% interest rate over 10 years, on a $1000 loan, a perpetuity costs $50 a year (or $500 in payments over 10 years). For a fixed-payment loan, this would be $129.50 per year (or $1295 in payments over the same 10-year period). For a discount loan, this loan would require a lump sum payment of $1628.89 in 10 years. For a coupon bond, assuming the same $50 coupon payment as the perpetuity implies a $1000 face value. Thus, for the coupon bond, the total payments at the end of 10 years will be $1500.

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

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

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

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

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

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

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

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

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

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

ANSWERS TO APPLIED PROBLEMS 14. If the interest rate is 10%, what is the present value of a security that pays you $1100 next year, $1210 the year after, and $1331 the year after that? $1100/(1 + 0.10) + $1210/(1 + 0.10)2 + $1331/(1 + 0.10)3 = $3000.

15. Calculate the present value of a $1000 discount bond with five years to maturity if the yield to maturity is 6% PV = FV/(1 + i)n, where FV = 1000, i = 0.06, n = 5. Thus, PV = 747.26.

16. A lottery claims its grand prize is $10 million, payable over five years at $2 million per year.

If the first payment is made immediately, what is this grand prize really worth? Use an interest rate of 6%.

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

17. Suppose that a commercial bank wants to buy Treasury bills. These instruments pay $5000 in one year and are currently selling for $5012. What is the yield to maturity of these bonds? Is this a typical situation? Why? The yield to maturity of these bonds solves the following equation: 5000/(1+i) = 5012. After some algebra, the yield to maturity happens to be around – 0.24%. This is not a typical situation. In normal times, banks will not choose to pay more than the face value of a discount bond, since that implies negative yields to maturity. This example illustrates situations as the ones described in the Global box in this chapter.

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

14.9%, derived as follows: The present value of the $2 million payment five years from now is $2/(1 + i)5 million, which equals the $1 million loan. Thus 1 = 2/(1 + i)5. Solving for i, (1 + i)5 = 2, so that i = 5 2 −1 = 0.149 =14.9%.

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19. Which $1000 bond has the higher yield to maturity, a 20-year bond selling for $800 with a current yield of 15% or a 1-year bond selling for $800 with a current yield of 5%?

If the 1-year bond did not have a coupon payment, its yield to maturity would be ($1000 – $800)/ $800 = $200/$800 = 0.25, or 25%. Because it does have a coupon payment, its yield to maturity must be greater than 25%. However, because the current yield is a good approximation of the yield to maturity for a 20-year bond, we know that the yield to maturity on this bond is approximately 15%. Therefore, the 1-year bond has a higher yield to maturity.

20. Consider a bond with a 4% annual coupon and a face value of $1000. Complete the following table. What relationships do you observe between years to maturity, yield to maturity, and the current price?

Years to Maturity Yield to Maturity Current Price 2

2%

2

4%

3

4%

5

2%

5

6%

Years to Maturity Yield to Maturity Current Price 2

2%

1038.83

2

4%

1000.00

3

4%

1000.00

5

2%

1094.27

5

6%

915.75

When yield to maturity is above the coupon rate, the bond’s current price is below its face value. The opposite holds true when yield to maturity is below the coupon rate. For a given maturity, the bond’s current price falls as yield to maturity rises. For a given yield to maturity, a bond’s value rises as its maturity increases. When yield to maturity equals the coupon rate, a bond’s current price equals its face value regardless of years to maturity.

21. Consider a coupon bond that has a $1000 par value and a coupon rate of 10%. The bond is currently selling for $1044.89 and has two years to maturity. What is the bond’s yield to maturity? $1044.89 = $100/(1 + i) + $100/(1 + i)2 + $1000/(1 + i)2. Solving for i gives a yield to maturity of 0.075, or 7.5%.

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22. What is the price of a perpetuity that has a coupon of $50 per year and a yield to maturity of 2.5%? If the yield to maturity doubles, what will happen to the perpetuity’s price?

The price would be $50/0.025 = $2000. If the yield to maturity doubles to 5%, the price would fall to half its previous value, to $1000 = $50/0.05.

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

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

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

The coupon payment C = $100, thus the current yield is $100/$960 = 0.104, or 10.4%. The expected rate of capital gain, g = ($980 − $960)/$960 = 20/960 = 0.021, or 2.1%. The expected rate of return, R = iC + g = 10.4% + 2.1% = 12.5%.

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

The bank will charge you a nominal interest rate equal to 1% + 3% = 4%. However, if actual inflation turns out to be lower than expected, then you will be worse off than originally planned, since the real cost of borrowing (measured by the real interest rate) turned out to be 4–0.5% = 3.5%.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download monthly data from January 1953 to December 2020 for the three-month T-bill rate (series V122541) and the total consumer price index (series V41690973). a. What is the average year-over-year inflation rate, using the formula

 t = 100  ( Pt − Pt −12 ) / Pt −12 It is 3.50%.

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b. What is the average T-bill rate?

It is 5.12%. c. Assume that the expected inflation rate is the same as the actual inflation rate (a restrictive assumption!) and calculate the average real interest rate, r.

The average real interest rate is 5.12% - 3.50% = 1.62%.

2. Go to the CANSIM database, and download monthly data (from November 1991 to January 2021) for the interest rate on long-term Canada Real Return Bonds (series V122553). This is a direct measure of the real interest rate. a. What is the mean real interest rate over the sample period?

It is 2.32%. b. What is its standard deviation? (The standard deviation is the square root of the variance.)

The standard deviation is 1.60.

3.

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

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

Solving yields FP = $20,000/3.535, or a $5657.28 payment per year. Spread over four years, this is $22,629.12 total in payments for the $20,000 loan.

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Solutions to Chapter 4 Mini-Case Interest Rates, Bond Yields, and Duration 1. $40.00 2. $840.00 3. $55.77 4. a. 10.75% b. 11.63% 5. a. 12.25% b. 12.50% 6. a. −3.28% b. 4.71% 7. a. $968.30 b. $940.20 c. $37.80 d. $80.70 e. 4.06% f. 9.39% g. Changes in interest rates make investments in long-term bonds more risky. Prices and returns for long-term bonds are more volatile than those for short-term bonds.

8. a. 400 b. 1000 c. $1433 d. $1452 e. 13.50% = {[(1433 − 930.50)/930.50]  100} ÷ 4 f. 14.01% = {[(1452 − 930.50)/930.50]  100} ÷ 4 g. Because earning interest on interest affects total return on the investment. h. 3.5 years 9. 4.38% 10. 7.00%

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

One teaching device that we have found helps students develop their intuition is the use of summary tables such as Table 5-1 in class. We use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change. This exercise gives them good practice in developing their analytic abilities. We use this device continually throughout our courses and in this book, as is evidenced from similar summary tables in later chapters. We recommend this approach highly.

Chapter 5 goes on to lay out two partial equilibrium approaches to the determination of interest rates: supply and demand in the bond market and the liquidity preference framework (supply and demand in the money market). As is made clear in this chapter, these approaches are not inconsistent with each other but are two different and useful ways of looking at the same thing.

(A third approach to the determination of interest rates used by some practitioners in financial markets is the so-called loanable funds framework. An appendix to the chapter found in MyLab Economics shows how the supply and demand analysis of the bond market developed in this chapter relates to the loanable funds framework.)

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

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Another important feature of this chapter is that it lays out supply and demand analysis of the bond and money markets at a similar level to that found in principles of economics textbooks.

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

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

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Explain why you would be more or less willing to buy a share of BlackBerry stock in the following situations: a. Your wealth falls.

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

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

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

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

More, because it has become less risky relative to bonds

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2. Explain why you would be more or less willing to buy a house under the following circumstances: a. You just inherited $100 000.

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

More, because the house has become more liquid c. You expect BlackBerry stock to double in value next year Less, because its expected return has fallen relative to BlackBerry stock d. Prices in the stock market become more volatile.

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

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

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

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

More, because its expected return has risen d. You expect interest rates to rise.

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

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

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

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

Less, because their expected return has fallen .

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e. Brokerage commissions on bonds fall.

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

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

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

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

Maria is choosing a bond with higher standard deviation but also with higher expected return than Jennifer. In order to decide whether Maria or Jennifer is more risk-averse, one will need to compare two bonds with the same expected return and different standard deviations of their expected returns. Since a high expected return is a desirable characteristic of a bond and a high volatility of its expected return (high standard deviation) is a non-desirable characteristic, it is not uncommon that highly volatile bonds exhibit higher expected returns, as the bond preferred by Maria.

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

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

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

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

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

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

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

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

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

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

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

If the public believes the Bank of Canada’s program will be successful, interest rates will fall. The governor’s announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases, and the demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd, causes the equilibrium interest rate to fall.

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14. Suppose that people in France decide to permanently increase their savings rate. Predict what will happen to the French bond market in the future. Can France expect higher or lower domestic interest rates?

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

15. Suppose you are in charge of the financial department of your company and you have to decide whether to borrow short or long term. Checking the news, you realize that the government is about to engage in a major infrastructure plan in the near future. Predict what will happen to interest rates. Will you advise borrowing short or long term?

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

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

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

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

When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money. Thus, the money demand curve Md shifts to the right, and the interest rate rises.

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

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

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19. M1 money growth in the United States was about 15% in 2011 and 2012 and 10% in 2013.

Over the same time period, the yield on three-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low rather than increase?

What does this say about the income, price-level, and expected-inflation effects?

With unusually high rates of money growth, this should lead to higher expected inflation, a jump in the overall price level, and stronger economic growth. These factors should all result in interest rates rising over time, notwithstanding the liquidity effect. However, in the period from 2011 to 2013, unemployment remained high, economic growth was weak, and if anything, policymakers were worried about deflation (a decrease in the price level) rather than any inflationary effects from the money growth. In other words, the income, price-level, and expected inflation effects of the unusually high money growth conditions were very small relative to the liquidity effect. This is similar to case (a) shown in Figure 5-11.

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

Bonds

Commodities

Probability Return Probability Return Probability Return 0.25

12%

0.6

10%

0.2

20%

0.25

10%

0.4

7.50%

0.25

12%

0.25

8%

0.25

6%

0.25

6%

0.25

4%

0.05

0%

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

The expected return on the stock portfolio is 0.25(12%) + 0.25(10%) + 0.25(8%) + 0.25(6%) = 9%. The expected return on the bond portfolio is 0.6(10%) + 0.4(7.5%) = 9%.

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

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

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

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

In the bond framework, when the economy booms, the demand for bonds increases. The public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right (shown in the following graph), but as is indicated in the text, the demand curve probably shifts less than the supply curve, so the equilibrium interest rate rises.

Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the interest rate falls.

The conclusion is that interest rates rise during booms and fall during recessions: that is, interest rates are procyclical. The same answer is found with the liquidity preference framework. When the economy booms, the demand for money increases (shown in graph below); people need more money to carry out an increased amount of transactions and also because their wealth has risen. The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. When the economy enters a recession, the demand for money falls and the demand curve shifts to the left, lowering the equilibrium interest rate. Again, interest rates are seen to be procyclical.

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

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

24. The demand curve and supply curve for one-year discount bonds with a face value of $1000 are represented by the following equations: Bd: Price = − 0.6 * Quantity + 1140 Bs: Price = Quantity + 700 a. What is the expected equilibrium price and quantity of bonds in this market?

Solving for the equilibrium gives: –0.6 Quantity + 1140 = Quantity + 700; 1.6 Quantity = 440; or Quantity = 275.

Using the bond supply equation Price = 275 + 700 = 975

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b. Given your answer to part (a), what is the expected interest rate in this market?

The expected interest rate on a one-year discount bond with face value of $1000 and current price of $975 is given as i = (1000 – 975)/975 = 0.0256, or 2.56%.

25. The demand curve and supply curve for one-year discount bonds with a face value of $1000 are represented by the following equations Bd: Price = − 0.6 * Quantity + 1140 Bs: Price = Quantity + 700 Suppose that, as a result of monetary policy actions, the Bank of Canada sells 80 bonds that it holds. Assume that bond demand and money demand are held constant. a. How does the Bank of Canada policy affect the bond supply equation?

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

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

Using the bond supply curve, Price = 325 + 620 = 945. Thus, the expected interest rate on a one-year discount bond with face value of $1000 and current price of $945 is given as i = (1000 – 945)/945 = 0.0582, or 5.82%. This is an increase from 2.56% in the initial equilibrium, which was calculated in the answer to the previous question. Note that as we will see the open market sale leads to a decline in the money supply and so the liquidity preference framework would then also indicate that the interest rate would rise.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download monthly data from 1962:1 to 2021:1 for the three-month T-bill rate (series V122531). a. What is the average nominal interest rate?

5.47 b. Calculate the change in it, it = it+1 - it. What is the average change? The average standard deviation?

Average -0.00086 s.d. 0.46292

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

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

Money Growth and Contemporaneous 10-Year Rate 2000:Q1 to 2020:Q1 y = -0.1579x + 4.4467 R² = 0.4036

7.00 6.00

Interest Rate

5.00 4.00 Series1

3.00

Linear (Series1) 2.00 1.00 0.00

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

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

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See scatter plot below. The effects of money growth one year later still seem to indicate money growth lowers the interest rate on net. However, since the regression coefficient is smaller, the net effect after one year is less than the initial (liquidity) effect. That is, if the liquidity effect lowered the 10-year yield by 15.8 basis points on average in a given quarter as in (a) above, but it was lowered by only 12.5 basis points one year later, then the feedback effects from the income, price-level, and expected inflation effect must be helping to offset some of the liquidity effect (on the order of around 3.3 basis points) after one year, on average.

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

Interest Rate

5 4 3

Series2 Linear (Series2)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

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

See scatter plot below. Assuming all the effects run their course after two years, the data after two years suggest that a one percentage point increase in money growth, on average, will leave the 10-year yield lower by about 10 basis points. Thus, putting the liquidity, income, price-level, and expected inflation effects together, on net indicates that higher money growth should leave nominal interest rates lower overall according to this data.

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

y = -0.0998x + 3.816 R² = 0.2217

Interest Rate

5 4 3

Series3 Linear (Series3)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 5-11 of this chapter?

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

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Solutions to Chapter 5 Mini-Case The Behaviour of Interest Rates 1. a. 25.00% b. 17.65% c. 11.11% d. 5.26% e. 0.00% 2.

$833.33

3.

Wealth Expected returns on bonds relative to alternative assets Risk of bonds relative to alternative assets Liquidity of bonds relative to alternative assets

4.

Expected profitability of investment opportunities Expected inflation Government activities

5.

The Fisher effect is named for Irving Fisher, who pointed out that “when expected inflation rises, interest rates will rise.”

6.

The loanable funds framework provides a theory of how interest rates are determined by examining the supply and demand for bonds. The liquidity preference framework focuses on the supply and demand for money, indicating how interest rates are determined. Both theories attempt to monitor the direction and degree of change in interest rates.

7.

Note: Various predictions are possible in some of the following, leading to in-class discussions. Consider the following possible initial responses: Bonds: a. b. c. d. e. f.

If supply curve shifts more than demand, equilibrium interest rates rise.

With other economic variables constant, interest rates rise.

In general, interest rates rise.

As demand falls, interest rates rise.

Equilibrium interest rates fall.

If government securities supplied exceed demand, interest rates rise.

Money: a. b. c. d.

As income increases, interest rates rise.

As the price level increases, interest rates rise.

Increases interest rates.

Demand shifts from bonds, raising interest rates.

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

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. If junk bonds are “junk,” then why do investors buy them?

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

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

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

Canadian government-issued securities are usually considered to be default free. However, securities issued by other governments usually have a positive risk premium, depending in general on the fiscal imbalances that each country exhibits at a given point in time.

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4. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake.

How would this affect, if at all, the yield and risk premium on AIG corporate debt?

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

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

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

6. Just before the collapse of the U.S. subprime mortgage market in 2007, the most important credit-rating agencies rated mortgage-backed securities with Aaa and AAA ratings. Explain how it was possible that a few months into 2008, the same securities had the lowest possible ratings. Should we always trust credit-rating agencies?

Historically, mortgage-backed securities were considered low-risk assets, since homeowners had the highest incentives to pay their mortgages (otherwise they might lose their home).

However, after standards on lending practices decreased during the first years of the new century, many individuals were able to buy a house but not to make their mortgage payments. This resulted in poor quality mortgage-backed securities that should never have had such good ratings. Both Standard and Poor’s and Moody’s were investigated for assigning such good ratings and therefore misleading investors in buying these instruments.

Sometimes credit-rating agencies also make mistakes in assigning risks.

7. The Canadian government offers some of its debt as Real Return Bonds, in which the price of bonds is adjusted for inflation over the life of the debt instrument. Real Return Bonds are traded on a much smaller scale than nominal Canada bonds of equivalent maturity. What can you conclude about the liquidity premiums of Real Return Bonds versus nominal Canada bonds?

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

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

What will happen to the interest rates on Canada bonds?

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

9. Predict what would happen to the risk premiums of corporate bonds if brokerage commissions were lower in the corporate bond market.

Risk premiums of corporate bonds would fall.

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

The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system and doubt about the soundness of even the most healthy banks and financial companies. As a result, there was a sharp decrease in demand for financial commercial paper relative to the seemingly safer nonfinancial commercial paper. This resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investments.

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

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

12. Prior to 2008, mortgage lenders in the United States required a house inspection to assess a home’s value and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this inspection was arranged through a third party.

How does the pre-2008 scenario illustrate a conflict of interest similar to the role that creditrating agencies played in the global financial crisis?

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

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

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

14. If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds and (b) the segmented markets theory of the term structure holds. (a) Under the expectations theory of the term structure, if 30-year bonds become less desirable, this will increase the demand for bonds of other maturities, since they are viewed as perfect substitutes. The result is a higher price and a lower yield at all other maturities, and an increase in yield at the end of the yield curve. In other words, the yield curve would steepen at the end, and flatten somewhat along the rest of the curve. (b) Under the segmented markets theory, the assumption is that each type of bond maturity is an independent market, and therefore not linked in any particular way. Thus, changes in long rates won’t affect shorter- and medium-term bond yields. Thus, the yield curve under the segmented markets theory will result in a jump in the 30-year rate, with the remainder of the yield curve unchanged.

15. Suppose the interest rates on one-, five-, and ten-year Canada bonds are currently 3%, 6%, and 6%, respectively. Investor A chooses to hold only 1-year bonds, and Investor B is indifferent with regard to holding 5- and 10-year bonds. How can you explain the behaviour of Investors A and B? Investor A, even though she receives a lower expected return, clearly prefers to hold shortterm debt, perhaps because it is more liquid. Investor A’s preferences are consistent with the segmented markets theory. Investor B is apparently maximizing expected return, but since he is indifferent between the 5- and 10-year bonds, Investor B doesn’t appear to favour any particular maturity and so views the 5- and 10-year bonds as essentially perfect substitutes, an assumption consistent with the expectations theory of the term structure.

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

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

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

The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the

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

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

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

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

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

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

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

21. Suppose that the Bank of Canada made an announcement that it would purchase up to $300 billion of longer-term Canada securities over the following six months. What effect might this policy have on the yield curve?

If the Bank of Canada purchases a significant amount of longer-term government debt, this will reduce the effective supply of bonds of those particular maturities, resulting in a higher price and lower yield. This should have the effect of lowering the “long end” of the curve, decreasing medium and longer-term yields. In other words, the yield curve will shift down, but mostly on medium- and long-term maturities.

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

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As the risk of default by the Greek government increased, this reduced the demand for Greek bonds relative to U.S. Treasuries. The result was lower prices and higher yields of Greek debt relative to U.S. debt, similar to the graphs in Figure 6-2 shown in the text.

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

The downward-sloping yield curve in (b) would be less steep and might have a slight positive upward slope if the long-term bonds have a positive liquidity premium.

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

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

Year

One-Year Bond Rate Multiyear Bond Rate

1

2%

2%

2

3%

3%

3

4%

5%

4

6%

6%

5

7%

8%

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

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download monthly data from January 1976 to January 2021 on the three-month T-bill rate (series V122531) and the interest rate on long-term Canada bonds (series V122544). a. Calculate the mean and standard deviation as well as the maximum and minimum values for each series over the sample period.

T-bill: mean 5.57 s.d. 4.45 max 20.9 min 0.06 Long-term bond: mean 6.92 s.d. 3.76 max 18.14 min 0.95

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b. Which were the worst and the best years in terms of spread between interest rates in the recent eight years?

The highest was in 2010, since the average spread is 3.14. The lowest was in 2020, since the average spread is 0.75.

2. Go to the CANSIM database, and find monthly yield data from January 1983 to January 2021 on the following government securities: 1-month (series V122529), 3-month (series V122531), 6-month (series V122532), 1-year (series V122533), 2-year (series V122538), 3year (series V122539), 5-year (series V122540), 10-year (series V122543), and long-term (series V122544). Download the last full year of data available into a spreadsheet. a. Construct a yield curve by creating a line graph for January 2021, and for the same month in 2020, across all the maturities.

1.6

Yield Curve of January 2021

1.4 1.2 1 0.8 0.6

Series1

0.4 0.2 0 1m

3m

6m

1y

2y

3y

5y

10y Long term

Yield Curve of January 2020 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0

Series1

1m

3m 6m

1y

2y

.

3y

5y

10y Long term

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b. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

The yield curve of January 2021 is steeper than the one of January 2020, suggesting that the economy is getting better since interest rates are increasing.

3. Go to the St. Louis Federal Reserve FRED database and find data on Moody’s Aaa corporate bond yield (AAA) and Moody’s Baa corporate bond yield (BAA). Download the data into a spreadsheet. a. Calculate the spread (difference) between the Baa and Aaa corporate bond yields for the most recent month of data available. What does this difference represent?

The Baa yield for June 2020 was 3.64%, and the Aaa yield that month was 2.44%. Thus, the credit spread was 1.20 percentage points, or 120 basis points. This difference represents the risk premium. b. Calculate the spread again, for the same month but one year prior, and compare the result to your answer to part (a). What do your answers say about how the risk premium has changed over the past year?

One year prior in June 2019, the Baa yield was 4.46% and the Aaa yield was 3.42%, representing a risk premium of 1.04 percentage points, or 104 basis points. Thus, the risk premium has declined somewhat over the last year of available data. c. Identify the month of highest and lowest spreads since the beginning of the year 2000.

How do these spreads compare to the most current spread data available? Interpret the results.

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

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Solutions to Chapter 6 Mini-Case Yield Curve Hypotheses and the Effects of Economic Events 1.

Use your favourite search engine to find such key words/phrases as “yield curve,” “expectations theory,” “preferred habitat theory,” and “liquidity premium theory.” Consider sites from Bloomberg, Stocktrader, Bondbasics, and various other sites.

2.

Consider the most recent site at www.bloomberg.com.

3.

Plot Canadian Yield Curve.

Note: Plot is provided at the Bloomberg site. a. Pure expectations theory views long-term interest rates as equalling the average of future short-term interest rates. b. Market segmentation theory views the curve as the result of supply/demand within market segments. c. Liquidity premium theory combines the features of pure expectations and market segmentation theories. d. Answers differ based on current picture of the curve and student opinion—showing that no clear answer to this question ever exists.

4.

Given the information in responses 1, 2, and 3 above, use the pure expectations theory to determine and predict interest rates as follows: a. If the one-year interest rate is expected to be the same as the current yield curve over the next three years, what interest rate is expected on a two-year bond? Note: Answer varies based on current Internet search. Use Chapter 6 equation 2 for calculating the interest rate on a two-year bond. b. What interest rate is expected on a three-year bond? Note: Answer varies based on current Internet search. Use Chapter 6 equation 2 for calculating the interest rate on a three-year bond. c. As maturities rise, interest rates also rise. d. If investors attach term premiums of 0.0025, 0.0075, and 0.0085 to the one-, two- and three-year bonds: i. Adjust answer to liquidity premium theory by adding two-year premium to answer above. ii. Adjust answer to liquidity premium theory by adding three-year premium to answer above. iii. Answer based on Internet findings and equation in Chapter 6 equation 3 for the forward rate. iv. Answer based on Internet findings and equation in Chapter 5 for adjusted forward rate.

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After describing the current yield curve and forecasting interest rates using the pure expectations hypothesis: a. Answer depends on initial Internet data and selection of preferred model for term structure. Answer must include 2% add-on and accounting for term premium. b. The interest rate charged would have to be adjusted up accordingly by the amount of credit risk.

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

An important development in monetary theory that has far-reaching implications for the way we evaluate economic policy is the theory of rational expectations. Chapter 7 explains this theory and its application to financial markets, which is referred to as the efficient market hypothesis.

Although the theory of rational expectations can be laid out in mathematical terms, we have found that it is best to give the students an example such as Joe Commuter’s expectations to give them an intuitive sense of what “rational expectations” means. When provided with a graphic example like that used in the text, students have no trouble understanding the theory of rational expectations, which is really just good common sense.

The implications of rational expectations theory become much clearer when this theory is used to understand behavior in the financial markets as in the efficient market hypothesis. Research has been dredging up fascinating anomalies that cast doubt on these theories. This chapter has therefore been written to give a more balanced view of these theories: It reflects this latest research, including a discussion of the new field of behavioral finance, which applies concepts from other social sciences such as anthropology, sociology, and particularly psychology, to understand the often anomalous behavior of security prices.

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What basic principle of finance can be applied to the valuation of any investment asset?

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

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

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

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

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

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

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

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

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

6. “Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. When it is not snowing, his expectations of the driving time are perfectly accurate. Considering that it snows only once every 10 years where Joe lives, Joe’s expectations are almost always perfectly accurate.” Are Joe’s expectations rational? Why or why not?

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

7. Suppose that you decide to play a game. You buy stock by throwing dice a few times, using that method to select which stock to buy. After 10 months you calculate the return on your investment and the return earned by someone who followed “expert” advice during the same period. If both returns are similar, would this constitute evidence in favour of or against the efficient market hypothesis?

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

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

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

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

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

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

The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.

11. If you read in the Globe and Mail that the “smart money” on Bay Street expects stock prices to fall, should you follow that lead and sell all your stocks?

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

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

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

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

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

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14. Suppose that in every last week of November stock prices go up by an average of 3%. Would this constitute evidence in favour of or against the efficient market hypothesis?

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

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

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

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

Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and long-term interest rates would fall. The decline in long-term interest rates implies that long-term bond prices would rise.

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

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

18. Assume that the efficient market hypothesis holds. Marcos has been recently hired by a brokerage firm and claims that he now has access to the best market information. However, he is the “new guy,” and no one at the firm tells him much about the business. Would you expect Marcos’s clients to be better or worse off than the rest of the firm’s clients?

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

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

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

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

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

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

Behavioural finance suggests that when stock prices rise, market participants are less likely to engage in short sales, which would otherwise capture unexploited profit opportunities and push misaligned stock prices back down to fundamental values. This is due to the notion that people are more averse to downside risk than upside risk, and since short sellers can incur nearly unlimited losses, very little short selling occurs in practice. In addition, short selling is sometimes seen as taboo, since it is viewed as profiting off the losses of others.

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

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

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

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

25. A company has just announced a three-for-one stock split, effective immediately. Prior to the split, the company had a market value of $5 billion with 100 million shares outstanding.

Assuming the split conveys no new information about the company, what are the value of the company, the number of shares outstanding, and the price per share after the split? If the actual market price immediately following the split is $17.00 per share, what does this tell us about market efficiency?

Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split conveys no new information, the market value of the company does not change, remaining at $5 billion. But with the split, every share becomes three shares, so 300 million shares are outstanding. The new price/share is $5 billion/300 million, or $16.67/share. If the actual price is $17.00/share, the price appears too high. This can be viewed in two ways. One possibility is that markets are inefficient—some type of anomaly has occurred, and it’s not clear if the market will correct itself. Another possibility is that the stock split actually conveyed information about the company. Investors may believe (possibly incorrectly) that the price/share is expected to increase significantly and that is why the firm implemented the stock split.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download data from January 1956 to December 2021 on the S&P TSX Composite Index (series V122620). a. Calculate the mean and standard deviation as well as the maximum and minimum values for this series.

Mean 5419.36 s.d. 5182.59 max 17433.4 min 432.11 b. Which were the worst and best months in terms of the stock rate of return?

Best month: January 1975, when rate of return is 17.26%.

Worst month: October 1987, when rate of return is -22.63%.

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

The DJIA on July 10, 2020, was 26,075.30, and one year prior on July 10, 2019, was 26,860.20. With no dividend, and assuming the 2020 price was perfectly predicted, the required return is found by solving: 26,860.20= 0/(1 + ke) + 26,075.30/(1 + ke). Solving for ke implies ke = –2.9% required rate of return on equity investment. If a $100 dividend were paid out, then 26,860.20= 100/(1 + ke) + 26,075.30/(1 + ke) gives ke = –2.5% required rate of return on equity investment.

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Solutions to Chapter 7 Mini-Case Adaptive Expectations, Rational Expectations, and Optimal Forecasts 1.

a. 5% b. 6%

2.

Forecast errors may occur because people may find it takes too much effort to make their expectation the best guess and/or people might be unaware of some relevant information.

3.

The rational expectations theory leads to the efficient markets implications that (1) a change in the way a variable moves will change expectations of the variable and (2) forecast errors of expectations will on average be zero and cannot be predicted ahead of time.

4.

a. 8% b. Efficient markets theory views expectations of future prices as equal to optimal forecasts using currently available information.

5.

The expected return equals the equilibrium return, which equates the quantity supplied and demanded for that security.

6.

Current prices will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return.

7.

If the market is efficient, all unexploited profit opportunities will be eliminated.

8.

Past performance success does not indicate that an investment adviser or a mutual fund will perform well in the future.

9.

If prices follow a “random walk,” future changes in stock prices should, for all practical purposes, be unpredictable.

10. Evaluations of technical analysis rules indicate that this approach does not outperform the market, beat financial analysts, or produce consistently repeatable results. In general, technical analysis is discredited.

11. a. Research shows that small firms earn abnormally higher risk-adjusted returns. b. Over the long run, stock prices tend to rise abnormally from December to January. c.

Stock prices may overreact to news and correct slowly.

d.

Stock prices vary more than is warranted by fundamentals.

e.

Mean reversion indicates that stocks with low returns today tend to have high returns in the future and vice versa.

12. Exchange rates should approximately follow random walks because people would immediately bid currency prices up (or down) to match predictions, stopping only when the predictable change in the exchange rate dropped to zero, matching the optimal forecast of return.

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

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

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

The chapter has been designed to keep the textbook very flexible. The concepts of adverse selection and moral hazard were explained in Chapter 2 and are explained again in Chapter 12, so that Chapter 8 does not have to be covered in order to teach this or later chapters.

Furthermore, the applications at the end of the chapter do not need to be covered in order to teach other chapters in the book.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. For each of the following countries, identify the single most important (largest) and least important (smallest) source of external funding: Canada, United States, Germany, Japan.

Comment on the similarities and differences among the countries’ funding sources.

For each country, the largest (most important) is listed first, and smallest (least important) is listed second, as reported in Figure 8-1 in the text. Canada: bank loans, stocks. United States: nonbank loans, stocks. Germany: bank loans, bonds. Japan: bank loans, stocks. For the United States, bank loans are relatively unimportant, but for the other countries, this makes up a very large part of overall external financing. For these countries (with the exception of the United States), stock and bond financing are relatively unimportant.

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

Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transactions costs, explain why financial intermediaries exist and are so important to the economy.

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

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

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

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

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

During your visit at the bank, you will probably realize that you will receive an annual interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you better off. However, you would probably like to know that individual better, in particular, his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?). This process will probably be time-consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding all the transaction costs associated with making a loan.

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

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

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

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

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

One would expect corruption measures to be negatively correlated with living standards.

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

9. Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why? Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off.

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

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

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

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

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

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

13. How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?

The free-rider problem means that private producers of information will not obtain the full benefit of their information-producing activities, and so less information will be produced.

This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

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

The issuer of a good-quality (low-risk) bond would have an incentive to disclose information, whereas the issuer of a bad-quality (high-risk) bond would not. This is because when information is created and made available, potential bond buyers can make a better decision.

The issuer of the bad-quality bond will most probably end up receiving a lower price than the average price. Note that in the absence of information, every bond sells at the average price.

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

Standardized accounting principles make profit verification easier, thereby reducing adverse selection and moral hazard problems in financial markets, hence making them operate better.

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

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

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

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

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

18. “The more collateral there is backing a loan, the less the lender has to worry about adverse selection.” Is this statement true, false, or uncertain? Explain your answer.

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

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

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

20. Many policymakers in developing countries have proposed the implementation of a system of deposit insurance similar to the system that exists in Canada. Explain why this might create more problems than solutions in the financial system of a developing country.

Although it might seem a good idea to “copy and paste” regulatory frameworks that ensure the soundness of a financial system from one country to the other, this is usually not a good idea. Developed and developing countries have quite different financial systems.

Incorporating a system of deposit insurance will surely result in an increase in deposits at financial intermediaries. However, without proper regulations (i.e., prudential regulation and supervision) to limit the moral hazard problems associated with a system of deposit .

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insurance, banks will probably accept more risks than they would otherwise do. This is obviously not a desired consequence. The increase in moral hazard problems will probably offset the benefit derived from avoiding bank runs (the most immediate effect of a system of deposit insurance).

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

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

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

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

Why? Assume that you care only about the expected value of the car you will buy and that the car values are symmetrically distributed.

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

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23. Refer to Problem 22. Now you believe the dealer knows more about the car than you do.

How much are you willing to pay? Why? How can this asymmetric information problem be resolved in a competitive market?

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

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

Profit Probabilities Profit = $10 000

Profit = $50 000

Lazy

60%

40%

Hard worker

20%

80%

If Ron is lazy, he will surf the Internet all day, and he views this as a zero-cost opportunity.

However, Ron views working hard as a “personal cost” valued at $1000. What fixed percentage of the profits should you offer Ron? Assume Ron cares only about his expected payment less any “personal cost.”

Let P be the percent of profits you pay Ron. If Ron is lazy, his expected payment is 0.60  10 000 P + 0.40  50 000 P = 26 000 P If Ron works hard, his expected payment is

0.20 10 000 P + 0.80  50 000 P − 1000 = 42 000 P −1000 To induce Ron to work hard, you need

42 000 P − 1000 = 26 000 P 16 000 P = 1000 P = 0.0625 So, offer Ron slightly more than 6.25% of the profits, and this should induce him to work hard.

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

With full insurance: Without a seawall, the expected loss is 400 000  0.02 = 8000 With a seawall, the expected loss is 400 000  0.005 = 2000 The insurance company will charge the expected loss as a premium. Your expected cost under either scenario each year is the premium.

With partial insurance: Without a seawall, the expected loss is 300 000  0.02 = 6000 With a seawall, the expected loss is 300 000  0.005 = 1500 The insurance company will charge the expected loss as a premium. Your expected cost each year is: Without a seawall:

0.02  (300 000 − 400 000) + 0.98(0) − 6000 = −8000 With a seawall:

0.005  (300 000 − 400 000) + 0.98(0) − 1500 = −2000 Unfortunately, neither insurance policy is better nor worse. Although the premiums under the partial insurance policy are lower, the expected cost each year is the same as with full insurance. In either scenario, you will build the seawall if the annual cost of building and maintaining a seawall is less than $6000/year.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Statistics Canada CANSIM database, and find quarterly series (from 2000Q1 to 2017Q2) for the net new issues of securities by financial and non-financial corporations, series V122334 (total bonds) and V122335 (total stocks). a. Compare the bonds series to the stocks series. Which is a more important source of finance, stocks or bonds, in terms of its share?

Total bonds have a larger share (0.79) than total stocks, so we think total bonds have a more important source of finance. b. What is the correlation coefficient between the two series? Has the correlation changed in the aftermath of the global financial crisis (after 2008)?

The correlation coefficient is 0.112. After 2008, it becomes -0.122.

2. Go to the St. Louis Federal Reserve FRED database and find data on net worth of households (BOGZ1FL192090005Q) and the net percentage of domestic banks tightening standards for auto loans (STDSAUTO). Adjust the units setting for the net worth indicator to “Percent Change from Year Ago,” and download the data into a spreadsheet. a. Calculate the average, over the most recent four quarters and the four quarters prior to that, for the bank standards indicator and the “percent change in net worth” indicator.

Do these averages behave as you would expect?

See summary table below for the periods of 2019:Q2 to 2020:Q1 and 2018:Q2 to 2019:Q1.

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

Net Tightening of Auto Lending Standards, Average

Net Worth Average Growth Rate

3.6 2.1

5.1 5.0

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

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

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

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Chapter 9: Economic Analysis of Financial Regulation Chapter Overview and Teaching Tips Chapter 9 stresses the economic way of thinking by conducting an economic analysis using the adverse selection and moral hazard concepts to show why our regulatory system takes the form it does and how it can lead to banking crises.

An appendix in MyLab Economics goes into more detail on banking crises in other countries.

This material will be useful to instructors who want to give their course a more international focus.

Note that Chapter 8 does not need to be covered in order to teach this chapter. However, if Chapter 8 is covered in class, Chapter 9 is a nice application of the analysis in that chapter.

Indeed, the instructor might want to stress in class the counterparts in private financial markets to the methods financial regulators use to cope with adverse selection and moral hazard.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Why are deposit insurance and other types of government safety nets important to the health of the economy?

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

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

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

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

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

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

The economy would benefit from reduced moral hazard; that is, banks would not want to take on too much risk, because doing so would increase their deposit insurance premiums.

The problem is, however, that it is difficult to monitor the degree of risk in bank assets because often only the bank making the loans knows how risky they are.

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

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

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

What if your deposit were $100,000?

If you have deposited $300,000 at the failed bank, it would be better for you if the CDIC uses the purchase and assumption method. This way, the bank never closes, and you do not lose a penny.

If the payoff method was used, you will get a cheque for $100,000 and you will have to wait a few years to get around 90 cents per dollar of the remaining $200,000. If your balance was $100,000, you are indifferent as to which method the CDIC would use to handle this failed bank.

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

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

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

What could be the Treasury’s rationale for doing this?

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

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

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

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

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

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

Chartering banks helps reduce the adverse selection problem because it attempts to screen proposals for new banks to prevent risk-prone entrepreneurs and crooks from controlling them.

It will not always work because risk-prone entrepreneurs and crooks have incentives to hide their true nature and thus may slip through the chartering process.

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

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

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

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

14. Suppose Universal Bank holds $100 million in assets, which are composed of the following: Required reserves: Excess reserves: Mortgage loans: Corporate bonds: Stocks: Commodities:

$10 million $ 5 million $20 million $15 million $25 million $25 million

Do you think it is a good idea for Universal Bank to hold stocks, corporate bonds, and commodities as assets? Why or why not?

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

15. Why might more competition in financial markets be a bad idea? Would restrictions on competition be a better idea? Why or why not?

With more competition in financial markets, there are more firms making less profits. Thus, there is greater incentive for financial firms to take on greater risk in an effort to increase profits. Although restrictions on competition would decrease the incentive for risk by financial firms, it may not be altogether beneficial. It is likely that lower competition would result in higher fees to consumers and decreased efficiency of banking institutions.

16. In what way might consumer protection regulations negatively affect a financial intermediary’s profits? Can you think of a positive effect of such regulations on profits?

Consumer protection regulations in general make sure that all relevant information is disclosed to potential borrowers (including costs and conditions of loans) and forbid discrimination against lenders. Complying with these regulations can be costly for financial intermediaries (both in terms of the disclosing of information and lost opportunities if they for example only lend to richer potential borrowers), and thereby negatively affect their profits. However, by disclosing information and not discriminating, financial intermediaries .

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might attract more potential customers, that will now have a fair chance of getting a loan and to thoroughly understand its conditions.

ANSWERS TO APPLIED PROBLEMS 17. Consider a failing bank. A deposit of $350,000 is worth how much to the depositor if the CDIC uses the payoff method given the typical recovery rate? How much is the same deposit worth to the depositor if the purchase-and-assumption method is used? Which is more costly to taxpayers?

Under the payoff method, the depositor only gets around $0.90/dollar on the amount of the deposit above $100,000. Hence, the $350,000 is worth only $325,000 ($100,000 + $250,000 × 0.90). Under the purchase and assumption policy, the bank is completely absorbed, and all accounts are worth their full value, so the $350,000 deposit is still worth $350,000. Since the recovery rate for the insurance fund is typically the same whatever method is used, but it pays out more in the purchase and assumption method, the purchase and assumption method cost taxpayers more than the payoff method.

18. Consider a bank with the following balance sheet:

Assets Required reserves Excess reserves Municipal bonds Residential mortgages Commercial loans

Liabilities $17 million $3 million $65 million $70 million $60 million

Chequable deposits Bank capital

$205 million $10 million

Calculate the bank’s risk-weighted assets.

Reserves and T-bills have a zero weight. So, $20 million has zero weight. Municipal bonds and Residential Mortgages carry a 50% weight. Risk-weighted assets = $135 million × 0.50 = $67.5 million. Commercial loans carry a 100% weight. Risk-weighted assets = $60 million.

Total risk-weighted assets = $67.5 + $60 = $127.5 million.

Problems 19–21 relate to a sequence of transactions at Oldhat Financial.

19. Oldhat Financial starts its first day of operations with $9 million in capital. A total of $130 million in chequable deposits is received. The bank makes a $25 million commercial loan and another $50 million in mortgages with the following terms: 200 standard, 30-year, fixed rate mortgages with a nominal annual rate of 5.25%, each for $250,000.

Assume that required reserves are 8%. a. What does the bank balance sheet look like? b. How well capitalized is the bank? c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day.

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a.

Assets

Liabilities

Required Reserves

$10.4 million

Chequable Deposits

Excess Reserves Loans

$53.6 million

Bank Capital

$130 million $9 million

$75 million

b. The bank is well capitalized, at 9/139 = 6.47%. c. Reserves have a zero weight. So, $64 million has zero weight. Residential mortgages carry a 50% weight, which implies $25 million in risk-weighted assets. Commercial loans carry a 100% weight, which implies another $25 million in risk-weighted assets; thus, total risk-weighted assets are $50 million. The bank’s risk-weighted capital ratio = 9/50 = 18%.

20. Early the next day, the bank invests $50 million of its excess reserves in commercial loans.

Later that day, terrible news hits the mortgage markets, and mortgage rates jump to 13%, implying a present value of Oldhat’s current mortgage holdings of $124,798 per mortgage.

Bank regulators force Oldhat to sell its mortgages to recognize the fair market value. What does Oldhat’s balance sheet look like? How do these events affect its capital position?

The sale of each mortgage would be recorded as: Debit

Credit

Cash

$124,798

Loss

$125,202

Mortgages

$250,000

After the fact, the actual balance sheet is: Assets

Liabilities

Required Reserves

$10.4 million

Chequable Deposits

$130 million

Excess Reserves Loans

$28.6 million $75 million

Bank Capital

−$16 million

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21. To avoid insolvency, regulators decide to provide the bank with $25 million in bank capital.

However, the bad news about the mortgages is featured in the local newspaper, causing a bank run. As a result, $30 million in deposits is withdrawn. Show the effects of the capital injection and the bank run on the balance sheet. Was the capital injection enough to stabilize the bank? If the bank regulators decide that the bank needs a capital ratio of 10% to prevent further runs on the bank, how much of an additional capital injection is required to reach a 10% capital ratio?

The effect of the capital injection and bank run are shown in the balance sheet below: Assets

Liabilities

Required Reserves

$ 8 million

Chequable Deposits

Excess Reserves Loans

$26 million

Bank Capital

$100 million $ 9 million

$75 million

The bank now has a 9/109 = 8.3% capital ratio; it is again well capitalized. With the run on the bank, chequable deposits fall to $100 million. In order to have a bank capital ratio of 10%, it must be the case that 0.10 = BC/(100 + BC ), where BC represents the required level of bank capital. Solving for BC yields a level of bank capital needed of $11.1 million. Thus, the regulators would need to inject an additional $2.1 million to reach a 10% capital ratio.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and find monthly data on total chartered bank assets (series V36883), total liabilities and shareholders’ equity (series V36936), and shareholders’ equity (series V36960 + V36961 + V36962 + V36964 + V41598372 + V53843372). Download the data from January 2011 through the most recent month available into a spreadsheet and plot the series. For each monthly observation, calculate the bank leverage ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in Canadian chartered banks over time?

After dropping sharply in the end of 2011 and during the coronavirus pandemic, the bank leverage ratio has been increasing over time. At current levels it does not imply an increase in moral hazard problems.

Leverage ratio

0.062

0.06

0.058

0.056

0.054

0.052

0.05 2011

2014

2017

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2020

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2. Go to the St. Louis Federal Reserve FRED database, and find data on the number of commercial banks in the United States in each of the following categories: average assets less than $100 million (US100NUM), average assets between $100 million and $300 million (US13NUM), average assets between $300 million and $1 billion (US31NUM), average assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15 billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories, as a percentage of the total number of banks, for the most recent quarter of data available, and for 1990:Q1. What has happened to the proportion of very large banks? What has happened to the proportion of very small banks? What does this say about the “too-bigto-fail” problem and moral hazard?

In 1990:Q1, there were 25 ‟very large” banks, and 9,529 ‟very small” banks, representing 0.2% and 76.5% of total commercial banks in the United States, respectively. For the most recent quarter of 2020:Q1, there were 95 ‟very large” banks, and 1,000 ‟very small” banks, representing 2.1% and 22.5% of total commercial banks in the United States, respectively.

Thus, the proportion of very large banks in the banking system has increased substantially over this period while very small banks have shrunk dramatically; because of the proportional increase in these very large banks, the “Too Big to Fail” problem has steadily worsened over this time. This implies that government safety nets, along with the increase in the number of very large banks, can increase moral hazard in the banking system.

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Chapter 10: Banking Industry: Structure and Competition Chapter Overview and Teaching Tips Chapter 10 supplements Chapter 2 by going into much greater detail about the structure of the banking system. This chapter differs from conventional chapters on the banking industry in other money and banking textbooks by stressing a more dynamic, analytical framework than in other books. In particular, it provides an analytic framework for understanding the process of financial innovation in which financial institutions respond to changes in the financial environment by searching for innovations that are likely to be profitable. This framework is then used to show how financial innovation and changes in the ability to process information have led to a decline in the traditional banking business and to fundamental changes in the structure of the banking industry.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Describe how the 2001 Bank Act Reform attempted to introduce more competition in Canada’s financial services marketplace.

The 2001 Bank Act Reform introduced a bank holding company structure, new ownership rules, expanded access to the payments and clearance system, and new opportunities for strategic alliances and joint ventures.

2. Which regulatory agency has the primary responsibility for supervising the following categories of financial institutions? a. chartered banks b. trust and loan companies c. credit unions and caisses populaires a. The Office of the Superintendent of Financial Institutions (OSFI), the Bank of Canada, and the CDIC. b. the OSFI and provincial banking authorities. c. provincial banking authorities.

3. “The commercial banking industry in Canada is less competitive than the commercial banking industry in the United States because in Canada only a few large banks dominate the industry, while in the United States there are around 5000 commercial banks.” Is this statement true, false, or uncertain? Explain your answer.

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False. Although there are many more banks in the United States than in Canada, this does not mean that the American banking system is more competitive. The reason for the large number of U.S. banks is anticompetitive regulations such as restrictions on banking.

4. How did new technology cause banks’ traditional lending activities to decline in balancesheet importance?

Improvements in technology made it easier for investors to screen out bad from good credit risks. This made it easier for corporations to issue long-term debt securities as in the junk bond market and also to raise funds by issuing short-term debt securities like commercial banks.

5.

Contrast the activities of a Schedule I bank, a Schedule II bank, a trust company, and a credit union.

Schedule I and Schedule II banks have identical powers; the only difference between them is in the ownership structure permitted (according to current ownership policy, all Schedule I banks must be widely held whereas Schedule II banks are exceptions to this rule if small).

Unlike chartered banks and trust companies that accept deposits from and lend funds to the general public, credit unions accept deposits from and lend funds only to their members.

Moreover, unlike chartered banks and trust companies, credit unions are not directly covered by the CDIC; they are covered by provincial government agencies, commonly called stabilization funds. The asset portfolios of trust companies and credit unions are made up largely by residential mortgages, whereas those of chartered banks are made up mostly by commercial and industrial loans.

6.

Explain how sovereign loans in the 1970s and early 1980s caused problems for the Big Six. The Big Six were severely punished in the early 1980s when the recession hit hard the less developed countries. When Argentine, Brazil, Mexico, and Peru threatened to default on their loans, the banks chose to make loans to enable them to service their debts instead of declaring these countries in default and acknowledging losses. This increased the indebtedness of these countries and led to a number of debt conversion schemes (such as debt-debt swaps, debt-currency swaps, and debt-equity swaps) to alleviate their debt service obligations.

7.

Explain how the early development of chartered banks in Canada differed from the development of commercial banks in the United States.

The commercial banking industry in Canada is radically different from that in the United States; there is a small number of chartered banks in Canada, whereas there is a very large number of commercial banks in the United States. The presence of so many commercial banks in the United States is because of past, restrictive state-branching regulations that prohibited branching across state lines and led to a large number of banks.

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What incentives do Canadian regulatory agencies have to encourage the establishment of foreign banks in Canada?

To introduce new competition into the Canadian financial services industry.

9.

Explain how securitization can be used to change illiquid assets into liquid assets.

Securitization is the transformation of traditionally illiquid assets (such as residential mortgages, automobile loans, credit card receivables, and commercial and computer leases) into marketable securities for trade in the capital markets. What happens is that banks bundle portfolios of illiquid assets into standardized amounts and then sell the claims to these standardized amounts to third parties (lenders) as liquid securities. In doing so, banks earn a return from servicing the assets in the bundle. That is, they collect the interest and principal payments on the assets in the bundle and pass them through (pay them out) to the lenders, for a fee.

10. If a bank at which you keep your chequing account is owned by foreigners, should you worry that your deposits are less safe than if the bank were owned by Canadians?

No, because the foreign-owned bank is subject to the same regulations as the Canadianowned bank.

11. What are the essential differences between chartered banks, trust and loan companies, and credit unions and caisses populaires?

Chartered banks specialize in commercial and industrial loans, whereas trust and mortgage loan companies and credit unions and caisses populaires specialize in residential mortgages.

In recent years, however, Canada’s financial markets have opened up, and financial institutions directly compete on each other’s traditional territory.

12. Why have banks been losing cost advantages in acquiring funds in recent years?

The rise in inflation and the resulting higher interest rates on alternatives to chequable deposits meant that banks had a big shrinkage in this low-cost way of raising funds. The innovation of money market mutual funds also meant that the banks lost deposit account business.

13. “If inflation had not risen in the 1960s and 1970s, the banking industry might be healthier today.” Is the statement true, false, or uncertain? Explain your answer.

True. Higher inflation helped raise interest rates, which caused the disintermediation process to occur and helped create money market mutual funds. As a result, banks lost cost advantages on the liabilities side of their balance sheets, leading to a less healthy banking industry. However, improved information technology would still have eroded the banks’ income advantages on the assets side of their balance sheet, so the decline in the banking industry would still have occurred.

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14. Why have banks been losing income advantages on their assets in recent years?

The growth of the commercial paper market and the development of the junk bond market meant that corporations were now able to issue securities rather than borrow from banks, thus eroding the competitive advantage of banks on the lending side. Securitization has enabled other financial institutions to originate loans, again taking away some of the banks’ loan business.

15. “The invention of the computer is the major factor behind the decline of the banking industry.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting information, both of which have made other financial institutions more competitive with banks and have allowed corporations to bypass banks and borrow directly from securities markets. Therefore, computers were an important factor in the decline of the banking system. However, another source of the decline in the banking industry was the loss of cost advantages for the banks in acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as the rise in inflation and its interaction with regulations, which produced disintermediation.

16. Why are there only 2 U.S. banks among the 10 largest banks in the world?

Because of tighter regulation in the United States compared to the rest of the world, there are many more banks, which has kept even the largest banks in the United States relatively small compared to those in other countries. In addition, the United States has been slower to consolidate in the banking sector than most other countries. However, as the banking sector continues toward consolidation, it is likely that the size of the largest U.S. banks will grow.

17. What factors explain the rapid growth of international banking?

There are three main factors that have contributed to rapid growth in international banking: the growth in international trade and expansion of multinational corporations, the increased profitability of global investment banking, and the expansion of dollar–denominated deposits abroad (Eurodollars).

18. Why has the number of bank holding companies dramatically increased?

Because becoming a bank holding company allows a bank to (a) circumvent branching restrictions since it can own a controlling interest in several banks even if branching is not permitted, and (b) engage in other activities related to banking that can be highly profitable.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Canada Deposit Insurance Corporation website, and access the CDIC deposit insurance calculator.

Use the calculator to find out if your savings are protected by CDIC in the event that your financial institution fails.

N/A (I have no savings!)

2. Go to the CANSIM database, and find data on the level of money market investment fund assets (series V37245). Download the data into a spreadsheet. a. When did assets start entering money market mutual funds? What was the total worth of assets in money market mutual funds at the end of 1977?

In January 1977. The total worth of assets in money market mutual funds at the end of 1977 was $58 million. b. For each decade period, calculate the total percentage change in assets from the beginning of the decade to the end of the decade: 1980:M1–1990:M1; 1990:M1– 2000:M1; 2000:M1–2010:M1; 2011:M1-2020:M11. For each decade period, divide the total percentage change by 10 to get the average yearly percent increase. Which decade had the largest average yearly growth in money market investment funds?

1990:M1–2000:M1 with an average yearly percent increase of 1.56. c. Calculate the growth rate from the most recent month of data available to the same month a year prior. How does this growth rate compare to the highest average yearly growth rate for the decades from part (b)?

The most recent growth rate (2020:M11 to 2019:M11) is 0.15 -0.12, which is higher than the average yearly growth rate for the decade 2011:M1-2020:M11.

3. Go to the St. Louis Federal Reserve FRED database and find data on the 30-year fixed rate average mortgage rate (MORTGAGE30US) and the 5/1-year adjustable-rate mortgage (MORTGAGE5US). a. What are the mortgage rates reported for the most recent week of data available?

For the week of July 30, 2020, the 30-year fixed rate mortgage was 2.99%, and the 5/1 adjustable-rate mortgage (ARM) was 2.94%. b. If the principal payment for a given month were $2,000, then what would be the interest payment per month (using simple interest) for each of the mortgage types, using the most recent week of data?

At 2.99%, the interest payment for the 30-year mortgage using simple interest would be $2000 x 0.0299 = $59.80 per month, and the ARM interest payment would be $2000 x 0.0294 = $58.80 per month. c. Over a one-year period, how much would the difference in interest payments between the two mortgage types amount to?

The two imply a difference of $1 per month, or $12 per year.

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Solutions to Chapter 10 Mini-Case The Changing Landscape for Domestic and Global Financial Markets 1.

a. The degree of financial globalization increases with domestic and global financial-sector reform. For example, removing restrictions on mergers and acquisitions and easing restrictions on corporate structures and foreign ownership advances the globalization of national economies. b. Capital mobility and the emergence of global players in financial markets led to the globalization of the financial services industry. c. The introduction of common currencies has brought benefits to national economies and has driven the globalization of finance. d. The formation of economic communities and trading blocs had similar effects to those of the introduction of common currencies.

2.

a. The Internet has enabled the introduction of new products, new product providers, and new delivery mechanisms. For example, phenomenal declines in the price of microprocessors over the past 20 years, together with advances in fibre optics and communications technologies, have enhanced the power of computers and enabled financial institutions to serve their customers better. b. The recent adoption of inflation targets by many countries has produced lower inflation rates and, as a result, lower returns on bank deposits. This has led investors to shift away from insured products and into market-based instruments and mutual funds. In doing so, they are also looking beyond their national borders, thereby increasing the degree of competition in domestic and global financial markets. c. Regulators are becoming increasingly aware of how the Internet and the recent technological advances in telecommunications are shaping financial markets. They have responded by forcing new standards in domestic and global financial services marketplaces.

3.

a. Financial reform can act as a force on its own. A good recent example is the reform efforts of Japan. In the past 10 years, Japan has allowed foreign banks the same freedoms as Japanese banks, abolished restrictions on foreign management of pension funds, and eliminated the separation between different financial service sectors. b. Developments in financial markets are also driving country-specific as well as international reform efforts. For example, regulators respond to economic and financial crises by introducing new risk management systems. They also respond to the emergence of global players that are too big to be successfully supervised by any single national regulator.

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Chapter 11: Financial Crises Chapter Overview and Teaching Tips Financial crises are inherently interesting because they are so dramatic. This has become even more the case with the recent global financial crisis that has had such devastating consequences for not only the U.S. economy, but for Europe as well. Indeed, teaching this material on the financial crises has engaged students’ interest more than anything else we have taught in our entire careers of over thirty years of teaching.

This chapter makes use of an asymmetric information analysis (agency theory) to explain the dynamics and adverse impact of financial crises. Teaching Chapter 8 in full is not necessary to cover Chapter 11 as long as the instructor goes over the concepts of asymmetric information, adverse selection, and moral hazard. Although Chapter 11 defines these concepts, many instructors will prefer to cover these concepts in more detail using the material in the first part of Chapter 8.

After defining the basic asymmetric information concepts, the chapter outlines the dynamics of financial crises in advanced economics by separating crises into three phases: the initial phase in which financial innovation or liberalization occurs, but is deeply flawed, so it leads to a credit boom and bust, the second phase of a banking crisis, and the third phase, which only occurs in the worst financial crises, of debt-deflation, in which a decline in the price level causes a further deterioration in household and businesses balance sheets. Figure 11-1 is particularly useful to get students to see the sequence of events and dynamics of financial crises, and going through all the stages in the figure helps students get the big picture of what is happening during financial crises.

Students will be most interested in using the analysis to discuss the application on recent financial crisis in 2007–2009, which was the worst financial crisis to hit the world since the Great Depression. Nonetheless, the application on the Great Depression is worth covering because it contains so many lessons for today.

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

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. How does the concept of asymmetric information help to define a financial crisis?

Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channelling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted, with harmful consequences for economic activity.

2. How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?

When an asset-price bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth means that businesses have less skin in the game and so have incentives to take on more risk at the lender’s expense, increasing the moral hazard problem. In addition, lower net worth means there is less collateral and so adverse selection increases. The bursting of an asset-price bubble therefore makes borrowers less credit-worthy and causes a contraction in lending and spending. The asset-price bust can also lead to a deterioration in financial institutions’ balance sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.

3. How does an unanticipated decline in the price level cause a drop in lending?

An unanticipated decline in the price level leads to firms’ real burden of indebtedness increasing while there is no increase in the real value of their assets. The resulting decline in firms’ net worth increases adverse selection and moral hazard problems facing lenders, making it more likely a financial crisis will occur in which financial markets do not work efficiently to get funds to firms with productive investment opportunities.

4. Define “financial frictions” in your own terms and explain why an increase in financial frictions is a key element in financial crises.

Financial frictions are a set of conditions that prevent financial markets from effectively assigning funds to the best investment opportunities. In general, they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channelling of funds through the financial market is interrupted or limited, the economy slows down.

This could trigger an asset-price decline, increase in uncertainty, and the deterioration in financial institutions’ balance sheets.

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5. How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of financial institutions, there is a loss of information production in financial markets and a direct loss of banks’ financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and leads to a further contraction in lending and economic activity.

6. How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems?

The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity.

7. What is a credit spread? Why do credit spreads rise significantly during a financial crisis?

Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007–2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.

8. Some countries do not advertise that a system of deposit insurance like the CDIC in Canada exists in their banking system. Explain why some countries would want to do that.

Some countries do not fully advertise the fact that there exists a system of deposit insurance precisely because this information makes depositors and bank clients less likely to monitor bank’s activities. Not advertising deposit insurance may limit the moral hazard problem created by a system of deposit insurance in which banks accept too much risk. If the early stages of a banking crisis occur, then the authorities can advertise the existence of a system of deposit insurance and prevent a bank panic.

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9. Describe the process of “securitization” in your own words. Was this process solely responsible for the Great Recession financial crisis of 2007–2009?

The process of securitization converts a series of financial instruments (i.e., loans) into marketable securities. This process was extensively used in the U.S. financial system starting in the 1970s. However, in the early 2000s, the type of loans that were used to create marketable securities was of dubious quality, a characteristic that was directly translated into these marketable securities. The process of securitization by itself was not solely responsible for the Great Recession. That funds were lent to less than prime borrowers and that such loans (mostly mortgages) were securitized were also contributing factors of the crisis.

10. Provide one argument in favour of and one against the idea that the Fed was responsible for the U.S. housing price bubble of the mid-2000s.

Supporters of the idea that the Fed was responsible for the Great Recession financial crisis argue that it helped to create the conditions for a housing market bubble by setting the federal funds rate (a benchmark interbank loan rate) at an extremely low level. This action made funds cheaper to financial intermediaries, who were therefore more willing to lend to homeowners. Another argument in favour of such a hypothesis is that the Fed was not stringent enough in its administrative task of regulating and monitoring financial intermediaries. On the other side, supporters of the Fed’s policy during this period cite other facts that contributed to the housing market bubble—in particular, the lowering of lending standards and funds inflows from India and China coupled with no attractive investment opportunities (so that eventually those funds ended up fuelling the housing market bubble).

This is still an ongoing and very interesting debate.

11. What role does weak financial regulation and supervision play in causing financial crises?

Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net.

When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.

12. Describe two similarities and two differences between the United States’ experiences during the Great Depression and the Great Recession financial crisis of 2007–2009.

Answers may vary. Both the Great Depression and the Great Recession were preceded by sharp increases in asset prices. During the two episodes, credit spreads widened, the availability of credit shrank, and economic activity sharply declined. The two episodes differ in the source of asset-price increases: during the Great Depression, rising stock prices were the trigger, whereas in the Great Recession a housing bubble was the primary trigger. During the Great Depression, many bank failures led to a bank panic, causing more banks to fail.

During the Great Recession, even though the banking system was hit hard and bank failures did occur, they were much less pronounced, and no bank panic occurred. Finally, although both episodes resulted in significant declines in GDP and increases in unemployment, this was much more pronounced during the Great Depression, when unemployment peaked at

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25% (as opposed to the recent crisis, in which the unemployment rate reached 10.2%). In part, this is the result of Federal Reserve policymakers trying much more aggressively to contain the financial crisis and reverse the decline in economic activity during the Great Recession than was true during the Great Depression.

13. What do you think prevented the financial crisis of 2007–2009 from becoming a depression?

Answers may vary. In general, it is believed that the country as a whole probably learned from the experience of the Great Depression and has put in place more sophisticated policy frameworks to help deal with severe economic downturns more effectively. For instance, bank panics, which were widespread during the Great Depression, were virtually nonexistent during the 2007–2009 crisis; this is probably due to bank accounts now being insured by the FDIC, when they were not during the Great Depression. Another factor seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by instituting more aggressive, swifter policies to avoid any contagion effects that would unnecessarily deepen or lengthen the crisis.

14. What technological innovations led to the development of the subprime mortgage market?

The use of data mining to give households numerical credit scores that can be used to predict defaults and the use of computer technology to bundle together many small mortgage loans and cheaply package them into securities. Together both enable the origination of subprime mortgages, which then can be sold off as securities.

15. Why is the originate-to-distribute business model subject to the principal–agent problem?

Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a good credit risk.

16. True, false, or uncertain: Deposit insurance always and everywhere prevents financial crises.

False. Deposit insurance is a very good system to prevent bank panics, but these events are just one potential element in a financial crisis. As the events that unfolded during the Great Recession illustrate, financial crises have many aspects evolving at the same time. A system of deposit insurance might help to prevent bank panics, but it is unable to prevent the effects of the asset-price decline in the housing market or the spreading of the crisis to international financial markets. Also, deposit insurance creates moral hazard incentives, encouraging risktaking on the part of banks that might make a financial crisis more likely.

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17. How did a decline in housing prices help trigger the subprime financial crisis in the United States that began in 2007?

The decline in housing prices led to many subprime borrowers finding that their mortgages were “underwater” because they owed more on them than their houses were worth. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, causing losses to financial institutions, which then deleveraged, causing a collapse in lending.

18. What role did the shadow banking system play in the 2007–2009 financial crisis?

The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms. They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fuelled some of the housing bubble. Because of their large presence in financial markets, when credit markets began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.

19. Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?

During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly. This leads to the expectation that asset prices may fall further in the future and increases the uncertainty over the value of assets put up as collateral. As a result, firms accepting collateral assets require larger and larger haircuts, or discounts on the value of collateral in expectation of future lower values. This requires firms to put up increasingly more collateral for the same loans over time. Due to the falling asset prices and rising haircuts, it becomes a “buyer’s market” for these rapidly falling assets; any firms needing to raise funds quickly would then be forced to sell assets at a fraction of their original worth.

20. How did the global financial crisis promote a sovereign debt crisis in Europe?

The contraction in economic activity reduced tax revenues at the same time that government bailouts of failed financial institutions required an increase in government outlays. The result was a surge in budget deficits that led to fears that the governments of hard-hit countries would default on their debt. The result was a huge sell-off in the sovereign bonds of these countries that led to a surge in interest rates on these bonds.

21. Why is it a good idea for macroprudential policies to require countercyclical capital requirements?

Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, .

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when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.

22. How does the process of financial innovation impact the effectiveness of macroprudential regulation?

The process of financial innovation is generally good for the economy: its goal is to create new financial instruments as a response to the ever-changing preferences of financial system participants. One of its most beneficial effects is to increase the efficiency of the financial system. This process also can be risky at times. The creation of new financial instruments is often associated with their mismanagement. Sometimes this can result in the creation of asset-price bubbles, as happened with mortgage-backed securities (or CDOs, or SIVs) in the 2007–2009 crisis. When these instruments are improperly priced, this can disrupt the financial system. Regulators can at best be one step behind in this process, since usually as a profitable opportunity is created (e.g., by trading MBSs, CDOs, etc.) many financial intermediaries will follow this path. Only after there is a thorough understanding of the structure and risk of new financial instruments can proper regulations be written and enforced. But this usually only happens after there is a disruption in the financial system.

23. What are the three approaches to limiting the too-big-to-fail problem? Briefly describe the advantages and disadvantages of each of the approaches.

The S&L crisis can be blamed on the principal–agent problem because politicians and regulators (the agents) did not have the same incentives to minimize costs of deposit insurance as do the taxpayers (the principals). As a result, politicians and regulators relaxed capital standards, removed restrictions on holdings of risky assets, and engaged in regulatory forbearance, thereby increasing the cost of the S&L bailout.

24. What was the Canadian experience during the 2007–2009 global financial crisis?

The global financial crisis that led to a number of banking crises throughout the world did not have any big negative effects on the Canadian economy. This has been attributed to the prudent Canadian mortgage landscape and the better regulation of Canadian banks.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and find data (over the period from 2000 to 2020) on household final consumption expenditure (series V61989012), stock prices (series V122620), and house prices (series V111955443). Download the data into a spreadsheet and convert the monthly stock price and house price series to quarterly frequency. Make sure the data align correctly with the appropriate dates. For all three series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, and then divide by the previous quarter data. Multiply by 100 to change each result to a percent, and multiply by 4 to annualize the data. a. For the three series, calculate the growth rates over the first three quarters of 2020.

Comment on the relationships among house prices, stock prices, and consumption as they relate to your results.

From 2020Q1 to 2020:Q3, stock prices and consumption are sensibly related to each other. Housing prices do not follow the same pattern, however. b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, and consumption as they relate to your results, before and during the crisis.

The period prior to the financial crisis and the crisis period itself are starkly different. In the 2005 period, house prices were rising quickly, and stock prices were growing sharply, contributing to a strong increase in household net wealth and strong autonomous consumption growth. During the deepest parts of the financial crisis in late 2008 into 2009, the data reverses strongly, with large, sharp declines in stock prices, house prices, and net wealth leading to shrinking consumption by households. c. How do the current household data compare to the data from the period prior to the financial crisis and during the crisis? Do you think the current data are indicative of a bubble?

The most current data overall shows modest growth in these household indicators compared to the pre-crisis period in 2005. However, they are growing from relatively low levels so are probably not reflective of a bubble in the current data. The current data are significantly better than the crisis period.

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2. Go to the St. Louis Federal Reserve FRED database, and find data on corporate net worth of nonfinancial businesses (TNWMVBSNNCB), private domestic investment (GPDIC1), and a measure of financial frictions, the St. Louis Fed financial stress index (STLFSI). For all three measures, be sure to convert the frequency setting to “Quarterly.” Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For corporate net worth and private domestic investment, calculate the annualized growth rates from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, then divide by the previous-quarter data. Multiply by 100 to change the results to percentage form, and then multiply by 4 to annualize the data. a. Calculate the average growth rates over the most recent four quarters of data available for the corporate net worth and private domestic investment variables. Calculate the difference between the value of the stress index during the most recent quarter and the value of the stress index one year earlier. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment.

See the table below. The most recent four quarters available from 2019:Q2 to 2020:Q1 indicates that financial frictions as measured by the stress index have fallen slightly, and corporate net worth is growing at 6.8%; both of these factors should lead to an improving lending and investment environment; however, in the most recent period investment grew by a relatively moderate rate of 1.9%. b. Repeat part (a) for the four quarters of 2005 and for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment before and during the crisis as they relate to your results. Assuming the financial stress measure is indicative of heightened asymmetric information problems, comment on how the crisis-period data relate to the typical dynamics of a financial crisis.

See table below. During the pre-crisis period in 2005, financial frictions were essentially flat. However, net worth of corporations was increasing well over 10% on an annual basis, providing significant reassurance to lending institutions that strong corporate balance sheets would reduce lending risk. As a consequence, investment grew at 6.1% on average for the year. During the crisis period, there was a strong increase in financial frictions (although the net change during the period was slightly negative); with asset prices declining, this lead to rapid deterioration of corporate balance sheets and net worth, and as a consequence, lending and investment contracted sharply by 28.9%. This is entirely consistent with the first stage of a financial crisis, where declining asset prices lead to lower net worth of firms, and lending contracts sharply. Moreover, financial frictions increased sharply during that time, which is indicative of asymmetric information problems rising.

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c. How do the current investment data compare to the data for the period prior to the financial crisis and during the crisis? Do you think the current data are indicative of a bubble?

Financial frictions have increased significantly over the last year by 1.5 points, and although corporate net worth has grown substantially, overall investment fell 4.3% on average indicating a bubble is probably not present.

2019:Q2 to 2020:Q1 2008:Q3 to 2009:Q2 2005:Q1 to 2005:Q4

Average Change, Stress Index

Corporate Net Worth Growth Rate

Investment Growth Rate

1.5

11.1

–4.3

–0.4

−10.7

−28.9

0.2

10.7

6.1

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Chapter 12: Banking and the Management of Financial Institutions Chapter Overview and Teaching Tips Although this chapter performs the conventional function of outlining what banks (depository institutions) do and what their balance sheets look like, it also emphasizes the economic way of thinking about how banks manage their assets and liabilities to make a profit. Three tools are used throughout this chapter and the rest of the book—the asymmetric information concepts of adverse selection and moral hazard, introduced in Chapter 2, the theory of portfolio choice developed in Chapter 5, and T-accounts, introduced in this chapter. In teaching this material, it is worth emphasizing to the student that mastery of these tools will pay high dividends in helping them to learn (and perform well on exams) in this course.

The economics of bank management is important, not only because it will help students comprehend the operation of banks, the most important of our financial intermediaries, but also because bank management affects the money supply, as shown in Chapter15. The first three sections of the chapter—“The Bank Balance Sheet,” “Basic Banking,” and “General Principles of Bank Management”—place particular emphasis on the question of why banks hold excess reserves, since banks’ decisions about the amount of excess reserves they hold play an important role in the money supply process.

The subsection, “Capital Adequacy Management,” and the final three sections in the chapter, “Managing Credit Risk,” “Managing Interest-Rate Risk,” and “Off-Balance-Sheet Activities,” discuss issues that have become increasingly important in recent years. Many instructors may therefore want to include this material in their courses, yet none of this material is essential to understanding later chapters, so it can be skipped without any loss of continuity. The application on how a capital crunch caused a credit crunch during the global financial crisis particularly piques the interest of students because it shows how changes in banks’ behaviours can have major effects on the economy.

Chapter 12 has two appendices in MyLab Economics. The first outlines duration gap analysis and the second discusses how to measure bank performance. For instructors who are teaching students who might want to go into the financial industry, these appendices can give these students extra tools that they can use in their future jobs.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Why might a bank be willing to borrow funds from other banks at a higher rate than the rate at which it can borrow from the Bank of Canada?

Because if the bank borrows too frequently from the Bank of Canada, the Bank of Canada may restrict its ability to borrow in the future.

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

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

Liabilities

Reserves

$ 75 million

Deposits

$500 million

Loans

$525 million

Bank Capital

$100 million

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

The $50 million deposit outflow means that reserves fall by $50 million to $25 million.

Since desired reserves are $45 million (10% of the $450 million of deposits), your bank needs to acquire $20 million of reserves. You could obtain these reserves by either calling in or selling off $20 million of loans, borrowing $20 million in advances from the Bank of Canada, borrowing $20 million from other banks or corporations, selling $20 million of securities, or some combination of these.

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

Liabilities

Reserves

$100 million

Deposits

$500 million

Loans

$500 million

Bank Capital

$100 million

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

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

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

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

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

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

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

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

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

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

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

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

The benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Liabilities –$50

Chequable Deposits –$50

Second National Bank Assets Reserves

Liabilities $50

Chequable Deposits

$50

20. What happens to reserves at the First National Bank if one person withdraws $1000 of cash and another person deposits $500 of cash? Use T-accounts to explain your answer.

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

Liabilities –$500

Chequable Deposits –$500

21. Angus Bank holds no excess reserves. The desired reserves ratio is 9%, and reserves are currently $27 million. Determine the amount of deposits, the reserve shortage created by a deposit outflow of $5 million, and the cost of the reserve shortage if Angus Bank borrows in the overnight funds market (assume the overnight interest rate is 0.25%).

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

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22. Excess reserves act as insurance against deposit outflows. Suppose that on a yearly basis Malcom Bank holds $12 million in excess reserves and $88 million in desired reserves.

Suppose that Malcom Bank can earn 3.5% on its loans and that the interest paid on reserves is 0.2%. What would be the cost of this insurance policy?

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

23. Victory Bank reports an EM of 25, while Batovi Bank reports an EM equal to 14. Which bank is better prepared to respond against large losses on loans?

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

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

The assets fall in value by $8 million (= $100 million × –2% × 4 years), while the liabilities fall in value by $10.8 million (= $90 million × –2% × 6 years). Because the liabilities fall in value by $2.8 million more than the assets do, the net worth of the bank rises by $2.8 million.

The interest-rate risk can be reduced by shortening the maturity of the liabilities to a duration of four years or lengthening the maturity of the assets to a duration of six years.

Alternatively, you could engage in an interest-rate swap, in which you swap the interest earned on your assets with the interest on another bank’s assets that have a duration of six years.

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

The gap is $10 million ($30 million of rate-sensitive assets minus $20 million of ratesensitive liabilities). The change in bank profits from the interest rate rise is +$0.5 million (5%  $10 million); the interest-rate risk can be reduced by increasing rate-sensitive liabilities to $30 million or by reducing rate-sensitive assets to $20 million. Alternatively, you could engage in an interest-rate swap in which you swap the interest on $10 million of ratesensitive assets for the interest on another bank’s $10 million of fixed-rate assets.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Office of the Superintendent of Financial Institutions (OSFI), and find data (as of December 31, 2020) for all domestic banks on total liabilities, total deposits, and residual of assets less liabilities. a. What is the balance sheet interpretation of the residual of assets less liabilities? b. Use the three indicators listed above to calculate the total amount of borrowings by banks. (a) The residual of assets less liabilities is bank capital. (b) Since liabilities equal total deposits + borrowings + bank capital, then borrowings can be solved for. Using the data for December 31, 2020 (in billions of Canadian dollars): Borrowings = liabilities – deposits – bank capital = $6946 – $4612 – $374 = $1960.

2. Go to the OSFI website, and find data for all domestic banks on total assets, reserves, securities held, commercial and industrial loans, and other assets. Use the data for December 31, 2020, across all indicators. a. What is the total amount of loans held by banks? What is this number as a percentage of total bank assets?

Total loans are $3951 billion, which represents 56.8% of the $6946 billion in assets held by banks. b. What is the total amount of securities held by banks? What is this number as a percentage of total bank assets?

Total securities held are $1518 billion, representing 21.8% of total assets held by banks. c. What is the total amount of cash items held? What is this number as a percentage of total bank assets?

Cash items held are $752 billion, representing 10.8% of total bank assets.

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Solutions to Chapter 12 Mini-Case 1 Bank Performance Analysis 1.

Using the balance sheet for each year. a. Balance sheet with assets as a percentage of total assets and liabilities as a percentage of total liabilities: Assets (Use of Funds)

Your Bank, Year 3

Your Bank, Year 2

Your Bank, Year 1

Reserves Cash items in process of collection Deposits at other banks Securities Federal government Provincial and local governments Loans Commercial and industrial Real estate Consumer Interbank Other Other assets (i.e., physical capital) Total Liabilities (Sources of Funds) Chequable deposits Nontransaction deposits Savings deposits Small-denomination time deposits Large-denomination time deposits Borrowings Bank capital Total

7.25 3.00

5.78 2.10

6.22 1.88

Banks in Your Region, Year 3 5.61 3.00

2.00

1.11

2.00

1.95

16.75 6.00

20.00 6.00

18.89 6.00

18.43 6.00

16.00 22.00 15.00 2.83 2.17 7.00

16.01 22.00 15.00 2.84 2.17 7.00

16.01 22.01 15.01 2.83 2.16 7.00

16.00 22.00 15.00 2.83 2.17 7.00

100.00

100.00

100.00

100.00

24.00

24.00

23.99

24.00

21.00 14.00

16.54 14.00

21.00 14.00

21.00 14.00

11.00

11.00

11.00

11.00

24.00 6.00 100.00

24.00 10.46 100.00

24.00 6.00 100.00

18.93 11.07 100.00

Items increasing: Reserves, Cash items. Items decreasing: Federal government securities.

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b. The bank’s liquidity has improved over the past three years. Moreover, the bank’s liquidity position is better than that of the regional banks. The bank will have insufficient reserves if deposits increase by 40%. c. Equity Multiplier Ratio = Assets/Equity Capital: Your Bank, Year 3 6.66

Your Bank, Your Bank, Year 2 Year 1

9.56

16.67

Banks in Your Region, Year 3 9.04

Equity multiplier starts high in Year 1, declines in Year 2, and returns to Year 1 level in Year 3 and further declines in Year 3. Also, equity multiplier is higher than regional banks.

2.

a. Income statement with operating income items as a percentage of total operating income: Operating Income

Your Bank, Year 3

Your Bank, Year 2

Your Bank, Year 1

Banks in Your Region, Year 3

Interest on loans Interest on securities Other interest Total interest income

42.22 9.28 3.63 55.13

44.78 11.25 3.50 59.54

44.73 9.84 3.85 58.42

47.18 8.74 3.40 59.32

Service charges on deposit accounts Other noninterest income Total noninterest income Total operating income

27.84

27.87

29.51

26.22

17.03 44.87 100.00

12.59 40.46 100.00

12.07 41.58 100.00

14.47 40.68 100.00

Non-interest income is rising—your bank needs to reverse that. Compared to regional banks, the bank has lower interest income and higher non-interest income.

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b. Income statement with operating expenses as a percentage of total operating expenses: Operating Expenses

Your Bank, Year 3

Interest expenses On deposits On overnight funds and repos Other Noninterest expenses Salaries and employee benefits Premises and equipment Other Provisions for loan losses Total operating expenses

Your Bank, Year 2

Your Bank, Year 1

Banks in Your Region, Year 3

24.11 8.25 4.84

33.42 2.58 4.66

32.69 2.86 5.14

38.31 2.08 3.61

24.35

22.61

34.97

20.67

14.12 13.72 10.63 100.00

13.47 13.13 10.14 100.00

3.43 10.97 9.94 100.00

12.98 12.60 9.74 100.00

The bank has declining interest on deposits and salaries. It has increasing interest on overnight funds and premises and equipment. Compared to regional banks, your bank has lower interest on deposits, higher interest on overnight funds, salaries and employee benefits, premises and equipment, and other.

3.

a. Return on assets (ROA) = Net profit after taxes/assets Your Bank, Year 3

Your Bank, Year 2

1.17

1.01

Your Bank, Banks in Your Year 1 Region, Year 3 1.00

1.00

Hence, ROA increased over the past three years. It is higher than regional banks. b. Return on equity (ROE) = Net profit after taxes/equity capital Your Bank, Year 3

Your Bank, Year 2

19.49

9.63

Your Bank, Banks in Your Year 1 Region, Year 3 16.73

9.07

Clearly, ROE is down in Year 2 but back up in Year 3. It is much higher than regional banks.

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Your bank has much greater ROE and ROA than the regional banks and trends toward higher profitability than the regional banks. It needs to work on generating interest income and controlling cost of salaries, premises, equipment, and other expenses relative to the regional banks.

Solutions to Chapter 12 Mini-Case 2 Calculating and Comparing GAP, Duration, and Risk Management Alternatives 1. (Using assumptions in the chapter example): a. 29 (= 4 + 9 + (20% of 15) +13) b. 59.4 (= 5 + 21 + (20% of 17) + 30) 2. a. 55.4 (= 10% of 10 + 5 + (20% of 12 + 6 + 19 + 10) + 12) b. 71.6 (= 10% of 14 + 9 + (20% of 16 + 12 + 14 + 14) + 18) 3. a. The income on assets declines by 0.03  29 million = 0.87 million. The payments on the liabilities decline by 0.03  55.4 million = 1.662 million. Hence, profits increase by 0.792 million, and the net interest margin is [–0.87 – (–1.662)]/150 = 0.792/150 = 0.00528 = 0.53%. b. Doing the same calculations as in (a), NIM = 0.22%.

4. a. 0.31% b. 0.31% 5. a. –26.4 b. –12.2 6. Calculate the weighted duration of each asset and liability.

Assets (Your Firm) Asset Amount Duration Amount  Duration

3 4 3 7 9 15 13 31 55 10 150

0 0.6 1.6 5 0.4 5.5 0.9 1.8 6 0

0 2.4 4.8 35 3.6 82.5 11.7 55.8 330 0

Weighted Duration

0.000 0.016 0.032 0.233 0.024 0.550 0.078 0.372 2.200 0.000 3.505

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Liabilities (Your Firm) Amount

Duration Amount  Duration Weighted Duration

10 5 12 6 19 8 15 10 12 9 39 145

1 0.6 1 0.4 0.3 1.1 2.9 0 0.4 1.2 2.9

10 3 12 2.4 5.7 8.8 43.5 0 4.8 10.8 113.1

0.069 0.021 0.083 0.017 0.039 0.061 0.300 0.000 0.033 0.074 0.780 1.477

Assets (Your Competition) Asset Amount 4 5 7 9 21 17 30 22 30 25 170

Duration 0 0.3 1.2 4 0.9 4.4 0.6 1.4 5.4 0

Amount  Duration

Weighted Duration

0 1.5 8.4 36 18.9 74.8 18 30.8 162 0

0.000 0.010 0.056 0.240 0.126 0.499 0.120 0.205 1.080 0.000 2.336

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Liabilities (Your Competition) Amount

Duration Amount  Duration Weighted Duration

14 9 16 12 14 10 10 14 18 12 31 160

1 0.5 1 0.6 0.5 1.8 2.2 0 0.7 1.8 3.8

14 4.5 16 7.2 7 18 22 0 12.6 21.6 117.8

0.097 0.031 0.110 0.050 0.048 0.124 0.152 0.000 0.087 0.149 0.812 1.660

7. a. 3.50 b. 2.33 c. 1.47 d. 1.66 8. a. 2.07 [= 3.50 – (145/150)  1.47] b. 0.767 [= 2.33 – (160/170)  1.66] (Assuming an initial interest rate of 10%) 9. a. 5.65% {= –2.07  [–0.03/(1 + 0.10)]} b. 2.09% {= –0.767  [–0.03/(1 + 0.10)]} (Assuming an initial interest rate of 10%) 10. a. –5.65% b. –2.09% 11. a. Shorten the duration of assets b. Adjust assets and liabilities to GAP of zero

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Chapter 13: Risk Management with Financial Derivatives Chapter Overview and Teaching Tips The treatment of financial derivatives markets (forwards, futures, options, and swaps) in this book differs markedly from that in other money and banking textbooks. Financial derivatives are approached from the perspective of managers of financial institutions, and this is why this material is placed in the financial institutions part of the book. Rather than go into a lot of facts about these different markets, this chapter focuses on how the markets work and how they can be used to hedge the risk faced by financial institutions. This approach makes more sense to students who now clearly see why studying these markets and their operation is relevant.

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

Other money and banking textbooks tend to give only a cursory treatment of what profits arise for a holder of an option contract given different market outcomes. They may have a figure illustrating the profits, but do not give a detailed explanation of how profits are generated. We think that this is a terrible mistake because students often do not find financial derivatives contracts to be particularly intuitive, and this is particularly true for the options contract. This chapter takes a different approach by containing an extensive explanation and discussion of Figure 13-3, which outlines the profits and losses that occur on financial options and futures contracts depending on what happens to the price of bonds. To get the students to understand these contracts and what their differences are, the instructor needs to carefully walk the students through the numerical example of Figure 13-3. Our experience in class suggests that unless this is done, many students will just not understand what these financial derivatives, and particularly options, are all about.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What are the advantages and disadvantages of using forward contracts to hedge?

The big advantage to forward contracts is their flexibility, as they can be designed in any way that the counterparties would like them to be. The two main disadvantages are first, that it may be difficult for one party to find a counterparty to enter into the forward contract, as they can be quite specific. Because of this, there may be a lack of liquidity in certain forwards markets, leading to less favourable terms on forward contracts to attract counterparties. The second main disadvantage is that forward contracts are subject to default risk, and the only recourse for a counterparty defaulting on its contract is to take legal action, which can be costly and lengthy.

2. What advantages do futures contracts have over forward contracts?

There are several advantages of futures over forward contracts. For instance, quantities and delivery dates of futures are standardized to improve liquidity and limit the ability of someone to corner the market. Futures can be traded at any time up to the delivery date, which is not possible with forward contracts. And in contrast to forwards, futures contracts are cleared through a clearinghouse, limiting default risk. Finally, in a futures contract, physical delivery of the underlying asset can be avoided, thus lowering the costs of trading in futures.

3. Suppose that the Bank of Canada did not increase the overnight interest rate target but somewhat let the markets know that there could be a rise in the near future. How do you think that financial managers will react to this news? Which instruments can they use to hedge against a change in interest rates?

Financial managers should be prepared for an increase in interest rates somewhere in the near future. The fact that the Bank announced a possible increase in interest rates as the economy recovers does not mean that interest rates will increase immediately, but they should be considering this scenario with higher probability. The instruments used by each financial manager will depend on the characteristics of their business and the portfolio they manage. In essence, they should be prepared for a price decrease in securities (as the discount factor increases) and will have to find the specific instrument that better helps them to hedge this risk (forwards contracts, financial futures contracts, options, etc.).

4. What are the advantages and disadvantages of using an options contract rather than a futures contract?

The advantages of using options contracts are that the buyers of options are not obligated to take action (i.e., buy or sell the underlying asset) at a disadvantageous price when the option is “out of the money” and that their potential losses are limited to the premium paid for the option. There is also no need to maintain a margin account and make daily settlement payments into or out of that account, as is the case with futures contracts. The disadvantage

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of an options contract is that you have to pay a premium that you would not have to pay with a futures contract.

5. Explain why greater volatility or a longer term to maturity leads to a higher premium on both call and put options.

Because an option has the feature that you win big if the price has a large change in one direction but don’t lose big if the price has a large change in the other direction. More volatility of the price means that on average you will have a larger profit because you are more likely to win big with either a call or a put option and thus their premiums will be higher.

6. Why does a lower strike price imply that a call option will have a higher premium and a put option a lower premium?

Because for any given price at expiration, a lower strike price means a higher profit for a call option and a lower profit for a put option. A lower strike price makes a call option more desirable and raises its premium and makes a put option less desirable and lowers its premium.

7. What are the advantages and disadvantages of using interest-rate swaps?

Advantages of interest-rate swaps are that they allow institutions to convert fixed-rate assets into rate-sensitive assets without affecting their balance sheets (which otherwise may be quite difficult) at relatively low cost. Another advantage of interest-rate swaps is that they can be written over long horizons, whereas futures and options are typically of much shorter duration. The main disadvantages of interest-rate swaps are that they may lack liquidity, and they are subject to default risk similar to forward contracts.

8. If the finance company you manage has a gap of +$5 million (rate-sensitive assets greater than rate-sensitive liabilities by $5 million), describe an interest-rate swap that would eliminate the company’s income gap.

You would swap interest on $5 million of variable-rate assets for the interest on $5 million of fixed-rate assets, thereby eliminating the income gap.

9. If the bank you manage has a gap of −$42 million, describe an interest-rate swap that would eliminate the bank’s income risk from changes in interest rates.

You would swap the interest on $42 million of fixed-rate assets for the interest on $42 million of variable-rate assets, thereby eliminating the income gap.

10. How can financial derivatives create excessive risk in the financial system?

Derivatives allow financial institutions to increase their leverage, in essence making huge bets with a limited ability to pay up if they are on the wrong side of the bet, which can quickly and unexpectedly bring down large financial institutions. In addition, banks hold

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significant notional amounts of derivatives many times larger than their bank capital, exposing them to serious risk of failure. These factors present significant risk in the financial system, and the failure of one large institution that is systemically important can jeopardize the entire financial system.

ANSWERS TO APPLIED PROBLEMS 11. If the pension fund you manage expects to have an inflow of $120 million six months from now, what forward contract would you seek to enter into to lock in current interest rates?

You would like to enter into a contract that specifies that you will purchase $120 million of bonds with an interest rate equal to the current interest rate six months from now.

12. If the portfolio you manage is holding $25 million of 6s of 2041 Canada bonds with a price of 110, what forward contract would you enter into to hedge the interest-rate risk on these bonds over the coming year?

You would enter into a contract that specifies that you will sell the $25 million of 6s of 2041 at a price of 110 one year from now.

13. Suppose that you buy a call option on a $100 000 Canada bond futures contract with an exercise price of 105. If the price of the Canada bond is 115 at expiration, is the option at the money, in the money, or out of the money? Determine the premium if the profit equals $8000.

The call option is “in the money” because you would want to exercise the right to buy the Canada bonds at $105 and then sell them at $115, for a profit. If the profit equalled $8000, this means that the premium was (115 – 105) × 100 000 – 8000 = $2000.

14. Jason bought a put option on a $100 000 Canada bond futures contract with an exercise price of 105 for a premium of $2000. If on expiration the futures contract sells for 110, determine Jason’s profits and explain if he will exercise the right to sell the futures contract.

How would your answer change if the futures contract sells for 95 on expiration?

If price on expiration is 110: the option is “out of the money,” and Jason does not exercise his right to sell the futures contract. His profit is –$2000. If price on expiration is 95: the option is “in the money,” and Jason exercises his right to sell the futures contract. His profit is: (105 – 95) × 100 000 – $2000 = $8000.

15. If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125 000-euro futures contracts?

You would buy 200 million euro of futures contracts that mature one year from now. With a contract size of 125 000 euros, you would buy 200 million/125 000 = 1600 contracts.

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16. If your company has to make a 10 million euro payment to a German company three months from now, how would you hedge the foreign exchange risk in this payment with a 125 000euro futures contract?

You would hedge the risk by buying 80 euro futures contracts that mature three months from now.

17. Suppose your company will be receiving 30 million euros six months from now, and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract should you enter into?

You would want to enter into a contract in which you agree to deliver 30 million euros six months from now in exchange for US$30 million.

18. Suppose the pension fund you are managing is expecting an inflow of funds of $100 million next year, and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

You would buy $100 million worth (i.e., 1000 long-term bond futures contracts with an expiration date of one year in the future). This means that you would be entitled to delivery of the long-term bond at today’s price so that the current rate would be locked in.

19. If you buy a put option on a $100 000 Canada bond futures contract with an exercise price of 95 and the price of the Canada bond is 120 at expiration, is the contract in the money, out of the money, or at the money? What is your profit or loss on the contract if the premium was $4000?

The put option is out of the money because you would not want to take the option to sell the futures at 95 when the price at expiration is 120. Since the premium is $4000 and you did not exercise the contract, your loss on the contract is $4000.

20. Suppose that you buy a call option on a $100 000 Canada bond futures contract with an exercise price of 110 for a premium of $1500. If, upon expiration, the futures contract has a price of 111, what is your profit or loss on the contract?

You have a profit of 1 point ($1000) when you exercise the contract, but you have paid a premium of $1500 for the call option, so your net profit is –$500, a loss of $500.

21. Canada Bank and Trust has $100 million in assets and $83 million in liabilities. The duration of the assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures contracts does this bank need to fully hedge itself against interest-rate risk? The available Canada bond futures contracts have a duration of 10 years, have a face value of $1 million, and are selling for $979 000.

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This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the duration of the liabilities, so the bank will take a short position, effectively increasing its liabilities.

Assume that the dollar amount of the position is Y. DURgap = 5 −

83 + Y  83 Y   1.8 + 10 = 0 100  83 + Y 83 + Y 

500 = 149.40 + 10Y, Y = 35.06, or a position in $35 060 000 futures. At the current price, this requires $35 060 000/979 000 = 35.812 contracts, or 36.

22. Futures are available on three-month T-bills with a contract size of $1 million. If you take a long position at 96.22 and later sell the contracts at 96.87, what is the total net gain or loss on this transaction?

Gain = (96.87 – 96.22)  10 000 = $6500 per contract.

23. A bank customer will be going to London in June to purchase £100 000 in new inventory.

The current spot and futures exchange rates are as follows: Exchange Rates (dollars/pound) Period

Rate

Spot

1.5342

March

1.6212

June

1.6901

September

1.7549

December

1.8416

The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

She paid an actual rate of $1.6901 per pound, or $169 010. Had she simply taken the spot rate at the time, the cost would have been $172 500. She saved $3490.

24. Consider a put contract on a Canada bond with an exercise price of 101.38. The contract represents $100 000 of bond principal and has a premium of $750. The actual Canada bond price falls to 98.50 at the expiration. What is the gain or loss on the position?

The gain per contract is (10112 32 − 98 16 32) (101.38-98.50) x 1000 = $2880. If you include the premium paid, the gain is $2130 per contract.

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25. A swap agreement calls for Durbin Industries to pay interest annually, based on a rate of 1.5% above the one-year T-bill rate, currently 6%. In return, Durbin receives interest at a rate of 6% on a fixed-rate basis. The notional principal for the swap is $50 000. What is Durbin’s net interest for the year after entering into the agreement?

Durbin pays 7.5%  $50 000 and receives 6%  $50 000, or net, pays 1.5%  $50 000 = $750.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on the U.S. dollar/euro exchange rate (DEXUSEU). Suppose that one month ago you entered into a forward contract to sell 10 million euros at the forward rate equivalent to the spot rate one month ago. What exchange rate was specified on the forward contract? (Find the most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 11, 2017, the spot exchange rate was $1.1811/€, and on July 11, 2017, when the forward contract was entered into, the exchange rate was $1.1430/€. Thus, locking in the forward contract exchange rate (assumed at the July 11 spot rate) would mean you receive €10 000 000 × $1.1430/€ = $11 430 000 one month later on August 11. Had the forward contract not been entered into, the €10 000 000 would be worth €10 000 000 × $1.1811/ € = $11 811 000. In this case, since the dollar depreciated, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a risk-neutral world, you are worse off with utilizing the forward contract.

2. Go to the St. Louis Federal Reserve FRED database, and find data on crude oil prices (DCOILWTICO). Suppose that one month ago you entered into a forward contract to sell 1 million barrels of oil at the forward rate equivalent to the spot rate one month ago. What price was specified on the forward contract? (Find the most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 14, 2017, the spot price of WTI oil was $47.59/barrel, and on July 14, 2017, when the forward contract was entered into, the price was $46.53/barrel. Thus, locking in the forward contract exchange rate (assumed at the July 14 spot rate) would mean you receive 1 000 000 barrels × $46.53/barrel = $46 530 000 one month later on August 14. Had the forward contract not been entered into, the 1 000 000 barrels would be worth 1 000 000 barrels × $47.59/barrel = $47 590 000. In this case, since the price of oil increased, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a riskneutral world, you are worse off with utilizing the forward contract.

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Solutions to Chapter 13 Mini-Case Micro Hedge, Macro Hedge, Managing Interest-Rate Risk, and Duration 1.

Short. To protect against decline in price.

2. 1.17 [HR = ΔPa/ΔPf  βaf = 1.3  0.90 = 1.17] 3. 81.9 [Contracts = HR  ΔVa/ΔVf = 1.17  7 000 000/100 000] 4. a. $560 000 [= 7 000 000  0.08] b. $655 200 [= 81.9  100 000  0.08] 5. a. –$3 Because %ΔNW = –DURgap  Δi/(1 + i) = –2.2  0.01/(1 + 0.06) = –0.0207 = –2.07%.

Hence, when i increases by 1% from 6% to 7%, NW declines by 3 million [= 150 million  (–0.0207)]. b. Offsets decline in net worth. c. Zero for a perfect hedge 6. a. 75 Because Vf = –DURgap  Va/DURf = –150 million  2.2/4.4 = –75 million b. Exact amount to offset change in net worth c. Same as above d. No change 7. Prices of hedged asset and underlying asset may not move together over time, creating less than a perfect hedge.

8. Bank is required to show profits or losses effects from hedges without recognizing offsetting events.

9. 54 contracts 10. [= β  (value of portfolio)/(value of contract) = 0.90  (12 million)/(200 ,000)] a. –1 080 000 b. +1 080 000 c. Zero for a perfect hedge 11. Bank would set up the hedge to offset adverse changes in foreign exchange rates relative to the dollar. Gains in futures market would offset losses in cash markets, and losses in futures market positions would be offset by gains in the cash markets.

12. (Same general answer as for question 11 above.) Bank would set up the hedge to offset adverse changes in foreign exchange rates relative to the dollar. Gains in futures market would offset losses in cash markets, and losses in futures market positions would be offset by gains in the cash markets.

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Chapter 14: Central Banks and the Bank of Canada Chapter Overview and Teaching Tips Chapters 14-17 explore in detail how monetary policy is conducted. Although most professors covering monetary theory will want to include much of this material in their courses, later chapters on monetary theory do not directly depend on Chapters 14-17, so they can be skipped without loss of continuity. Other professors covering monetary theory may prefer to teach this material after they have taught the chapters on monetary theory.

The chapter starts by discussing how the central bank in Canada—the Bank of Canada— operates. The basic point that should be driven home in class is that although the Bank of Canada has a complicated bureaucratic structure, in practice it functions like many other central banks around the world. Students should enjoy the discussion of how foreign central banks are structured, and how foreign central banks are similar to or differ from the Bank of Canada.

To help the instructor spice up the discussion of central banking, the chapter contains a detailed description of the structure and independence of the central bank in the United States—the Federal Reserve System. We also emphasize that until recently the Federal Reserve had no significant rivals in the central banking world. This changed in January 1999 with the startup of the European Central Bank (ECB), which now conducts monetary policy for countries that are members of the European Monetary Union, which in total have a population that exceeds that of the United States and a GDP comparable to that of the United States Because of growing student interest in the workings of the European Central Bank, the chapter has an extensive discussion of the structure and independence of the European Central Bank. To motivate this material, we focus on how the ECB is similar to the Federal Reserve and how it differs. The chapter also contains brief descriptions of the structure and independence of two other important central banks of interest to students: the Bank of England and the Bank of Japan.

In addition to the institutional detail on the Bank of Canada that is usually found in money and banking textbooks, Chapter 14 also tries to provide the student with a feel for what motivates central bankers. Furthermore, discussing the theory of bureaucratic behaviour shows students that the economic way of thinking is useful in understanding a wider range of problems than they might otherwise have thought.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What political realities might explain the creation of the Bank of Canada in 1934?

The primary motivation for the formation of the Bank of Canada was political. As the Great Depression undermined faith in the existing market economy and inflation was blamed on the concentrated banking industry, support was given to the idea of a central bank.

2. In what ways can the government influence the conduct of monetary policy?

Under the “joint responsibility system,” the governor of the Bank of the Canada and the minister of finance consult regularly about monetary policy. Also, in the event of a serious policy conflict, the minister of finance can issue a directive that the Bank must follow.

3. Who is responsible for monetary policy in Canada?

The Bank Act was amended in 1967 to give the ultimate responsibility for monetary policy to the government. In practice, however, the Bank of Canada does essentially control monetary policy. In the event of a disagreement between the Bank of Canada and the government, the minister of finance can issue a directive that the Bank must follow.

4. Do you think that the seven-year renewable term for the governor of the Bank of Canada effectively insulates the Bank from political pressure?

No. The seven-year renewable term does not insulate the Bank from political influence. The governors know that their bureaucratic power can be reined in by a change in government and so must still curry favour with the government.

5. How did the “Coyne Affair” motivate the current system of joint responsibility for monetary policy?

After Governor Coyne tendered his resignation in 1961 and Louis Rasminsky became the third governor of the Bank of Canada, upon assuming office he issued a public statement making clear his views regarding the division of responsibility between the Bank and the governor. The matter rested until 1967 when the Bank of Canada Act was amended to confirm that the minister and the governor of the Bank of Canada should consult regularly on monetary policy.

6. Over time, which entities have gained power in the conduct of monetary policy in Canada and which have lost power? Why do you think this has happened?

The Bank of Canada has gained power, since the responsibility for monetary policy rests entirely with the Bank. Although under the “joint responsibility system” the minister of finance can issue a directive that the Bank of Canada must follow, it is unlikely that such a directive will be issued, and none has been issued to date.

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7. “The strongest argument for an independent Bank of Canada rests on the view that subjecting the Bank of Canada to more political pressures would impart an inflationary bias to monetary policy.” Is this statement true, false, or uncertain? Explain your answer.

True. Assuming that politicians are driven by the need to win the next election, they are likely to seek short-run solutions to problems like high unemployment and interest rates. For example, they are likely to increase money growth in order to reduce unemployment and interest rates in the short run. In the long run, however, such policies will lead to more inflation.

8. The Bank of Canada is the most independent of all Canadian government agencies. What is the main difference between it and other government agencies that explains its greater independence?

The Bank of Canada is more independent because its substantial revenue from securities and overdraft loans and advances allows it to control its own budget.

9. How can the government directly influence the Bank of Canada?

By not renewing the governor’s appointment when it expires.

10. How is the responsibility for monetary policy shared in the Eurosystem?

The Eurosystem is governed by the European Central Bank’s Executive Board and Governing Council. The Governing Council comprises the Executive Board of the European Central Bank and the governors of the national central banks, with each member having one vote. Its main task is the formulation of the single monetary policy. The Executive Board consists of the European Central Bank’s president, vice-president, and four other members and is responsible for the implementation of monetary policy in accordance with the guidelines set by the Governing Council, by giving instructions to the national central banks of the euro area countries.

11. “The theory of bureaucratic behaviour indicates that the Bank of Canada never operates in the public interest.” Is this statement true, false, or uncertain? Explain your answer.

False. Maximizing one’s welfare does not rule out altruism. Operating in the public interest is clearly one objective of the Bank of Canada. The theory of bureaucratic behaviour only points out that other objectives, such as maximizing power, also influence Bank of Canada decision making.

12. Why might eliminating the Bank of Canada’s independence lead to a more pronounced political business cycle?

Eliminating the Bank of Canada’s independence might make it more short-sighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the Bank might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

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13. “The independence of the Bank of Canada leaves it completely unaccountable for its actions.” Is this statement true, false, or uncertain? Explain your answer.

False. The Bank of Canada is still subject to political pressure because the government might not renew the governor’s appointment when it expires. Also, if the Bank is performing badly, the minister of finance can issue a directive that the Bank of Canada must follow.

14. “The independence of the Bank of Canada means that it takes the long view and not the short view.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although independence may help the Bank of Canada take the long view, because its personnel are not directly affected by the outcome of the next election, the Bank of Canada can still be influenced by political pressure. In addition, the lack of Bank of Canada accountability because of its independence may make the Bank more irresponsible. Thus it is not absolutely clear that the Bank of Canada is more far-sighted as a result of its independence.

15. Why did Canada show little interest in the establishment of a central bank during the first 60 or so years of Confederation?

During the first 60 or so years after Confederation, there was little need for a central bank in what was a scattered and mainly rural economy. The branch bank network, influenced by the British tradition, was sufficient to serve the banking needs of the small, scattered, rural settlements.

16. What is the primary tool that the U.S. Congress uses to exercise some control over the Fed? The threat that Congress will acquire greater control over the Fed’s finances and budget.

17. Should the Federal Reserve be subject to periodic auditing of its policies, procedures, and finances? Why or why not?

On the one hand, if the Fed were subject to additional scrutiny, particularly on policy matters, it is possible that the prospects of policy auditing could place implicit pressure on the Fed to pursue (or not pursue) particular policies for political reasons. This could make the Fed less independent, leading to less desirable economic outcomes. On the other hand, auditing the Fed makes it more accountable, which is consistent with democratic principles.

18. The Fed promotes secrecy by not releasing the minutes of FOMC meetings to Congress or the public immediately. Discuss the arguments for and against this policy.

The argument for not releasing the FOMC minutes immediately is that it keeps Congress off the Fed’s back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the minutes immediately is that it would make the Fed more accountable. Increased transparency can help develop market expectations that help to further promote the objectives of monetary policy actions.

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19. Which is more independent, the Federal Reserve or the European Central Bank? Why? The ECB is more independent than the Fed because its charter can only be changed by revision of the Maastricht Treaty, a very difficult process because all signatories to the treaty must agree to accept any proposed change, while the Fed’s charter can be changed by legislation, which is much easier to do. On the other hand, the goal for the ECB is more clearly specified than it is for the Fed because the Maastricht Treaty states that the overriding long-run goal of the ECB is price stability, although it doesn’t specify exactly what “price stability” means.

20. Why did the Bank of England up until 1997 have a low degree of independence?

Prior to 1997, the Bank of England had very little independence, since interest rate policy was determined exclusively by Her Majesty’s Treasury (Chancellor of the Exchequer).

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and find data on the unemployment rate in Quebec (series V2063760), Ontario (series V2063949), and British Columbia (series V2064705). For the most recent month of data available, determine which province had the highest, and which had the lowest, unemployment rate.

In January 2021, Ontario had the highest unemployment rate at 10.2% and British Columbia had the lowest at 8%.

2. Go to the Bank of Canada’s website, and find data on the overnight interest rate target.

When was the last time the overnight interest rate target was changed? Did the rate increase or decrease?

As of the time of writing (February 15, 2021), the last time the overnight interest rate was adjusted was on March, 2020. It decreased to 0.25%.

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Chapter 15: The Money Supply Process Chapter Overview and Teaching Tips This chapter provides an analysis of how the money supply is determined. One point that needs to be emphasized at the outset is that the money supply is not determined solely at the whim of the central bank; rather, there are two other players in the money supply process who also play an important role: banks and depositors. Chapter 15 first extensively discusses the simple model of multiple deposit creation, even though it is unrealistic and does not feature all of the players, because it illustrates the basic principles used later in the chapter. The critique of the simple model of multiple deposit creation then leads to a discussion of the money multiplier and a more complete treatment of the money supply process.

We have found that going over the Summary Table 15-1 with students in class is an excellent device to help them review the money supply model; it gives them an overall and complete picture of how the money supply is determined.

Chapter 15 ends with an application on quantitative easing and the money supply in recent years.

There has been tremendous confusion about this topic in the media because many pundits claim that quantitative easing has led to an explosion of high-powered money that will be highly inflationary. However, as the application shows, a change in the Fed’s rules so that it could pay interest on reserves meant that a massive expansion of the Fed’s balance sheet during and after the global financial crisis resulted in only a moderate increase in the money supply. This application should convince students that the analysis they have learned is not mere theory, but a useful means of explaining topics that are hotly debated in the media.

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

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS Unless otherwise noted, the following assumptions are made in all the applied problems: the desired reserve ratio on chequable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

1. Classify each of these transactions as either an asset, a liability, or neither, for each of the “players” in the money supply process—the Bank of Canada, banks, and depositors. a. You get a $10 000 loan from the bank to buy an automobile.

Public: Assets rise by $10 000 due to automobile purchase, liabilities rise by $10 000 due to loan. Banks: Assets rise by $10 000 due to loan; this is offset by a decrease in reserves assets of $10 000. b. You deposit $400 into your chequing account at the local bank.

Public: Assets are unaffected ($400 increase in chequing deposits is offset by a $400 decrease in currency holdings). Banks: Assets increase by $400 from reserves; liabilities increase by $400 due to chequing account balance. Bank of Canada: Liabilities are unaffected (reserves increase by $400, currency decreases by $400). c. The Bank of Canada provides an emergency loan to a bank for $1 million.

Banks: Assets increase by $1 million in reserves; liabilities increase by the same amount due to borrowing from the Bank of Canada. Bank of Canada: Assets increase by the $1 million from the loan; liabilities increase by $1 million due to the increase in reserves. d. A bank borrows $500 000 in overnight loans from another bank.

Banks: Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change due to the loan. e. You use your debit card to purchase a meal at a restaurant for $100.

Public: Assets rise by the value of the meal of $100 and are offset by a fall in assets due to lower chequing account balances of $100. Banks: Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change as funds are transferred from your bank account to the restaurant’s bank account.

2. The First National Bank receives an extra $100 of reserves but decides not to lend out any of these reserves. How much deposit creation takes place for the entire banking system?

None. Since there are no loans created from the new reserves, no additional deposit creation will occur.

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3. Suppose that the Bank of Canada buys $1 million of bonds from the First National Bank. If the First National Bank and all other banks use the resulting increase in reserves to purchase securities only and not to make loans, what will happen to chequable deposits?

Chequable deposits will remain the same.

4. If a bank depositor withdraws $1000 of currency from an account, what happens to reserves, chequable deposits, and the monetary base?

Reserves will decrease by $1000, chequable deposits will decrease by $1000, but the monetary base will be unchanged, since reserves decrease by the same amount as currency increases.

5. If a bank sells $10 million of bonds to the Bank of Canada to pay back $10 million on the loan it owes, what is the effect on the level of chequable deposits?

None. The reduction of $10 million in Bank of Canada advances and increase of $10 million of bonds held by the Bank of Canada leaves the level of reserves unchanged so that chequable deposits remain unchanged.

6. If you decide to hold $100 less cash than usual and therefore deposit $100 more cash in the bank, what effect will this have on chequable deposits in the banking system if the rest of the public keeps its holdings of currency constant?

The deposit of $100 in the bank increases its reserves by $100. This starts the process of multiple deposit expansion, leading to an increase in the money supply.

7. “The Bank of Canada can perfectly control the amount of reserves in the system.” Is this statement true, false, or uncertain? Explain.

False. Even though it can control the monetary base fairly precisely through open market operations, it has much less control over the amount of bank reserves in the system because banks decide how much to borrow from the Bank of Canada, while the public decides how much currency it wants to hold relative to deposits, both of which affect the amount of bank reserves. In addition, float and government deposits can unexpectedly change the amount of reserves in the banking system, which is essentially out of the control of the Bank of Canada.

8. “The Bank of Canada can perfectly control the amount of the monetary base but has less control over the composition of the monetary base.” Is this statement true, false, or uncertain? Explain.

False. Since the Bank of Canada cannot control the amount of lending to financial institutions, it does not have perfect control over the amount of reserves and hence does not have perfect control over the monetary base.

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9. The Bank of Canada buys $100 million of bonds from the public and also lowers the desired reserve ratio. What will happen to the money supply?

Both the Bank’s purchase of $100 million of bonds (which raises the monetary base) and the lowering of the desired reserve ratio (which increases the amount of multiple expansion and raises the money multiplier) lead to a rise in the money supply.

10. Describe how each of the following can affect the money supply: (a) the central bank, (b) banks, and (c) depositors. (a) The central bank can affect the money supply through open market operations, which changes the nonborrowed monetary base. It can also affect the monetary base and hence money supply by issuing loans to financial institutions, which increases borrowed reserves. (b) Banks can affect the money supply through their holdings of excess reserves; less excess reserves means more loans and hence a greater money supply. (c) Depositors can influence the money supply through their holdings of currency versus deposits. A higher currency deposit ratio leads to a lower money multiplier and hence a lower money supply for a given monetary base.

11. “The money multiplier is necessarily greater than 1.” Is this statement true, false, or uncertain? Explain your answer.

False. As the formula in Equation (4) indicates, if rD + e is greater than 1, the money multiplier can be less than 1. In practice, however, e is so small that rD + e is less than 1 and the money multiplier is greater than 1.

12. What effect might a financial panic have on the money multiplier and the money supply?

Why? A financial panic would probably decrease the money multiplier and the money supply for a given monetary base. In a financial panic, you would expect banks to want to make less risky loans and have more liquidity on hand, which would increase the excess reserve ratio and decrease the money multiplier. In addition, depositors may get worried about the health of banks and increase their holdings of currency, which also would decrease the money multiplier.

13. During the Great Depression years from 1930 to 1933, both the currency ratio c and the excess reserves ratio e rose dramatically. What effect did these factors have on the money multiplier?

Both of these factors worked to reduce the money multiplier. This can be seen in Figure 15A3-3 in a Chapter 15 online appendix available on MyLab Economics, which indicates a dramatically declining money supply, while the monetary base grew modestly if at all.

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14. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held by banks. How, if at all, might this affect the multiplier process and the money supply?

Paying interest on reserves gives banks incentive to hold more reserves rather than lend them out, which should raise the excess reserve ratio, reduce the money multiplier, and reduce the money supply, holding the monetary base constant.

15. The money multiplier declined significantly during the period 1930–1933 and also during the recent financial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the Depression period but increased by more than 20% during the recent financial crisis. What explains the difference in outcomes?

The difference is that the monetary base increased dramatically during the recent financial crisis, which was more than enough to offset the fall in the multiplier. During the Great Depression, the monetary base rose modestly if at all.

ANSWERS TO APPLIED PROBLEMS Unless otherwise noted, the following assumptions are made in all the applied problems: the desired reserve ratio on chequable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

16. If the Bank of Canada sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Reserves and the monetary base fall by $2 million, as the following T-accounts indicate: First National Bank Assets

Liabilities

Reserves

−$2 million

Securities

+$2 million Bank of Canada

Assets Securities

Liabilities −$2 million

Reserves

.

−$2 million

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17. If the Bank of Canada sells $2 million of bonds to Irving the Investor, who pays for the bonds with a briefcase filled with currency, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Reserves are unchanged, but the monetary base decreases by $2 million due to the currency reduction, as the following T-accounts show: Irving the Investor Assets

Liabilities

Currency

−$2 million

Securities

+$2 million Bank of Canada

Assets Securities

Liabilities −$2 million

Currency

−$2 million

18. If the Bank of Canada lends five banks a total of $100 million, but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base?

Use T-accounts to explain your answer.

The initial effect of the loans on the banking system, Bank of Canada, and public are shown below.

Banking System (all five banks) Assets Reserves

Liabilities +$100 million

Loans (borrowings from the Bank) +$100 million

Bank of Canada Assets

Liabilities

Loans (borrowings from the Bank)

+$100 million

Public Assets

Liabilities

No change

No change

.

Reserves

+$100 million

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After the public withdraws $50 million in deposits to hold as currency, the T-accounts look like this: Banking System (all five banks) Assets Reserves

Liabilities +$50 million

Loans (borrowings from the Bank)

+$100 million

Chequable Deposits

−$ 50 million

Bank of Canada Assets

Liabilities

Loans (borrowings from the Bank)

+$100 million

Reserves

+$50 million

Currency

+$50 million

Public Assets

Liabilities

Chequable Deposits

−$50 million

Currency

+$50 million

19. Using T-accounts, show what happens to chequable deposits in the banking system when the Bank of Canada lends $1 million to the First National Bank.

The initial effect of the loans provided by the Bank is shown in the T-accounts below: Bank of Canada Assets

Liabilities

Loans (borrowings from the Bank)

+$1 million

Reserves

+$1 million

Banking System Assets Reserves

Liabilities +$1 million

Loans (borrowings from the Bank) +$1 million

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After the banks receive the reserves, those excess reserves are loaned out; through multiple deposit creation, the increase in reserves of the banking system will support $10 million in new loans and chequable deposits, increasing the money supply by $10 million. The final effect of the multiple deposit creation is shown in the T-accounts below: Bank of Canada Assets

Liabilities

Loans (borrowings from the Bank)

+$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Reserves

+$ 1 million Loans (borrowings from the Bank) +$ 1 million

Loans

+$10 million Chequable Deposits

+$10 million

20. Using T-accounts, show what happens to chequable deposits in the banking system when the Bank of Canada sells $2 million of bonds to the First National Bank.

The Bank of Canada sale of bonds to the First National Bank reduces reserves by $2 million.

The net result is that chequable deposits in the banking system decline by $20 million. The initial effect on the Bank and the banking system is shown below: Bank of Canada Assets Securities

Liabilities −$2 million

Reserves

−$2 million

Banking System Assets

Liabilities

Securities

+$2 million

Reserves

−$2 million

After the decline in bank reserves, the multiple deposit creation process works in reverse, so the final effect on the Bank and banking system balance sheets is shown below: Bank of Canada Assets Securities

Liabilities −$2 million

Reserves

.

−$2 million

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Banking System Assets

Liabilities

Securities

+$ 2 million

Reserves

−$ 2 million

Loans

−$20 million

Chequable Deposits −$20 million

21. If the Bank of Canada buys $1 million of bonds from the First National Bank, but an additional 10% of any deposit is held as excess reserves, what is the total increase in chequable deposits? (Hint: Use T-accounts to show what happens at each step of the multiple expansion process.)

The total increase in chequable deposits is only $5 million, substantially less than the $10 million that occurs when no excess reserves are held. The reason is that banks now end up holding 20% of deposits as reserves and only lend out 80% so that the increase in deposits found in the T-accounts is $1 000 000 + $800 000 + $640 000 + $512 000 + $409 600 + . . . = $5 million. The T-accounts below show the effect of the securities purchase: Bank of Canada Assets Securities

Liabilities +$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Securities

−$1 million

Reserves

+$1 million

After the increase in reserves and the multiple deposit creation process, the Bank of Canada and Banking system balance sheets are as follows:

Bank of Canada Assets Securities

Liabilities +$1 million

Reserves

.

+$1 million

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Banking System Assets

Liabilities

Securities

−$1 million Chequable Deposits

Reserves

+$1 million

Loans

+$5 million

+$5 million

22. If reserves in the banking system increase by $1 billion because the Bank of Canada lends $1 billion to financial institutions, and chequable deposits increase by $9 billion, why isn’t the banking system in equilibrium? What will continue to happen in the banking system until equilibrium is reached? Show the T-account for the banking system in equilibrium.

The banking system is still not in equilibrium because there continues to be $100 million of excess reserves (+$1 billion of reserves minus $900 million of desired reserves, 10% of the $9 billion of deposits). The excess reserves will be lent out until equilibrium is reached with an additional $1 billion of chequable deposits. The T-account for the banking system when it is in equilibrium is as follows: Banking System Assets

Liabilities

Reserves

+$ 1 billion Loans (borrowings from the Bank) +$ 1 billion

Loans

+$10 billion Chequable Deposits

+$10 billion

23. If the Bank of Canada reduces reserves by selling $5 million worth of bonds to the banks, what will the T-account of the banking system look like when the banking system is in equilibrium? What will have happened to the level of chequable deposits?

Chequable deposits will decrease by $50 million when the banking system is in equilibrium (as a result of the $5 million decrease in reserves supporting the money supply). The Taccount is shown below: Banking System Assets

Liabilities

Reserves

−$ 5 million Chequable Deposits −$50 million

Securities

+$ 5 million

Loans

−$50 million

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24. If the Bank of Canada sells $1 million of bonds and banks reduce their borrowings from the Bank by $1 million, predict what will happen to the money supply.

The Bank of Canada’s sale of $1 million of bonds shrinks the monetary base by $1 million, and the reduction of borrowing from the Bank of Canada lowers the monetary base by another $1 million. The resulting $2 million decline in the monetary base leads to a decline in the money supply.

25. Suppose that currency in circulation is $600 billion, the amount of chequable deposits is $900 billion, and excess reserves are $15 billion. a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.

The money supply is given as M = C + D = $600 billion + $900 billion = $1500 billion; c = C/D = 600/900 = 0.667; e = ER/D = 15/900 = 0.017; m = (1 + c)/(rD + e + c) = 1.667/0.783 = 2.13. b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1400 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.

The monetary base will increase to $600 + $90 + $15 + $1400 = $2105 billion; given the money multiplier calculated in part (a), this implies the money supply should increase to $2105  2.13 = $4483.65 billion. c. Suppose the central bank conducts the same open market purchase as in part (b) except that banks choose to hold all these proceeds as excess reserves rather than loan them out due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

ER = $1415 billion; e = $1415/$900 = 1.57; m = (1 + 0.667)/(0.1 + 1.57 + 0.667) = 0.71.

The money supply is still $1500 billion since both currency and deposits have not changed. d. During the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below one for most of the time from October 2008 through 2011. How does this scenario relate to your answer to part (c)?

The results from part (c) demonstrate that if large amounts of reserves enter the banking system but are held as excess reserves, it is possible for the money multiplier to fall below one.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM webpage, and find monthly data (from January 1968 to December 2020) on the monetary base (series V37145), M1++ gross (series V37152), and M2++ gross (series V41552801). a. What is the average M1++ growth rate? Its variance?

The monthly average M1++ growth rate is 0.70, and its variance is 0.54. b. What is the average M2++ growth rate? Its variance?

The monthly average M2++ growth rate is 0.73, and its variance is 0.15. c. Which monetary aggregate is more variable?

The M1++ aggregate is more volatile; it has a higher variance than the M2++ aggregate. d. Calculate the M1++ money multiplier. What is its average value?

The average value of the M1++ money multiplier is 8.75. e. Calculate the M2++ money multiplier. What is its average value?

The average value of the M2++ money multiplier is 22.13. f. Compare the two money multipliers.

The M2++ money multiplier is larger than the M1++ money multiplier. g. Does it appear that the money multipliers are increasing or decreasing?

Both multipliers are increasing over time, as can be seen in the following figure. There is a big decline during the coronavirus pandemic.

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40 35 30 M1++ Multiplier M2++ Multiplier

25 20

15 10 5

2014-01

2012-01

2010-01

2008-01

2006-01

2004-01

2002-01

2000-01

1998-01

1996-01

1994-01

1992-01

1990-01

1988-01

1986-01

1984-01

1982-01

1980-01

1978-01

1976-01

1974-01

1972-01

1970-01

1968-01

0

M1++ and M2++ Money Multipliers M1++ and M2++ Money Multipliers 40 35 30 25

20 15 10 5 0 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 M1++ Multiplier

.

M2++ Multiplier

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2. Go to the St. Louis Federal Reserve FRED database, and find the most current data available on Currency (CURRNS), Total Checkable Deposits (TCDNS), and Excess Reserves (EXCSRESNS). a. Calculate the value of the currency deposit ratio c. c = CURRNS/TCDNS = 1857.0/3355.9 = 0.55 as of June 2020. b. Calculate the value of the excess reserve ratio e. e = EXCSRESNS/TCDNS = $3043.556/3355.9 = 0.907. c. Assuming a required reserve ratio rr of 11%, calculate the value of the money multiplier m.

Given the data above, m = 1.55/[0.55 + 0.907 + 0.11] = 0.99.

3. Go to the St. Louis Federal Reserve FRED database and find data on the M1 Money Stock (M1SL) and the Monetary Base (BOGMBASE). a. Calculate the value of the money multiplier using the most recent data available and the data from five years prior.

The money multiplier for June 2020 is 5210.0/5002.0 = 1.04; for June 2015 the multiplier is 3020.4/3919.6 = 0.77. b. Based on your answer to part (a), how much would a $100 million open market purchase of securities affect the M1 money supply today and five years ago?

The $100 million open market purchase of securities will increase the monetary base by $100 million, and would hypothetically increase the M1 money supply by 1.04  $100 million = $104 million in June 2020, and the same open market operation would result in 0.77  $100 million = $77 million increase in M1 in June 2015.

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Chapter 16: Tools of Monetary Policy Chapter Overview and Teaching Tips Chapter 16 examines in detail the tools at the Bank of Canada’s (and the Fed’s and the European Central Bank’s) disposal for conducting monetary policy. To fully understand how these tools are used in the conduct of monetary policy, this chapter shows how they affect the overnight interest rate directly. Students are introduced to the nitty gritty of how the Bank of Canada wields these tools and are exposed to current debates on whether Bank of Canada policymaking could be made more effective by altering their use of these tools.

To keep the material in this chapter from being too descriptive, we have started the chapter with an analytic analysis of how Bank of Canada actions influence the overnight funds rate. This analysis reflects the changes in the Bank’s operation of its standing liquidity facilities. The chapter also includes an application on the channel/corridor approach for setting interest rates also used by other countries. Teaching this application encourages students to use their economic intuition to understand the tools of monetary policy better.

One topic that frequently does not get enough attention in money and banking courses is the lender-of-last-resort function of central banks. We feel this function should be stressed in class, because students find it inherently interesting in the wake of the recent massive operations by the Bank of Canada and other central banks around the world during the global financial and coronavirus crises. Students particularly like to hear about real-world examples of central bank lending to avoid banking and financial panics.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. If government deposits at the Bank of Canada are predicted to increase, what open market operations could be undertaken to neutralize the effect on settlement balances?

The increase in government deposits at the Bank of Canada will reduce bank settlement balances. To counteract this effect, the manager will undertake a defensive open market purchase.

2. During the holiday season, when the public’s holdings of currency increase, what open market operations typically occur? Why? When the public’s holdings of currency increases during holiday periods, the currency– chequable deposits ratio increases and the money supply falls. To counteract this decline in the money supply, the Bank of Canada will conduct a defensive open market purchase of securities.

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3. If the government has just paid for major computer upgrades and as a result its deposits with the Bank of Canada fall, what open market operations could be undertaken?

When the government’s deposits at the Bank of Canada fall, the monetary base increases. To counteract this increase, the manager would undertake an open market sale.

4. “In the LVTS environment, government deposit shifting is effected by auctions of government balances.” Discuss.

In the pre-LVTS system, government deposit shifting was effected by the Bank’s daily cash setting. In the LVTS environment, however, the cash-setting mechanism is not a practical tool for government deposit shifting. Morning and afternoon auctions of government term deposits are used to effect the transfer.

5. Most open market operations are currently repurchase agreements. What does this tell us about the likely volume of open market operations relative to dynamic open market operations?

It suggests that defensive open market operations are far more common than dynamic operations because repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the monetary base.

6. “The only way that the Bank of Canada can affect the level of advances is by adjusting the bank rate.” Is this statement true, false, or uncertain? Explain your answer.

False. Adjustments in the bank rate do not affect the level of advances in the current Canadian institutional framework within which monetary policy is conducted. This statement would be true for the Federal Reserve in the United States, however. In fact, the Fed can also affect the level of discount loans by directly limiting the amount of discount loans an individual bank can have.

7. If the Bank of Canada did not administer the operating band, what do you predict would happen to the money supply if the bank rate were several percentage points below the overnight rate?

The monetary base and the money supply would increase indefinitely. Banks could borrow at the lower bank rate and then lend the proceeds at a higher interest rate. Hence banks would make a profit on every dollar borrowed from the Bank of Canada, so they would continue to borrow indefinitely, which would in turn increase the monetary base indefinitely.

8. Discuss how the operating band affects interest rates and the money supply in the economy.

A rise in the operating band increases short-term interest rates in the economy. This reduces the monetary base and the money supply. On the other hand, a fall in the operating band decreases short-term interest rates and increases the monetary base and the money supply.

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9. “Last-resort lending is no longer needed because the presence of the CDIC eliminates the possibility of bank panics.” Is this statement true, false, or uncertain?

This statement is incorrect. The CDIC would not be effective in eliminating bank panics without central bank lending to troubled banks in order to keep bank failures from spreading.

10. The benefits of using last-resort lending to prevent bank panics are straightforward. What are the costs?

The costs are that banks that deserve to go out of business because of poor management may survive because of Bank of Canada lending to prevent panics. This might lead to an inefficient banking system with many poorly run banks.

11. You often read in the newspaper that the Bank of Canada has just lowered the target overnight rate. Does this signal that the Bank is moving to a more expansionary monetary policy? Why or why not?

Usually yes, since declines in the bank rate occur because the operating band for the overnight rate has been lowered.

12. How can the procyclical movement of interest rates (rising during business-cycle expansions and falling during business-cycle contractions) lead to a procyclical movement in the money supply as a result of the Bank of Canada’s lending policy? Why might this movement of the money supply be undesirable?

When interest rates rise during a boom, the spread between market interest rates and the bank rate usually rises and the level of Bank of Canada advances increases. The result is a rise in the monetary base and the money supply during a boom. Similarly, during a recession, when interest rates rise, the level of Bank of Canada lending falls, which reduces the monetary base.

13. Explain how SPRAs and SRAs affect the overnight rate.

In a repo, the Bank of Canada buys government of Canada securities from participants with an agreement to resell them on the next business day. The Bank pays for the repos by crediting the participant’s account at the Bank, thereby increasing settlement balances. This increase in settlement balances puts downward pressure on the overnight interest rate, as banks would have to borrow less to meet their settlement requirements. In a reverse repo, the Bank of Canada sells government of Canada securities with an agreement to buy them back on the next day. When the bank of Canada sells these securities, it debits the participant’s account at the Bank, thereby reducing settlement balances. The reduction in settlement balances puts upward pressure on the overnight rate, as banks would have to borrow more to meet their settlement requirements.

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14. “The channel/corridor system for setting interest rates enables the Bank of Canada to set the overnight rate whatever the demand for reserves, including zero demand.” Discuss.

The channel/corridor system for setting the overnight funds rate enables the Bank of Canada to use its standing liquidity facilities and set the overnight rate of interest irrespective of the demand for reserves.

15. Compare the use of open market operations and government deposits shifting to control the money supply, using the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Open market operations are more flexible, reversible, and faster to implement than the other tools.

16. Following the global financial crisis in 2008, assets on the Federal Reserve’s balance sheet increased dramatically, from approximately $800 billion at the end of 2007 to over $4 trillion today. Many of the assets held are longer-term securities acquired through various loan programs instituted as a result of the crisis. In this situation, how could reverse repos (matched sale–purchase transactions) help the Fed reduce its assets held in an orderly fashion while reducing potential inflationary problems in the future?

Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public. But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer-maturity securities can be drawn off the balance sheet of the Fed. 17. What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the zero lower bound?

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer-term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: if credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion.

18. Why is the composition of the central bank’s balance sheet a potentially important aspect of monetary policy during an economic crisis?

By purchasing particular types of securities, the central bank can affect interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision of liquidity where it may be needed the most (as opposed to typical open .

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market purchases, which add reserves to the general banking system). For example, as a result of the global financial crisis, central banks purchased a significant amount of mortgage-backed securities from government-sponsored enterprises, which helped to lower mortgage rates and support the housing market.

19. What is the main advantage and the main disadvantage of an unconditional policy commitment?

The main advantage of an unconditional policy commitment is that it provides a significant amount of transparency and certainty, which makes it easier for markets and households to make decisions about the future. The main disadvantage is that it represents a tacit commitment by the central bank; if conditions suddenly change where a change in the policy stance may be warranted, then holding to the commitment could be destabilizing. On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and the central bank could lose significant credibility.

20. How do the monetary policy tools of the European System of Central Banks compare to the monetary policy tools of the Fed? Does the ECB have a discount lending facility? Does the ECB pay banks an interest rate on their deposits?

In general, the set of monetary policy tools available to the ECB is quite similar to the one at the Fed’s disposal. The ECB has a discount lending facility, called the marginal lending facility, that is ready to supply funds to member banks at the marginal lending rate. This rate also acts as a ceiling for the overnight market rate, as the discount rate does in the United States. The ECB pays bank members an interest rate for their deposits at the ECB, thereby creating a floor for the overnight rate, as the Fed does in the United States.

21. What is the main rationale behind paying negative interest rates to banks for keeping their deposits at central banks in Sweden, Switzerland, and Japan? What could happen to these economies if banks decide to loan their excess reserves but no good investment opportunities exist?

The main rationale is to motivate banks to convert their excess reserves into required or desired reserves, depending on the country. If banks decide to loan their excess reserves when the investment opportunities are not good, they might be making risky investments.

22. In early 2016, as the Bank of Japan began to push policy interest rates negative, there was a sharp increase in home sales in Japan. Why might this be, and what does it mean for the effectiveness of negative interest rate policy?

Negative policy interest rates have the effect of making deposit rates at banks negative. Thus, people can avoid negative returns on holding cash by simply pulling their money out of deposit accounts and keeping the cash in safes (with a zero return). This has two main implications for the effectiveness of negative interest rate policy. First, it has the potential side effect of decreasing liquidity in the banking sector as depositors pull their money from banks. This can destabilize the banking system and reduce the amount of money in the banking system available for lending. Second, the intended effect of negative interest rates is

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to penalize saving in the form of deposits and thereby encourage consumption and borrowing, which can help stimulate the economy. However, if depositors are simply pulling their deposits and instead holding them as cash in safes, it does not increase spending and create the intended stimulus.

ANSWERS TO APPLIED PROBLEMS 23. If a switch occurs from deposits into currency, what happens to the overnight interest rate?

Use the supply and demand analysis of the market for reserves to explain your answer.

The switch from deposits into currency lowers the amount of reserves in the T-accounts and this lowers the supply of reserves at any given interest rate, thus shifting the supply curve to the left. The fall in deposits also leads to lower desired reserves and a shift in the demand curve to the left. However, because the fall in desired reserves is only a fraction of the fall in the supply of reserves (because the desired reserve ratio is much less than one), the supply curve shifts left by more than the demand curve. Thus, the overnight interest rate will rise (as shown in the graph below).

Overnight Funds Rate

RS

ib

ior2 ior1 RD

NBR2 NBR1

R

24. Using the supply and demand analysis of the market for reserves in the United States, indicate what happens to the federal funds rate, borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations. a. The economy is surprisingly strong, leading to an increase in the amount of chequable deposits.

A rise in chequable deposits leads to a rise in required reserves at any given interest rate and thus shifts the demand curve to the right. If the federal funds rate is initially below the discount rate, this then leads to a rise in the federal funds rate. As shown below,

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borrowed reserves and non-borrowed reserves do not change. If the federal funds rate is initially at the discount rate, then the federal funds rate will just remain at the discount rate, but borrowed reserves will increase.

b. Banks expect an unusually large increase in withdrawals from chequing deposit accounts in the future.

If banks expect that an unusually large increase in withdrawals will occur in the future, they will want to hold more excess reserves today, meaning the demand for reserves will increase at any given interest rate. This will have the same effect on the federal funds rate, NBR, and BR as in part (a) above. c. The Fed raises the target federal funds rate.

To raise the target federal funds rate, the Fed will have to conduct an open market sale of securities, which will shift the supply of non-borrowed reserves to the left. The federal funds rate will increase, and as long as the equilibrium federal funds rate remains below the discount rate, borrowed reserves will remain the same.

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d. The Fed raises the interest rate on reserves above the current equilibrium federal funds rate.

Raising the interest rate on reserves above the current federal funds rate means that the floor of reserve demand will push the equilibrium federal funds rate up along with the interest rate on reserves. Both borrowed reserves and non-borrowed reserves will remain the same.

e. The Fed reduces reserve requirements.

A decrease in required reserves shifts the demand for reserves line to the left at any given interest rate. The result is that the federal funds rate decreases, and NBR and BR remain unchanged.

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f. The Fed reduces reserve requirements and then offsets this action by conducting an open market sale of securities.

With the decrease in required reserves, this reduces reserve demand as shown in part (e) above. This will decrease the equilibrium federal funds rate. In order to sterilize the effects and keep the federal funds rate unchanged, the Fed will conduct an open market sale of securities, shifting the reserve supply line to the left. The end result is that the federal funds rate and borrowed reserves will be unchanged, and non-borrowed reserves will decrease.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and download daily data, from January 1, 1997 to February 6, 2021, for the bank rate (series V39078) and the target overnight rate (series V39079). a. What is the difference between the two series?

The difference is 25 basis points, since the bank rate is 25 basis points higher than the policy rate (that is, the target overnight interest rate). b. Calculate the upper and lower bounds of the operating band. What does the time path of the operating band say about the easiness of monetary policy over this period?

A declining operating band for the overnight interest rate (and thus a declining policy rate) does not necessarily imply that monetary policy was easy.

2. Go to the St. Louis Federal Reserve FRED database, and find data on nonborrowed reserves (NONBORRES) and the federal funds rate (FEDFUNDS). a. Calculate the percent change in nonborrowed reserves and the percentage point change in the federal funds rate for the most recent month of data available and for the same month a year earlier.

From June 2019 to June 2020, nonborrowed reserves increased by $1,344,656 million, or 84.0% and the federal funds rate decreased from 2.38% to 0.08%, or a decrease of 230 basis points. b. Is your answer to part (a) consistent with what you expect from the market for reserves?

Why or why not?

Nonborrowed reserves increased significantly over the one-year period, while the federal funds rate decreased significantly. This is generally consistent with what you would expect in the market for reserves: as the supply of nonborrowed reserves decreases, the federal funds rate should increase (similar to what is shown in Figure 2, panel (a)). However, given the current ample reserves monetary policy environment, and that the federal funds rate is near the interest rate on excess reserves, it is more likely that decreases in the interest rate on excess reserves are decreasing the federal funds rate (the opposite of what is shown in Figure 5, panel (b)), rather than increases in nonborrowed reserves.

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Solutions to Chapter 16 Mini-Case Quantitative Easing, Bank Reserves, and Inflation 1. Assuming that Bank B cannot raise new deposits quickly or obtain a similar loan from another bank, the bank will have to reduce its loans by $40. The cutback in lending by Bank B will reduce total deposits, because those who borrowed from the bank will scramble for funds to repay their loans. The decline in loans and deposits will lead to a contraction in the level of economic activity.

2. The central bank can react to this freeze in interbank lending by lending $40 directly to Bank B. It does so by crediting the bank’s settlement balances (reserves) with the central bank. Bank B can then use these funds to repay Bank A. In this case, there would be no reduction in lending by Bank B and no contraction in economic activity. The balance sheets of the two banks will look as follows.

Bank A Assets Reserves Loans Securities

Bank B Liabilities

50 Deposits 50 10 Capital

100 10

Assets Reserves Loans Securities

Liabilities 10 Deposits 130 Due to Central Bank 10 Capital

100 40 10

Thus, the central bank’s lending is highly effective, as it promotes lending by preventing Bank B from having to reduce its lending (to households and businesses). However, while loans and deposits are unchanged, total bank reserves increase from $20 to $60, as Bank A now holds as reserves the funds that it previously lent to Bank B. Thus, a by-product of the central bank’s intervention and lending to banks during a financial crisis is the creation of excess reserves.

3. During normal times, the opportunity cost of holding excess reserves (the revenue forgone by banks when they do not lend out their reserves) is positive, either because bank reserves earn no interest, or if they do, the interest rate is less than the market interest rate. In this case, banks will increase lending and expand deposits until excess reserves are converted into desired (or required) reserves. The money supply will increase (as the money multiplier will be fully operational), the level of economic activity will rise, and this may generate inflation.

However, when the central bank pays interest on bank reserves at its target interest rate, the opportunity cost of holding reserves is zero. In this case, banks have no incentives to lend out their excess reserves, and multiple deposit creation does not come into play (that is, the money multiplier fails); the level of economic activity will not rise, and this will not generate inflation.

Therefore, by paying interest on bank reserves, the central bank can follow a path for market interest rates that is independent of the quantity of reserves.

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This is exactly what the Federal Reserve did in October 2008. For the first time in its history, the Fed began paying interest on bank reserves and in fact set that interest rate equal to its target for the federal funds rate in order to reduce the opportunity cost of holding excess reserves close to zero. From April 1, 2009, to June 1, 2010, the Bank of Canada also lowered the band for the overnight interest rate from 50 basis points to 25 basis points (from ¼% to ½%), and instead of targeting ior at the midpoint of the band (as it does during normal times), it started targeting ior at the bottom of the operating band. On June 1, 2010, the Bank of Canada re-established the normal operating band of 50 basis points for the overnight interest rate, ior, currently being from ¾% to 1¼%.

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Chapter 17: The Conduct of Monetary Policy: Strategy and Tactics Chapter Overview and Teaching Tips Chapter 17 outlines the goals, strategies, and tactics of central bank policymaking. It starts by laying out modern theories of central banking: It first discusses the price stability goal and the role of a nominal anchor in solving the time-inconsistency problem, and then discusses the other goals of monetary policy and why price stability is now viewed as the primary goal of monetary policy.

The time-inconsistency problem is one of the most important ideas in monetary theory in the last thirty years. We illustrate the time-inconsistency problem in class by using the example of how many people cannot stick to a diet even though they know this is the right thing for them to do in the long run. Many other examples can bring this idea home to the student. Another good example is the fact that it is optimal not to give in to children when they are behaving badly, but parents still have a tendency to renege on this optimal plan. A third example is that governments usually provide funds to rebuild in coastal areas after a hurricane, even though it is not optimal to build in areas that are likely to be ravaged by hurricanes. You might ask the students to think of other examples in order to hammer home this important idea.

The chapter then goes on to discuss two monetary policy strategies. The first is inflation targeting, which involves announcement of an inflation target objective, with a commitment by the central bank to achieve it. There is an additional monetary policy strategy that central banks used in the past, but not currently—monetary targeting. For those instructors who would like to cover this material, we have provided an appendix to Chapter 17 found in MyLab Economics that covers monetary targeting. We have found that discussing the pros and cons of different monetary policy strategies piques students’ interest. One teaching technique is to have students debate which strategy is best.

The chapter concludes the discussion of monetary policy strategy first, with a section on lessons from the global financial crisis. Then it discusses a particularly hot topic in central banking circles after the crisis, the debate on how central banks should respond to asset-price bubbles.

Asset-price bubbles are particularly interesting to students because they involve huge booms in asset prices and then crashes, which are very dramatic. The issue of what should be done about asset-price bubbles is very controversial, and so one way of teaching this material is to stage a debate in class with two opposing views: that central banks should not respond at all, which is the position associated with Alan Greenspan, or alternatively, that monetary policy should try to pre-emptively prick bubbles.

The chapter then moves on to discuss monetary policy tactics: in particular, what policy instrument should be chosen to conduct monetary policy. Figures 17-3 and 17-4 illustrate why targeting on a monetary aggregate like nonborrowed reserves implies a loss of control of interest rates like the overnight interest rate, while targeting on the overnight interest rate implies a loss of control of monetary aggregates. This analysis can also be done in terms of the supply and demand for money framework. Indeed, covering this topic is an excellent way of providing .

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students with another application to give them practice with the supply and demand analysis for the market for reserves or the market for money.

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

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What are the benefits of using a nominal anchor for the conduct of monetary policy?

A nominal anchor helps promote price stability by tying inflation expectations to low levels directly through its constraint on the value of money. It can also limit the time-inconsistency problem by providing an expected constraint on monetary policy.

2. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy?

Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy even though in the long run this just leads to higher inflation with no gains to increasing output or lowering unemployment. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies.

3. Why would it be problematic for a central bank to have a primary goal of maximizing economic growth?

This could pose a problem for a couple reasons. First of all, monetary policy has limited ability to encourage long-run economic growth other than through its ability to maintain low, stable, long-run inflation and interest rates. Moreover, a strictly interpreted focus on economic growth may result in an unhealthy focus on keeping short-term interest rates low for a prolonged period of time to raise investment and consumption in the near term. This

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could lead to imbalances in the economy that, if not properly addressed, could lead to bubbles and financial crises.

4. “Since financial crises can impart severe damage to the economy, a central bank’s primary goal should be to ensure stability in financial markets.” Is this statement true, false, or uncertain? Explain.

Uncertain. Most economists probably would not dispute that trying to maintain stability in financial markets is important to the economy. However, having a constant and prioritized focus on financial market stability in order to prevent crises in most cases is probably unnecessary since financial crises are generally pretty rare. In addition, constantly focusing on maintaining stability in financial markets could come at the expense of ignoring more important factors that can be far more costly to the economy on a day-to-day basis, such as stabilizing output, unemployment, or other related short-term movements in the business cycle.

5. “A central bank with a dual mandate will achieve lower unemployment in the long run than a central bank with a hierarchical mandate in which price stability takes precedence.” Is this statement true, false, or uncertain? Explain.

False. There is no long-run trade-off between inflation and unemployment, so in the long run a central bank with a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no more success at reducing unemployment than one whose primary goal is price stability.

6. Why is a public announcement of numerical inflation rate objectives important to the success of an inflation-targeting central bank?

The success of inflation targeting relies on its ability to credibly anchor inflation expectations at a low, desirable level. Without formal public announcements and reminders about the numerical inflation target, markets and the public may have less faith that policymakers are committed to maintaining the inflation target. And if a formal inflation target is not announced at all, market participants and the public may not know the exact target and be forced to infer or estimate the target, creating uncertainty that can raise inflation expectations and unanchor inflation expectations from a low, desirable level.

7. How does inflation targeting help reduce the time-inconsistency problem of discretionary policy?

Inflation targeting increases the accountability of monetary policymakers and is a mechanism of self-discipline that effectively ties the hands of policymakers to commit to a policy path.

Because of the transparency of an inflation-targeting framework, it is very easy to verify whether policymakers are faithful to a committed policy path. As a result, there is much less ability and incentive for policymakers to deviate to a discretionary policy that could increase output or raise the inflation rate, therefore mitigating the time-inconsistency problem.

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8. What methods have inflation-targeting central banks used to increase communication with the public and to increase the transparency of monetary policymaking?

Inflation-targeting central banks engage in extensive public information campaigns that include the distribution of glossy brochures, the publication of Inflation Report–type documents, making speeches to the public, and continual communication with the elected government.

9. Why might inflation targeting increase support for the independence of the central bank in conducting monetary policy?

Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined inflation target can be instrumental in building public support for a central bank’s independence and for its policies. Also, inflation targeting is consistent with democratic principles because the central bank is more accountable.

10. “Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations.” Is this statement true, false, or uncertain? Explain.

False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targeters do worry about output fluctuations, and inflation targeting may even be able to reduce output fluctuations because it allows monetary policymakers to respond more aggressively to declines in demand because they don’t have to worry that the resulting expansionary monetary policy will lead to a sharp rise in inflation expectations.

11. What are the key advantages and disadvantages of the monetary strategy recently used by the Federal Reserve, in which the nominal anchor is only implicit?

This strategy has the following advantages: (a) it enables monetary policy to focus on domestic considerations; (b) underscoring the importance of price stability has helped it to mitigate the time-inconsistency problem; and (c) it has had a demonstrated success, producing low inflation with the longest business-cycle expansion since World War II. However, it has the following disadvantages: (a) it is strongly dependent on the preferences, skills, and trustworthiness of individuals in the central bank and the government; and (b) it has some inconsistencies with democratic principles because the central bank is not highly accountable.

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12. “The effective lower bound on short-term interest rates is not a problem, since the central bank can just use quantitative easing to lower intermediate and longer-term interest rates instead.” Is this statement true, false, or uncertain? Explain.

False. Although it is true that quantitative easing and other types of nonconventional policy can be used once the zero lower bound is reached on short-term interest rates, it is not a panacea. In particular, when the economy reaches the zero lower bound, this often can be coupled with deflationary conditions, which can be hard to design effective policies for, since the outcomes from such policies are much more uncertain than conventional interest rate policy under typical conditions. In addition, nonconventional policies such as quantitative easing are more complex to implement, so it may be harder to effectively use these programs to push the economy away from the zero lower bound.

13. If higher inflation is bad, then why might it be advantageous to have a higher inflation target rather than a lower target that is closer to zero?

The zero lower bound on nominal interest rates makes it harder to implement expansionary policy as actual inflation (and hence short-term interest rates) fall closer to zero. As a result, there is less room to use monetary policy as a stabilization tool in a low-inflation environment. In this context, it is argued that a higher inflation target may be appropriate to give policymakers more flexibility. The downside of this, of course, is that in general higher inflation rates can be costly to society, posing a trade-off for monetary policymakers in terms of flexibility versus efficiency of monetary policy.

14. Why might macroprudential regulation be more effective in managing asset-price bubbles than monetary policy?

There are several reasons why monetary policy may not be effective in eliminating assetprice bubbles. The main reason is that asset-price bubbles are extremely difficult to identify in real time; in many cases, by the time there is a consensus among policymakers and the public that a bubble exists, it is usually too late to implement policies to effectively deflate the bubble. And even if an asset-price bubble is identified in a timely manner, monetary policy is often thought of as too blunt an instrument to be able to deal effectively with most asset-price bubbles. In particular, interest rate changes may have some modest short-term effects on reducing the asset-price bubble, but the interest rate changes may have far more consequential effects on real economic activity and cause far worse collateral damage. Thus, because of the limitations of monetary policy, proactively identifying potential problems in advance and implementing safeguards in the banking and financial system can provide a more targeted and effective backstop against bubbles than monetary policy can.

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15. Why might it be better to lean against credit-driven bubbles rather than just clean up after other types of asset bubbles burst?

In general, the question of appropriate policy response is one of minimizing loss. Creditdriven bubbles (such as the housing bubble experience that resulted in the global financial crisis) can be far more devastating to the economy if a crash occurs than if policymakers acted to reduce the size of the bubble pre-emptively. In other words, raising interest rates to try to reduce the bubble may cause collateral damage to the economy, but it would result in far less damage than would presumably occur if nothing were done at all and the bubble were allowed to continue to build. On the other hand, non-credit-driven bubbles can more easily be dealt with after a crash; since financial markets generally function relatively normally following these types of bubble crashes, conventional monetary policy can be relatively effective at mitigating any recessionary conditions in the aftermath. Acting pre-emptively to address the bubble is likely to cause more collateral damage than is inflicted by any downturn related to a non-credit-driven bubble crashing.

16. According to the Greenspan doctrine, under what conditions might a central bank respond to a perceived stock market bubble?

Because a stock market bubble may be hard to identify (at least through consensus) and policy could cause more damage than necessary, in general Greenspan would advocate not acting directly on the stock market bubble. However, insofar as the stock market bubble raised wealth and increased consumption and investment, raising interest rates would be seen as prudent in order to maintain low, stable inflation and minimize near-term output fluctuations as a result of the higher wealth. In other words, the Greenspan doctrine would say not to act directly on the bubble but to pursue policy as normal to maintain price stability and stability in real economic activity.

17. Classify each of the following as either a policy instrument or an intermediate target, and explain your choice. a. The 10-year Canada bond rate The 10-year bond is an intermediate target because it is not directly affected by the tools of the Bank of Canada but is linked to economic activity. b. The monetary base The monetary base is a policy instrument because it can be directly affected by the tools of the Fed and is only linked to economic activity through its effect on the money supply. c. M1+ M1+ is an intermediate target because it is not directly affected by the tools of the Bank of Canada and has some direct effect on economic activity. d. The overnight interest rate The overnight interest rate is a policy instrument because the tools of the Bank of Canada can directly affect it.

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18. “If the demand for reserves did not fluctuate, the Bank of Canada could pursue both a reserves target and an interest-rate target at the same time.” Is this statement true, false, or uncertain? Explain.

True. In such a world, hitting a reserves target would mean that the Bank of Canada would also hit its interest-rate target or vice versa. Thus the Bank of Canada could pursue both a reserves target and an interest-rate target at the same time, but only if there were no variation in reserve demand.

19. What procedures can the Bank of Canada use to control the overnight interest rate? Why does control of this interest rate imply that the Bank will lose control of nonborrowed reserves?

The Bank of Canada can control the overnight interest rate by buying and selling bonds in the open market. When the overnight interest rate rises above the target level, the Bank would buy bonds, which would increase nonborrowed reserves and lower the interest rate to its target level. Similarly, when the overnight interest rate falls below the target level, the Bank would sell bonds to raise the interest rate to the target level. The resulting open market operations would of course affect the quantity of reserves and the money supply and cause them to change. The Bank of Canada would be giving up control of reserves and the money supply to pursue its interest-rate target.

20. Compare the monetary base to M1+ on the grounds of controllability and measurability.

Which do you prefer as an intermediate target? Why? The monetary base is more controllable than M1+ because the tools of the Bank of Canada more directly influence it. It is measured more accurately and quickly than M1+ because the Bank can calculate the base from its own balance sheet data, while it constructs M1+ numbers from surveys of banks, which take some time to collect and are not always that accurate. Even though the base is a better intermediate target on the grounds of measurability and controllability, it is not necessarily a better intermediate target because its link to economic activity may be weaker than that between M1+ and economic activity.

21. “Interest rates can be measured more accurately and quickly than reserve aggregates; hence an interest rate is preferred to the reserve aggregates as a policy instrument.” Do you agree or disagree? Explain your answer.

Disagree. Although nominal interest rates are measured more accurately and more quickly than reserve aggregates, the interest-rate variable that is of more concern to policymakers is the real interest rate. Because the measurement of real interest rates requires estimates of expected inflation, it is not true that real interest rates are necessarily measured more accurately and more quickly than reserves. Interest-rate targets are therefore not necessarily better than reserve targets.

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22. How can forward guidance as a tool of the central bank affect the policy instrument, intermediate targets, and goals?

There are two main channels by which forward guidance can ultimately affect goal variables.

First off, the central bank can communicate information about the expected path of future short-term interest rates (policy instrument). This can affect intermediate targets such as longer-term interest rates. Thus changes in borrowing costs such as longer-term interest rates can affect economic activity and ultimately other related goals, such as price or exchange rate stability. The second channel is through the expected holdings of reserves; as the central bank communicates about the expected path of its asset holdings, this affects the expected reserve aggregates (policy instrument), which then can affect short-term and long-term interest rates (intermediate targets) and similarly affect goal variables.

23. What does the Taylor rule imply that policymakers should do to the overnight interest rate under the following scenarios? a. Unemployment rises due to a recession.

If unemployment rises, this would lower the output gap and trigger a lower overnight interest rate according to the Taylor rule. b. An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%.

If inflation rises by 1%, this alone would prompt the overnight interest rate to rise by 1.5 percentage points. The decrease in the output gap alone would imply the overnight interest rate would fall by 0.5 percentage points. Thus, the two factors together imply a net effect of increasing the overnight interest rate by one percentage point according to the Taylor rule. c. The economy experiences prolonged increases in productivity growth while actual output growth is unchanged.

Prolonged increases in productivity growth would increase potential output, and with the same rate of actual output growth, this would cause the output gap to decline, resulting in a decline in the overnight interest rate according to the Taylor rule. d. Potential output declines while actual output remains unchanged.

If potential output declines, this is the opposite of (c) above, so the overnight interest rate would rise according to the Taylor rule. e. The Bank of Canada revises its inflation target downward.

If the inflation target is revised downward, this would increase the inflation gap at any given inflation rate. This would result in a higher overnight interest rate according to the Taylor rule. f. The equilibrium real overnight interest rate decreases.

If the equilibrium real overnight interest rate decreases, all else equal, the Taylor rule would prescribe a decrease in the nominal overnight interest rate. .

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ANSWERS TO APPLIED PROBLEMS 24. If the Bank of Canada has an interest-rate target, why will an increase in the demand for reserves lead to a rise in the money supply? Use a graph of the market for reserves to explain.

An increase in the demand for reserves will raise the overnight interest rate. In order to maintain the interest rate target, the Bank will buy bonds, thereby increasing the amount of nonborrowed reserves, which shifts the supply curve for reserves to the right, thereby keeping the overnight interest rate from rising, as shown below. The open market purchase will then cause the monetary base and the money supply to rise.

25. Since monetary policy changes made through the overnight interest rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate rather than the current inflation rate. In light of this, suppose that monetary policymakers employ the Taylor rule to set the overnight interest rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the inflation and output gaps are ½, the equilibrium real overnight interest rate is 2%, the inflation rate target is 2%, and the output gap is 1%. a. If the expected inflation rate is 4%, then at what target should the overnight interest rate be set according to the Taylor rule?

Assuming the output gap and all other parameters remain constant, the Taylor rule is ior = e + 2 + 0.5(e – 2) + 0.5 (1) , where e is expected inflation. Thus, if e = 4%, then the overnight interest rate should be set to 4 + 2 + 0.5(2) + 0.5 = 7.5%.

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b. Suppose half of Bank of Canada economists forecast inflation to be 3%, and half of Bank economists forecast inflation to be 5%. If the Bank of Canada uses the average of these two forecasts as its measure of expected inflation, then at what target should the overnight interest rate be set according to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then e = 0.5 (3% + 5%) = 4%. In this case, again the Taylor rule would imply a setting of the overnight interest rate of 7.5%. c. Now suppose half of Bank of Canada economists forecast inflation to be 0%, and half forecast inflation to be 8%. If the Bank uses the average of these two forecasts as its measure of expected inflation, then at what target should the overnight interest rate be set according to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then e = 0.5 (0% + 8%) = 4%. In this case, again the Taylor rule would imply a setting of the overnight interest rate of 7.5%. d. Given your answers to parts (a)–(c) above, do you think it is a good idea for monetary policymakers to use a strict interpretation of the Taylor rule as a basis for setting policy?

Why or why not?

Probably not. In the situation in part (a), it is assumed that there is very little uncertainty about what inflation will be, thus a Taylor rule approach to policy may work fine.

However, in (b) and (c), there is clearly more uncertainty about the state of the economy, and therefore having a mechanical rule to dictate policy without accounting for this uncertainty could be problematic. For instance, in part (c), if future inflation actually turned out to be closer to 0%, the Taylor rule policy may prove to be too tight and could push the economy into a deflationary situation. This example highlights why judgment and discretion in interpreting data are important parts of the monetary policy process.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Bank of Canada’s website, and find inflation data (under “Statistics,” then “Key Monetary Policy Variables”) based on total CPI and core CPI-trim. a. What was the 12-month growth rate for each of total CPI and core CPI-trim in December 2020?

The 12-month growth rate of total CPI was 0.7% and that of core CPI-trim was 1.6%. b. How do the inflation rates in (a) compare to the inflation target?

The inflation target range is from 1% to 3%, with 2% being regarded as the most desirable inflation rate. Thus, the inflation rate based on the total CPI was close to the lower limit of the inflation target band.

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2. Go to the Bank of Canada’s website, and find quarterly data (under “Indicators of Capacity and Inflation Pressures for Canada”) on the output gap and the unemployment rate. a. For the fourth quarter of 2020, is the output gap positive or negative?

It is negative, –5.8. b. Is the unemployment rate increasing or decreasing over the 2019 to 2020 period?

It is increasing. It was 8.7% in the fourth quarter of 2020.

3. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), real GDP (GDPC1), an estimate of potential GDP (GDPPOT), and the federal funds rate (FEDFUNDS). For the price index, adjust the units setting to “Percent Change From Year Ago” to convert the data to the inflation rate; for the federal funds rate, change the frequency setting to “Quarterly.”

Download the data into a spreadsheet. Assuming the inflation target is 2% and the equilibrium real fed funds rate is 2%, calculate the inflation gap and the output gap for each quarter, from 2000 until the most recent quarter of data available. Calculate the output gap as the percentage deviation of output from the potential level of output. a. Use the output and inflation gaps to calculate, for each quarter, the fed funds rate predicted by the Taylor rule. Assume that the weights on inflation stabilization and output stabilization are both ½ (see the formula in the chapter). Compare the current (quarterly average) federal funds rate to the federal funds rate prescribed by the Taylor rule. Does the Taylor rule accurately predict the current rate? Briefly comment.

For the most recent period in 2020:Q2, the federal funds rate is 0.06%, while the Taylor rule predicts –3.34%, underrepresenting actual policy by a gap of 3.4 percentage points.

Compared to other significant deviations, this is a fairly large departure from the baseline Taylor rule. b. Create a graph that compares the predicted Taylor rule values with the actual quarterly federal funds rate averages. How well, in general, does the Taylor rule prediction fit the average federal funds rate? Briefly explain.

See the graph below. The Taylor rule since 2000 has periods in which they are fairly closely correlated, particularly from 2000 to 2002. However, there are significant gaps in other times, or periods in which they do not seem to move together, such as the period from 2002 to 2006. From 2008 onward, there are significant differences between the two, particularly the period late in 2008 through 2010, in which the Taylor rule predicts the federal funds rate should be negative by as much as almost –4%, which is not possible.

It also predicted a significant rise in the federal funds rate in 2011, which did not materialize, and generally speaking, the post-crisis Taylor rule has significantly overprescribed the actual fed funds rate. The coronavirus pandemic period beginning in 2020 created sharp declines in the actual fed funds rate and Taylor rule implied rate. c. Based on the results from the 2008–2009 period, explain the limitations of the Taylor rule as a formal policy tool. How do these limitations help explain the use of nonconventional monetary policy during this period?

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Since the Federal funds rate was at the effective lower bound during that time, conventional monetary policy through adjustments in the federal funds rate was not possible, and highlights a limitation of the Taylor rule: under ‟normal” conditions the Taylor rule provides a good approximation to appropriate federal funds rate policy.

However in extreme situations such as the financial crisis period and the coronavirus pandemic period, the Taylor rule is less useful, since other (nonconventional) monetary policy tools are needed to achieve stimulus. d. Suppose Congress changes the Fed’s mandate to a hierarchical one in which inflation stabilization takes priority over output stabilization. In this context, recalculate the predicted Taylor rule value for each quarter since 2000, assuming that the weight on inflation stabilization is ¾ and the weight on output stabilization is ¼. Create a graph showing the Taylor rule prediction calculated in part (a), the prediction using new “hierarchical” Taylor rule, and the fed funds rate. How, if at all, does changing the mandate change the predicted policy paths? How would the fed funds rate be affected by a hierarchical mandate? Briefly explain.

See the graph below. For the most part, the baseline Taylor rule and the hierarchical Taylor rule predict nearly the same federal funds paths. The only significant deviations are from 2008 to 2014, where the hierarchical version predicts a significantly higher federal funds rate due to the inflation spike during that time. And from about 2010 to 2014, it implied a federal funds rate around 2%, which is much higher than during that time and what the baseline rule predicts, and the actual fed funds rate was. For the most recent period of 2020:Q2, under such a hierarchical Taylor rule, the federal funds rate would be predicted to be about –1.1%, much lower than the current 0.06%. e. Assume again equal weights of ½ on inflation and output stabilization, and suppose instead that beginning after the end of 2008, the equilibrium real fed funds rate declines by 0.05 each quarter (i.e., 2009:Q1 is 1.95, then 1.90, etc.), and once it reaches zero, it remains at zero thereafter. How does it affect the prescribed fed funds rate? Why might this be important for policymakers to take into consideration?

A decline in the equilibrium real fed funds rate has the effect of reducing the implied Taylor rule fed funds rate lower. In fact, under this policy rule, it would have implied the fed funds rate to be negative during 2015, which also coincided with a period of low inflation. Of all three of the variations, the declining equilibrium real rate rule is the closest to the actual path of the fed funds rate since the financial crisis period. This may help explain why the actual path of the fed funds rate was lower than standard Taylor rules would imply. Moreover, if the real equilibrium fed funds rate did decline, but was not taken into account (for instance, by using the baseline rule in part (a)), this would imply that monetary policy would be overly contractionary. The graph below shows the distinction between the baseline Taylor rule and the declining natural rate Taylor rule.

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Chapter 18: The Foreign Exchange Market Chapter Overview and Teaching Tips Chapter 18 explains behaviour in the foreign exchange market by using a modern asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in the literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in money and banking textbooks.

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

The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea that must be transmitted to the student is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets.

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

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

In teaching our classes, we again describe a recent news report on the foreign exchange markets and then conduct a case discussion using the analysis developed in the chapter. The case discussion is always very lively and the students love it.

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Suppose that you are considering going on vacation abroad and that the euro has appreciated by 15% with respect to the Canadian dollar. Would you be more or less willing to visit Rome and Paris?

Assuming you have to buy euros with Canadian dollars before you travel or that you use a credit card that automatically converts euros into Canadian dollars at the new exchange rate, you would be less willing to visit Rome and Paris, since goods and services will be 15% more expensive for you and your family.

2. “A country is always worse off when its currency is weak (falls in value).” Is this statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy.

3. When the Canadian dollar depreciates, what happens to exports and imports in Canada?

Canadian dollar depreciation makes Canadian domestic goods cheaper, thus both domestic and foreign consumers buy more Canadian-produced goods. At the same time, imported goods become more expensive since they require more dollars per foreign currency to purchase. Thus, Canadian exports will increase and imports into Canada will decrease.

4. If the Japanese price level rises by 5% relative to the price level in Canada, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

It predicts that the value of the yen will fall 5% in terms of dollars.

5. If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will the country’s currency tend to appreciate or depreciate in the long run?

In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain.

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6. When the Bank of Canada conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets?

The money supply increases, but this has an insignificant effect on the supply of dollar assets. Since dollar currency is a small part of total Canadian dollar–denominated assets, changes in the money supply are relatively small and therefore do not shift the supply curve.

7. From 2009 to 2011, the economies of Australia and Switzerland suffered relatively mild effects from the global financial crisis. At the same time, many countries in the euro area were hit hard by high unemployment and burdened with unsustainably high government debts. How should this have affected the euro/Swiss franc and euro/Australian dollar exchange rates?

This would reduce the demand for euro-denominated assets, resulting in a depreciation of the euro and an appreciation of the Swiss franc and Australian dollar.

8. In the mid- to late 1970s, the yen appreciated in value relative to the U.S. dollar, even though Japan’s inflation rate was higher than the United States’. How can this be explained by improvements in the productivity of Japanese industry relative to American industry?

Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese to continue to sell their goods at a profit at a high value of the yen.

9. Suppose the governor of the Bank of Canada announces a new set of reforms that includes a new anti-inflation program. Assuming the announcement is believed by the public, what will happen to the exchange rate on the Canadian dollar?

The dollar will appreciate. Because expected Canadian inflation falls as a result of the announcement, there will be an expected appreciation of the dollar and so the expected return on dollar assets will rise. As a result, the demand curve will shift to the right, and the equilibrium value of the dollar will rise.

10. If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now, what will happen to the value of the Indian rupee today?

The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for rupee-denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises.

11. If nominal interest rates in Canada rise but real interest rates fall, predict what will happen to the Canadian dollar exchange rate.

The dollar will depreciate. A rise in nominal interest rates but a decline in the real rate implies a rise in expected inflation that produces an expected depreciation of the dollar that is larger than the increase in the domestic interest rate. As a result, the expected return on dollar assets falls at any exchange rate, shifting the demand curve to the left and leading to a fall in the exchange rate. .

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12. If American auto companies make a breakthrough in automobile technology and are able to produce a car that gets 200 miles to the gallon, what will happen to the U.S. dollar exchange rate?

The dollar will appreciate. The increase in U.S. productivity raises the expected future exchange rate and thus raises the expected return on dollar assets at any exchange rate. The resulting rightward shift of the demand curve leads to a rise in the equilibrium exchange rate.

13. If Mexicans go on a spending spree and buy twice as much French perfume and twice as many Japanese TVs, English sweaters, Swiss watches, and bottles of Italian wine, what will happen to the value of the Mexican peso?

The peso will depreciate. Consider Mexico to be the domestic country. An increased demand for imports would lower the expected future exchange rate and result in a lower expected appreciation of the peso. The resulting lower expected return on peso assets at any given exchange rate would then shift the demand curve to the left, leading to a fall in the peso exchange rate.

14. Through the summer and fall of 2008, as the global financial crisis began to take hold, international financial institutions and sovereign wealth funds significantly increased their purchases of U.S. Treasury securities as a safe haven investment. How should this have affected U.S. dollar exchange rates?

This should (and did) lead to a sharp appreciation of the dollar relative to many other currencies. The strong demand for U.S. Treasuries led to a rise in the demand for U.S. dollar–denominated assets during this time, hence appreciating the dollar.

15. In September 2012, the Federal Reserve announced a large-scale asset-purchase program (known as QE3) designed to lower intermediate and longer-term interest rates. What effect should this have had on the U.S. dollar/euro exchange rate?

This should have led to a depreciation of the U.S. dollar.

16. On June 23, 2016, voters in the United Kingdom voted to leave the European Union. From June 16 to June 23, 2016, the exchange rate between the British pound and the dollar increased from 1.41 U.S. dollars per pound to 1.48 U.S. dollars per pound. What can you say about market expectations regarding the result of the referendum?

As noted in the text, a vote to leave the European Union would lower future U.K. exports and thus lead to a lower long-run value of the British pound. The fact that the British pound rose in value prior to the vote suggests that the markets believed that the probability of an exit vote was declining, thus leading to a higher long-run value of the British pound than previously expected.

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ANSWERS TO APPLIED PROBLEMS 17. A German sports car is selling for 70 000 euros. What is the dollar price in Canada of the German car if the exchange rate is 0.90 euro per dollar?

70 000 euros  ($1/0.90 euros) = $77 777.78.

18. If the Canadian dollar to U.S. dollar exchange rate is 1.28 and the British pound to U.S. dollar exchange rate is 0.62, what must be the Canadian dollar to British pound exchange rate?

Spot exchange rate = 1.28 CAD/$  ($1/£0.62) = 2.0645 Canadian dollars/pound 19. The New Zealand dollar to U.S. dollar exchange rate is 1.36, and the British pound to U.S. dollar exchange rate is 0.62. If you find that the British pound to New Zealand dollar is trading at 0.49, what can you do to earn a riskless profit?

Complete the following transactions simultaneously: i. Exchange $1.00 into 1.36 New Zealand dollars. ii. Exchange the 1.36 New Zealand dollars into 0.6664 British pounds. iii. Exchange the 0.6664 British pounds into $1.0748.

This yields a riskless $0.0748 per U.S. dollar invested.

20. In 1999, the euro was trading at US$0.90 per euro. If the euro is now trading at US$1.16 per euro, what is the percentage change in the euro’s value? Is this an appreciation or a depreciation? % Change = (1.16 – 0.90)/0.90 = 28.88%. The euro has appreciated by 28.88%.

21. The Mexican peso is trading at 10 pesos per dollar. If the expected U.S. inflation rate is 2% while the expected Mexican inflation rate is 23% over the next year, given PPP, what is the expected exchange rate in one year?

Expected exchange rate = 10  (1.23/1.02) = 12.059 pesos per dollar.

22. If the price level recently increased by 20% in England while falling by 5% in Canada, by how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.55 pound per Canadian dollar.

Expected exchange rate = 10  (1.23/1.02) = 12.059 pesos per Canadian dollar.

For Problems 23–25, use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.

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23. If expected inflation drops in Europe so that interest rates fall there, what will happen to the exchange rate on the Canadian dollar?

The Canadian dollar will depreciate.

24. If the European Central Bank decides to pursue a contractionary monetary policy to fight inflation, what will happen to the value of the Canadian dollar?

The dollar will depreciate. The drop of expected inflation in Europe, which leads to a decline in the foreign interest rate (which is smaller than the drop in expected inflation) leads to a decline in the relative expected return on dollar assets, because the expected euro appreciation is greater than the decline in the foreign interest rate. The result of the decline in the relative expected return on dollar assets is a leftward shift of the demand curve, and the equilibrium dollar exchange rate falls. The graph is shown below.

25. If a strike takes place in France, making it harder to buy French goods, what will happen to the value of the Canadian dollar?

The contractionary policy will increase European interest rates and raise the future value of the euro, both of which will decrease the relative expected return on dollar assets. The demand curve will then shift to the left, and the dollar will depreciate. The graph is shown below.

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Consider France to be the domestic country. Because it is harder to get French goods, people will buy more foreign goods, and the value of the euro in the future will fall. The expected depreciation of the euro lowers the expected return on euro assets at any exchange rate, so the demand for euros declines and the demand for dollars shifts to the right, as shown in the graph below. Thus, the dollar will appreciate.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the exchange rate of U.S. dollars per British pound (DEXUSUK). A Mini Cooper can be purchased in London, England, for £17,865 or in Boston, United States, for $23,495. a. Use the most recent exchange rate available to calculate the real exchange rate of the London Mini per Boston Mini.

According to the exchange rate for July 31, 2020, the real exchange rate is $1.3133/£  [£17,865/London mini]/[$23,495/Boston mini] = 0.9986 Boston mini/London mini, or 1.001 London mini/Boston mini. b. Based on your answer to part (a), are Mini Coopers relatively more expensive in Boston or in London?

Since you can buy 1.001 minis in London for every one purchased in Boston, they are slightly relatively less expensive in London. c. What price in British pounds would make the Mini Cooper equally expensive in both locations, all else being equal?

If the real exchange rate equaled 1, this would imply 1 Boston mini/London mini = $1.31334/£  [X/London mini]/[$23,495/Boston mini]; solving for X yields a price of £17,890.05 for a London mini.

2. Go to the St. Louis Federal Reserve FRED database and find data on the daily dollar exchange rates for the euro (DEXUSEU), British pound (DEXUSUK), and Japanese yen (DEXJPUS). Also find data on the daily three-month London Interbank Offer Rate, or LIBOR, for the United States dollar (USD3MTD156N), euro (EUR3MTD156N), British pound (GBP3MTD156N), and Japanese yen ( JPY3MTD156N). LIBOR is a measure of interest rates denominated in each country’s respective currency.

31-Jul-20 31-Jul-19

USD LIBOR 0.24875 2.26563

EUR LIBOR −0.44471 −0.41971

GBP LIBOR 0.08438 0.77263

JPY LIBOR −0.05517 −0.07333

31-Jul-20 31-Jul-19 One Year Change

USD-EUR LIBOR 0.69346 2.68534 −1.99188

USD-GBP LIBOR 0.16437 1.49300 −1.32863

USD-JPY LIBOR 0.30392 2.33896 −2.03504

USD per EUR 1.1822 1.1130 EUR appreciated

USD per GBP 1.3133 1.2220 GBP appreciated

JPY per USD 105.78 108.58 JPY appreciated

31-Jul-20 31-Jul-19

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a. Calculate the difference between the LIBOR rate in the United States and the LIBOR rates in the three other countries using the data from one year ago and the most recent data available.

See the table above for data from July 31, 2020. b. Based on the changes in interest rate differentials, do you expect the dollar to depreciate or appreciate against the other currencies?

All three LIBOR rates for the euro currency area, United Kingdom, and Japan all increased relative to LIBOR rates in the United States. Thus, you would expect all three currencies should appreciate relative to the U.S. dollar. c. Report the percentage change in the exchange rates over the past year. Are the results you predicted in part (b) consistent with the actual exchange rate behavior?

See the table above. The British pound, the euro, and Japanese yen all appreciated according to prediction.

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Solutions to Chapter 18 Mini-Case The Foreign Exchange Market and Financial Derivatives 1.

View the monthly Canadian dollar per U.S. dollar exchange rate series. a. The fundamental determinants of exchange rates are purchasing power parity and interest rate parity. b. A foreign exchange rate can be quoted as the domestic currency value of one unit of domestic currency ($/euro) or as the foreign currency value of one unit of domestic currency (euro/$). In the text, the latter exchange rate quotation convention is used. c. Spot exchange rates pertain to transactions in the foreign exchange market that take two business days to complete. Forward exchange rates pertain to transactions that will occur at a designated date in the future. d. In December 2020, the Canadian dollar depreciated against the U.S. dollar.

2.

You are short 10 million Japanese yen. a. The foreign exchange risk is that the yen will appreciate, in which case you would need more dollars to come up with the 10 million yen one year from now. b. If you use forwards or futures to eliminate the foreign exchange risk, you will have to buy one-year forward Japanese yen, thereby locking in an exchange rate and eliminating the risk that the yen will appreciate. If you use options, a call option will protect against a rise in the value of the yen. If you use a currency swap, you would have to swap yen for dollars. In all cases, of course, you forego the opportunity to benefit from a depreciation of the yen. c. In a currency swap there is an exchange of both interest payments and principal. In an interest rate swap only interest payments are exchanged.

3.

In general, there are two types of foreign exchange options: options on the foreign exchange and options on foreign exchange futures contracts. a. When you buy a call, the maximum loss is the call premium, whereas when you write a put, the maximum gain is the put premium. b. Over long periods of time, a lot can happen to even a very low-volatility asset. Because of this, the premiums will be higher for the option with the longer time to maturity. c. Because deep-in-the-money options are not worthless when they expire, it would make sense for such options to expire unexercised.

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Chapter 19: The International Financial System Chapter Overview and Teaching Tips Chapter 19 shows why international financial transactions have important implications for the conduct of monetary policy. The beginning of the chapter explains how foreign exchange market intervention affects the exchange rate, a country’s international reserves, and the money supply.

It then discusses the balance of payments, but this sometimes-dry topic can be spiced up for students by a discussion of the box on why large current account deficits worry economists.

The chapter then goes on to discuss the evolution of the international financial system and how fixed exchange rate systems work. Two applications in this section make the material come alive for students. The first examines the September 1992 foreign exchange crisis and recent foreign exchange crises in emerging market countries. This application captures the imagination of students because huge profits were made during this crisis and because government intervention in the markets was massive. The second examines how China has accumulated over $4 trillion of international reserves, a subject of great interest to students. These applications also give students further practice with the model of the foreign exchange market developed in Chapter 18.

The currency and financial crises in recent years have caused policymakers throughout the world to focus on how the architecture of the international financial system might be reformed in order to limit the threat of financial crises. Concerns about international financial architecture have led to a lively debate, to say the least, about the role of the International Monetary Fund and capital controls. We use the discussion in the text on these subjects to stimulate a lively debate among the students, which gets them to realize that what happens outside Canada is still of tremendous importance to us. The next section on international considerations and monetary policy explains how international financial transactions and movements in the exchange rate can affect monetary policy, and this material is closely related to the discussion in Chapter 17 about the conduct of monetary policy.

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. If the Bank of Canada sells dollars in the foreign exchange market but conducts an offsetting open market operation to sterilize the intervention, what will be the effect on international reserves, the money supply, and the exchange rate?

The sale of dollars involves a purchase of foreign assets, which means that both international reserves, the monetary base, and the money supply increase. However, the offsetting open market sale means that the monetary base and the money supply will remain unchanged.

There is thus no change in the domestic interest rate and therefore in the expected return on dollar assets, so the demand curve does not shift, and the exchange rate also remains unchanged.

2. If the Bank of Canada buys dollars in the foreign exchange market but does not sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

The purchase of dollars involves a sale of foreign assets, which means that international reserves fall and the monetary base decreases. The resulting fall in the money supply causes interest rates to rise and lowers the future price level, thereby raising the future expected exchange rate. Both of these effects raise the expected return on dollar assets at any given exchange rate, shifting the demand curve to the right and raising the equilibrium exchange rate.

3. For each of the following, identify whether they increase or decrease the current account balance: a. A Canadian citizen’s purchase of an airline ticket from Air France Decrease b. A Japanese citizen’s purchase of California oranges Increase c. Sending $50 million of foreign aid to Honduras Decrease d. A worker in Toronto who sends money to his parents in Mexico Decrease e. The services a Canadian accounting firm provides to a German firm Increase

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4. Suppose that you travel to Cali (Colombia), where the exchange rate is 1 Canadian dollar to 2900 Colombian pesos. As you enter a McDonald’s restaurant, you realize you need 17 400 Colombian pesos to buy a Big Mac. Assuming a Big Mac sells for $5 in Canada, would you say that the Colombian peso is over- or undervalued in terms of PPP? Since the exchange rate is 1 Canadian dollar to 2900 COP (Colombian pesos), a Big Mac should sell for 14 500 COP if it has the same CA$5 cost as in Canada. However, a Big Mac sells for more than that, indicating that currently the COP is overvalued in terms of PPP because the Big Mac is more expensive in Columbia at the current exchange rate.

5. Refer to the previous exercise. Which type of foreign market intervention must the central bank of Colombia conduct to keep the exchange rate at a level where the currency is not under- or overvalued in terms of PPP? To eliminate the overvaluation in terms of PPP, the exchange rate for the Columbian peso needs to decline. The central bank of Colombia should undertake an unsterilized foreign market intervention in which it will sell the domestic currency (COP) and buy foreign reserves in order to increase reserves of its banking system, decrease the domestic interest rate, and shift the expected return on domestic currency denominated assets curve to the left.

6. What would be the effect of a devaluation on a country’s imports and exports? If a country imports most of the goods included in the basket of goods and services used to calculate the CPI, what do you think the effect will be on this country’s inflation rate?

When a country devalues its currency, the fixed exchange rate is set at a lower level, meaning that the central bank will no longer exchange domestic currency at the previous (higher) exchange rate. This means that foreigners with the same amount of foreign currency can get more units of domestic currency, thereby making that country’s exports cheaper for them, leading to an increase in the country’s exports. On the other hand, domestic buyers of foreign products now need more units of domestic currency to buy the same amount of foreign currency, so imports become more expensive, and imports will decrease. If many of the goods that are taken into consideration to measure the cost of living are imported, then the cost of living (as measured by the percentage change in the CPI) will most probably increase after the devaluation.

7. Under the gold standard, if Britain became more productive relative to Canada, what would happen to the money supply in the two countries? Why would the changes in the money supply help preserve a fixed exchange rate between Canada and Britain?

The increase in British productivity would create a tendency for the pound to appreciate relative to the dollar. The higher value of the pound would now cause Canadians to exchange dollars for gold, ship the gold to Britain, and then buy British pounds with the gold. The result is that British holdings of gold (international reserves) would increase, which would raise the money supply because the monetary base would increase. The higher British money supply would then tend to lower the exchange rate back down to its par level because it would cause the price level to rise, which would lead to a depreciation of the pound.

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8. What is the exchange rate between dollars and Swiss francs if one dollar is convertible into 1/20 ounce of gold and one Swiss franc is convertible into 1/40 ounce of gold?

Two francs per dollar.

9. “Inflation is not possible under the gold standard.” Is this statement true, false, or uncertain? Explain your answer.

False. Inflation occurred when the world was under the gold standard before World War I. The gold discoveries in the Klondike and South Africa before World War I led to a continuing increase in the quantity of gold, which caused a more rapid growth in money supplies throughout the world. The result was worldwide inflation.

10. What are some of the disadvantages of China’s pegging the yuan to the dollar?

There are several disadvantages to China’s exchange rate strategy. First, diversification is a problem in that the Chinese own a very large amount of U.S. assets, including low-yielding U.S. Treasuries. Secondly, it has created a backlash among trading countries that have threatened trade sanctions due to the cheap prices of Chinese exports due to the low yuan peg. Finally, having the undervalued yuan has resulted in the central bank selling large amounts of yuan currency and raising the domestic Chinese monetary base and money supply, which has the potential to create high inflation in the future.

11. If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange rate regime, what kind of intervention would that country’s central bank be forced to undertake, and what effect would the intervention have on the country’s international reserves and money supply?

The situation would be as depicted in Figure 19-2, Panel (b). The central bank would need to sell domestic currency and buy foreign assets, thus increasing its international reserves and the monetary base. The resulting rise in the money supply would then lead to a decline in the domestic interest rate, which would shift demand for domestic assets to the left so that the equilibrium exchange rate would be at par.

12. Why might a country that is suffering a recession not want to intervene in the foreign exchange market if its currency is overvalued? Assume this country participates in a fixed exchange rate regime.

When a country is engaged in a fixed exchange rate regime, it has a commitment to intervene in the foreign exchange market to maintain the system of fixed exchange rates. However, the combination of a recession and an overvalued currency is quite complicated to solve. The required unsterilized foreign exchange market intervention implies buying the domestic currency, decreasing reserves of the banking system, and thereby increasing the domestic interest rate. This increase in domestic interest rates negatively affects the economy, reducing credit and expenditure on durable goods. This is why countries engaged in fixed exchange rate regimes were sometimes reluctant to intervene in the foreign exchange market.

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13. “If a country wants to keep its exchange rate from changing, it must give up some control over its monetary policy.” Is this statement true, false, or uncertain? Explain your answer.

True, because when the exchange rate is falling, the central bank must buy its currency, which lowers its holdings of international reserves and its monetary base. Similarly, when the exchange rate is rising, it must sell its currency, which raises its holdings of international reserves and its monetary base. The necessary central bank intervention to keep its exchange rate fixed thus affects the monetary base and hence the money supply and interest rates.

14. Why is it that in a pure, flexible exchange rate system, the foreign exchange market has no direct effect on the money supply? Does this mean that the foreign exchange market has no effect on monetary policy?

There are no direct effects on the money supply because there is no central bank intervention in a pure flexible exchange rate regime; therefore, changes in international reserves that affect the monetary base do not occur. However, monetary policy can be affected by the foreign exchange market because monetary authorities may want to manipulate exchange rates by changing the money supply and interest rates.

15. Why did the exchange-rate peg lead to difficulties for the countries in the ERM after the German reunification?

German reunification produced tight monetary policy in Germany to limit inflation, which raised interest rates for the other ERM countries because their currencies were pegged to the German mark. The high interest rates then slowed economic growth and increased unemployment in the other countries.

16. How can exchange-rate targets lead to a speculative attack on a currency?

With a pegged exchange rate, speculators are sometimes presented with a one-way bet in which the only direction for a currency to go is down in value when a country’s central bank is unable or unwilling to defend the currency’s value. In this case, selling the currency before the likely depreciation gives speculators an attractive profit opportunity with potentially high expected returns. As a result, they jump on board and attack the currency.

17. The IMF does not enjoy a great reputation in many countries that were recipients of IMF loans or bailouts. Explain why many citizens were not happy with the role played by the IMF. In general, IMF loans provided to help countries cope with either financial or currency crises were accompanied by various conditions. These conditions usually meant that recipient governments should increase taxes, increase the domestic interest rate, and reduce expenditures, thereby making the downturns that these economies were facing even worse.

On top of this, the recovery of the recessions created by financial or currency crises were usually very severe, and countries saw their social cohesion badly affected. Eventually, real GDP per capita started to increase again, but it took a long time for this to occur.

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18. How can the long-term bond market help reduce the time-inconsistency problem for monetary policy? Can the foreign exchange market also perform this role?

The long-term bond market can help reduce the time-inconsistency problem because politicians and central banks will realize that pursuing an overly expansionary policy will lead to an inflation scare in which inflation expectations surge, interest rates rise, and there is a sharp fall in long-term bond prices. Similarly, they will realize that overly expansionary monetary policy will result in a sharp fall in the value of the currency. Avoiding these outcomes constrains policymakers and politicians, so time-inconsistent monetary policy is less likely to occur.

19. What are the key advantages of exchange-rate targeting as a monetary policy strategy?

First, the exchange-rate target directly keeps inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country to which its currency is pegged. Second, it provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem. Third, it has the advantage of simplicity and clarity.

20. When is exchange-rate targeting likely to be a sensible strategy for industrialized countries?

When is exchange-rate targeting likely to be a sensible strategy for emerging market countries?

Exchange rate targeting is likely to be a sensible strategy for industrialized countries when domestic monetary and political institutions are not conducive to good monetary policymaking and when there are other important benefits of an exchange rate target that have nothing to do with monetary policy. Exchange rate targeting is likely to be sensible for emerging market countries whose political and monetary institutions are weak so that it is the only way to break inflationary psychology and stabilize the economy.

ANSWERS TO APPLIED PROBLEMS 21. Calculate the overvaluation of the Thai baht (THB) if you can get 34.6 THB per Canadian dollar at the exchange counter, but a lunch menu that costs 25 Canadian dollars in Montréal sells for 948.25 THB in Bangkok.

The implicit exchange rate is 25 Canadian dollars to 948.25 THB, or CA$1 to 37.93 THB. Using the THB as the domestic currency, the exchange rate is 0.0289 = 1/34.6, and the implicit exchange rate is 0.02636 = 1/37.93. The THB is thereby [(0.0289 / 0.02636) ‒ 1] × 100 = 9.64% overvalued.

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22. Suppose the Bank of Canada purchases $1 million worth of foreign assets. a. If the Bank of Canada purchases the foreign assets with $1 million in currency, show the effect of this open market operation, using T-accounts. What happens to the monetary base?

The Bank’s assets increase by $1 million, and it increases currency in circulation by $1 million. This results in the monetary base increasing by $1 million.

Bank of Canada Assets Foreign assets (international reserves)

Liabilities +$1 million

Currency in circulation

+$1 million

b. If the Bank of Canada purchases the foreign assets by selling $1 million in T-bills, show the effect of this open market operation, using T-accounts. What happens to the monetary base?

The Bank’s assets increase by the increased foreign assets, but this is offset by a decrease in T-bill holdings of the same amount. Overall, the Bank’s assets are unchanged, and its liabilities and hence the monetary base are also unchanged.

Bank of Canada Assets

Liabilities

Foreign assets (international reserves)

+$1 million

Government bonds

–$1 million

Currency in circulation

23. Suppose the Mexican central bank chooses to peg the peso to the U.S. dollar and commits to a fixed peso/dollar exchange rate. Use a graph of the market for peso assets (foreign exchange) to show and explain how the peg must be maintained if a shock in the U.S. economy forces the Fed to pursue contractionary monetary policy. What does this say about the ability of central banks to address domestic economic problems while maintaining a pegged exchange rate?

An increase in U.S. interest rates as a result of the contractionary monetary policy will increase the demand for dollar assets and reduce the demand for peso assets from D1 to D2, which will appreciate the dollar and depreciate the peso. This results in the peso being valued below the peg; in order to maintain the peg, the Mexican central bank must increase domestic interest rates by selling foreign assets and buying domestic peso currency. This results in the demand for peso assets increasing back up to D1 as shown in the graph below. This demonstrates one of the main disadvantages to pegging the domestic currency in that domestic monetary policy in the pegging country is dependent on foreign business cycles, meaning that there is no scope for domestic monetary policy stabilization. In this case, Mexico was forced to import a contractionary policy, which could create unexpected and undesirable contraction in the domestic economy. .

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Visit the Bank of Canada’s web site at www.bankofcanada.ca. Click on Statistics and then Exchange Rates. a. What is the Canadian effective exchange rate index (CEER)?

It is a weighted average of bilateral exchange rates against the Canada’s major trading partners. b. How many foreign currencies are included in the index?

It includes 17 foreign currencies.

2. Go to the St. Louis Federal Reserve FRED database, and find data on net exports (NETEXP), transfers (A123RC1Q027SBEA), and the current account balance (NETFI). a. Calculate net investment income for the most recent quarter available, and for the same quarter a year earlier.

See the table below. Net investment income is equal to the current account – transfers – net exports. b. Calculate the percentage change in the current account balance from the same quarter one year earlier. Which one of the three items making up the current account balance had the largest effect in percentage terms on the change of the current account? Which one had the smallest effect?

In percentage terms, the current account balance declined significantly (became more negative). Among the three items, net exports changed the most, decreasing by 19.7% (becoming more negative), while transfers changed the least, increasing by only 2.7%.

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2020:Q1 2019:Q1

Current Account Balance ($Bil.) −423.4 −532.0

Percent Change

−0.4

Transfers 316.7 308.4

Net Exports −494.3 −615.5

Net Investment Income −245.8 −224.9

2.7

−19.7



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3. Go to the St. Louis Federal Reserve FRED database and find data on the monthly U.S. dollar exchange rate to the Chinese yuan (EXCHUS), the Canadian dollar (EXCAUS), and the South Korean won (EXKOUS). Download the data into a spreadsheet. a. For the most recent five-year period of data available, use the average, max, min, and stdev functions in Excel to calculate the average, highest, and lowest exchange rate values, as well as the standard deviation of the exchange rate to the dollar (this is an absolute measure of the volatility of the exchange rate). b. Using the maximum and minimum values of each exchange rate over the last five years, calculate the ratio of the difference between the maximum and minimum values to the average level of the exchange rate (expressed as a percentage by multiplying by 100).

This value gives an indication of how tightly the exchange rate moves. Based on your results, which of the three countries is most likely to peg its currency to the U.S. dollar?

How does this country’s currency compare with the other two? c. Calculate the ratio of the standard deviation to the average exchange rate over the last five years (expressed as a percentage by multiplying by100). This value gives an indication of how volatile the exchange rate is. Based on your results, which of the three currencies is most likely to be pegged to the U.S. dollar? How does this currency compare with the other two? a. See table below for July 2015 to July 2020.

Average Maximum Minimum Standard Deviation

South Korean Won 1148.53 1228.13 1065.64 41.5

Chinese Yuan 6.73 7.11 6.30 0.24

Canadian Dollar 1.32 1.42 1.23 0.04

0.14 0.04

0.12 0.04

0.15 0.03

Max Min Difference/Average SD/Average

b. (b) See the table above. The Chinese yuan has a smaller band that it moves in relative to the average value; at only 12% of the average, this is slightly smaller than the South Korean won and the Canadian dollar bands that they fluctuated in over the last five years. Hence the Chinese yuan is the most likely to be pegged.

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c. The results are somewhat consistent with part (b) in that the fluctuations of all three currencies are somewhat similar, although Canada’s currency is slightly less volatile than China’s or South Korea’s.

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Chapter 20: Quantity Theory, Inflation, and the Demand for Money Chapter Overview and Teaching Tips Chapter 20 discusses two of the basic building blocks of monetary theory, the quantity theory of money and the demand for money, examining how these theories can explain inflation in the long run, This material is more appropriate for a course that emphasizes monetary theory, and many professors will prefer not to cover it. Later chapters do not depend on this material, so dropping it from your course will not hinder students’ ability to understand later chapters.

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

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

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

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. How would you expect velocity to typically behave over the course of the business cycle?

Since nominal GDP falls during recessions, and as a result expansionary monetary policy, which increases the money supply, is implemented, in most cases velocity will decline during recessions. During expansions, the money supply will be less expansionary, and nominal GDP will rise, typically leading to an increase in velocity.

2. If velocity and aggregate output are reasonably constant (as the classical economists believed), what will happen to the price level when the money supply increases from $1 trillion to $4 trillion?

The price level will quadruple.

3. If credit cards were made illegal by government legislation, what would happen to velocity?

Explain your answer.

Velocity would fall because a greater quantity of the money supply (M) would be needed to carry out the same level of transactions (PY); PY/M = V would then fall.

4. “If nominal GDP rises, velocity must rise.” Is this statement true, false, or uncertain?

Explain your answer.

False. Velocity is equal to nominal GDP divided by the money supply. If nominal GDP increases but the money supply increases by an even greater amount, velocity will decline.

5. Why would a central bank be concerned about persistent, long-term budget deficits?

Persistent long-term budget deficits can lead to the perception or worry that policymakers will satisfy the government budget constraint by monetizing the debt in the future, leading to large increases in the monetary base that would be highly inflationary. Even if the central bank has no intention of monetizing the debt, the belief or appearance that the central bank may do this will increase inflation expectations, making it harder for monetary policymakers to keep inflation anchored at a low, stable level.

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6. “Persistent budget deficits always lead to higher inflation.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. As long as a country (such as the United States) has reliable access to bond markets, and bond holders are willing to accept and hold Treasury debt, a country can continue to rely on borrowing to meet financial obligations. This relies on the perception that the government will be able to repay the debts in the future, and there is a low risk of default.

However, once bond holders believe that budget deficits have reached unsustainable levels, they may decide not to hold bonds anymore, and this could force the government to monetize the debt in order to meet financial obligations. In this case, higher inflation may result.

7. Why might a central bank choose to monetize the debt, knowing that it could lead to higher inflation?

If the government is running large deficits, this could lead to higher interest rates, which could be contractionary to the economy or be misaligned from the central bank’s optimal policy interest rate to the point where the central bank may want to reduce interest rates.

Thus, by purchasing bonds and monetizing the debt, even though it may be increasing the monetary base and raising inflation risk, it can be beneficial in reducing interest rates (or slowing the increase in interest rates) as a result of elevated debt issuance by the Treasury.

This is particularly useful in situations where output or employment goals may need to be prioritized over price-stability objectives.

8. Consider two central banks: one with a history of maintaining price stability and low inflation, and the other with a history of high inflation and poor inflation management. All else equal, if the same level of government budget deficit is monetized in both countries, how is inflation likely to behave in each country?

Central banks with a poor history of inflation management can easily experience an unanchoring of (or sharp increase in) inflation expectations. So if the monetary base increases by the same amount in both countries as a result of the monetization of the debt, it is likely that inflation will increase much more in the country with poor inflation management than the one with a history of price stability.

9. Some payment technologies require infrastructure (e.g., merchants need to have access to credit card swiping machines). In most developing countries, historically this infrastructure has either been nonexistent or very costly; however, recent mobile payment systems have expanded rapidly in developing countries as they have become cheaper. Everything else being equal, would you expect the transaction component of the demand for money to be increasing or decreasing in a developing country relative to a rich country?

In general, the need for costly infrastructure to support new payment technologies would mean that cash would be used more in developing countries relative to rich countries. As a result, the transactions demand for money would be large in comparison. However, with rapid improvements in mobile payments technology in developing countries, this would decrease the transactions demand for money relative to rich countries.

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10. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? On the basis of these motives, what variables did he think determined the demand for money?

The three motives are precautionary, speculative, and transactions motives. From these three motives, Keynes believed that money demand was positively related to income and negatively related to the nominal interest rate.

11. In many countries, people hold money as a cushion against unexpected needs arising from a variety of potential scenarios (e.g., banking crises, natural disasters, health problems, unemployment, etc.) that are not usually covered by insurance markets. Explain the effect of such behaviour on the precautionary component of the demand for money.

This would lead to an increase in demand for money through the precautionary motive.

12. Why is Keynes’s analysis of the speculative demand for money important to his view that velocity will undergo substantial fluctuations and thus cannot be treated as constant?

Because it indicates that money demand and hence velocity is affected by interest rates, and since interest rates fluctuate a lot, velocity will as well. Furthermore, as the answer to Question 11 suggests, changes in people’s expectations about what the normal level of interest rates are will cause money demand and hence velocity to fluctuate. Keynes’s analysis of the speculative demand for money thus suggests that velocity will be far from constant; rather, it will undergo substantial fluctuations.

13. According to the portfolio theories of money demand, what are the four factors that determine money demand? What changes in these factors can increase the demand for money?

The four factors determining money demand under portfolio theory are interest rates (decreases in interest rates increase money demand), wealth (higher wealth leads to higher money demand), risk of alternative assets (a higher risk of alternative assets increases money demand), and liquidity of other assets (a decrease in liquidity of alternative assets increases the demand for money).

14. Explain how the following events will affect the demand for money according to the portfolio theories of money demand: a. The economy experiences a business-cycle contraction.

Since risk of alternative assets increases, liquidity of alternative assets likely decreases, and interest rates likely will fall; this will lead to an increase in money demand. Note that even though wealth decreases, this will have a modest negative effect on money demand. b. Brokerage fees decline, making bond transactions cheaper.

Cheaper bond transactions make the bond market more liquid, leading to an increase in demand for bond holdings and hence a decrease in the demand for money.

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c. The stock market crashes. (Hint: Consider both the increase in stock price volatility following a market crash and the decrease in wealth of stockholders.)

The stock market crash would lead to higher volatility and hence risk in stocks, which would increase demand for money. The stock market crash would reduce wealth, but this would likely have a modest negative effect on money demand, leaving money demand overall higher.

15. Suppose a given country experienced low and stable inflation rates for quite some time, but then inflation picked up and over the past decade has been relatively high and quite unpredictable. Explain how this new inflationary environment would affect the demand for money according to portfolio theories of money demand. What would happen if the government decided to issue inflation-protected securities?

The demand for money would likely fall. Compared to other assets, money would be more risky, so people would rather hold more stable assets and less money. In addition, high and unpredictable inflation will result in very high interest rates, which would reduce money demand. If the government issues inflation-protected securities, then the demand for money would decrease further as an alternative to risky money holdings.

16. Consider the portfolio choice theory of money demand. How do you think the demand for money would be affected during a hyperinflation (i.e., monthly inflation rates in excess of 50%)?

The demand for money would decrease, similar to Question 15, but much more sharply.

Compared to other assets, money would be more risky, so people would rather hold more stable assets and less money. In addition, hyperinflation will result in very high interest rates, which would further reduce money demand.

17. Both the portfolio choice and Keynes’s theories of the demand for money suggest that as the relative expected return on money falls, demand for it will fall. Why does the portfolio choice approach predict that money demand is affected by changes in interest rates? Why did Keynes think that money demand is affected by changes in interest rates?

In Keynes’s view, a rise in interest rates leads to a lower relative expected return of money and hence a lower demand for money. In the portfolio choice view, a rise in interest rates leads to an increase in the implicit interest paid on chequable deposits, so the relative expected return of money only falls by a small amount. Hence, in the portfolio choice view, the demand for money changes little when interest rates rise.

18. Why does the Keynesian view of the demand for money suggest that velocity is unpredictable?

In Keynes’s view, velocity is unpredictable because interest rates, which have large fluctuations, affect the demand for money and hence velocity. In addition, Keynes’s analysis suggests that if people’s expectations of the normal level of interest rates change, the demand for money changes. Keynes thought that these expectations moved unpredictably, meaning that money demand and velocity are also unpredictable. .

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19. What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand, and how has this conclusion affected monetary policymaking?

Velocity is used to indicate if the money demand function is stable. If velocity is predictable and stable, then the money demand function is also stable and vice versa. Up until the early 1970s, the money demand function was stable, but after that, financial innovation made velocity relatively unpredictable and hence implied a more unstable money demand function.

Because of this, the Federal Reserve moved away from using the money supply as its main policy indicator and moved to interest rates as its main monetary policy indicator.

20. Suppose that a plot of the values of the money supply, M, and nominal GDP for a given country over 40 years shows that these two variables are very closely related. In particular, a plot of their ratio (nominal GDP/M) yields very stable and easy-to-predict values. On the basis of this evidence, would you recommend that the monetary authorities of this country conduct monetary policy by focusing mostly on the money supply rather than on setting interest rates? Explain.

This stable relationship implies that the velocity of the money supply is very stable, and hence money demand is relatively stable. In this case, adjusting the money supply would provide a tight link to aggregate spending so should be used in the conduct of monetary policy rather than interest rate adjustment.

ANSWERS TO APPLIED PROBLEMS 21. Suppose the money supply M has been growing at 10% per year, and nominal GDP, PY, has been growing at 20% per year. The data are as follows (in billions of dollars): 2021

2022

2023

M

100

110

121

PY

1000

1200

1440

Calculate the velocity for each year. At what rate is the velocity growing?

Velocity is approximately 10 in 2021, 10.9 in 2022, and 11.9 in 2023. The rate of velocity growth is approximately 9% per year.

22. Calculate what happens to nominal GDP if velocity remains constant at 5 and the money supply increases from $200 billion to $300 billion.

Nominal GDP increases from $1 trillion to $1.5 trillion.

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23. What happens to nominal GDP if the money supply grows by 20% but velocity declines by 30%?

Nominal GDP declines by approximately 10%.

24. If velocity and aggregate output remain constant at 5 and $1000 billion, respectively, what happens to the price level if the money supply declines from $400 billion to $300 billion?

The price level declines from 2 (= 2000/1000) to 1.5 (= 1500/1000).

25. Suppose the liquidity preference function is given by L(i, Y ) =

Y − 1000i 8

Use the money demand equation, along with the following table of values, to calculate the velocity for each period.

Period 1

Period 2 Period 3 Period 4 Period 5 Period 6 Period 7

Y (in billions)

12 000

12 500

12 250

12 500

12 800

13 000

13 200

Interest rate

0.05

0.07

0.03

0.05

0.07

0.04

0.06

Period 1

Period 2 Period 3 Period 4 Period 5 Period 6 Period 7

Y (in billions)

12 000

12 500

12 250

12 500

12 800

13 000

13 200

Interest Rate

0.05

0.07

0.03

0.05

0.07

0.04

0.06

L(i, Y)

1450

1492.5

1501.25

1512.5

1530

1585

1590

V = Y/L(i, Y)

8.28

8.38

8.16

8.26

8.37

8.20

8.30

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. The formula for computing the velocity of money is Y/(M/P), where Y is real GDP, M is a money supply measure, and P is the price level. Go to the St. Louis FRED database, and download quarterly Canadian data from 1981:Q1 to 2017:Q1 on the GDP deflator (series CANGDPDEFQISMEI) and M3 (series MABMM301CAQ189S). Also download nominal GDP from CANSIM (series V62295562).

Compute the velocity of M3 money in 2020:Q3, and compare it to its level in 1981:Q1. Has it risen or fallen?

The M3 velocity declined from 1.74 in 1981:Q1 to 0.75 in 2020:Q3. The decline is due to financial innovation.

2. Use the data from the previous exercise and also download the three-month T-bill rate (CANSIM series V122531). Run a regression of real money balances on a constant, real GDP, and the nominal interest rate. a. Comment on the fit of the regression.

The R2 is 0.941, which is quite high. b. What is the estimated income elasticity of the demand for real money balances? What is the estimated interest rate elasticity?

The income elasticity is 1.402, and the interest rate elasticity is -0.094. c. Are your estimates in (b) statistically significant?

They both are statistically significant with p-values less than 0.000. d. Is your evidence consistent with the Baumol-Tobin model or with the quantity theory of money?

The evidence is more consistent with the quantity theory of money.

3. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 Money Stock (M1SL), M1 Money Velocity (M1V), and Real GDP (GDPC1). Convert the M1SL data series to “Quarterly” using the frequency setting, and for all three series, use the “Percent Change from Year Ago” setting for units. a. Calculate the average percentage change in real GDP, the M1 money stock, and velocity since 2000:Q1.

From 2000:Q1 to 2020:Q2, average growth in real GDP is about 1.9%, average growth in velocity has been –2.5%, and the M1 money stock has grown about 6.9% per year. b. Based on your answer to part (a), calculate the average inflation rate since 2000 as predicted by the quantity theory of money.

Based on part (a), the average inflation rate should be about %ΔM + %ΔV – %ΔY = 6.9 – 2.5 – 1.9 = 2.5%.

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c. Next, find the data on the GDP deflator price index (GDPDEF), download the data using the ‟Percent Change from Year Ago” setting, and calculate the average inflation rate since 2000:Q1. Comment on the value relative to your answer in part (b).

Average inflation per year for the period using GDPDEF is 1.9%, which is lower than the implied inflation rate calculated above, so is not entirely consistent with the quantity theory of money.

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Chapter 21: The IS Curve Chapter Overview and Teaching Tips This chapter introduces the basic concept of aggregate demand and develops one of the key building blocks of the AD/AS model, the IS curve. The framework here is pretty conventional, first outlining the components of planned expenditure—consumption expenditure, planned investment spending, government purchases, and net exports. Then the chapter goes into detail about goods market equilibrium, when planned equals actual expenditure, and shows how this equilibrium generates the IS curve, the relationship between the real interest rate and equilibrium output. Spending a fair amount of time in class on the concept of goods market equilibrium, and why the economy will gravitate to this equilibrium, is worthwhile because this concept is so important to short-run macroeconomic analysis.

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

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

One teaching device that we have found helps students develop their intuition is the use of Summary Table 21-1 in class. You can use the blackboard to write a list of changes in variables that shift the IS curve and ask students to fill in the table by saying which way the IS curve shifts in response to each change and explaining what the reasoning is. This exercise gives them good practice in developing their analytic abilities. We use this device continually throughout this part of the book, as is evidenced from similar summary tables in later chapters. We recommend this approach highly.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. “When the stock market rises, investment spending is increasing.” Is this statement true, false, or uncertain? Explain your answer.

False. Stocks do not add directly to investment in a macroeconomic sense; since the buying and selling of stocks represents transfers of existing assets, it does not directly create new production. However, increases in the stock market are likely to coincide with increases in investment, since higher stock market prices may occur during periods of higher economic growth, which could cause firms to increase autonomous investment.

2. Why is inventory investment counted as part of aggregate spending if it isn’t actually sold to the final end user?

Since inventories of unsold goods are goods that have been produced, in an accounting sense, they add to output and hence aggregate demand. However, since the final end user hasn’t purchased them yet, they are counted as inventory until they are sold.

3. “Since inventories can be costly to hold, firms’ planned inventory investment should be zero, and firms should acquire inventory only through unplanned inventory accumulation.” Is this statement true, false, or uncertain? Explain your answer.

False. Although inventories are costly to hold, many firms prefer to have extra inventories of unsold goods on hand in the event that there is an unpredictable increase in demand for their goods, because this allows firms to satisfy customers’ demands. As a result, planned inventory investment may very well be positive.

4. During and in the aftermath of the financial crisis of 2007–2009, planned investment fell substantially despite significant decreases in the real interest rate. What factors related to the planned investment function could explain this?

During the height of the crisis, financial frictions f increased dramatically, which effectively raised the real cost of investment. In addition, firms’ planned autonomous investment I decreased dramatically as the prospects for economic growth and profits in the future weakened sharply. Both of these factors reduced planned investment, even though real interest rates may have decreased.

5. If households and firms believe the economy will be in a recession in the future, will this necessarily cause a recession or have any impact on output at all?

These shifts in “animal spirits,” according to Keynes, could very well create a recession. If the beliefs are strong enough, this could significantly reduce autonomous consumption and autonomous planned investment to the point where equilibrium output decreases substantially, leading to a recession.

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6. Why do increases in the real interest rate lead to decreases in net exports and vice versa?

When the real interest rate increases, this increases the demand for domestic assets, resulting in an appreciation of the domestic currency. As a result, imported goods become cheaper domestically, and exported goods become more expensive to foreigners. This reduces net exports, implying an inverse relationship between the real interest rate and net exports.

7. How would a decline in house prices or decrease in stock market prices affect the IS curve?

Either a decline in house prices or a decrease in stock market prices would reduce household wealth. As a result, autonomous consumption would decline, leading to a leftward shift of the IS curve. In addition, the decline in house prices could discourage the building of new housing because of reduced profitability of housing. This would reduce planned investment spending and also shift the IS curve to the left.

8. If firms suddenly become more optimistic about the profitability of investment and planned investment spending rises by $100 billion, while consumers become more pessimistic and autonomous consumer spending falls by $100 billion, what happens to aggregate output?

Nothing. The $100 billion increase in planned investment spending is exactly offset by the $100 billion decline in autonomous consumer expenditure, and autonomous spending and aggregate output remain unchanged.

9. If an increase in autonomous consumer expenditure is matched by an equal increase in taxes, will aggregate output rise or fall?

Rise. The fall in spending from an increase in taxes is always less than the change in taxes because the marginal propensity to consume is less than 1. By contrast, autonomous spending rises one for one with a change in autonomous consumer expenditure. If taxes and autonomous consumer expenditure rise by the same amount, autonomous spending must rise, and aggregate output also rises.

10. If a change in the interest rate has no effect on planned investment spending or net exports, what does this imply about the slope of the IS curve?

In this case, as interest rates fall, planned investment spending and net exports do not change, so equilibrium output remains unchanged. This means that the IS curve is vertical.

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11. Inventories typically increase starting at the beginning of recessions and begin to decline near the end of recessions. What does this say about the relationship between planned spending and aggregate output over the business cycle?

At the beginning of recessions, planned spending falls as consumers reduce spending and firms reduce investment, while production generally stays constant. As a result, an excess supply of goods is produced, leading to rising inventories. In the middle stages of recessions, firms may reduce production, but this may also be met with further decreases in planned spending leading to further buildup of inventories. However, near the end of a recession, firms are slow to increase production, while planned spending typically increases; this leads to reductions in inventories due to the excess demand for goods.

12. Why do companies cut production when they find that their unplanned inventory investment is greater than zero? If they didn’t cut production, what effect would this have on their profits? Why? Companies cut production when their unplanned inventory investment is greater than zero because they are then producing more than they can sell. If they continue at current production, profits will suffer because they are building up unwanted inventory, which is costly to store and finance.

13. “Firms will increase production when planned investment is less than (actual) total investment.” Is this statement true, false, or uncertain? Explain your answer.

False. In this case, if actual investment is greater than planned investment, firms are adding to inventory, thus unplanned inventory investment is positive. This leads firms to reduce production in order to bring inventories to more desirable levels.

14. In each of the following cases, determine whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift. a. The real interest rate rises.

This is a movement along the IS curve and so does not shift the IS curve. b. The marginal propensity to consume declines.

This results in a decrease in equilibrium output at any given interest rate, which shifts the IS curve to the left. c. Financial frictions increase.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. d. Autonomous consumption decreases.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left.

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e. Both taxes and government spending decrease by the same amount.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. f. The sensitivity of net exports to changes in the real interest rate decreases.

Equilibrium output increases at any given interest rate, which shifts the IS curve to the right. g. The government provides tax incentives for research and development programs for firms.

Equilibrium output increases at any given interest rate, which shifts the IS curve to the right.

15. “Financial frictions are not a problem for the economy, since they do not affect the safe policy rate, which is controlled by the central bank.” Is this statement true, false, or uncertain? Explain your answer False. When financial frictions increase, they lead to an increase in market borrowing rates that are independent of the safe policy interest rate. As a result, assuming policy interest rates are unchanged, planned (investment) spending would be reduced (potentially very sharply) and thus shift the IS curve left and lead to declines in aggregate output.

16. When the Bank of Canada reduces its policy interest rate, how, if at all, is the IS curve affected? Briefly explain.

The IS curve is not affected at all—that is, it does not shift. Changes in the real interest rate represent movements along a given IS curve and do not shift the curve.

17. Suppose you read that prospects for stronger future economic growth have led the Canadian dollar to strengthen and stock prices to increase. a. What effect does the strengthened dollar have on the IS curve?

A more expensive dollar will result in fewer Canadian exports and more Canadian imports (everything else the same) thus decreasing net exports. Graphically, this shifts the IS curve to the left, decreasing aggregate output at every interest rate. b. What effect does the increase in stock prices have on the IS curve?

Usually the increase in stock prices is interpreted as having a positive effect on autonomous planned investment, as investors become more confident about the future prospects of the economy. Therefore, we should expect autonomous planned investment to increase and the IS curve to shift to the right. c. What is the combined effect of these two events on the IS curve?

This is an example in which it is quite difficult to measure the net effect of these events.

Depending on the relative magnitude of the shifts, the IS curve might end up shifting to the left, to the right, or not shifting at all. This problem arises because these events have opposite effects on the IS curve. .

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ANSWERS TO APPLIED PROBLEMS 18. Calculate the value of the consumption function at each level of income in the table below if autonomous consumption = 300, taxes = 200, and mpc = 0.9.

Income Y Disposable Income YD

Consumption C

0 100 200 300 400 500 600 Income Y Disposable Income YD Consumption C 0

–200

120

100

–100

210

200

0

300

300

100

390

400

200

480

500

300

570

600

400

660

19. Assume that autonomous consumption is $1625 billion and disposable income is $11 500 billion. Calculate consumption expenditure if an increase of $1000 in disposable income leads to an increase of $750 in consumption expenditure.

If an increase of $1000 in disposable income leads to an increase of $750 in consumption expenditure, then mpc = 0.75. Using this implies that C = 1625 + 0.75  11 500 = 10 250.

Consumption expenditure is therefore $10 250 billion.

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20. Suppose that Dell Corporation has 20 000 computers in its warehouses on December 31, 2022, ready to be shipped to merchants (each computer is valued at $500). By December 31, 2023, Dell Corporation has 25 000 computers ready to be shipped, each valued at $450. a. Calculate Dell’s inventory on December 31, 2022.

Dell’s inventory on December 31, 2022, is the market value of the 20 000 computers at its warehouses. Therefore, Dell’s inventory equals 20 000 × $500 = $10 000 000 on December 31, 2022. b. Calculate Dell’s inventory investment in 2023.

Dell’s inventory spending is the change in the level of its inventory during the course of 2023. On December 31, 2023, Dell’s inventory equals 25 000 × $450 = $11 250 000.

Therefore, Dell’s inventory spending in 2023 is $1 250 000 = $11 250 000 - $10 000 000. c. What happens to inventory spending during the early stages of an economic recession?

During the early stages of an economic recession, as soon as households’ income starts to fall, firms realize that their sales drop. This results in fewer orders by their dealers and therefore an increase in the number of goods they stock at their warehouses (since they probably have already decided about production levels for that period). The consequence is that inventory spending will be positive for some time, but firms will quickly cut production and will try to sell their already manufactured goods before increasing production again.

21. If the consumption function is C = 100 + 0.75YD, I = 200, government spending is 200, and net exports are zero, what will be the equilibrium level of output? What will happen to aggregate output if government spending rises by 100?

Equilibrium output of 2000 occurs when Y = Yad and the aggregate demand function Yad = C + I + G + NX = 500 + 0.75Y. Solving for Y implies 0.25Y = 500, or Y = 2000. If government spending rises by 100, equilibrium output will rise by 400 to 2400.

22. If the marginal propensity to consume is 0.75, by how much would government spending have to rise to increase output by $1000 billion? By how much would taxes need to decrease to increase output by $1000 billion?

The change in output Y is given as the change in spending G, multiplied by 1/(1 – mpc).

Thus $1000 = 4G, implying government spending would have to increase by $250 billion in order to increase equilibrium output by $1000 billion. Alternatively, the change in output is given as the change in taxes T, multiplied by [–mpc]/(1 – mpc). Thus $1000 = –3T, implying taxes would have to decrease by $333.3 billion in order to increase equilibrium output by $1000 billion.

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23. Assuming both taxes and government spending increase by the same amount, derive an expression for the effect on equilibrium output.

Formally, the effects on output from a change in government spending and a change in taxes are given, respectively, as YG = G/(1 – mpc) and YT = –T  mpc/(1 – mpc). If both taxes and spending increase by the same amount, then G = T and the net effect on output is given as Y = YG + YT = G/(1 – mpc) –T  mpc/(1 – mpc) = G[1/(1 – mpc) – mpc/ (1 – mpc)] = G. Thus, if both taxes and government spending increase by the same amount, output will increase by exactly the amount of the increase in spending (or increase in taxes).

24. Consider an economy described by the following data:

C

= $3.25 trillion

I

= $1.3 trillion

G

= $3.5 trillion

T

= $3.0 trillion

NX

= −$1.0 trillion

f

= 1

mpc

= 0.75

d

= 0.3

x

= 0.1

a. Derive simplified expressions for the consumption function, the investment function, and the net export function.

C = 3.25 + 0.75(Y – 3) = 1 + 0.75Y. I = 1.3 – 0.3(r + 1) = 1 – 0.3r. NX = –1 – 0.1r. b. Derive an expression for the IS curve.

The IS curve can be found by setting Y = Yad and solving: Y = 1 + 0.75Y + 1 – 0.3r + 3.5 – 1 – 0.1r. This implies 0.25Y = 4.5 – 0.4r, or Y = 18 – 1.6r. c. If the real interest rate is r = 2, what is equilibrium output? If r = 5, what is equilibrium output?

At r = 2, equilibrium output is Y = 18 – 1.6(2) = $14.8 trillion; At r = 5, equilibrium output is Y = 18 – 1.6(5) = $10 trillion.

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d. Draw a graph of the IS curve showing the answers from part (c) above.

e. If government purchases increase to $4.2 trillion, what will happen to equilibrium output at r = 2? What will happen to equilibrium output at r = 5? Show the effect of the increase in government purchases in your graph from part (d).

An increase of government spending of $0.7 trillion will lead to an 0.7/(1 – 0.75) = $2.8 trillion increase in equilibrium output at any given interest rate. Thus, the IS curve will shift horizontally to the right by $2.8 trillion.

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25. Consider an economy described by the following data:

C = $4 trillion I = $1.5 trillion G

= $3.0 trillion

T

= $3.0 trillion

NX

= $1.0 trillion

f = 0 mpc = 0.8

d = 0.35 x = 0.15 a. Derive an expression for the IS curve.

Using equation (12) in the chapter, the IS curve is given as Y = 35.5 – 2.5r. b. Assume that the Bank of Canada controls the interest rate and sets the interest rate at r = 4. What is the equilibrium level of output?

At an interest rate of r = 4, output is Y = 35.5 – 2.5(4) = 25.5. c. Suppose that a financial crisis begins, and f increases to f = 3. What will happen to equilibrium output? If the Bank of Canada can set the interest rate, then at what level should the interest rate be set to keep output from changing?

The IS curve is now Y = 30.25 – 2.5r; at an interest rate of 4, equilibrium output is now Y = 20.25. In order to maintain the output level from part (b), the Bank of Canada would have to set the interest rates such that 25.5 = 30.25 – 2.5r, implying the interest rate setting of r = 1.9 to offset the increase in f of 3. Thus, the Bank of Canada will reduce r from r = 4 to r = 1.9. d. Suppose the financial crisis causes f to increase as indicated in part (c) and also causes planned autonomous investment to decrease to I = $1.1 trillion. Will the change in the interest rate implemented by the Bank of Canada in part (c) be effective in stabilizing output? If not, what additional monetary or fiscal policy changes could be implemented to stabilize output at the original equilibrium output level given in part (b)?

With the increase in f and the reduction in I the IS curve is now Y = 28.25 – 2.5r. At the current interest rate of r = 1.9, output is Y = 28.25 – 2.5(1.9) = $23.5 trillion, which is less than the level of output before the crisis, which does not stabilize output. In order to keep output at $25.5 trillion, monetary policymakers can set the interest rate such that 25.5 = 28.25 – 2.5r, or r = 1.1. Alternatively, fiscal policymakers could increase government spending by $0.4 trillion or reduce taxes by $0.5 trillion (while keeping the interest rate at r = 1.9). All three of these policies separately would maintain output at Y = $25.5 trillion.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, find Table 3800067, and find data on household final consumption expenditure (series V61989012), household consumption expenditure on goods (series V61989013), household consumption expenditure on durable goods (series V61989014), household consumption expenditure on semi-durable goods (series V61989015), household consumption expenditure on non-durable goods (series V61989016), and household consumption expenditure on services (series V61989017). a. What is the annual growth rate of each series?

The annual growth rates are: V61989012 V61989013 V61989014 V61989015 V61989016 V61989017 2.44016

2.410275075

3.980897

2.939154

1.475195

2.549757

b. Which series is more volatile?

The standard deviations are: V61989012 V61989013 V61989014 V61989015 V61989016 V61989017 6.76509

6.790975893

15.4642

11.75647

3.299622

7.46962

suggesting that household consumption expenditure on durable goods is more volatile.

2. Go to the CANSIM database, locate Table 228-0069, and find data on Canadian merchandise exports to the United States (V87008956) and Canadian merchandise imports from the United States (V87008840). a. Move the data into an Excel spreadsheet and calculate the difference between exports and imports. What does this difference represent?

This is net exports. b. Prepare a graph and show the three series, with the exports and imports series on the y1 axis and the series you calculated in (a) in the y2 axis. Comment on the values of the series you plotted on the y2 axis.

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Canadian Merchandise Exports, Imports, and Net Exports 4.5E+10

V87008956

1.4E+10

V87008840

4E+10

1.2E+10

3.5E+10 1E+10 3E+10 2.5E+10

8E+09

2E+10

6E+09

1.5E+10 4E+09 1E+10 2E+09

5E+09

Canadian merchandise net exports are positive over the sample period.

.

2019

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

0

1997

0

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Chapter 22: The Monetary Policy and Aggregate Demand Curves Chapter Overview and Teaching Tips Chapter 22 develops two other building blocks of the AD/AS framework, the monetary policy curve and the aggregate demand curve. It explains why monetary policymakers raise interest rates when inflation rises so that there is a positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve. It also explains that shifts in monetary policy involve autonomous easing or tightening of monetary policy, which involve changes in the real interest rate for a given level of inflation. Students often struggle with the difference between movements along the MP curve and shifts in the MP curve. Two applications help clarify this for students. These two applications provide useful illustration to cover in class to hammer home the distinction between movements along and shifts in the MP curve.

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

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. When the inflation rate increases, what happens to the overnight interest rate?

Operationally, how does the Bank of Canada adjust the overnight interest rate?

The Bank of Canada adjusts the overnight interest rate up in response to higher inflation.

This requires open market sales of bonds to remove reserves from the banking system, which results in the desired higher overnight interest rate.

2. What is the key assumption underlying the Bank of Canada’s ability to control the real interest rate?

The Bank of Canada can control the (nominal) overnight interest rate, but what matters for affecting economic activity are real interest rates. The underlying assumption is that inflation is relatively sticky in the short run so that changes in the nominal interest rate also imply similar changes in the real interest rate.

.

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3. Why does the MP curve necessarily have an upward slope?

The upward-sloping MP curve implies that real interest rates rise, rather than fall, when inflation increases. This is necessary because otherwise a rise in inflation would lead to a fall in real interest rates, which would lead to an increase in output, a further increase in inflation, and a further fall in real interest rates, which would lead to even higher inflation. In other words, the MP curve must be upward sloping in order to keep inflation from spinning out of control.

4. If  = 0, what does this imply about the relationship between the nominal interest rate and the inflation rate?

When  = 0, this means that the real interest rate will stay constant at r even when inflation changes. The implication is that as inflation increases, the nominal interest rate will increase by exactly the same as the inflation rate so that the real interest rate stays constant.

5. How does an autonomous tightening or easing of monetary policy by the Bank of Canada affect the MP curve?

An autonomous tightening of policy results in r increasing and the MP curve shifting upward; an autonomous easing of policy results in r decreasing, shifting the MP curve downward.

6. How is an autonomous tightening or easing of monetary policy different from a change in the real interest rate caused by a change in the current inflation rate?

An autonomous tightening or easing of policy may occur if, holding the current inflation rate constant, there is a change in the expected future inflation rate, a projected weakening of economic activity, or some other change in the future outlook of the economy or financial markets that warrants a change in monetary policy stance independent of the current inflation rate.

7. Suppose that a new Bank of Canada governor is appointed and that his or her approach to monetary policy can be summarized by the following statement: “I care only about increasing employment. Inflation has been at very low levels for quite some time; my priority is to ease monetary policy to promote employment.” How would you expect the monetary policy curve to be affected, if at all?

In this case, the MP curve will shift down if there is an autonomous easing of monetary policy. In addition, if the Bank of Canada begins to pay less attention to the inflation rate, this would be equivalent to a reduction in , which would reduce the slope of the MP curve.

.

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8. “The Bank of Canada decreased the overnight interest rate in late 2007, even though inflation was increasing. This action demonstrated a violation of the Taylor principle.” Is this statement true, false, or uncertain? Explain your answer.

False. Even though current inflation was relatively high, the Bank’s distaste for inflation (characterized by the parameter ) did not change and remained positive. The Bank reduced the overnight interest rate through an autonomous monetary policy easing due to the outlook for weakened economic activity going forward.

9. What factors affect the slope of the aggregate demand curve?

As equation (4) in the chapter indicates, the (inverse) slope of the aggregate demand curve is given as: –(d + x)/(1 – mpc). Thus, an increase in , d, x, or mpc will all decrease the slope (make the slope of the AD curve flatter).

10. “Autonomous monetary policy is more effective at changing output when  is higher.” Is this statement true, false, or uncertain? Explain your answer.

False. Since  is independent of the autonomous component of monetary policy r, any change in r will affect the real interest rate the same regardless of the value of . Thus, for a given IS curve, any change in autonomous monetary policy will have the same impact on output, independent of the value for .

11. If net exports were not sensitive to changes in the real interest rate, would monetary policy be more or less effective in changing output?

Monetary policy would be less effective in changing output, since net exports represent a reinforcing channel, in addition to investment, through which interest rate changes can affect output.

12. If an asset-price bubble begins to form, assuming the central bank responds, how is it likely to respond, and what will be the effect on the MP curve?

If the central bank wishes to directly address the asset-price bubble, it would likely autonomously tighten policy by increasing r. This would increase the real policy interest rate at any given inflation rate and shift the MP curve up.

13. For each of the following situations, describe how (if at all) the IS, MP, and AD curves are affected. a. A decrease in financial frictions The IS curve shifts to the right; the MP curve does not shift; the AD curve shifts to the right.

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b. An increase in taxes and an autonomous easing of monetary policy The increase in taxes shifts the IS curve to the left, and the easing of monetary policy moves the economy along the IS curve; the tax change does not affect the MP curve, but the monetary policy change shifts the MP curve down; the monetary policy easing shifts the AD curve to the right, while the tax increase shifts the AD curve to the left; the net effect on the AD curve cannot be determined without knowing the relative shifts due to the tax and monetary easing effects. c. An increase in the current inflation rate An increase in the current inflation rate represents a movement along the MP curve, which increases the real interest rate; the increase in the real interest rate due to the higher inflation represents a movement along the IS curve to lower output (but does not shift the IS curve); the increase in inflation represents a movement along the AD curve, reducing output, and does not shift the AD curve. d. A decrease in autonomous consumption A decrease in autonomous consumption shifts the IS curve to the left; the MP curve does not shift; the AD curve shifts to the left. e. Firms become more optimistic about the future of the economy.

Autonomous investment increases, which shifts the IS curve to the right; the MP curve does not shift; the AD curve shifts to the right. f. The new Bank of Canada governor begins to care more about fighting inflation.

This represents an increase in , which does not affect the IS curve; the MP curve becomes steeper; the slope of the AD curve becomes flatter.

14. What would be the effect of an increase in Canadian net exports on the aggregate demand curve? Would an increase in net exports affect the monetary policy curve? Explain.

An increase in Canadian net exports directly affects the IS curve, since planned expenditure increases at every real interest rate. Assuming the goods market is in equilibrium, aggregate output increases, shifting the IS curve to the right. The monetary policy curve does not shift, since net exports are not a determinant of the monetary policy curve. The monetary policy curve represents the monetary authorities’ willingness to set a given real interest rate in the short run according to current inflation rates. Given the same monetary policy curve and a new IS curve, the aggregate demand curve shifts to the right. This means that aggregate output increases at every inflation rate.

15. Why does the aggregate demand curve shift when “animal spirits” change?

The aggregate demand curve shifts because a change in “animal spirits” causes autonomous consumer expenditure or planned investment spending to change, which then causes the quantity of aggregate output demanded to change at any given inflation rate.

.

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16. Suppose that government spending is increased at the same time that an autonomous monetary policy tightening occurs. What will happen to the position of the aggregate demand curve?

The effect on the aggregate demand curve is uncertain because increased government spending would shift the AD curve to the right while the autonomous policy tightening shifts the AD curve to the left.

17. If financial frictions increase, how will this affect credit spreads, and how might the central bank respond? Why? The increase in financial frictions, if left alone, will increase the cost of borrowing and result in higher credit spreads. This will lead to a decrease in planned investment, shifting the AD curve to the left and reducing aggregate output demanded. Therefore, if the central bank wants to avoid a recession, it needs to reduce the real interest rate for investments. It can do this through an autonomous easing of policy by reducing r, which reduces the real policy interest rate r. This will help offset the negative effects of the financial frictions and shift the AD curve back to the right. Alternatively, the central bank can pursue policies to directly reduce financial frictions by providing liquidity to key credit markets. This reduces financial frictions at the source and allows the policy real interest rate to remain the same while directly reducing the real interest rate for investments and lowering credit spreads.

18. “If f increases, then the Bank of Canada can keep output constant by reducing the real interest rate by the same amount as the increase in financial frictions.” Is this statement true, false, or uncertain? Explain your answer.

False. If the Bank of Canada changes interest rates by exactly the amount of the change in f , this will mitigate the adverse effects of financial frictions on investment. However, the decrease in the real interest rate will increase net exports so that aggregate output will increase. Therefore, to offset the increase in financial frictions, the Bank would need to reduce the real interest rate by a little bit less than the change in f to keep output constant.

ANSWERS TO APPLIED PROBLEMS 19. Assume that the monetary policy curve is given by r = 1.5 + 0.751. a. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%.

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 3%, 3.75%, and 4.5%, respectively. b. Draw a graph of the MP curve, labelling the points from part (a).

See graph in (d) below.

.

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c. Assume now that the monetary policy curve is given by r = 2.5 + 0.751. Does the new monetary policy curve represent an autonomous tightening or loosening of monetary policy?

Since r increases, this represents an autonomous tightening of policy. d. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%, and draw the new MP curve, showing the shift from part (b).

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 4%, 4.75%, and 5.5%.

The graph is below.

20. Use an IS curve and an MP curve to derive graphically the AD curve.

See Figure 24-4 in the textbook.

21. Suppose the monetary policy curve is given by r = 1.5 + 0.751, and the IS curve is given by Y = 13 – r. a. Calculate an expression for the aggregate demand curve.

Y = 11.5 – 0.75. b. Calculate the real interest rate and aggregate output when the inflation rate is 2%, 3%, and 4%.

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 3%, 3.75%, and 4.5%, respectively. Aggregate output is 10, 9.25, and 8.5, respectively.

.

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c. Draw graphs of the IS, MP, and AD curves, labelling the points from part (b) on the appropriate graphs.

Graphs are below.

.

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22. Consider an economy described by the following: C

= $4 trillion

I

= $1.5 trillion

G

= $3.0 trillion

T

= $3.0 trillion

NX

= $1.0 trillion

f

= 0

mpc = 0.8 d = 0.35 x = 0.15  = 0.5 r

= 2

a. Derive expressions for the MP curve and the AD curve.

The MP curve is given as r = 2 + 0.5. The AD curve is given as Y = 30.5 – 1.25. b. Calculate the real interest rate and aggregate output when  = 2 and  = 4.

When  = 2 and  = 4, the real interest rate is r = 3% and 4%. Aggregate output is 28 and 25.5, respectively. c. Draw a graph of the MP curve and the AD curve, labelling the points given in part (b).

Graphs are shown below.

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23. Consider an economy described by the following: C

= $3.25 trillion

I

= $1.3 trillion

G

= $3.5 trillion

T

= $3.0 trillion

NX

= –$1.0 trillion

f

= 1

mpc = 0.75 d

= 0.3

x

= 0.1



= 1

r

= 1

a. Derive expressions for the MP curve and the AD curve.

The MP curve is given as r = 1 + . The AD curve is given as Y = 16.4 – 1.6. b. Assume that  = 1. Calculate the real interest rate, the equilibrium level of output, consumption, planned investment, and net exports. r = 2; Y = 14.8; C = 12.1; I = 0.4; NX = –1.2. c. Suppose the Bank of Canada increases r to r = 2. Calculate the real interest rate, the equilibrium level of output, consumption, planned investment, and net exports at this new level of r .

The real interest rate increases to r = 3. Y = 13.2; C = 10.9; I = 0.1; NX = –1.3. d. Considering that output, consumption, planned investment, and net exports all decreased in part (c), why might the Bank of Canada choose to increase r ?

The Bank may believe that the economy will strengthen in the future or there is a risk that inflation will rise in the future, so they increased r.

24. Consider the economy described in Applied Problem 23. a. Derive expressions for the MP curve and the AD curve.

The MP curve is given as r = 1 + . The AD curve is given as Y = 16.4 – 1.6. b. Assume that  = 2. What are the real interest rate and the equilibrium level of output? r = 3; Y = $13.2 trillion.

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c. Suppose government spending increases to $4 trillion. What happens to equilibrium output?

When government spending increases by $0.5 trillion, output will increase by $2 trillion to Y = $15.2 trillion. d. If the Bank of Canada wants to keep output constant, then what monetary policy change should it make?

In order to keep output constant at Y = $13.2 trillion, the Bank of Canada will have to increase the real interest rate to r = 4.25.

24. Suppose the MP curve is given by r = 2 + , and the IS curve is given by Y = 20 – 2r. a. Derive an expression for the AD curve, and draw a graph labelling points at  = 0,  = 4, and  = 8.

Y = 16 – 2. At  = 0,  = 4, and  = 8, output is given as Y = 16, Y = 8, and Y = 0, respectively. Graph is shown below. b. Suppose that  increases to  = 2. Derive an expression for the new AD curve, and draw the new AD curve using the graph from part (a).

Y = 16 – 4. Graph is shown below, with graph from part (a).

c. What does your answer to part (b) imply about the relationship between a central bank’s distaste for inflation and the slope of the AD curve?

As the central bank cares more about inflation (i.e., has more distaste for inflation),  increases and the slope of the AD curve becomes flatter.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. A measure of real interest rates can be approximated by the interest rate on inflationprotected long-term Canada bonds, or Real Return Bonds. Go to the CANSIM database, and find monthly data from January 1992 to December 2020 on the long-term Real Return Bond (series V122553) and the (all items) Consumer Price Index (CPI), a measure of the price index (series V41690914). Convert the price index data to annualized inflation rates by taking the month-to-month percent change in the price index and multiplying it by 12. Be sure to multiply by 100 so that your results are percentages. a. Calculate the average inflation rate and the average real interest rate over the most recent 12 months of data available.

For the period of 2020:M1 to 2020:M12, average inflation was 0.65%, and the average real interest rate was -0.007%. b. Calculate the standard deviation of the real interest rate and the annualized inflation rate over the most recent 12 months of data available.

For the period of 2020:M1 to 2020:M12, the standard deviation of the real interest rate is 0.25 and that of the annualized inflation rate is 5.73.

2. Continuing from the previous problem, use the monthly CPI and calculate the percent change from a year ago. Then plot both series on the same graph, using data from 2007 through the most current data available.

The Real Interest Rate and the Inflation Rate V122553 4 3 2 1 0

2007

2010

2013

2016

-1

-2

.

2019

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The Real Interest Rate and the Inflation Rate V122553 4 3 2

0 -1

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 Jul-14 Dec-14 May-15 Oct-15 Mar-16 Aug-16 Jan-17 Jun-17

1

-2

.

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Chapter 23: Aggregate Demand and Supply Analysis Chapter Overview and Teaching Tips The basic tool used to analyze the role of money in the economy in this book is a dynamic aggregate demand and supply analysis. The aggregate demand/aggregate supply model in this book differs from that in many other textbooks because it is inherently dynamic and emphasizes the interaction of inflation and economic activity. In contrast to older AD/AS frameworks that have the price level on the vertical axis, the dynamic AD/AS approach in this textbook has inflation on the vertical axis.

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

The chapter starts with a recap of the aggregate demand curve. There are two reasons for doing so. First, it drives home the intuition behind the aggregate demand curve, and recaps like this are a good way of getting students to really understand the material. Second, many instructors who are pressed for time might not want to go into so much detail about the derivation of the aggregate demand curve and so would prefer to skip Chapters 21 and 22. The recap in Chapter 23 allows instructors to skip Chapters 21 and 22 and still get across the major ideas in monetary theory. In teaching this material, it is again useful in class to make use of the teaching device of the Summary Table 23-1, which summarizes what factors cause the aggregate demand and supply curves to shift. Listing changes in the variables that shift the AD curve and then asking students to fill in the tables by saying which way the curve will shift and the reasons behind the shift will give them the practice they need to master the aggregate demand curve.

The chapter then develops the remaining building block of the AD/AS framework, the aggregate supply curve. This chapter develops the aggregate supply intuitively, stressing that the long-run aggregate supply curve is a vertical line determined by the amount of capital in the economy, the amount of labour supplied at full (the natural rate level of) employment, and the available technology. It develops the short-run aggregate supply curve using the intuition that there are three factors that drive inflation: (1) expectations of inflation, (2) output gap, and (3) price (supply) shocks. The Summary Table 23-2 can be used to hone students’ intuition by listing changes in the variables that shift the short-run AS curve and then asking students to fill in the tables by saying which way the curve will shift and the reasons behind the shift. This intuitive approach to understanding the aggregate supply curve works extremely well with students. The next step is to describe the equilibrium in AD/AS analysis, while getting across the key point that there are two equilibria. The short-run equilibrium occurs at the intersection of the AD curve .

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with the short-run AS curve, while the long-run equilibrium occurs at the intersection of the AD curve and the long-run aggregate supply curve. The chapter then shows them how the economy has a self-correcting mechanism because over time, a sequence of short-run equilibria lead the economy to go to the long-run equilibrium at which output returns to potential and the economy is at full employment.

Starting with Figure 23-11, the AD/AS diagram is converted to one with an aggregate output index (where it has a value of 100 when aggregate output equals potential output) on the horizontal axis rather than aggregate output. This is the AD/AS diagram that is used throughout the rest of the text. It has the important advantage that the output gap, which is what tells us how well the economy is doing in the short run, is immediately obtained from the equilibrium value of the aggregate output index, and so enables the instructor to talk about actual business cycle output gaps, rather than hypothetical numbers, making AD/AS analysis more real world.

The rest of the chapter shows how inflation and equilibrium output changes as a result of either aggregate demand shocks or aggregate supply (inflation) shocks. To drive home the analysis and also show students how useful the AD/AS model is, the chapter goes through a large number of applications, including applications involving foreign countries.

The chapter ends with two applications, “AD/AS analysis of the Great Recession of 2007–2009” and “An AD/AS Analysis of the Covid-19 Recession,” which describe what happened during the two most recent recessions. They show how the economy can be devastated by the double whammy of adverse supply and demand shocks. All of these applications are self-contained, so an instructor can pick and choose the ones he or she would like to teach in class. However, we think there is nothing more fun than to explain important historical episodes, which all of the applications do, and show how powerful economic models can be used to explain real-world phenomena.

In order to bring international factors into the aggregate demand and supply analysis of the chapter, net exports are included in the definition of aggregate demand. This enables the instructor to discuss how international trade flows can affect aggregate output and inflation. If the instructor wants to stick with a closed-economy framework, he or she can easily ignore the material in the chapter that deals with international trade by just leaving net exports out of his or her discussion. None of the basic analysis in this or later chapters will be affected by this choice.

However, if the instructor wants to fully internationalize the course, he or she might want to teach Chapters 18 and 19, which provide a more complete description of how monetary policy affects foreign exchange rates, before teaching this chapter.

For those instructors who want to spend more time on monetary theory and delve deeper into the dynamic AD/AS model, the chapter has two appendices available in MyLab Economics. The first, “The Effects of Macroeconomic Shocks on Asset Prices,” is worth teaching to students who are interested in pursuing careers in finance. It shows how the AD/AS model can explain how macroeconomic events that students are seeing reported in the media every day affect both stock prices and interest rates. The second appendix in MyLab Economics provides a numerical example of aggregate demand and supply analysis.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. Explain why the aggregate demand curve slopes downward and the short-run aggregate supply curve slopes upward.

A rise in inflation causes monetary policymakers to raise the real interest rate. This reduces planned expenditures and lowers the level of output necessary for goods market equilibrium.

The opposite occurs if inflation falls. Therefore, goods market equilibrium will occur at lower levels of output when the inflation rate rises and at higher levels of output when inflation falls. The downward slope of the aggregate demand curve reflects this. The shortrun aggregate supply curve slopes upward to reflect the increase in the inflation rate that occurs when the economy’s aggregate output of goods and services exceeds the potential output level in the short run and the decrease in inflation that occurs when output is below potential output.

2. Identify three factors that can shift the aggregate demand curve to the right and three different factors that can shift the aggregate demand curve to the left.

The following changes shift the aggregate demand curve to the right: monetary policy easing, increase in government purchases, decrease in taxes, autonomous increase in consumption, autonomous increase in investment, autonomous increase in net exports, and a decrease in financial frictions. The opposite changes in these factors shift the aggregate demand curve to the left.

3. “The appreciation of the U.S. dollar from 2012 to 2018 had a negative effect on aggregate demand in the United States.” Is this statement true, false, or uncertain? Explain your answer.

The statement is correct. An appreciation of the U.S. dollar makes U.S. exports more expensive for foreign consumers at the same time it makes imports into the United States cheaper. As a result, exports decrease, imports increase, and net exports decrease. According to aggregate demand and supply analysis, the aggregate demand curve shifts downward and to the left, reducing output. Note that the appreciation of the U.S. dollar might also affect the short-run aggregate supply curve if U.S. firms import many of their inputs. A decrease in the price of inputs will shift the short-run aggregate supply curve down and to the right, which will mitigate some of the declines in output from the aggregate demand shift.

4. In many countries around the world, the population is aging and large segments of the population are retiring or close to retirement. What effect would this have on a country’s long-run aggregate supply curve? What will happen to income as a result?

If the labour supply is reduced as a result of large portions of the population retiring, this reduces the productive capacity of the economy, resulting in a leftward shift of the long-run aggregate supply curve. All else equal, this will result in a decline in income in the country.

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5. If the labour force becomes more productive over time, how would the long-run aggregate supply curve be affected?

As labour productivity grows, the long-run aggregate supply curve shifts to the right. This is because the existing labour force, along with a given amount of capital and other resources, can produce more output, indicating a greater amount of potential output.

6. Why are central banks so concerned with inflation expectations?

When inflation expectations rise, it shifts the short-run aggregate supply curve up, leading to higher actual inflation in the short run in addition to any inflationary effects that may occur, for instance through negative price shocks. This illustrates the danger when inflation expectations become “unanchored” from a low level, in that it is more difficult for the central bank to then stabilize inflation, particularly when a temporary inflation shock leads to higher expected inflation.

7. “If prices and wages are perfectly flexible, then γ = 0 and changes in aggregate demand have a smaller effect on output.” Is this statement true, false, or uncertain? Explain your answer.

False. As prices and wages become more flexible, γ becomes larger, and the short-run aggregate supply curve becomes steeper. (In the limit, with perfect flexibility, γ approaches infinity.) Thus, for a given aggregate demand shock, as the short-run aggregate supply curve becomes steeper the effects on output are smaller.

8. What factors shift the short-run aggregate supply curve? Do any of these factors shift the long-run aggregate supply curve? Why? Shifts in the short-run aggregate supply curve result from changes in expected inflation, price shocks, and persistent output gaps. None of these factors shift the long-run aggregate supply curve because price and wage flexibility ensures that in the long run the economy produces at its potential output level. Potential output depends not on actual or expected inflation but rather on the capital, labour, and technology available for producing goods and services.

However, a change in potential output shifts the long-run aggregate supply curve and also the short-run aggregate supply curve because it changes the output gap at any given level of actual output.

9. If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the short-run aggregate supply curve when budget deficits rise?

The short-run aggregate supply curve will shift upward because wages and production costs rise, since workers and firms expect prices to be higher.

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10. In the aftermath of the financial crisis in the United States, labour mobility has decreased significantly. How, if at all, might this affect the natural rate of unemployment?

If labour mobility decreases within an economy, it makes it harder for workers and firms to find each other; thus it is likely to take much longer for the job-matching process to occur, and for those who don’t move to other areas where jobs are plentiful, this could also result in elevated structural unemployment. As a result, the natural rate of unemployment will increase.

11. When aggregate output is below the natural rate of output, what happens to the inflation rate over time if the aggregate demand curve remains unchanged? Why? When output is less than potential output, unemployment is above the natural rate and labour market slack causes wages to rise less rapidly. As the Phillips curve suggests, this causes firms to raise their prices less rapidly and thus decreases the inflation rate. As a result, expected inflation will be lower in the following time period and the short-run aggregate supply curve will shift downward. This adjustment process in which inflation and expected inflation fall and the short-run aggregate supply curve shifts downward continues over time until output increases to the potential output level, the output gap increases to zero, and the economy reaches long-run equilibrium.

12. Suppose the public believes that a newly announced anti-inflation program will work and so lowers its expectations of future inflation. What will happen to aggregate output and the inflation rate in the short run?

The inflation rate will be lower than it otherwise would be, and aggregate output will be higher. The lower expected inflation will cause the short-run aggregate supply curve to shift down so that the intersection of the short-run aggregate supply curve with the aggregate demand curve will be at a higher level of output and a lower inflation rate.

13. If the unemployment rate is above the natural rate of unemployment, holding other factors constant, what will happen to inflation and output?

When the unemployment rate is above the natural rate of unemployment, there is slack in the labour market and output is below potential. This causes the short-run aggregate supply curve to shift downward, leading to lower inflation and higher output over time, until the economy reaches a long-run equilibrium.

14. What happens to inflation and output in the short run and the long run when taxes decrease?

A decrease in taxes will lead to a rightward shift of the aggregate demand curve. In the short run, inflation and output will both rise. This leads to tightness in the labour market, which raises inflation expectations and shifts the short-run aggregate supply curve up; as this occurs, the economy moves to a new long-run equilibrium, output falls back to potential, and inflation increases.

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15. If stagflation is bad (high inflation and high unemployment), does this necessarily mean low inflation and low unemployment is good?

Not necessarily. Even though low unemployment is desirable, if unemployment is too low relative to the natural rate of unemployment, future inflation risk could build even if the current inflation rate remains relatively low. In addition, having too low of an inflation rate could mean that an adverse shock could result in the conventional policy instrument hitting the zero lower bound and inflation turning negative, potentially triggering a deflationary episode, which can be particularly damaging.

16. Why did the Bank of Canada pursue inherently recessionary policies in the early 1980s?

The Bank of Canada’s policies during that time were not intentionally recessionary; however, they were necessary in order to reanchor inflation (and inflation expectations) at a permanently lower level. The only way to achieve this, given that the Bank of Canada had very little credibility in fighting inflation at the time, was to pursue highly contractionary policies to bring the inflation rate down, a necessary side effect of which was a sharp decrease in aggregate demand.

17. In what ways is the Bank of Canada’s disinflation considered a success? In what ways is it considered a failure?

The Bank of Canada’s disinflation is considered a success in that the Bank was finally able to bring inflation down to a permanently lower, stable level after a decade of high and volatile inflation through most of the 1970s. Unfortunately, the policies to get the economy on a path of low, stable long-term inflation required significantly contractionary policies.

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ANSWERS TO APPLIED PROBLEMS 18. Suppose the government passes legislation that encourages investment in research and the development of new technologies. Assuming this policy leads to a positive productivity change for the Canadian economy, use aggregate demand and supply analysis to predict the effects on inflation and output. Demonstrate these effects on a graph.

Technological change and infrastructure improvements affect the long-run aggregate supply curve. More fuel-efficient cars result in a decrease in the demand for gas at the same time that innovations in energy production make it possible to increase the supply of energy at any price level. Innovations in these fields result in a shift to the right in both the short- and long-run supply curves. Improvements in infrastructure make transportation of goods to market more efficient, and raise productivity in a variety of ways. In conclusion, inflation decreases and output increases in the long run.

19. Proposals have been made that advocate an increase in the national sales tax. Predict the effects of such a tax on the aggregate supply and demand curves, showing the effects on output and inflation. Use a graph of aggregate supply and demand to demonstrate these effects.

Because goods would cost more, the national sales tax would raise production costs, and the short-run aggregate supply curve would shift to the left. The intersection of the short-run aggregate supply curve with the aggregate demand curve would then be at a higher inflation rate and a lower level of the aggregate output index; aggregate output would fall, and the inflation rate would rise.

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20. Suppose the inflation rate remains relatively constant while output decreases and the unemployment rate increases. Using an aggregate demand and supply graph, show how this scenario is possible.

In order for the unemployment rate to rise and inflation to remain constant, both the aggregate supply and demand curves would have to shift to the left. If they shift horizontally to the left by the same amount, the result is inflation remaining the same, but output falling and the unemployment rising in the short run, as shown in the graph below.

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21. Classify each of the following as a supply shock or a demand shock. Use a graph to show the effects on inflation and output in the short run and in the long run. a. Financial frictions increase.

Negative demand shock. An increase in financial frictions reduces aggregate demand.

The aggregate output index and inflation fall in the short run; in the long run, the aggregate output index rises back to potential, and inflation falls.

b. Households and firms become more optimistic about the economy.

Positive demand shock. This increases autonomous consumption and investment, which increases aggregate demand. The aggregate output index and inflation increase in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases.

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c. Favourable weather produces a record crop of wheat and corn in the Prairie provinces.

Positive supply shock. This shifts the short-run aggregate supply curve to the right (down). The aggregate output index increases and inflation decreases in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases, returning to the original level.

d. Auto workers go on strike for four months.

Negative supply shock. This shifts the short-run aggregate supply curve to the left (up).

The aggregate output index decreases and inflation increases in the short run; in the long run, the aggregate output index increases back to potential, and inflation decreases, returning to the original level.

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22. During 2017, some Bank of Canada officials discussed the possibility of increasing interest rates as a way of fighting potential increases in expected inflation. If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve? Use an aggregate demand and supply graph to illustrate your answer.

If the public assumes that the current Bank of Canada officials are not that worried about inflation, expected inflation will increase, shifting the short-run aggregate supply curve upward and to the left (as shown in the graph below). During 2017, Bank of Canada officials were in the difficult position of worrying when they might have to increase interest rates to fight inflation as the economy was largely recovered, but inflation remained low. Increasing interest rates too late could fuel expectations about higher inflation, while increasing interest rates too soon will slow down the recovery or even send the economy back into recession. It is quite difficult to make this decision, which is why most of the time the conduct of monetary policy is more an art than a science.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the CANSIM database, and find monthly data from January 1992 to December 2020 on the total unemployment rate (series V2062815) and the (all items) Consumer Price Index (series V41690914). a. What is the average annual inflation rate?

1.76%. b. Is the correlation between the annual inflation rate and the unemployment rate negative or positive?

The correlation coefficient is –0.05928.

2. Go to the St. Louis Federal Reserve FRED database, and find data on real GDP (GDPC1), potential GDP (GDPPOT), and the unemployment rate (UNRATE) from 1960 to the most recent period. For the unemployment rate data, convert the frequency to Quarterly. Download all of the data into a spreadsheet, and calculate the output gap and aggregate output index for each quarter. a. In which quarter is the output gap the most negative? What is the Aggregate Output Index for that quarter?

From the period of 1960 through the second quarter of 2020, the most negative output gap occurred during Q2 2020. During this quarter, the output gap was –9.9%, or an AOI of 90.1. b. In which quarter is the unemployment rate highest?

The highest unemployment rate during this period occurred in Q2 2020, at 13.0%. c. Are these periods of time close to each other? What does this tell you about the relationship between output gaps and the unemployment rate?

Yes, since 1960, both the highest unemployment rate and most negative output gap coincide at the same time in Q2 2020. This indicates that higher unemployment rates are consistent with more negative output gaps, and vice versa.

3. Go to the St. Louis Federal Reserve FRED database and find data on real government spending (GCEC1), real GDP (GDPC1), taxes (W006RC-1Q027SBEA), and the personal consumption expenditure price index (PCECTPI), a measure of the price level. Download all of the data into a spreadsheet, and convert the tax data series into real taxes. To do this, for each quarter, divide taxes by the price index and then multiply by 100. a. Calculate the level change in real GDP over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below.

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b. Calculate the level change in real government spending and real taxes over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. c. Are your results consistent with what you would expect? How do your answers to part (b) help explain, if at all, your answer to part (a)? Explain using the IS and AD curves.

No, this is not entirely consistent with what would be expected for tax and spending changes. Over the most recent year period of 2019:Q1 to 2020:Q1, a mixed fiscal policy change took place with government spending increasing, while taxes decreased. With government spending much higher than taxes, you would expect this should increase output by shifting both the IS and AD curves to the right, which appears to be the case since output rose over that period. In the period from 2018:Q1 to 2019:Q1 the results are similar, but the magnitude of changes is reversed: government spending increases modestly, while tax receipts increases much more. In this case, you might expect the IS and AD curves to shift to the left and decrease output given the magnitude effects, however, output actually went up anyway. Clearly, there are other factors in the economy that are offsetting the contractionary tax effects to increase GDP overall in the economy.

Gov’t Spending Chg., $Bil.

Real Tax Chg., $Bil.

Real GDP Chg., $Bil.

2019:Q1 to 2020:Q1



9.3

60.5

2018:Q1 to 2019:Q1

55.7



419.9

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Chapter 24: Monetary Policy Theory Chapter Overview and Teaching Tips Chapter 24 brings a new set of actors into the AD/AS framework—policymakers—and develops the theory behind monetary policy making, examining how monetary policymakers react to shocks to the economy in order to stabilize both inflation and economic activity. One unique feature of the dynamic AD/AS framework in this book is that it can address policy questions that other frameworks cannot, such as “When does stabilizing inflation, stabilize output (i.e., when does the divine coincidence occur)?”

The chapter starts by seeing how policymakers respond to shocks to aggregate demand or aggregate supply to achieve these objectives. The analysis in the chapter makes clear that stabilizing inflation stabilizes economic activity, so there is no policy trade-off, except when there are shocks to aggregate demand or permanent shocks to aggregate supply. On the other hand, temporary shocks to aggregate supply do involve a policy trade-off because in this case stabilizing inflation does not stabilize economic activity.

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

The chapter also discusses what causes inflation and one of the most famous adages in macroeconomics, coined by Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.” It then delves more deeply into why inflationary monetary policy occurs. The AD/AS model shows that overly expansionary monetary policy that leads to high inflation can occur when the policymakers try to achieve high employment targets.

The chapter ends with a discussion of monetary policy at the zero lower bound. The dynamic aggregate demand and supply framework in this text is especially suited to explaining the impact of the zero lower bound and how nonconventional monetary policy works in this situation. The first step is to show students how the zero lower bound results in a backward bending aggregate demand curve, which means that the self-correcting mechanism is no longer operational.

Applying this analysis then allows the instructor to show how nonconventional monetary policy and quantitative easing works. To show students how relevant this analysis is it can be used to show how the historic shift in Japanese monetary policy in 2013, which has been dubbed Abenomics, might help get the Japanese economy out of the funk it has been in for the last fifteen years.

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What does it mean when we say that the inflation gap is negative?

When the inflation gap is negative, this means that the current inflation rate is less than the target inflation rate.

2. “If autonomous spending falls, the central bank should lower its inflation target in order to stabilize inflation.” Is this statement true, false, or uncertain? Explain your answer.

False. If the central bank pursues stabilization policy, it can stabilize both inflation and output simultaneously by an autonomous easing of policy. If it lowered its inflation target, this would stabilize inflation temporarily; however, output would still be below potential. In addition, as the economy recovered from the recession, inflation would naturally begin to fall more due to the self-correcting mechanism. Thus, in order to allow the economy to move back to the potential level of output, the central bank would need to then continuously adjust its inflation target. Constant adjustment of the inflation target would be inefficient, and could send mixed signals to the public about what it is doing and why.

3. For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a long-run equilibrium. a. Consumers reduce autonomous consumption.

A reduction in autonomous consumption reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity. b. Financial frictions decrease.

A reduction in financial frictions increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity c. Government spending increases.

An increase in government spending increases aggregate demand, so monetary policymakers would pursue an autonomous tightening of monetary policy to stabilize economic activity. d. Taxes increase.

An increase in taxes reduces aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity. e. The domestic currency appreciates.

An appreciation of the domestic currency leads to lower exports and higher imports, which reduces net exports and aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity.

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4. During the global financial crisis, how was the Bank of Canada able to help offset the sharp increase in financial frictions without the option of lowering interest rates further?

Did the Bank of Canada’s plan work?

The Bank of Canada lowered the overnight interest rate to near zero during the crisis to offset falling aggregate demand; however, this was insufficient to stabilize aggregate demand and output. As a result, the Bank of Canada resorted to nonconventional monetary policy to help offset the financial frictions. This involved liquidity provision and asset purchases, which helped to lower medium and longer-term interest rates, and helped to increase aggregate demand, despite having reached the effective lower bound on the federal funds rate. However, due to the severity of the crisis, these policies were insufficient to fully stabilize economic activity and bring output to potential.

5. Why does the divine coincidence simplify the job of policymakers?

The divine coincidence exists when policies that are appropriate to achieve price stability also stabilize economic activity. In this case, policymakers have easier jobs because there is no tradeoff between policy objectives and that they do not have to choose between them. They can, in other words, have their cake and eat it, too. The divine coincidence occurs when the economy is beset with aggregate demand shocks, but not when it experiences supply shocks.

When faced with a demand shock, policymakers can stabilize both inflation and economic activity by enacting policies to shift the economy’s aggregate demand curve and return to long-run equilibrium at potential output. In the case of a supply shock, however, policies that shift the aggregate demand curve to achieve inflation stability will move the economy further away from potential output and those aimed at stabilizing economic activity at potential output will cause the inflation rate to move further away from the target rate.

6. Why do negative supply shocks pose a dilemma for policymakers?

With negative supply shocks, both inflation and the unemployment rate increase. In order to reduce the unemployment rate, an expansionary policy must be pursued, which further increases inflation. On the other hand, pursuing a policy to reduce the inflation rate requires a contractionary policy, which further increases the unemployment rate. Thus, with negative supply shocks stabilization policy requires a tradeoff between achieving the objectives of inflation stabilization and stabilization of real economic activity.

7. Suppose three economies are hit with the same negative supply shock. In country A, inflation initially rises and output falls; then inflation rises more and output increases. In country B, inflation initially rises and output falls; then both inflation and output fall. In country C, inflation initially rises and output falls; then inflation falls and output eventually increases.

What type of stabilization approach did each country take?

In country A, policymakers chose a policy to stabilize output. In country B, policymakers chose a policy to stabilize inflation. In country C, policymakers chose no policy response, that is, left autonomous monetary policy unchanged.

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8. “Policymakers would never respond by stabilizing output in response to a positive supply shock.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. A positive supply shock has the dual benefits of increasing output and also reducing inflation, so in some sense policymakers get the best of both worlds by not pursuing any type of stabilization policy. However, if the supply shock is large enough, it could reduce inflation and/or increase output enough such that it could create more variability and hence uncertainty in inflation, which could actually be destabilizing. In this case, it may be in the best interest of policymakers to pursue a policy that stabilizes the inflation rate in the short run, until the supply shock wears off (this would have the added benefit of temporarily increasing output more than if policymakers did nothing).

9. The fact that it takes a long time for firms to get new plants and equipment up and running is an illustration of what policy problem?

This demonstrates the problem of effectiveness lags in the implementation of monetary policy. Changes in monetary policy impact interest rates, which affect the cost of investment in new plant and equipment. Since it can be many months before new plants and equipment are purchased and put into use, the interest rate effects of monetary policy occur with a lag.

10. In the United States, many observers have commented in recent years on the “political gridlock in Washington D.C.” and referred to Congress as a ‟Do Nothing Congress.” What type of policy lag is this describing?

This refers to the legislative lag (of fiscal policy).

11. Is stabilization policy more likely to be conducted through monetary policy or through fiscal policy? Why? Stabilization policy is conducted more frequently using monetary policy rather than fiscal policy because implementing fiscal policy requires making changes in taxes and government spending that take longer to deliberate and enact than monetary policy decisions do.

12. “If the data and recognition lags could be reduced, activist policy probably would be more beneficial to the economy.” Is this statement true, false, or uncertain? Explain your answer.

True. If the first parts of the statement could be achieved, the objection to activist policy would no longer be as serious. For instance, in response to aggregate demand shocks, the aggregate demand curve could be more quickly shifted to potential output, resulting in less variation in both inflation and output, and making an activist policy more desirable.

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13. If the economy’s self-correcting mechanism works slowly, should the government necessarily pursue discretionary policy to eliminate unemployment? Why or why not?

Not necessarily, because an activist policy to eliminate unemployment could lead to the demand-pull and cost-push inflations depicted in Figure 7 and Figure 8 in the chapter. In addition, the activist policy might lead to a higher probability that workers will push up their wages, which results in episodes of high unemployment.

14. In the early 1970s, an unexpected productivity slowdown led most economists to believe that potential output was larger than it actually was. How are policymakers likely to respond under this situation and what do you expect to be the outcome?

In this case, policymakers are likely to pursue overly expansionary policies to try to increase output above potential and lower unemployment below the natural rate. The result is that inflation will rise substantially as the economy begins to produce far beyond the sustainable level of production.

15. In both the 1960s and 1970s in Canada, inflation increased significantly. However, unemployment behaved very differently in the two decades. Why is this?

Even though inflation increased significantly in both decades, the sources of the increase were different, leading to much different effects on unemployment. In the case of the 1960s, much of the inflationary pressures were generated from demand-pull inflation policies due to highly expansionary fiscal and monetary policy pushing the aggregate demand curve far to the right, similar to Figure 24-8 in the chapter. This helped to reduce unemployment to low levels. On the other hand, in the 1970s, most of the inflation came from cost-push sources, such as adverse price shocks, declines in productivity, and sharp increases in inflation expectations. This resulted in substantial shifts of the short-run aggregate supply curve upward, and triggering spiraling inflation and higher unemployment similar to Figure 24-7 in the chapter.

16. Given a relatively steep and a relatively flat short-run aggregate supply curve, which curve would support the case for nonactivist policy? Why? When the short-run aggregate supply curve has a steeper slope, wages and prices in general are more flexible (i.e., changes in output result in larger changes in the inflation rate). This situation constitutes a stronger argument in favor of nonactivist policy, since changes in the aggregate demand curve will result in smaller changes in output and unemployment when the short-run aggregate supply curve is steeper. Alternatively, one might think that further efforts in terms of activist monetary or fiscal policy are needed to affect output if prices and wages are less flexible (which is the case when the short-run aggregate supply curve is flatter).

17. “Because government policymakers do not consider inflation desirable, their policies cannot be the source of inflation.” Is this statement true, false, or uncertain? Explain your answer.

False. Even though policymakers do not want inflation, if they pursue goals such as high employment or choose to run high budget deficits, inflationary monetary policy and inflation can result through the mechanisms discussed in this chapter. .

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18. How can monetary authorities target any inflation rate they wish?

Monetary policymakers can target any inflation rate they want to simply by implementing autonomous monetary policy easing (to target a higher inflation rate) or tightening (to target a lower one). However, although they can exert this control over inflation in the long run, they have no control over real interest rates or potential output in the long run, so the classical dichotomy and monetary neutrality hold just as they do in the classical framework.

19. What will happen if policymakers erroneously believe that the natural rate of unemployment is 7% when it is actually 5% and therefore pursue stabilization policy?

If policymakers believe that the natural rate of unemployment is 7% when it is actually 5%, then once the unemployment rate begins to drop below 7%, they are likely to pursue contractionary policy to avoid a perceived potential demand-pull inflation problem. In actuality, this would represent a situation where policymakers are contracting the economy when it is already in recession. The result of these policies is that this could create a downward spiral in inflation, which could lead to deflation and a severe economic downturn.

20. How can demand-pull inflation lead to cost-push inflation?

When inflation increases due to demand-side conditions, this could prompt workers to demand higher wages (which are greater than the growth in labor productivity) in anticipation of future higher inflation. This results in the aggregate supply curve shifting upward, and creating cost-push inflation (which was initiated by a demand-pull inflation source).

21. How does the policy rate hitting a floor a little below zero lead to an upward sloping aggregate demand curve?

When the effective lower bound is hit, a lower inflation rate leads to a higher real interest rate because the nominal interest rate is fixed at zero, and this higher real interest rate then causes planned expenditure and therefore aggregate output to decline. The fall in aggregate output as inflation falls, then results in an upward sloping aggregate demand curve.

22. Why does the self-correcting mechanism stop working when the policy rate hits the effective lower bound?

Because a negative output gap, which leads to a fall in the short-run aggregate supply curve, which lowers inflation, which then causes aggregate output to fall along the lines outlined in the answer to question 13, then leads to an even more negative output gap. The result is then a downward spiral where inflation keeps falling and output does as well, so the selfcorrecting mechanism is not operational.

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23. In what ways can nonconventional monetary policy affect the real interest rate for investments when the economy reaches the effective lower bound? How are credit spreads affected?

There are a number of ways the central bank can reduce the real interest rate for investments at the effective lower bound. By providing liquidity to key credit markets, the central bank can directly reduce financial frictions, which lowers the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The second way is by purchasing private assets. This has the effect of reducing financial frictions in specific asset classes, and therefore reducing the real interest rate for investments in those markets (Mortgage-Backed Securities and the housing market, for instance). The result of this is to lower the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The central bank can also purchase long-term government securities, which directly lowers the longer-term real interest rate at any given level of financial frictions. This results in a decline in the real interest rate for investments, but does not affect (at least directly) financial frictions or credit spreads. Finally, through forward guidance, information about the future path of policy can lower longer-term real interest rates, thereby lowering the real interest rate for investments.

ANSWERS TO APPLIED PROBLEMS 24. Suppose the government decides to decrease government expenditures as a means of cutting the existing government budget deficit. a. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.

According to aggregate demand and supply analysis, the decrease in government expenditures results in a shift to the left in the aggregate demand curve, as aggregate expenditures decrease at every inflation rate. As a result, the new intersection point with the short-run aggregate supply curve determines a lower inflation rate and aggregate output index than before, as shown below. At this point, output is below potential output and inflation is below its target. b. What will be the effect on the real interest rate, the inflation rate, and the aggregate output index if the Bank of Canada decides to stabilize the inflation rate?

If the Bank of Canada decides to use its monetary policy tools to stabilize inflation, it will effectively decrease the real interest rate at every inflation rate, thereby shifting the MP curve downward. This action will shift the AD curve to the right and restore the economy to its long-run equilibrium, where the inflation rate returns to its target  T and the aggregate output index is at potential again. The only long-run effect of this policy is to affect the real interest rate, which is now set at a lower level than the previous long-run equilibrium.

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25. Use a graph of aggregate demand and supply to demonstrate how lags in the policy process can result in undesirable fluctuations in output and inflation.

Suppose the economy is currently in recession at point A in the graph, and policymakers wish to stabilize output. Given current assumptions about the state of the economy, policymakers may devise a policy that they anticipate will shift aggregate demand out to ADA and stabilize the economy. However, because of lags in the policy process (which were presumably unaccounted for or unknown), it may take some time before the policy changes actually take effect. If the economy begins to recover and demand begins to expand independent of the policy effects, then once the policy actually takes hold, it could expand aggregate demand beyond potential output, to a point such as point C. In this case, the aggregate output index overshoots potential and inflation is higher than anticipated, which can lead to further increases in inflation as inflation expectations adjust upward. Moreover, once at point C, policymakers may try to correct the overshoot, which could lead to aggregate demand shifting back below ADA and lead to further volatility in both inflation and output.

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26. As monetary policymakers become more concerned with inflation stabilization, the slope of the aggregate demand curve becomes flatter. How does the resulting change in the slope of the aggregate demand curve help stabilize inflation when the economy is hit with a negative supply shock? How does this affect output? Use a graph of aggregate demand and supply to demonstrate.

As seen in the graph below, when the aggregate demand curve becomes flatter, then for a given negative aggregate supply shock this implies that the increase in inflation is smaller, and the reduction in the aggregate output index is larger. Thus, as the aggregate demand curve becomes flatter, inflation is kept closer to the original level; however, the output effects are more pronounced.

27. In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary. a. How might fears of the effective lower bound justify such a policy, even if the economy was not actually in a recession?

Policymakers were worried that a shock could push the economy into a deflationary spiral, in which the short-term nominal policy rate would be bound at the effective lower bound. At that point, conventional monetary policy would be ineffective. Policymakers viewed the risk of economic damage in the event of a deflationary spiral to be significant enough to overcome any potential inflation risk in implementing the policy. Thus, policymakers chose to err on the side of attempting to eliminate the deflationary threat.

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b. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

With the economy starting out at point A, an adverse shock would push the economy into a destabilizing deflation. An autonomous easing of policy would shift the MP curve down, and in the short run the economy would end up at point B. Note that even though the economy is not at a long-run equilibrium, at that point, the self-correcting mechanism can move the economy to a stable long-run equilibrium since the ELB inflection point lies to the right of the LRAS curve.

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28. Suppose that f is determined by two factors: financial panic and asset purchases. c. Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the effective lower bound and into a destabilizing deflationary spiral.

A financial panic will increase f , thus raising the real interest rate on investments at any given inflation rate. A sufficiently large panic will push the economy to point B, where the self-correcting mechanism will lower inflation, and real rates will rise since the economy is beyond the ELB. This results in a deflationary spiral in which the economy will move toward (and past) a point such as point C.

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d. Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases can reverse the effects of the financial panic depicted in part (a).

A sufficient enough asset purchase will lower f , reversing the effects of the panic, and lower the real interest rate on investments at any given inflation rate. This moves the economy from point A, to a point such as point B, where the economy is no longer at risk of a deflationary spiral. At point B, the self-correcting mechanism can move the economy to a stable long-run equilibrium since the ELB inflection point lies to the right of the LRAS curve along that AD curve.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find monthly data on the Canadian unemployment rate (aged 15 and over) and the monthly Canadian Consumer Price Index (all items) since 1961M1 for both series. a. For the most recent 12 months of data available, calculate the average inflation gap using the Bank of Canada’s 2% inflation target.

It is −1.65%. b. For the most recent 12 months of data available, calculate the average unemployment gap, using 5.6% as the presumed natural rate of unemployment.

It is −3.65%. c. Based on your answers to parts (a) and (b), does the divine coincidence apply to the current economic situation in Canada? Why or why not? What does your answer imply about the sources of shocks that have impacted the current economy? Briefly explain.

The divine coincidence does not apply. It is a combination of AD and AS shocks that hit the Canadian economy in 2020.

2. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to “Percent Change From Year Ago.” For the unemployment rate, adjust the frequency setting to ‟Quarterly.” Select the data from 2000 through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or cost-push movements in the inflation rate. Briefly explain your reasoning.

See the graphs below. The period from around early 2001 to around the end of 2003 appears to be influenced by demand-pull inflation conditions, since inflation is a bit lower than what appears to be normal at the time (2.5%), and the unemployment rate rises and remains above the estimated natural rate during this time. For a brief time from the middle of 2007 to the middle of 2008, the economy appears to be hit by a cost-push inflation episode, since the inflation rate spikes, and the unemployment rate rises above the natural rate of unemployment. From the middle of 2008 to about early 2014, inflation remains mostly at or below the 2% target, while the unemployment rate is well above the natural rate, suggesting that demand-pull forces are at work. From 2015 to 2019, inflation generally increased, while unemployment declined, indicating demand-pull factors. In late 2019 into 2020 with the coronavirus pandemic resulting in an economic lockdown, inflation fell and the unemployment rate spiked, indicative of severe adverse demand-pull conditions.

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Inflation and Unemployment 14.0

Unemployment Rate

12.0

10.0

Natural rate of Unemployment Unemployment Gap

6.0 4.0

2% Inflation Target

2.0 PCE Inflation Rate

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2019-11-01

2018-09-01

2017-07-01

2016-05-01

2015-03-01

2014-01-01

2012-11-01

2011-09-01

2010-07-01

2009-05-01

2008-03-01

2007-01-01

2005-11-01

2004-09-01

2003-07-01

-4.0

2002-05-01

-2.0

2001-03-01

0.0

2000-01-01

Rate

8.0

Inflation Gap

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Chapter 25: The Role of Expectations in Monetary Policy Chapter Overview and Teaching Tips Over the last thirty years, the role of the public and the market’s expectations has moved to the front and centre of the thinking about how the macro economy works. Chapter 25 discusses the most widely used theory to describe the formation of household and business expectations— rational expectations—and develops it from microeconomic principles. Using the AD/AS model developed earlier in the book, it then explores how this theory has shaped current policy making and debates.

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

The chapter next turns to a set of policy issues. The first is the debate over whether policymakers should follow rules or instead conduct policy with complete discretion, in which policy is conducted on a day-to-day basis. The argument for rules is based on the time-inconsistency problem, another one of the most important ideas in macroeconomics over the last thirty years.

The problem with discretion is that policymakers can’t commit to good long-run strategies.

Instead they have incentives to renege on the good strategy and therefore pursue policy that leads to poor outcomes. I like to illustrate this concept in class by presenting everyday examples. One is how we eat. We don’t want to eat unhealthy food, but when we see that juicy hamburger, we just can’t resist it. Another example is the inability to stay on a diet, as discussed in the text. I also like discussing the problem of child rearing and the temptation to give in to bad behaviour.

This example also illustrates why having a rule helps solve the time-inconsistency problem.

Rules, however, “are made to be broken,” as the adage says. The application “The Demise of Monetary Targeting in Switzerland,” illustrates how following rules can lead to policy mistakes.

A solution to the problems with both rules and complete discretion is provided by the concept of “constrained discretion,” a term that Ben Bernanke and Rick Mishkin coined in a paper published in 1997. Constrained discretion imposes rule-like behaviour on policymakers by imposing a discipline on them, but one that allows for some flexibility. This is exactly the approach in the policy framework of inflation targeting, which was discussed in Chapter 17.

The next policy issue the chapter discusses is the role of credibility and a nominal anchor. Here, the rational expectations conclusion that expectations about policy affect inflation expectations is embedded in the AD/AS model, which is then used to show that having a credible commitment to a nominal anchor produces better outcomes on both inflation and output when there are either

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demand or supply shocks. To demonstrate to students that the analysis is relevant to real-world outcomes, it is worth discussing in class the application “A Tale of Three Oil Shocks” to show that a surge in oil prices has adverse affects on the economy when the commitment to a nominal anchor is weak, as occurred in the two oil price shocks in the 1970s. On the other hand, when the central bank commitment to the nominal anchor of controlling inflation was strong, then an oil price shock like that in 2007 did not have as adverse consequences (although the financial crisis did).

Students also enjoy historical examples showing how credibility is critical to the success of antiinflation policies. The box on ending the Bolivian hyperinflation drives home the importance of credibility because it is so dramatic. The final section of the chapter discusses different approaches to establishing a credible nominal anchor. Besides the approaches of inflation targeting, outlined in Chapter 17, and exchange rate targeting, discussed in Chapter 19, this chapter discusses a variant of the inflation targeting approach, nominal GDP targeting, which has received a lot of attention lately.

Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. What does the Lucas critique state about the limitations of our current understanding of the way in which the economy works?

The Lucas critique says that policymakers’ priors about the effects of a given policy will generally be wrong, since it is difficult for policymakers to accurately take into account people’s reactions to changes in policies. This points out the limitation to our understanding of how the economy works in that current research cannot fully explain and model accurately the behaviour of individuals, and therefore policymakers have to rely on fundamentally flawed models to estimate the effects of policies on the economy.

2. “The Lucas critique by itself casts doubt on the ability of discretionary stabilization policy to be beneficial.” Is this statement true, false, or uncertain? Explain your answer.

True, because the Lucas critique indicates that the effect of policy on inflation and output depends on the public’s expectations about the policy. The outcome of a particular policy is therefore less certain in Lucas’s view than if expectations about it do not matter, and it is harder to design a beneficial activist stabilization policy.

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3. Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Bank of Canada increases the overnight interest rate. Assume the Bank of Canada is considering an increase in the overnight interest rate target to fight inflation and promote a low-inflation environment that will encourage investment and economic growth. a. Discuss the implications of the econometric model’s predictions if individuals interpret the increase in the overnight interest rate target as a sign that the Bank will keep inflation at low levels in the long run.

According to the rational expectation theory, individuals might interpret this increase in the overnight interest rate target as a signal that the Bank of Canada will commit to fight inflation. The increase in the overnight interest rate determines an increase in real interest rates in the short run and results in a higher user cost of capital. Although this might reduce investment, it is possible that individuals recognize the Bank of Canada’s intentions and therefore decide to increase investment in anticipation of a low-inflation economic environment that encourages investment. b. What would be Lucas’s critique of this model?

Lucas’s critique will point out the fact that the model was probably constructed by using past data in which domestic investment decreased after interest rates increased. But that model does not take into consideration that individuals might revise their expectations quite quickly and might decide to alter the way in which they respond to changes in economic variables, like the interest rate.

4. If the public expects the Bank of Canada to pursue a policy that is likely to raise short-term interest rates permanently to 5%, but the Bank does not go through with this policy change, what will happen to long-term interest rates? Explain your answer.

Long-term interest rates will fall. Theories of the term structure suggest that long-term interest rates are related to the expected average of future short-term interest rates. When the public expects the Bank of Canada to raise short-term interest rates permanently, they raise their expectations of future short-term rates and long rates are higher. Then, when the Bank does not go through with the expected policy of raising short-term rates, the public will realize that their expectations were mistaken and will revise their expectations of short-term rates downward. The result is that the Bank of Canada’s decision not to go through with the policy change causes long-term interest rates to fall.

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5. In what sense can greater central bank independence make the time-inconsistency problem worse?

When central banks are more independent, they are less formally accountable for pursuing stable inflation policies. In this sense, it is easier for central banks to give the appearance of desiring to pursue low-inflation policies while in actuality pursuing more expansionary policies to lower the unemployment rate and increase output. However, even with greater central bank independence, the time-inconsistency problem can be somewhat alleviated through greater transparency and communication, which means that there is less ability for the public to be fooled into false expectations and therefore less ability for the central bank to pursue overly inflationary policies to increase output and lower unemployment in the short run.

6. What are the arguments for and against policy rules?

Advocates of rules argue that they solve the time-inconsistency problem so that policymakers will achieve good long-run economic outcomes, that they will prevent repeating serious policy mistakes of the past, and that they will avoid political business cycles that might result if policymakers were free to adopt expansionary policies before an election followed by contractionary policies afterward. Opponents argue that rules are too rigid and deny policymakers the flexibility they need to deal with unforeseeable problems, that they do not allow any role for judgment in policy making, that they may be based on incorrect models of the economy, and that they will lead to bad economic outcomes if the economy undergoes structural changes.

7. If, in a surprise victory, a new government that the public believes will pursue inflationary policy is elected to office, predict what might happen to the level of output and inflation even before the new government comes into power.

The rise in expected inflation as a result of the election would shift the short-run aggregate supply curve upward, which would lead to a rise in inflation and a fall in output.

8. Many economists are worried that a high level of budget deficits may lead to inflationary monetary policies in the future. Could these budget deficits have an effect on the current rate of inflation?

Yes, if budget deficits are expected to lead to an inflationary monetary policy and expectations about monetary policy affect the short-run aggregate supply curve. In this case, a large budget deficit would cause the short-run aggregate supply curve to shift upward because expected inflation would be higher. The result is that the increase in the current inflation rate would be higher.

9. In some countries, the government chooses the head of the central bank. The same government can fire the head of the central bank and replace him or her with another one at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

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When the government has the authority to nominate or lay off the head of the central bank, it is quite plausible that the conduct of monetary policy would be discretionary. Adherence to monetary policy rules involves imposing some hardship on the economy sometimes. If the government can pressure the head of the central bank, then most likely monetary policy will be discretionary and follow the dictates of the government. This is actually what happened in many South American countries in the 1970s and 1980s. Not surprisingly, most of these countries could not reach long-run goals such as price stability during this period. Also, frequent changes in monetary policy (and fiscal policy) resulted in increased output volatility and low growth. Although most central banks are still subject to pressure from politicians, it is widely understood that some independence is desirable.

10. How would an unexpected change in the equilibrium real overnight interest rate be an argument against using a Taylor rule for monetary policy implementation?

One of the criticisms of using rules is that oftentimes, once implemented, structural changes in the economy necessitate updating the rule regularly to reflect appropriate policy outcomes.

However, in this case, if the equilibrium real fed funds rate changes and policymakers do not know it has changed, are uncertain of the magnitude or direction of change, or recognize the change but simply fail to update the policy rule, it is likely that monetary policy will be either too tight or too loose relative to what it should be. As a result, rather than relying solely on a mechanical rule, policymakers may be better off using discretion, which can much more flexibly account for these types of frequent and unexpected structural changes in the economy.

11. How is constrained discretion different from discretion in monetary policy? How are the outcomes of these policies likely to differ?

Constrained discretion is a more transparent and disciplined type of discretion in which the general objectives and tactics of the policymaker are committed to in advance. This allows for some flexibility in policy actions (as in a purely discretionary regime) but somewhat limits the ability of policymakers to pursue overly expansionary policies as long as they are committed to the general objectives and tactics laid out. The difference in outcomes is that under constrained discretion, since policymakers are likely to have more credibility through commitment and transparency, inflation and inflation expectations are likely to be lower than under pure discretion, without giving up much flexibility to address changes in the real economy.

12. In general, how does credibility (or lack thereof) affect the aggregate supply curve?

In general, when central banks lack credibility, there is little faith by the public that the central bank will pursue policies that will result in low, stable inflation. As a result, inflation expectations are likely to be higher, leading to an upward shift in the short-run aggregate supply curve. This results in higher actual inflation and lower output, which is obviously less desirable an outcome than if the central bank were to have full credibility.

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13. In Japan, the government and central bank have enacted policies recently to raise inflation permanently from persistently low levels; however, inflation continues to remain near zero.

How, if at all, might credibility of the central bank explain the low-inflation persistence?

Normally, expansionary fiscal or monetary policies (especially when implemented together) should result in higher inflation and consequently raise inflation expectations to permanently higher levels. However, in the case of Japan, since inflation has been near zero for many years, this has anchored inflation expectations near zero as well. More specifically, it has created a mindset among market participants and the public in Japan that even if the central bank or government acts, it may be less likely to be successful in raising inflation. Because of the lack of credibility by the central bank in its efforts to raise inflation, this is reflected in permanently low-inflation expectations and low actual inflation.

14. As part of its response to the global financial crisis, the Federal Reserve in the United States lowered the federal funds rate target to nearly zero by December 2008 and quadrupled the monetary base between 2008 and 2017, a considerable easing of monetary policy. However, survey-based measures of 5- to 10-year inflation expectations remained low throughout most of this period. Comment on the Fed’s credibility in fighting inflation.

This is a clear sign that the Fed enjoys a high level of credibility. This credibility was probably earned over the last three decades. Although the Fed never explicitly stated an inflation target until 2012, many people believe that Fed officials had an inflation target in their minds during this period. Even though it was not announced, this target was assumed to be above zero, and (here is where opinions differ) around 1.5% to 2.5% annual inflation rate.

Even if the Fed has not announced an inflation target, and can therefore not be held accountable for missing it, it is quite clear that individuals believe that the Fed is and has been concerned about keeping inflation at low and stable levels. Finally, even more impressive is the fact that the monetary base increased significantly as a consequence of the Fed’s actions to support the U.S. financial system, but this did not result in high expected inflation, either.

15. “The more credible the policymakers who pursue an anti-inflation policy, the more successful that policy will be.” Is this statement true, false, or uncertain? Explain your answer.

True, if expectations about policy affect the wage- and price-setting process. In models in which expectations about policy are relevant, a credible anti-inflation policy reduces inflation faster and at lower output costs than an anti-inflation policy that is not believed (and hence not expected) by the public.

16. Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks of 2007?

As Figure 25-3 in the chapter demonstrates, the oil price shocks in the 1970s resulted in significantly higher inflation and unemployment as compared to the shock that affected the economy beginning in 2007. The main distinction between the two episodes is the role of policy credibility. In the case of the 1970s, the central bank’s commitment to keeping

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inflation low was weak, so the oil price shocks shifted the aggregate supply curve upward not only due to the shock itself but also due to higher inflation expectations as a result of weak central bank credibility. In contrast, the central bank’s commitment to keep inflation low and stable in the last couple of decades has created strong central bank credibility. This kept inflation expectations from rising very much as a result of the 2007 shock, so the effects on actual inflation and the unemployment were more subdued than in the 1970s episodes.

17. Central banks that engage in inflation targeting usually announce the inflation target and time period for which that target will be relevant. In addition, central bank officials are held accountable for their actions (e.g., they could be fired if the target is not reached), and their success or lack thereof is also public information. Explain why transparency is such a fundamental ingredient of inflation targeting.

Announcements about the inflation targets and potential punishments for central bank officials are crucial for inflation targeting. It is very important for the public to be able to check whether the target has been reached or not. When central bank officials know that the public can easily check their performance, they have an extra incentive to do everything in their power to attain their goals, as their reputation is at stake. Even if their reputation is not that important to them, they have an incentive to do their job, since they might be fired otherwise. When the central bank officials and the general public know “the rules of the game,” there is a higher probability that monetary policy will be more credible. In conclusion, transparency could be a good ingredient in the conduct of any specific type of monetary policy.

18. In recent years, central banks have dramatically increased the amount of communication with market participants and the public, and at the same time in many of these countries, average inflation has declined and become less volatile. Is this coincidence, or is there a connection? Explain.

In general, this is not a coincidence. With increased communication, this increases transparency by the central bank and reduces the time-inconsistency problem inherent with discretionary monetary policy. As a result, inflation expectations, and credibility more broadly, are more closely aligned with policies of the central bank. Thus, one would expect that with greater transparency, greater accountability and credibility will result. And as demonstrated in the chapter in Figures 25-1, 25-2, and 25-4, this leads to better inflation outcomes and less volatile inflation.

19. What are the purposes of inflation targeting, and how does this monetary policy strategy achieve them?

Inflation targeting has two basic purposes: to keep inflation under control and to increase the credibility of monetary policymakers’ commitment to price stability. These are achieved by announcing a numerical target for inflation and a commitment to price stability as the primary long-run goal of monetary policy, increasing communications with the public and financial market participants about the goals and processes of monetary policy making, and holding policymakers accountable for achieving the inflation target that has been set.

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20. How can the establishment of an exchange-rate target bring credibility to a country with a poor record of inflation stabilization?

Tying its domestic currency to another country’s currency is an easy way for a country with a poor inflation record to establish credibility. This is because a formal exchange-rate target provides a simple and clear rule for monetary policymakers to follow, which is easily verifiable. Thus, commitment to the exchange rate target significantly reduces the timeinconsistency problem by limiting discretionary policy. Moreover, committing to an exchange-rate target with a country that has a good record of low, stable inflation means that the domestic economy will import that low-inflation environment as long as it maintains its commitment to the target.

21. What traits characterize a “conservative” central banker?

A conservative central banker is one who has a strong and notable dislike for inflation. In other words, a conservative central banker would be appointed to project a strong aversion to inflation and be committed to keeping inflation low and stable.

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ANSWERS TO APPLIED PROBLEMS 22. Suppose the central bank is following a constant-money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank’s credibility if it abandons the money growth rule to respond to the downturn?

A severe downturn would result in the aggregate demand curve shifting sharply to the left to AD2 below. With a strict constant money growth rule, this would result in a limited expansionary effect on aggregate demand, shifting aggregate demand back to AD3. However, this would be inadequate to fully stabilize output, and a recessionary condition would still persist. This could reflect poorly on the central bank in the sense that, by failing to stabilize output, it may be viewed by the public as not doing its job. The central bank could abandon the constant-money-growth-rate rule and expand aggregate demand enough to move the economy back to potential output (at AD1); however, this would be moving away from a rules-based policy, which helps keep credibility high and inflation expectations low, to a more discretionary framework in which credibility would be lower and inflation expectations higher.

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23. Suppose country A has a central bank with full credibility and country B has a central bank with no credibility. How does the credibility of each country’s central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

In country A, the public is more likely to believe announcements about future policy changes and therefore adjust inflation expectations in anticipation of changes in future policy. As a result, aggregate supply will adjust more quickly to policy announcements compared to country B in which the central bank has no credibility. If the central banks both announce an autonomous tightening policy to reduce the target inflation rate, the aggregate supply curve will shift down much quicker in country A than country B. With no credibility, country B would likely have to contract aggregate demand first and let expectations adjust after the policy is implemented to achieve the same lower long-term inflation rate as country A. The implication is that output will be more stable in country A than in country B, and the adjustment process is faster in country A than country B.

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24. Suppose two countries have identical aggregate demand curves and potential levels of output, and γ is the same in both countries. Assume that in 2016, both countries are hit with the same negative supply shock. Given the table of values below for inflation in each country, what can you say, if anything, about the credibility of each country’s central bank? Explain your answer.

Country A

Country B

2021

3.0%

3.0%

2022

3.8%

5.5%

2023

3.5%

5.0%

2024

3.2%

4.3%

2025

3.0%

3.8%

Since the aggregate demand curve, potential output, the parameter γ, and the price shock are identical in both countries, the only factor that can explain the difference in inflation between the two countries is expected inflation. Country B’s inflation rate jumps much higher and stays elevated for much longer than country A’s inflation rate, which must be reflective of higher inflation expectations in country B. The implication is that the central bank in country B has less credibility at maintaining low, stable inflation than country A, thus as a result of the negative supply shock, households and firms raised inflation expectations more as a result of the weak commitment by the central bank in country B. 25. How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

Positive aggregate demand shocks shift the aggregate demand curve to the right, causing both inflation and output to rise. Without a credible nominal anchor, the increase in inflation causes expected inflation to rise, which shifts the short-run aggregate supply curve upward and causes the inflation rate to increase further to 3. With a credible nominal anchor, however, expected inflation does not change, so there is no upward shift in the short-run aggregate supply curve. Thus, with a credible nominal anchor, inflation is more stable following the demand shock.

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The outcome is similar when a negative aggregate supply shock occurs. Inflation increases and output falls as the short-run aggregate supply curve shifts upward, but with a credible nominal anchor, expected inflation does not increase. As a result, no further upward shifts of the short-run aggregate supply curve occur, and the increase in inflation and decrease in output are not as great as they otherwise would be. Thus the credible nominal anchor brings about better outcomes for both inflation and output when a negative supply shock occurs, as shown in the graph below.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Bank of Canada’s website, and find data on the inflation rate (the 12-month growth rate in total CPI). a. Calculate the average inflation rate over the last 12 and the last 24 months of data available. How does it compare to the 2% inflation goal?

The average inflation rate over the last 12 months at the time of writing, from 2020:m1 to 2020:M12 is 0.725%, and over the last 24 months, from 2019:M1 to 2020:M12, is 1.333%. It is well below the 2% desirable inflation rate but within the inflation target range (from 1% to 3%). b. What, if anything, does your answer to part (a) imply about Bank of Canada credibility?

There is a bit of a disconnect, at least in the near-term data between inflation and the 2% target. Consistently missing the target, all else equal, may lead the public to believe the Bank of Canada has lost its ability to keep inflation stable, which can potentially unanchor inflation expectations and lead to a decline in credibility. This is a concern in this case since falling inflation expectations in a very low-inflation environment can eventually lead to falling actual inflation and at a relatively low rate of inflation can turn into deflation.

2. Go to the St. Louis Federal Reserve FRED database and find data on the core PCE price index (PCEPILFE) and the spot price of a barrel of oil (WTISPLC). For both variables, convert the units setting to “Percent Change from Year Ago,” and download the data from 1960 to the most recent available data. a. Identify periods in which oil price inflation is 80% or higher. b. In the periods identified in part (a), for how many months was oil price inflation 80% or higher? What was the average core inflation rate during each of those episodes? c. Based on your answers to parts (a) and (b) above, what can you conclude about the credibility of more recent monetary policy compared to its credibility in the earlier periods? a. See the graphs below. Oil price inflation was 80% or higher during the periods of January 1974–December 1974; September 1979–July 1980; July 1987; November 1999–March 2000; May 2008–June 2008; and December 2009–February 2010.

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Oil and Core Inflation

Core PCE Inflation (Left Axis)

2018-07-01

2016-05-01

2014-03-01

2012-01-01

2009-11-01

2007-09-01

2005-07-01

2003-05-01

2001-03-01

1999-01-01

1996-11-01

1994-09-01

1992-07-01

1990-05-01

1988-03-01

-100.0

1986-01-01

0.0

1983-11-01

-50.0

1981-09-01

2.0

1979-07-01

0.0

1977-05-01

4.0

1975-03-01

50.0

1973-01-01

6.0

1970-11-01

100.0

1968-09-01

8.0

1966-07-01

150.0

1964-05-01

10.0

1962-03-01

200.0

1960-01-01

12.0

Oil Price Inflation (Right Axis)

b. For the 1974 episode, it lasted 12 months, and average inflation during that time was 7.9%. The 1979–1980 episode was 11 months long, with average core inflation of 8.5%.

The 1987 episode was only one month long, with average core inflation of 3.2%. The 1999–2000 episode was five months long, with average core inflation of 1.6%. The 2008 episode was only two months long, and average core inflation was 2.3%. The 2009–2010 episode was three months long, and average core inflation was 1.7%. c. Clearly, the recent monetary policy has been much more credible in keeping inflation low and stable. In particular, looking at the average inflation during each episode, it is clear that sharp increases in oil prices in the 1970s led to much bigger changes in the inflation rate. More recent episodes of similar magnitude left inflation rates relatively low and stable, suggesting an anchoring of expectations inherent with high credibility.

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b. In the periods identified in part (a), how many months was oil price inflation 80% or higher? What was the average core inflation rate during each of those episodes?

For the 1974 episode, it lasted 12 months, and average inflation during that time was 7.9%. The 1979–1980 episode was 11 months long, with average core inflation of 8.4%.

The 1987 episode was only 1 month long, with average core inflation of 3.2%. The 1999–2000 episode was 5 months long, with average core inflation of 1.6%. The 1979–1980 episode was 11 months long, with average core inflation of 8.4%. The 2008 episode was only two months long, and average core inflation was 2.3%. The 2009–2010 episode was 3 months long, and average core inflation was 1.5%. c. Based on your answers to parts (a) and (b) above, what can you conclude about the credibility of more recent monetary policy compared to its credibility in the earlier periods?

Clearly, the recent monetary policy has been much more credible in keeping inflation low and stable. In particular, looking at the average inflation during each episode, it is clear that sharp increases in oil prices in the 1970s led to much bigger changes in the inflation rate. More recent episodes of similar magnitude left inflation rates relatively low and stable, suggesting an anchoring of expectations inherent with high credibility.

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Chapter 26: Transmission Mechanisms of Monetary Policy Chapter Overview and Teaching Tips Chapter 26 discusses the transmission mechanisms of monetary policy so that students can understand how monetary policy affects the economy. The two applications on monetary transmission mechanisms during the Great Recession and the lessons this research provide to monetary policymaking for Japan also stimulate student interest.

An appendix in MyLab Economics discusses the empirical evidence on whether or not money is important to aggregate economic activity and provides the student with an understanding of the transmission mechanisms of monetary policy. We teach this material because it gives students a feel for how tricky it is to interpret empirical evidence in economics and other social sciences.

The appendix starts off by dichotomizing evidence into two types: reduced-form versus structural-model evidence. We have found that the best way to teach the difference between these two types of evidence and the advantages and disadvantages of each type is to give several analogies. The link between coffee drinking and heart disease mentioned in the chapter is one useful analogy; others include the link between cholesterol and heart disease or jogging and long life. Explaining why correlation does not imply causation is also helped by stories such as the boxes on the Russian folktale or how to lose an election in Box 2. Students find these stories to be fun, and they really drive the point home.

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

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

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Answers to End-of-Chapter Questions and Problems ANSWERS TO QUESTIONS 1. From 2008 to 2015, auto loan rates in the United States declined from around 8% to near historic lows of around 4.0%. At the same time, auto sales increased to near historic high levels by 2017. How, if at all, does this relate to the monetary transmission mechanism?

Assuming that monetary policy was relatively accommodative during that period, that would have contributed to the decline in auto loan interest rates and thus encouraged greater purchases of automobiles. This effect highlights one dimension of the traditional interest rate channel, where accommodative monetary policy leads to an increase in consumer durable goods (automobiles).

2. “Considering that consumption accounts for nearly two-thirds of total GDP, this means that the interest rate, wealth, and household liquidity channels are the most important monetary policy channels in Canada.” Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although consumption is the largest part of overall Canadian GDP, and there is no doubt that these channels can be important to monetary policy effectiveness, some may disagree with this statement. For instance, even though investment is closer to 15% of GDP, investment fluctuations are much more pronounced over the business cycle than changes in consumption, leading to the possibility that interest rate effects on investment could be potentially more important. In addition, proponents of the credit view believe that credit market effects are much more important than interest rate effects, and since the credit view primarily affects investment, credit effects on investment could be potentially more powerful than consumption effects from monetary policy changes.

3. How can the interest rate channel still function when short-term nominal interest rates are at the zero lower bound?

If the central bank commits to a higher inflation policy while maintaining low nominal interest rates, this will raise inflation expectations and therefore lower real interest rates, even if the nominal interest rate is zero. In addition, the central bank can commit to keeping shortterm interest rates low for a long time, which can have the effect of lowering longer-term nominal interest rates, which also reduces real longer-term interest rates.

4. Lars Svensson, a former Princeton professor and deputy governor of the Swedish central bank, proclaimed that when an economy is at risk of falling into deflation, central bankers should be “responsibly irresponsible” with monetary expansion policies. What does this mean, and how does it relate to the monetary transmission mechanism?

Part of the problem with deflation is that lower (negative) inflation raises the real interest rate, which raises the cost of capital and lowers investment and consumption through the interest-rate channel, creating further deflationary pressure. In addition, short-term nominal interest rates reach the zero lower bound, meaning traditional monetary policy is rendered ineffective. Thus, by being “responsibly irresponsible,” central banks can commit to creating

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strong but temporary inflationary policies that are designed to raise inflation expectations (and hence lower real interest rates) enough to create stimulus through the interest rate channel and expand aggregate demand safely and surely to get out of a deflationary spiral.

5. Describe an advantage and a disadvantage of the fact that monetary policy has so many different channels through which it can operate.

An advantage to monetary policy having so many channels through which it can affect the economy is that if policy is rendered ineffective through any one particular channel, it doesn’t mean the policy is entirely ineffective, as there are other channels and other sectors of the economy in which the same policy can still affect the economy. On the other hand, having so many different channels through which monetary policy operates can increase uncertainty over the effects of any given policy.

6. “If countries fix their exchange rate, the exchange rate channel of monetary policy does not exist.” Is this statement true, false, or uncertain? Explain your answer.

True. When countries fix their exchange rate, they must use monetary policy to affect the interest rate in order to maintain the exchange rate. In other words, the central bank must change the real interest rate to maintain the exchange rate, which means net exports and aggregate demand will be unaffected as long as the exchange rate peg is maintained.

7. During the 2007–2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.

There are four main mechanisms through which the decline in stock prices could have reduced aggregate demand and contributed to the severity of the recession. First, the decline in stock prices lowered Tobin’s q and might have reduced investment spending. Second, the decline in financial wealth, as a result of the stock price decline, could have caused a drop in consumption because consumers’ lifetime resources were reduced. Third, the decline in stock prices lowered the value of financial assets, which increased the public’s probability of financial distress, and so they cut back on their purchases of consumer durables and housing.

Fourth, the decline in stock prices lowers the net worth of business firms, which increases adverse selection and moral hazard problems in lending and might have resulted in a reduction in lending and less investment spending.

8. “The costs of financing investment are related only to interest rates; therefore, the only way that monetary policy can affect investment spending is through its effects on interest rates.”

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

False. Monetary policy can affect stock prices, which affect Tobin’s q and adverse selection and moral hazard problems in lending, thereby affecting investment spending. In addition, monetary policy can affect loan availability, which may influence investment spending.

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9. From March 2009 to February 2020, the S&P 500 stock index increased by a cumulative 350% Over the same period, University of Michigan’s index of consumer confidence increased from 57.3 to 101.0 (an increase of 75%). Explain how this relates to the monetary transmission mechanism.

Assuming that monetary policy was relatively accommodative during that period of time, this could have contributed to the increase in stock prices. The higher value of the stock portfolio leads to higher wealth of households and is reflected in higher consumer confidence. As a result, you would expect that through this wealth effect, consumption would increase, demonstrating the wealth channel of the monetary transmission mechanism.

10. From mid-2008 to early 2009, the Dow Jones Industrial Average declined by more than 50%, while real interest rates were low or falling. What does this scenario suggest should have happened to investment?

The lower real interest rates would stimulate investment spending because the cost of financing investments would fall. However, the stock market decline would cause the market value of firms to fall and so Tobin’s q to fall. The decline in Tobin’s q would then lead to a decline in investment spending. Because the stock market and the Tobin’s q decline was so large, investment spending actually fell dramatically during this period.

11. Nobel Prize winner Franco Modigliani found that the most important transmission mechanisms of monetary policy involve consumer expenditure. Describe how at least two of these mechanisms work.

There are three mechanisms involving consumer expenditure. First, an expansionary monetary policy lowers interest rates and reduces the cost of financing purchases of consumer durables, and consumer durable expenditure rises. Second, an expansionary monetary policy causes stock prices and wealth to rise, leading to greater lifetime resources for consumers and causing them to increase their consumption. Third, an expansionary monetary policy that causes stock prices and the value of financial assets to rise also lowers people’s probability of financial distress, so they spend more on consumer durables.

12. In the late 1990s, the stock market was rising rapidly, the economy was growing, and the Federal Reserve kept interest rates relatively low. Comment on how this policy stance would affect the economy as it relates to the Tobin q transmission mechanisms.

This situation is consistent with Tobin’s q and the wealth effects of expansionary monetary policy. With lower interest rates, stock prices rise. Tobin’s q predicts that investment will increase, stimulating aggregate demand. In addition, with the higher stock prices, this will raise wealth and lead to higher consumption and increased aggregate demand.

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13. During and after the global financial crisis, the Bank of Canada reduced the overnight interest rate to nearly zero. At the same time, the stock market fell dramatically and housing market values declined somewhat. Comment on the effectiveness of monetary policy during this period with regard to the wealth channel.

The wealth channel suggests that this type of monetary policy would raise stock prices and increase house prices, which would raise homeowners’ equity and hence wealth through housing and stock markets. However, even though real interest rates were low, stock values and housing wealth declined, which ultimately decreased consumption and aggregate demand, suggesting monetary policy effects through the wealth channel were ineffective during the global financial crisis.

14. From August 2014 to August 2017, the Fed continued to reiterate that monetary policy was “accommodative.” And during this time, excess reserves by banks decreased from around $2.67 trillion to around $2 trillion, a decline of about 25%. What does this say about the bank lending channel?

With accommodative monetary policy and plenty of reserves in the banking system, the reduction in excess reserves can be interpreted as an increase in lending by banks. Through the bank lending channel of the monetary transmission mechanism, the increased lending should result in greater investment by firms and in new residential construction investment.

15. Why does the credit view imply that monetary policy has a greater effect on small businesses than on large firms?

Since small businesses are more dependent on bank loans than large firms, monetary policy changes that affect the availability of credit will disproportionately affect small businesses more than large firms.

16. Why might the bank lending channel be less effective today than it once was?

There are a couple reasons why this might be true. First, bank regulations in the United States have eased, making it easier for banks to raise funds through various sources that were cumbersome under Regulation Q. The implication is that the Fed has less control over the behaviour of banks in response to policy changes because of the change in regulations. In addition, there has been a worldwide decline in the traditional bank lending business, meaning the sheer size of bank lending is lower, making this channel less potent.

17. If adverse selection and moral hazard increase, how does this affect the ability of monetary policy to address economic downturns?

It would make it more difficult for the central bank to stimulate the economy. The credit view indicates that adverse selection and moral hazard play an important part in affecting investment behaviour and ultimately the economy. However, during downturns, asymmetric information problems increase, meaning that monetary policy must be more powerful to offset the contractionary effects of increases in adverse selection and moral hazard.

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18. How does the Great Depression demonstrate the unanticipated price level channel?

During the Great Depression, the fall in the price level led to a significant decrease in consumer wealth and a sharp decline in consumption. The decline in prices led to an increase in real debt of more than 20%, and overall, the effect on consumers was to reduce expenditure more than 50%, and housing expenditures fell 80%.

19. How are the wealth effect and the household liquidity effect similar? How are they different?

The two channels are similar in that increases in real interest rates lead to lower asset prices, which lead to lower spending on consumption and housing. The difference is in how changes in asset prices lead to lower spending. Under the wealth effect, people are simply less willing to spend when wealth is lower (due to lower overall lifetime resources), leading to a reduction in spending. The household liquidity effect instead indicates a substitution effect between more liquid assets (such as cash or stocks) and less liquid assets (such as consumer durables or housing). Thus, with lower asset values, households use their resources to purchase safer, more liquid assets rather than consumption or housing, leading to lower aggregate demand.

20. After the coronavirus pandemic hit the economy, mortgage rates reached record-low levels in 2020. a. What effect should this have had on the economy, according to the household liquidity effect channel?

Lower mortgage rates should lead to higher housing prices and raise the value of housing wealth. This should lead to a lower probability of financial distress and raise consumer durable and housing expenditure. b. During the same time, most banks raised their credit standards significantly, making it much more difficult to qualify for home loans and to refinance existing loans. How does this information alter your answer to part (a)?

Even though interest rates were extremely low, if nobody could qualify for the low mortgage rates it would not have an appreciable effect on raising the value of households’ financial assets (i.e., housing wealth). Thus, the likelihood of financial distress would remain elevated and not improve consumer durable and housing expenditure.

21. “If the overnight interest rate is at zero, the Bank of Canada can no longer implement effective accommodative policy.” Is this statement true, false, or uncertain? Explain.

False. Even though conventional monetary policy tools may be ineffective, the Bank of Canada can implement a number of nonconventional monetary policy tools to help provide accommodation if needed. The recent financial crisis of 2009 is a good case in point where central banks around the world were able to effectively implement large-scale asset-purchase programs, provide liquidity to key credit markets, and use forward guidance to effectively (if not slowly) generate a sustained recovery away from the zero lower bound.

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22. In December 2015, the Fed raised the fed funds rate for the first time in nearly a decade and gradually increased interest rates over a prolonged period of time after that. However, the Fed continued to reiterate in its policy statements during this time that “the stance of monetary policy remains accommodative.” Explain this seeming contradiction.

Even though the Fed was raising its conventional policy interest rate, the fact that inflation was higher than the fed funds rate indicates that real policy rates were still negative and therefore accommodative. In addition, during this time the Fed still held a sizable amount of assets from its previous large-scale asset-purchase programs, which also had accommodative impacts on mortgage rates and longer-term interest rates. Altogether, this reflects the fact that movements in the nominal policy rate are not necessarily indicative of the overall stance of monetary policy.

23. In general, if stock prices are rising, consumption growth is strong, house price appreciation is high, and unemployment is low, would you classify monetary policy as too tight, too loose, or just right?

In this case, it is likely that whatever the short-term nominal policy rate is, monetary policy is very easy.

24. How does the experience of Japan during the “two lost decades” lend support to the four lessons for monetary policy outlined in this chapter?

The experience of Japan directly supports the four lessons of monetary policy discussed in the chapter. First, short-term interest rates in Japan were near zero; however, due to deflation, real interest rates remained elevated, suggesting a contractionary monetary policy stance.

Second, if Japanese policymakers would have paid more attention to the collapse of stock and housing markets, this could have led to earlier and swifter action to shore up the economy. Third, Japan took no steps to stimulate the economy other than pushing short-term rates to zero. However, they could have done more to push longer-term rates down through asset purchases and raising inflation expectations. Finally, Japan allowed the economy to go into a deflationary period, leading to unanticipated and undesirable fluctuations in the price level.

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ANSWERS TO APPLIED PROBLEMS 25. Suppose the economy is in recession and the monetary policymakers lower interest rates in an effort to stabilize the economy. Use an aggregate supply and demand diagram to demonstrate the effects of a monetary easing when the transmission mechanisms are functioning normally and when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

When the transmission mechanisms are functioning normally (and predictably), policymakers can ease monetary policy with reasonable precision so that the aggregate demand curve shifts to the right from AD1 to AD3 and eliminates the output gap. Under periods in which the monetary transmission mechanisms are not functioning normally, such as during a financial crisis, some channels may not work as effectively or at all. As a result, for a given monetary policy prescription, the effects on aggregate demand may be muted or nonexistent. In this case, aggregate demand may only shift to the right to AD2, and an output gap may still remain at Y2. This illustrates the limitations of monetary policy to stabilize the output gap in such situations.

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ANSWERS TO DATA ANALYSIS PROBLEMS 1. A “rate cycle” is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), real business fixed investment (PNFIC1), real residential investment (PRFIC1), and consumer durable expenditures (PCDGCC96) for the United States. Use the frequency setting to convert the federal funds rate data to “quarterly,” and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy. b. Calculate the percentage change in business fixed investment, residential (housing) investment, and consumer durable expenditures over this rate cycle.

Over this period, business fixed investment decreased by 9.2%, residential investment decreased by 6.3%, and consumer durable spending decreased by 2.9%. c. Based on your answers to parts (a) and (b), how effective was the traditional interest rate channel of monetary policy over this rate cycle?

Based on the expansionary nature of the rate cycle, and the declines in all three components of the traditional interest rate channel, this transmission mechanism was not very effective in having the impact the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

2. As defined in Exercise 1, a “rate cycle” is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), bank reserves (TOTRESNS), bank deposits (TCDSL), commercial and industrial loans (BUSLOANS), real estate loans (REALLN), real business fixed investment (PNFIC1), and real residential investment (PRFIC1). Use the frequency setting to convert the federal funds rate, bank reserves, bank deposits, commercial and industrial loans, and real estate loans data to “quarterly,” and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy.

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b. Calculate the percentage change in bank deposits, bank lending, real business fixed investment, and real residential (housing) investment over this rate cycle.

Over this period, bank reserves increased by 97.3%, bank deposits increased by 45.5%.

As a result, business fixed investment decreased by 9.2%, C&I loans increased by 25.4%, while real estate loans increased by 3.4% and residential investment decreased by 6.3%. c. Based on your answers to parts (a) and (b), how effective was the bank lending channel of monetary policy over this rate cycle?

The results are somewhat mixed with the data. Based on the expansionary nature of the rate cycle, we would expect all of these variables to increase when the policy rate decreases, according to the bank lending transmission mechanism. However, with the exception of business fixed investment and residential investment, all of the variables increased. Thus, it appears that this transmission mechanism was modestly effective in having some impacts the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

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Appendix: Alternative Course Outlines Outline for General Money and Banking Course Core Chapters Ch 1 Ch 2 Ch 3 Ch 4 Ch 5 Ch 9 Ch 10 Ch 12 Ch 14 Ch 16 Ch 17 Ch 23 Ch 24

Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

The Meaning of Interest Rates The Behaviour of Interest Rates Economic Analysis of Financial Regulation Banking Industry: Structure and Competition Banking and the Management of Financial Institutions Central Banks and the Bank of Canada Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics Aggregate Demand and Supply Analysis Monetary Policy Theory

For a one-semester course, cover any five of the following optional chapters: Ch 6 Ch 7 Ch 8 Ch 11 Ch 15 Ch 18 Ch 19 Ch 20 Ch 21 Ch 22 Ch 25 Ch 26

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

A one-quarter course would probably only include one or two of the optional chapters unless some of the chapters on central banking and the conduct of monetary policy (Chapters 15, 16, and 17) were deleted.

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Outline for General Money and Banking Course with an International Emphasis Core Chapters Ch 1 Ch 2 Ch 3 Ch 4 Ch 5 Ch 12 Ch 9 Ch 10 Ch 11 Ch 14 Ch 16 Ch 17 Ch 18 Ch 19 Ch 23 Ch 24

Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

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

For a one-semester course, cover any three of the following optional chapters: Ch 6 Ch 7 Ch 8 Ch 13 Ch 15 Ch 20 Ch 21 Ch 22 Ch 25 Ch 26

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

A one-quarter course would probably not include any other chapters unless some of the chapters on central banking and the conduct of monetary policy (Chapters 15, 16, and 17) were deleted.

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Mishkin and Serletis • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, 8Ce

Outline for Financial Markets and Institutions Course Core Chapters Ch 1 Ch 2 Ch 3 Ch 4 Ch 5 Ch 6 Ch 7 Ch 8 Ch 12 Ch 9 Ch 10 Ch 11

Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

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

For a one-semester course, cover any seven of the following optional chapters: Ch 14 Ch 15 Ch 16 Ch 17 Ch 18 Ch 19 Ch 20 Ch 21 Ch 22 Ch 23 Ch 24 Ch 25 Ch 26

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

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

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Mishkin and Serletis • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, 8Ce

Outline for Monetary Theory and Policy Course Core Chapters Ch 1 Ch 2 Ch 3 Ch 4 Ch 5 Ch 14 Ch 15 Ch 16 Ch 17 Ch 20 Ch 21 Ch 22 Ch 22 Ch 24 Ch 25

Why Study Money, Banking, and Financial Markets?

An Overview of the Financial System What Is Money?

The Meaning of Interest Rates The Behaviour of Interest Rates Central Banks and the Bank of Canada The Money Supply Process Tools of Monetary Policy The Conduct of Monetary Policy: Strategy and Tactics Quantity Theory, Inflation, and the Demand for Money The IS Curve The Monetary Policy and Aggregate Demand Curves Aggregate Demand and Supply Analysis Monetary Policy Theory The Role of Expectations in Monetary Policy

For a one-semester course, cover any four of the following optional chapters: Ch 6 Ch 7 Ch 8 Ch 11 Ch 12 Ch 9 Ch 10 Ch 18 Ch 19 Ch 26

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

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

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