Economics of Money Banking & Financial Markets 13th Global Edition by Frederic Mishkin - SOLUTIONS

SOLUTION MANUAL

SOLUTION MANUAL

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

Chapter 2: An Overview of the Financial System Chapter 3: What Is Money?

Chapter 4: The Meaning of Interest Rates Chapter 5: The Behavior of Interest Rates Chapter 6: The Risk and Term Structure of Interest Rates Chapter 7: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis Chapter 8: An Economic Analysis of Financial Structure Chapter 9: Banking and the Management of Financial Institutions Chapter 10: Economic Analysis of Financial Regulation Chapter 11: Banking Industry: Structure and Competition Chapter 12: Financial Crises in Advanced Economies Chapter 13: Financial Crises in Emerging Market Economies Chapter 14: Central Banks Chapter 15: The Money Supply Process Chapter 16: Tools of Monetary Policy Chapter 17: The Conduct of Monetary Policy: Strategy and Tactics Chapter 18: The Foreign Exchange Market Chapter 19: The International Financial System Chapter 20: Quantity Theory, Inflation, and the Demand for Money Chapter 21: The IS Curve Chapter 22: The Monetary Policy and Aggregate Demand Curves Chapter 23: Aggregate Demand and Supply Analysis Chapter 24: Monetary Policy Theory Chapter 25: The Role of Expectations in Monetary Policy Chapter 26: Transmission Mechanisms of Monetary Policy

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

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

Frederic S. Mishkin

New York, NY

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

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

2. What effect does high volatility of financial markets have on people's willingness to spend?

The high volatility of financial markets decreases people's willingness to spend, primarily because it directly affects their wealth, and also because high volatility indicates that there are considerable fluctuations in the prices of securities over a short time span. It increases insecurities about the future of an economy. Refer to Figure 2 to see the extremely volatile nature of stock prices between 1950 and 2020.

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

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

4. What is the main role of a financial intermediary? Name two financial intermediaries.

A financial intermediary is a firm or institution that channels savings into investments––that is, it borrows funds from individuals who have saved and provides loans to those who need funds. Banks and mutual funds are two examples of such intermediaries.

5. What was the main cause of the global recession in 2020?

The recession in 2020, sometimes referred to as the COVID-19 Recession, was mainly caused by the global pandemic caused by the infectious coronavirus disease (Covid-19). In March 2020, the stock market fell by 25% in a single month.

According to the World Bank’s June 2020 Global Economic Prospects, the volatility induced by the coronavirus pandemic, lockdowns, and other preventive measures taken by global economies to contain it have led to a severe contraction in the global economy.

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

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

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

7. Why are banks important to the financial system?

Banks are one of the major financial intermediaries. They channel savings from private institutions or the general public to other institutions or people who need a loan. Well-functioning banks are very important for the savings-to-loans cycle and for the housing market.

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

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

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

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

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

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

12. Is everybody worse off when interest rates rise?

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

13. What is the main role of a central bank? Why are central banks, like the European Central Bank (ECB), important to financial analysts?

Central banks oversee the monetary policy for a specific country or a group of nations (as in the case of the ECB). This is done by setting a base interest rate or by forward guidance, which impacts the financial and real economy. Since money affects many economic variables that are important to the health of an economy, financial analysts (including politicians and policymakers) take an interest in the conduct of monetary policy, as well as in the management of money and interest rates.

14. Germany is one of the few countries that has maintained a budget surplus in the last five years, and according to Reuters, the federal government made a record surplus of €13.5 billion in 2019. How does a budget surplus arise?

A budget surplus results from tax revenues exceeding government expenditure, which leads to lower government debt burdens.

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

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

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

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

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

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

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

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

relatively cheaper, making it a good time to visit the Tower of London. This was also true, to a lesser extent, in the early 2000s.

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

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

20. While much of the Japanese government debt is held by domestic investors, some of it is also held by foreign investors. How do the fluctuations in the Japanese yen affect the value of that debt held by foreigners?

As the value of the Japanese yen depreciates (decreases in value) relative to a foreign currency, one yen is equivalent to (can be exchanged for) less foreign currency. Thus, for a given debt amount, a weaker yen will yield less home currency to foreigners, so the asset will be worth less to foreign investors. Similarly, an appreciation would increase the value of the debt.

ANSWERS TO APPLIED PROBLEMS 21. The following table lists the foreign exchange between euros (€) and British pounds (£) during October 2020. Which day would have been the best for converting €100 into British pounds? Which day would have been the worst? What would the difference be in pounds?

Date

€/£

10/1/2020

1.086

0.92

10/2/2020

1.084

0.92

10/5/2020

1.081

0.93

10/6/2020

1.07

0.93

10/7/2020

1.051

0.95

10/8/2020

1.042

0.96

10/9/2020

1.04

0.96

10/12/2020

1.038

0.96

10/13/2020

1.037

0.96

10/14/2020

1.036

0.97

10/15/2020

1.035

0.97

10/16/2020

1.034

0.97

10/19/2020

1.033

0.97

10/20/2020

1.05

0.95

10/21/2020

1.06

0.94

10/22/2020

1.07

0.93

10/23/2020

1.086

0.92

10/26/2020

1.09

0.92

10/27/2020

1.091

0.92

10/28/2020

1.1

0.91

10/29/2020

1.12

0.89

10/30/2020

1.1

0.91

The best day would be October 19, 2020. At the rate of €1.033/pound, you would have £96.805. The worst day is October 29, 2020. At €1.12/pound, you would have £89.286. The difference in pounds is £7.519.

ANSWERS TO DATA ANALYSIS PROBLEMS 1.

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

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

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

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

How do the averages compare?

June 2020

January 2000

Three-month rate avg.

0.17

5.53

30-year rate avg.

2.33

7.42

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

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

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

When money growth rises, the 10-year Treasury rate appears to fall, and vice versa; however, this effect is more obvious over some periods than others. c. Compare the money growth rate and the 10-year interest rate for the most recent month available to the rates for January 2000. How do the rates compare?

May M1 Money Growth 10-year Treasury rate

2020

January 2000

33.49

2.19

0.67

6.66

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

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

Chapter 2 ANSWERS TO QUESTIONS 1. If Marco buys a laptop today for €1,000, and it will be worth €2,000 next year because it enables him to work remotely as an assistant, should he take out a loan from Prestiti Di Pasquale, a small Italian loan firm, at a 90% interest rate? Marco cannot get a loan from anyone else. Will he be better or worse off for taking out this loan? Would you consider this a shark loan?

Yes, Marco should take out the loan, as he will be better off as a result of doing so.

His interest payment will be €900 (90% of €1,000), but as a result, he will earn an additional €100 since he is able to collect €1,000 more in terms of earnings in the first year. This would be an example of a shark loan as it involves a lender charging an extremely high interest rate (probably doing so illegally).

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

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

3. Luigi, who has just started to work as an engineer, asks his sister Maria, a finance graduate, to explain how financial markets are fundamental for him to get a new apartment. What do you think Maria’s explanation should be?

Maria should explain that while Luigi earns a good salary, he has just started to work and has not saved much. Financial markets will enable him to buy a house now and pay some interest, without having to wait to save enough. In the absence of financial markets, Luigi would have to save enough money to buy the house of his dreams, but by the time he purchases it, he might be too old to enjoy the full benefits of it.

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 the government of Albania issues a euro-denominated bond in Albania (Note: the currency of Albania is the Albanian Lek.). Is this debt instrument considered to be a Eurobond? How would you answer change if the bond were issued in London?

The euro-denominated bond issued in Albania and the one issued in London would be considered to be Eurobonds because the denomination differs from the local currencies.

6. Describe who issues each of the following instruments: a. Stocks Corporate organizations

b. Mortgage-backed securities Government agencies c. Corporate bonds Corporate organizations d. State and local government bonds Municipalities e. Consumer and bank commercial loans Banks and financial companies 7. What is the difference between a mortgage and a mortgage-backed security?

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

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

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

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

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

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

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

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

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

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

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

12. One of the factors contributing to the European debt crisis of 2010-2012 was the huge amounts of debt faced by governments of countries like Greece and Portugal.

What is the main difficulty in regulating governments?

The main problem with governments is that they are sovereign institutions. Unlike private firms, they do not have any regulators. In addition, the size of the debt is too high for any financial institution to absorb the investor losses.

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. ―The only reason a government regulates financial markets is to ensure the soundness of the financial system.‖ Is this statement true, false, or uncertain? Explain your answer.

The statement is false. The government regulates financial markets for two reasons: to increase the information available to investors and to ensure the soundness of the financial system.

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

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

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

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

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

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

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

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

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

Investment banks do not provide loans to the general public.

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

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

22. In 2010, the financial crisis, which started in the United States, was endangering the United Kingdom. In response the European Union’s financial system, the FSCS (Financial System Compensation Scheme), raised the limit on insured losses to bank depositors from £31,700 per account to £85,000 per account. How would this help stabilize the financial system?

During the financial panic, regulators were concerned that depositors would worry that their banks would fail, and that depositors (especially those with accounts over £31,700) 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 run in which otherwise healthy banks would fail. Raising the insurance limit would reassure depositors that their money was safe in banks and prevent a bank panic, helping to stabilize the financial system.

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

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

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

ANSWERS TO APPLIED PROBLEMS 24. George Hamilton was just notified by his lawyer that he has inherited £10,000 from his aunt Darsie and he is considering the following options for investing the money to maximize his return: Option 1: Put the money in an interest-bearing checking account that earns 2%. The Financial System Compensation Scheme (FSCS) 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 his friends, Agatha, at an agreed-upon interest rate of 8%, even though he believes there is a 7% chance that Agatha will leave town without repaying him.

Option 4: Hold the money in cash and earn zero return. a. If he is risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should he choose to maximize his 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 is his only possibility. If he could pay his friend Anne £100 to find out extra information about Agatha that would indicate with certainty whether she will leave town without paying, do you think he should 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 to be 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. b. This option implies the very real possibility of either receiving nothing (if she actually leaves town), or £10,800 (if she indeed pays as promised). If he doesn’t pay Anne, he has an expected return of £10,044 as shown above. If he paid Anne the £100 and learned that Agatha would leave without paying, then obviously he wouldn’t loan Agatha the money, and he would be left with £9900. However, if he paid Anne £100 and learned that Agatha would pay, he would have £10,700 (= £10,000  1.08 - £100).

After paying his friend Anne, but before knowing the true outcome, his expected return would be £10,644 (£9900  0.07 + £10,700  0.93).

Paying his friend £100 is definitely worth it because it increases his expected return and also dramatically reduces the risk that he makes a bad loan and increases the certainty of the payoff amount. That is, with asymmetric information (not paying Anne), he has a range of payoffs of £0 to £10,800, as opposed to£9900 to £10,700 without asymmetric information. Thus, paying a small amount to improve risk assessment can be very beneficial, a task for which financial intermediaries are well suited.

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

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

2020:Q1

Fed Private Investors Foreign Investors

2000:Q1

Held ($bil.)

% Share

Held ($bil.)

% Share

3559.6

14.4

501.7

10.5

14407.2

58.1

3182.8

66.7

6810.1

27.5

1085.0

22.7

Total

24776.9

4769.5

2. Go to the Bank of Albania’s statistics database (https://www.bankofalbania.org/Statistics/Monetary_Financial_and_Banking_statisti cs/Sectoral_balance_sheet_of_banks.html), and find data on the total assets of all banks. Calculate the percentage increase in growth of assets from 2006 to the most recent month available. Which date has the largest increase in assets and which one has the lowest percentage growth?

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

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

2. In the Solomon Islands, shells were used as a form of payment for some time. How is it possible for shells to solve the "double coincidence of wants" problem, even when an inhabitant of the islands did not like the shells?

Even if an inhabitant did not appreciate the shells, since they know that others on the islands will accept shells as a form of payment, they would be willing to accept shells as a form of payment. So, instead of inhabitants having to barter and trade favors, shells satisfy the double coincidence of wants, in that both parties to a trade stand ready to use them to ―purchase‖ goods or services.

3. Three services are produced in an economy by three individuals: Service

Service Provider

Babysitting

Francesca

Landscaping

Antonio

Repairing computers

Giacomo

If Francesca only needs only landscaping for her house, Antonio only requires his computer repaired, and Giacomo only needs a babysitter for his children, will any trade between these three persons take place in a barter economy? How will introducing money into the economy benefit these three individuals?

As Francesca only needs landscaping but Antonio doesn’t require her babysitting services, Antonio will not want babysitting in exchange for his landscaping services, and they will not trade. Similarly, Giacomo will not be willing to trade with Antonio because he does not need any landscaping work done. Francesca will not trade with Giacomo because she doesn’t need any repair work. 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, Francesca can sell her babysitting to Giacomo and then use the money to buy landscaping from Antonio. Similarly, Antonio can use the money he receives from Francesca to pay for computer repair from Giacomo, and Giacomo can use the money to pay for babysitting from Francesca. The result is that the need for a double coincidence of wants is eliminated, and everyone is better off because all three servicers are being serviced for what they need.

4. Why did a barter economy develop in Germany after World War I? Due to hyperinflation, money was losing its value so quickly that people did not want to hold on to money. Therefore, the barter economy developed.

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

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

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

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

6. In Venezuela, a country that underwent hyperinflation during 2019, many transactions were conducted in dollars rather than in bolivar, the domestic currency.

Why? Due to the rapid inflation in Venezuela, the domestic currency, the bolivar, had become a poor store of value. Therefore many people preferred to hold dollars, which were a better store of value, and used them for their daily shopping.

7. Was money a better store of value in Argentina in the 1990s than in the 2010 period?

Why or why not was it so? In which period would you have been more willing to hold money?

As money was losing value at a slower rate (the inflation rate was lower) in the 1990s

than in the 2010 period, it was a better store of value at that time, so you would have been willing to hold more of it in the 1990s.

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

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

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

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

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

Salt (even though used as payment for Roman soldiers) is more difficult to transport than gold and is also more perishable. Gold is thus a better store of value than salt. In addition, it leads to lower transaction costs. Therefore, it was a better candidate for use as money.

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

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

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

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

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

14. It is not unusual to find a business in Morocco that displays a sign saying, ―no credit cards, please.‖ Based on this observation, comment on the relative degree of liquidity of a credit card 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 credit card, which represents a balance on a bank account, is a very liquid type of money. After all, all that is needed to pay for goods or services using a credit card is the time it takes to slide it into a point-of-sale machine. However, the Moroccan example shows that some merchants refuse to accept credit cards as a means of payment. 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.

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

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

17. Suppose that in April 2020, year-over-year the growth rate of M1 in the Euro area was 2.2%, while the growth rate of M2 rose to 5.3%. In September 2020, the yearover-year growth rate of the M1 money supply was 1.5%, while the growth rate of the M2 money supply was about 8.3%. How should policymakers at the European

Central Bank (ECB) interpret these changes in the growth rates of M1 and M2?

During the period in question, the M1 growth rate fell, while the M2 growth rate increased. As these growth rates have 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 to GDP in the Indian economy over the past 20 years was a better predictor of inflation and the business cycle than M1 or M2. Does this discovery mean that we should define money as equal to the total amount of debt in the economy?

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

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

ANSWERS TO APPLIED PROBLEMS Q.19

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

2017 2018 2019 Currency 900 920 925 Current (cheque) 680 681 679 deposits Saving account deposits 5,500 5,780 5,96 8 Money market deposit 1,214 1,245 1,27 accounts 4 980 Demand deposits 1,000 972 Small denomination time 830 861 1,12 deposits checks 3 Traveler’s 4 4 3 3-month Australian 1,986 2,374 2,43 treasury bills 6 The M1 money supply is the sum of rows A, E, and G for each year. The M2 money supply is the sum of omponents A–G for each year. Note that 3-month Australian treasury bills are not considered part of the M1 or M2 money supply, even though they are fairly liquid assets. The table below shows the M1 and M2 money supplies along with the growth rates from the previous year. Note that while the M1 money supply is relatively flat, the M2 money supply grows at a much higher, positive rate. This is because the components of M2 are rising much more rapidly compared to the components of M1 (which are also included in M2).

Thus, movements in the money market, savings accounts, and time deposit measures will have a much bigger impact on M2 growth than the narrower M1 components will.

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

2017

2018

2019

2020

2020 931 688 6,105 1,329 993 1,566 2 2,502

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

Currency Current (cheque) deposits Savings account deposits Money market deposit accounts Demand deposits Small denomination time deposits Traveler’s checks 3-month Australian treasury bills

900 680 5500 1214 1000 830 4 1986

920 681 5780 1245 972 861 4 2374

925 679 5968 1274 980 1123 3 2436

931 688 6105 1329 993 1566 2 2502

Total M1 money stock Total M2 money stock

1904 10128

1896 10463

1908 10952

1926 11614

–0.4 3.3

0.6 4.7

0.9 6.0

M1 growth rate M2 growth rate ANSWERS TO DATA ANALYSIS PROBLEMS

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

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

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

Currency Demand Deposits Other Checkable Deposits M1

May 2019 $1650.8 Bil.

May 2020 $1818.7 Bil.

$1493.8 Bil.

$2166.7 Bil.

$647.9 Bil. $3792.5 Bil.

$1077.3 Bil. $5062.7 Bil.

May 2019 to May 2020 Currency Demand Deposits Other Checkable Deposits

10.2%

M1

33.5%

45.0%

66.3%

2. Go to the St. Louis Federal Reserve FRED database and find data on small-

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

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

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

May 2020

May 2019

January 2000

Small Time Deposits

$545.7 Bil.

$598.9 Bil.

$963.4 Bil.

Savings/MMDA

$11239.4 Bil.

$9373.2 Bil.

$1741.6 Bil.

Retail MMMF

$1196.3 Bil.

$888.7 Bil.

$828.6 Bil.

Non-M1 M2

$12981.4 Bil.

$10860.8 Bil.

$3533.6 Bil.

M1

$5062.6 Bil.

$3245.8 Bil.

$1122.2 Bil.

May 2019 to May 2020

January 2000 to May 2020

Small Time Deposits

8.9%

43.4%

Savings/MMDA

19.9%

545.3%

Retail MMMF

34.6%

44.4%

Non-M1 M2

19.5%

267.4%

M1

33.5%

351.1%

Chapter 4 ANSWERS TO QUESTIONS 1. Your brother Vincenzo asks you if the €100 he will have saved by next month would be worth more today if the interest rate is 5% or when it is 10% It would be worth €100/(1 + 0.05) = €95.23 when the interest rate is 5%, rather than €100/(1 + 0.10) =€90.91 when the interest rate is 10%. Thus, a euro tomorrow is worth less with a higher interest rate today.

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

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

3. Francesca, who has just enrolled at Bocconi University, has taken out a €1,000 loan that makes her pay €126 per year for 25 years. However, she doesn't have to start making these payments until she graduates from college two years from now. Why is the yield to maturity necessarily less than 12%? (This is the yield to maturity on a normal €1,000 fixed-payment loan on which you pay €126 per year for 25 years.)

If the interest rate is 12%, the present discounted value of the payments on the loan is necessarily less than the $1,000 loan amount because they do not start for two years.

Thus, the yield to maturity must be lower than 12% in order for the present discounted value of these payments to add up to $1,000.

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

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

Note: Check Equations 7 and 8 in this chapter.

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

6. You have observed that mortgage rates in India have increased from 4% to 8%. At the same time, the expected rate of increase in housing prices rose from 2% to 7%.

Do you think people are more or less likely to buy a house?

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 2% (from 4% to 2%) to 1% (from 8% to 7%). The real cost of financing the house is thus lower, even though nominal mortgage rates have risen.

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

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

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

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

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

9. Currently, German government bonds (German Bunds) with a maturity of two years, which pay coupons once a year, have a negative interest rate of -0.6%. Without knowing any other information, and if coupons can never be negative, do you think such bonds will be selling at a premium, at par, or at a discount?

Since coupons can never be negative, these bonds will be trading at a premium.

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. Considering the current negative nominal interest rates between -0.7% to -0.1% in

the eurozone, and an expected inflation rate of 1%, what do you think the current real interest rate is?

The current real interest rates vary between –1.7% to –1.1% in the eurozone (calculated by subtracting the inflation rate from the nominal rates).

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

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

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

15. Calculate the present value of a $1,000 discount bond with five years to maturity if the yield to maturity is 6% PV = FV/(1 + i)n, where FV = 1,000, i = 0.06, n = 5. Thus, PV = 747.26.

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

Use an interest rate of 6%.

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

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

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

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

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

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

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

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

20. An Indian government bond has a 4% annual coupon and a face value of 1,000 INR. 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

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

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

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

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

$1044.89 = $100/(1 + i) + $100/(1 + i)2 + $1,000/(1 + i)2. Solving for i gives a yield to maturity of 0.075, or 7.5%.

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

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

24. A £1,000-face-value UK Gilt has a 2% coupon rate, its current price is £1,100, and its price is expected to increase to £1,150 next year. Calculate the current yield, the expected rate of capital gain, and the expected rate of return.

The coupon payment C= £20, so the current yield is £20/£1,100 = 0.018, or 1.8%.

The expected rate of capital gain, g= (£1,150 - £1,100)/ £1,100 = 50/1,100 = 0.045, or 4.5%. The expected rate of return, R= iC+ g= 1.8% + 4.5% = 6.3%.

25. Gianluigi wants to take out a loan and Banca Mediolanum wants to charge him an annual real interest rate equal to 2%. Assuming that the annualized expected rate of inflation over the life of the loan is 1% in Italy, determine the nominal interest rate that the bank will charge him. What happens if, over the life of the loan, actual inflation is 1.5%?

The nominal rate will be equal to the real interest rate plus the inflation rate. In this case it will be 2% + 1% = 3% If the actual inflation over the life of the loan is 1.5%, the bank will charge him an annual nominal rate of 2% + 1.5% = 3.5%.

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

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

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

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



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



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



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



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



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

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

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

July 9, 2020 Nominal

TIIS

Difference (Inflation Expectations)

5 Year

0.28

–0.94

1.22

7 Year

0.46

–0.87

1.33

10 Year

0.62

–0.77

1.39

20 Year

1.09

–0.48

1.57

30 Year

1.32

–0.24

1.56

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

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

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

Chapter 5 ANSWERS TO QUESTIONS 1. Explain if your friend Hermann would be more or less willing to buy a share of Volkswagen stock if: a. he learns that his wife has been laid off from work due to reorganization.

Less willing if his wife was laid off from work, because it means that his overall wealth would have decreased. b. he expects the stock to depreciate.

Less willing, because its relative expected return has decreased c. the German bond market becomes more illiquid.

More willing, because it has become more liquid compared to bonds d. he expects the value of gold to depreciate, and the German bond market to become more volatile.

Less willing, because its expected return has fallen compared to gold 2. Explain if Alessandria would be more or less willing to buy a new car (for example, a Fiat Panda) under the following circumstances: a. She just inherited €200,000 from her aunt.

More willing, because her wealth has increased b. Prices in the stock market become more volatile.

More willing, because it has become less risky compared to stocks c. She expects car prices to fall.

Less willing, because its expected return has fallen d. She expects the aerospace company Leonardo’s stock to triple in value next year.

Less willing, because the car’s expected return has decreased compared to Leonardo stock 3. As you see that the price of gold is increasing, you become more interested in it as an asset. Would you be more or less willing to buy gold under the following circumstances? a. You expect political risks to decrease in the future.

A decrease in political risks is expected to decrease the price of gold, which is a safe haven asset, so you would be less willing to buy gold b. Prices in the gold market become less volatile.

A reduction of volatility means that you would be more willing to buy gold as its risk decreases c. You expect a period of hyperinflation.

Gold's price would increase in cases of hyperinflation so you would be more willing to buy gold

d. You expect developed central banks to keep monetary policy accommodative in a zero to negative interest rate environment.

A zero to negative interest rate makes the relative cost of buying and holding gold cheaper, so you would be more willing to buy gold 4. Explain if Parameswary would be more or less willing to buy long-term bonds of a company under the following circumstances: a. Trading in these bonds increases, making them easier to sell.

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

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

Less willing, because they have become less liquid compared to stocks d. Parameswary expects interest rates in India to rise.

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

More willing, 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. Rajesh observes that at the current level of interest rates there is a shortage in the supply of bonds, and therefore he anticipates an increase in the price of bonds. Is Rajesh correct?

Yes, Rajesh is correct. A shortage in the supply of bonds means that the price of the available bonds will increase as interest rates decrease.

7. Mario and Luigi are both looking to invest in Italian government bonds. Mario prefers to buy the 10-year maturity bond, with an expected return of 0.65% and a standard deviation of 3%, while Luigi prefers the 5-year bond, with an expected return of 0.08% and a standard deviation of 1%. Can you tell if Mario is more or less risk-averse than Luigi?

Since the two bonds have different risks and returns and the 10-year bond has a higher return along with higher risk compared to the 5-year bond, we cannot say who is more risk averse—Mario or Luigi.

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

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

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

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

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

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

11. During the coronavirus pandemic in 2020, the budget deficit for most euro-area Member States increased dramatically, yet interest rates in euro-area debt fell sharply and stayed low. Does this make sense? Why or why not?

The supply effect of large deficits should lead to higher interest rates. The larger leftward shift in the bond supply curve instead of the rightward shift in the bond demand curve would then result in a rise in bond prices and a fall in interest rates.

However, due to the severity of the coronavirus crisis, euro-area debt became a safehaven investment, reducing relative risk and increasing liquidity for euro-area government debt. Another important effect on the demand for government debt is the European Central Bank (ECB) acting through its government bond purchasing programme. This significantly raised government 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 prime minister of India 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 prime minister’s program will be successful, interest rates

will fall. The prime minister’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, will cause the equilibrium interest rate to fall.

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

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

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

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

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

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

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

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

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

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

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

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

Slower rate of money growth will lead to a liquidity effect, which raises interest rates,

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

19. M1 money growth in the Eurozone was about 6% in 2018 and 8% in 2019. Over the same time period, the yield on 3-month German treasury bills was close to -0.5%.

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 expectedinflation 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 2017 to 2019, 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.

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

Bonds

Commodities

Probability

Return

Probability

Return

Probability

Return

0.25

12%

0.6

10%

0.2

20%

0.25

10%

0.4

7.50%

0.25

12%

0.25

8%

0.25

6%

0.25

6%

0.25

4%

0.05

0%

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

The expected return on the stock portfolio is 0.25(12%) + 0.25(10%) + 0.25(8%) + 0.25(6%) = 9%. The expected return on the bond portfolio is 0.6(10%) + 0.4(7.5%) = 9%. The expected return on the commodities portfolio is 0.2(20%) +

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

21. An important way in which the Reserve Bank of India 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 Reserve Bank of India 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 the bond supply and demand analysis is consistent with the answer from the liquidity preference framework.

22. Using both the liquidity preference framework and the supply and demand for bonds

framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).

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

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

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

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

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

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

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

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

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

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

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

1.6 Quantity = 520; or Quantity = 325.

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

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

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

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

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

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

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

y = -0.1579x + 4.4467 R² = 0.4036

7.00 6.00

Interest Rate

5.00 4.00 Series1

3.00

Linear (Series1) 2.00 1.00 0.00

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

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

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

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

Interest Rate

5 4 3

Series2 Linear (Series2)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

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

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

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

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

y = -0.0998x + 3.816 R² = 0.2217

Interest Rate

5 4 3

Series3 Linear (Series3)

2 1 0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Money Growth

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

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

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

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

2. Which government bond should have a higher risk premium on its interest rates, a German bond with an S&P rating of AAA or an Italian bond with a rating of BBB? Why? The Italian bond with a BBB 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 AAA German bond.

3. Do you think that a French government 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 Cyprus?

The French bill will have a risk premium that is lower than the Cyprus bill because it has a lower default risk.

4. In the aftermath of the 2008-2009 crisis, Lloyds Bank, one of the largest banks in the United Kingdom, was at risk of defaulting after incurring huge losses. The UK government decided to rescue the bank from an imminent collapse with capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on Lloyds corporate debt?

The risk of default would significantly decrease demand for Lloyds’ corporate debt, resulting in a much higher yield. After the announcement that the UK government would provide extraordinary assistance to support Lloyds 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. During the Eurozone debt crisis, the credit rating agencies were subject to criticism for very high and loose ratings on European sovereign bonds, especially Greece.

Only 1 year before default, Greece was rated BB+ by two of the three rating agencies. Should we always trust rating agencies?

The magnitude and quick deterioration of the fiscal situation in some of the Eurozone countries left investors and rating agencies in an unanticipated situation. Rating agencies had a large impact on the perceived safety of the bonds. Investors should rely not only on the rating agencies reviews, but also their own analysis and expertise.

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

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

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

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

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

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

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

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

11. In Germany, suppose that the state of North Rhine-Westphalia issues a tax-exempt bond for German investors. How would its interest rate compare to a bond that is not

exempt from taxes issued by the state of Baden-Württemberg?

The interest rate on the tax-exempt bond would be lower because of the additional advantage from the tax exemption.

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

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

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

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

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

15. Suppose the interest rates on one-, five-, and ten-year German government bonds are currently −0.5%, −0.3%, and 0%, respectively. Hans chooses to hold only one-year

bonds, and Dietrich is indifferent to holding five- and ten-year bonds. How can you explain the behavior of Hans and Dietrich?

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

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

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

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

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

18. If, on average, the French government’s yield curve is 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, on average, the yield curve is flat, this would suggest that the risk premium on long-term bonds relative to short-term bonds would equal zero and you would be more willing to accept the expectations hypothesis.

19. Suppose while looking at your Bloomberg app this morning you notice that the Indian government bond yield curve suddenly became steeper. How would you revise your predictions of interest rates in the future?

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

20. You notice in the market that the expectations of future short-term interest rates in the Eurozone suddenly rises. What would happen to the slope of the yield curve?

The slope of a yield curve indicates the direction of future short-term interest rates.

You would observe an upward sloping yield curve because the rise in expected future

short-term rates means that the average of expected future short-term rates rises, so the long-term rate rises.

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

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

ANSWERS TO APPLIED PROBLEMS 22. In 2012, the government of Portugal risked defaulting on its debt due to a severe budget crisis. Describe the effects on the risk premium between German government debt and comparable-maturity Portuguese debt.

As the risk of default by the Portuguese government increased, this reduced the demand for Portuguese bonds relative to German treasuries. The result was lower prices and higher yields of Portuguese debt relative to German debt.

23. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for Spanish government maturities of one to five years, and describe the resulting yield curves for the following paths of one-year interest rates over the plot the resulting yield curves for the following paths of oneyear interest rates over the next five years: a. −0.2%, −0.1%, 0%, 0.1%, 0.2% b. 0%, −0.2%, −0.3%, −0.2%, 0% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds? (a) The yield to maturity would be −0.2% for a one-year bond, −0.15% for a two-year bond, −0.1% for a three-year bond, −0.05% for a four-year bond, and 0.0% for a fiveyear bond. (b) The yield to maturity would be 0% for a one-year bond, −0.1% for a two-year bond. −0.17% for a three-year bond, −0.18% for a four-year bond, and −0.14% for a five-year bond. The upward sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds, because long-term bonds would then have a positive liquidity premium. The downward- 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.

24. Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for Indian government maturities of one to five years, and describe the resulting yield curves for the following paths of one-year interest rates over the next five years: a. 3.75%, 3.93%, 4.49%, 4.84%, 5.14%

b. 3.75%, 2.8%, 2.2%, 2.6%, 3.5% How would your yield curves change if people preferred shorter-term bonds over longer-term bonds? (a) The yield to maturity would be 3.75% for a one-year bond, 3.84% for a two-year bond, 4.06% for a three-year bond, 4.25% for a four-year bond, and 4.43% for a fiveyear bond; (b) the yield to maturity would be 3.75% for a one-year bond, 3.28% for a two-year bond, 2.92% for a three-year bond, 2.84% for a four-year bond, and 2.97% for a five-year bond. The upward sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive liquidity premium. The downward- and then upwardsloping yield curve in (b) also would tend to be more upward sloping because of the positive risk premium for long-term bonds.

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

Year

One-Year Bond Rate

Multiyear Bond Rate

1

0.2%

0.5%

2

0.3%

0.8%

3

0.4%

0.95%

4

0.6%

1.0%

5

0.7%

1.1%

The liquidity premium for a given year is the current rate on a multi-year 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= 0.5 − 0.2/1 = 0.3%. l21= 0.8 − (0.3 + 0.2)/2 = 0.55%. l31= 0.95 − (0.4 + 0.3 + 0.2)/3 = 0.65%. l41= 1.0 − (0.6 + 0.4 + 0.3 + 0.2)/4 = 0.55%. l51 =1.1 − (0.7 + 0.6 + 0.4 + 0.3 + 0.2)/5 = 0.66%

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

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

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

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

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

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

Interpret the results.

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

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

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

Yield Curves - Current and One Year Ago 3.00 2.50

Yield

2.00 9-Jul-19

1.50

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

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

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

Yield Curves - Policy Announcement 1.60 1.40 1.20

Yield

1.00 9-Jun-20

0.80

10-Jun-20

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

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

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

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

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

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

3. Suppose that the Reserve Bank of Australia is worried that the stock market is almost in bubble territory and wants to intervene to prevent a market crash from developing down the road. Meanwhile, growth has been positive in the last few years, and inflation is above 3%. Do you think it should lower or increase the base interest rate?

What effect would this have on stock prices according to the Gordon growth mode?

If it is worried by a stock bubble and inflation is above 3%, the Reserve Bank of Australia should increase interest rates. This 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, keeping stock prices from climbing.

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

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

5. Francesco works in an investment advisory firm in Milan. His boss asks him to forecast future stock prices of Intesa Sanpaolo Bank, so he proceeds to collect all available information. The day Francesco announces his forecast, Unicredit Bank, a major competitor announces a major plan to buy another bank and reshape the banking industry in Italy. Would Francesco's forecast still be considered optimal?

Since the change in industry was not available at the time that Francesco did his research, and because a change in industry is a major development it changes the critical components of the pricing of Intesa Sanpaolo. Francesco's forecast is not optimal anymore. He must review the new information and update the forecast accordingly.

6. "Anytime his favorite player, Cristiano Ronaldo is not playing, Luigi misjudges the result of a football match. When Cristiano Ronaldo is playing, his result forecast is perfectly accurate. Considering that Cristiano Ronaldo only misses one match in a year, Luigi's expectations are almost always perfectly accurate." Are Luigi's expectations rational? Why or why not?

Although Luigi’s expectations are typically quite accurate, they could still be improved by him taking account of Cristiano Ronaldo not playing in his forecasts.

Since his expectations could be improved, they are not optimal and hence are not rational expectations.

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

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

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

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

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

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

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

loss is announced?

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

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

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

12. Anita always consults her investment advisor before buying or selling a stock. The advisor has been right in his previous seven buy and sell recommendations. Should Anita continue listening to his advice?

Probably not. Although Anita’s broker has done well in the past, efficient markets theory suggests that he has probably been lucky. Unless Anita believes that her broker has better information than the rest of the market, efficient markets theory indicates that she cannot expect the broker to beat the market in the future.

13. Hans expects the price of Volkswagen to decrease by 10% in the next month. Do you think he is a person with rational expectations?

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

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

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

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

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

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

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

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

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

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

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

18. Altin is thinking about investing in a mutual fund. He has two alternatives: mutual fund A has double the management fees of mutual fund B, because it claims it can consistently outperform the market, because of its very smart and knowledgeable analysts. Indeed, in the last two years it has outperformed the market compared to mutual fund B. If the efficient market hypothesis holds, should he choose mutual fund A or B? If the efficient market hypothesis holds, Altin should choose mutual fund B, as, for long periods of time, both funds will perform similarly, but Altin's net profit after fees will be higher from fund B than A. 19. Suppose that you work as a forecaster of future monthly inflation rates and that your last six forecasts have been off by minus 1%. Is it likely that your expectations are optimal?

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

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

It may be considered a bubble in that stock market prices rose well above true fundamental values. However, given the relatively new and rapid technology advances during the time, there was a great deal of uncertainty over what the true fundamental values of many technology-related companies were. Thus, even though it might be easy to identify the bubble after the fact, the efficient market hypothesis

could still hold in that market participants were at the time acting on the best information available in valuing the stocks, considering much of the technology was new and had seemingly unlimited growth potential.

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

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

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

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

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

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

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

25. Brembo just announced a 2-for-1 stock split, effective immediately. Prior to the split, the company had a market value of €2 billion with 10 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 €105.00 per share, what does this tell us about market efficiency?

Prior to the split, each share was worth €2 billion/10 million, or €200/share. If the split conveys no new information, the market value of the company does not change, remaining at €2 billion. However, with the split, every share becomes two shares, so

20 million shares are outstanding. The new price/share is €2 billion/20 million, or €100/share. If the actual price is €105.00/share, the price appears to be too high. This can be viewed in two ways. One possibility is that markets are inefficient—some type of anomaly has occurred, and it’s not clear if the market will correct itself. Another possibility is that the stock split actually conveyed information about the company.

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

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

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

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

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

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

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

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

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

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

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

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

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

3. ―The lemons problem applies not only to corporate debt but also to government debt.‖ Is this statement true or false? Explain.

Like corporate debts, government debts also suffer from the lemons problem.

Investors will buy a government bond only if its interest rate is high enough to compensate them for the average default risk of well-run or poorly run governments trying to sell their debt. A knowledgeable ministry of finance of a well-run government realize that they will be paying a higher interest rate than they should, so they are unlikely to borrow from the market. Only poorly run governments will be willing to borrow.

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

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

5. Alessandro goes to his local bank in Milan, intending to buy a certificate of deposit with his savings. Explain why he 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 student loans), to the next individual who enters the bank and applies for a student loan.

During his visit at the bank, Alessandro will probably realize that he will receive an annual interest rate of 1% or 2% if he buys a certificate of deposit, while an individual asking for a student loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for him to offer an interest rate of 4%, which would make both better off. However, he 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 Alessandro. Even if he decides to engage in this transaction, he will probably want to write a contract in order to be able to recover his money if this individual does not pay him back. As before, this will be costly. His local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information, so much so that he is better off buying a certificate of deposit and avoiding all the transaction costs associated with making a loan.

6. Kabir just applied for a mortgage loan from the State Bank of India (SBI). The loan officer tells him that to get the loan, he must leave the house as collateral with the bank until he pays back the loan. Which problem of asymmetric information is the bank trying to solve?

In this case, the bank wants to make sure that Kabir does not sell his house, get the money, and never pay back the loan Thus, the bank is trying to lessen the adverse selection effect and solve the moral hazard problem by placing a lien on Kabir’s house title.

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

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

8. After Fabrizio compares the measures of corruption and living standards of some countries, he sees a direct relationship between these measures. Explain the relationship between these measures.

There seems to be a positive relationship between low corruption and high living standards in different countries. A poorly functioning system of property rights (the presence of corruption, etc.) makes it hard for the financial system to work efficiently, making collateral and restrictive covenants difficult to use as tools. This makes it harder for lenders to channel funds to the borrowers with the most productive investment opportunities, leading to less productive investments, a slower economy, and lower living standards.

9. Mario has two close friends: Gianluigi and Rebecca. On the one hand, Gianluigi has

just put all his life savings into a restaurant. On the other hand, Rebecca, who has a regular job, has not done so. Both ask Mario for a loan. Should he be more willing to lend to Gianluigi or Rebecca if there is no other difference between them? Why? Mario should loan the money to Gianluigi. The person who is putting his life savings into his business has more to lose if he takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So he will act more strongly in the interest of the lender, making it more likely that the loan will be paid off.

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

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

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

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

12. In March 2020, the Prime Minister of Lebanon confirmed that the country would default on its debt for the first time. According to an official statement the country could not pay a €1.35 billion Eurobond due that month. Obviously, many investors were left holding bonds priced at a fraction of their previous value. 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 Lebanon?

Information asymmetries are also present in government bond markets. Investors usually resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Lebanon 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 Lebanon default, investors are unwilling to buy bonds issued by its

government. And even in the future they will probably be willing to buy them only at a significant risk premium, making it very costly for Lebanon to raise funds in bond markets.

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

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

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

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

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

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

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

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

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

Because there is asymmetric information and the free-rider problem, not enough information is available in financial markets. Thus there is a rationale for the government to encourage information production through regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection

problem. The government can also help reduce moral hazard and improve the performance of financial markets by enforcing standard accounting principles and prosecuting fraud.

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

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

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

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

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

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

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

21. Artan is a young lawyer who lives in Albania, a country with a relatively inefficient legal and financial system. When Artan applied for a mortgage, he found that banks usually required collateral for up to 150% of the amount of the loan. Explain why banks might require that much collateral in such a financial system. Comment on the consequences of such a system for economic growth.

Financial intermediaries operating in countries with relatively weak property rights and legal systems usually require a lot of collateral when making loans. The rationale for that behavior is that in the event that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its loan. Therefore, requesting extra collateral might help the bank speed up the process. In practice, a bank that has requested two other houses as collateral for a mortgage has better chances to recover its loan in the event of default. Of course, this means that fewer individuals will have access to mortgages (even those with excellent credit risk are left out), since it is quite difficult to come up with such an amount of collateral (usually having your parents as cosigners and using your parents’ house as collateral is not enough). Inefficient

financial systems make access to credit much more difficult in some countries, but it is fair to say that this might be the result of inefficient legal systems. As explained earlier, inefficient financial systems contribute to lower economic growth rates. This example illustrates how difficult it can be for a young individual to buy a house, resulting in lower expenditure on residential investments.

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

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

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

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

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

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

Profit Probabilities Profit = $10,000

Profit = $50,000

Lazy

60%

40%

Hard worker

20%

80%

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

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

If Ron works hard, his expected payment is

0.20  10,000 P  0.80  50,000 P  1,000  42,000 P  1,000 To induce Ron to work hard, you need

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

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

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

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

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

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

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

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

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

Net Tightening of Auto Lending Standards, Average

Net Worth Average Growth Rate

3.6

5.1

2.1

5.0

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

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

Chapter 9 ANSWERS TO QUESTIONS 1. Describe the main reasons why small banks hold deposits in larger banks.

Small banks hold deposits in larger banks for a variety of reasons like check collections, foreign exchange transactions, and security purchases.

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

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

Liabilities

Reserves

$75 million

Deposits

$500 million

Loans

$525 million

Bank capital

$100 million

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

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

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

Liabilities

Reserves

$100 million

Deposits

$500 million

Loans

$500 million

Bank capital

$100 million

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

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

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

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

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

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

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

8. If Banka Intesa Sanpaolo has been notified by its regulator that it needs to increase its capital by €5,000,000, and at the same time it had planned on not paying any dividends this year, what can it do to rectify the situation?

It can raise €1 million of capital by issuing new stock or selling assets.

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

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

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

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

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

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

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

14. You are looking to buy the stock of a commercial bank in Israel. After looking into the balance sheet and the investor relations presentations you understand that it only makes loans to the oil companies. Would you be willing to buy stock in that bank?

Why or why not?

While the bank might be profitable, the fact that it is exposed only to one sector means that in times of difficulties in the oil sector it might suffer huge losses. So, you should be careful about buying the stock of that bank.

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. Parameshwar works as a junior analyst at a local commercial bank in India. Her boss tells her he believes that interest rates will rise in the future but he is not sure if they should make more short-term loans or long-term loans. What should Parameshwar suggest?

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

17. Her boss tells Parameshwar that "Bank managers should always seek the lowest risk possible on their assets.‖ Is this statement true, false, or uncertain? Explain your answer.

False. If an asset has very low risk, it also probably has a very low return. A bank manager might not want to hold such an asset because there might be assets that have a similar risk but higher returns. Therefore, a bank manager must consider risk as well as the expected return when deciding to hold an asset.

18. Describe what can be done to reduce the principal-agent problem in financial

institutions.

Managers of financial institutions must set up internal controls that include the separation of people in charge of trading activities from those in charge of bookkeeping for trades. They must scrutinize risk assessment procedures and set limits to the total amount of traders' transactions and on the institution's risk exposure.

ANSWERS TO APPLIED PROBLEMS 19. Develop the T-accounts of Intesa Sanpaolo and Unicredit Bank. Describe what happens when Giancarlo Pisano writes a €3,000 check on her account at Intesa Sanpaolo to pay his friend Alessandra Pavone, who in turn deposits the check in her account at Unicredit Bank.

The T-accounts for the two banks are as follows: INTESA SANPAOLO Assets Reserves

Liabilities €3,000

Checkable Deposits

€3,000

UNICREDIT Bank Assets Reserves

Liabilities €3,000

Checkable Deposits

€3,000

20. What happens to reserves at Banca Mediolanum if one person withdraws €1,000 of cash and another person deposits €500 of cash? Use T-accounts to explain your answer.

If these transactions take place, the reserves drop by €500. The T-account for Banca Mediolanum is as follows: Banca Mediolanum Assets Reserves

Liabilities €500

Checkable Deposits

€500

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

Deposits = 27/0.09 = 300. The reserve shortage is calculated as outstanding reserves after the deposit outflow, minus required reserves after the deposit outflow: 22 ‒ 295 × 0.09 = ‒ 4.55

Angus Bank has to borrow $4.55 million. Borrowing from the Fed will cost Angus Bank: 0.0025 × 4.5 = $11,250 dollars.

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

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

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

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

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

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

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

25. Thomas is a risk manager at Barclays Bank. The bank has £150 million of fixed-rate assets, £300 million of rate-sensitive assets, £250 million of fixed-rate liabilities, and £200 million of rate-sensitive liabilities. Thomas must conduct a gap analysis for the bank and show what will happen to bank profits if interest rates rise by 2 percentage points. What actions could he take to reduce the bank’s interest-rate risk?

The gap is GBP 100 million (GBP 300 million of rate-sensitive assets minus £200 million of rate-sensitive liabilities). The change in bank profits from the interest rate rise is £2 million (2%  £100 million); the interest-rate risk can be reduced by increasing rate-sensitive liabilities to £300 million or by reducing rate-sensitive assets to £200 million. Alternatively, he could suggest that the bank engage in an interestrate swap in which it swaps the interest on £100 million of rate-sensitive assets for the interest on another bank’s £100 million of fixed-rate assets.

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

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

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

2. What was the main reason for the EU Bank Recovery and Resolution Directive (BRRD) introduced by the European Union for failing banks after the financial crisis?

During the financial crisis of 2012, many banks were considered too big to fail and were bailed out with public funds. The EU BRRD aims to address moral hazard and permits banks to fail in an orderly manner, so that government bailouts are not needed.

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

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

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

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

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

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

6. Suppose that Altin has 500,000 ALL in deposits in a bank in Albania. Due to a severe shock, the bank is considered insolvent by the Albanian Deposit Insurance Agency.

Which methods would he prefer the Deposit Insurance Agency to apply considering that the agency insures deposits of up to 250,000 ALL, and that it either uses the payoff method or the purchase and assumption method? What if his deposits were 200,000 ALL? If Altin has 500,000 ALL in deposits he would prefer that the deposit insurance agency use the purchase and assumption method, since he would get more of his

money back compared to the payoff method. In the second case, he would prefer the payoff method. Not only he would get all his money back, but the cost for the taxpayers would be lower.

7. The Deposit Insurance Agency is the institution in charge of deposit insurance in Albania of up to 250,000 ALL. Considering the country has weak institutions and prevalent corruption, do you think it was a good idea for the government to have founded it many years ago?

Even though the country has weak institutions and a high level of corruption, the presence of the deposit insurance agency has helped to increase the trust of the public in the banking system, especially after a failed Ponzi scheme in 1997. This, along with a generally healthy banking system, has been a staple in the last two decades.

8. During the financial crisis the Irish government had to intervene and bail out a number of commercial banks by injecting capital. What could have been the government's rationale for doing this?

The intervention was necessary to prevent widespread disruption to the financial markets and the real economy.

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. The government safety net creates both an adverse selection problem and a moral hazard problem. Explain.

The adverse selection problem occurs because risk-loving individuals might view the banking system as an opportunity to misuse other peoples' funds, knowing that those

funds are protected. The moral hazard problem comes about because depositors will not impose discipline on the banks since their funds are protected As the banks knowthis, they will be tempted to take on more risk than they would otherwise.

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

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

13. During the financial crisis the Irish government had to intervene and bail out a number of commercial banks by injecting capital. What could have been the government's rationale for doing this?

The intervention was necessary to prevent widespread disruption to the financial markets and real economy.

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

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

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

With more competition in financial markets, there are more firms making less profits.

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

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

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

ANSWERS TO APPLIED PROBLEMS 17. Consider a failing bank. How much is a deposit of $290,000 worth if the FDIC uses the payoff method? The purchase and assumption method? Which method is more costly to taxpayers?

If the FDIC uses the payoff method, a deposit of $290,000 is worth $261,000. If the FDIC uses the purchase and assumption method, a deposit of $290,000 is worth $290,000. The purchase and assumption method would be costlier to taxpayers.

18. Consider a bank with the following balance sheet: Assets Required reserves Excess reserves T-bills Commercial loans

Liabilities $9 million $2 million $46 million $39 million

Checkable deposits Bank capital

$90 million $6 million

The bank makes a loan commitment for $15 million to a commercial customer.

Calculate the bank’s capital ratio before and after the agreement. Calculate the bank’s risk-weighted assets before and after the agreement.

Before the commitment, the bank's capital ratio equals 6.25 %. After the commitment, the bank's capital ratio equals 6.25 %. Before the loan commitment, the bank's risk-weighted assets are $39 million. After the loan commitment, the bank's risk-weighted assets are $ 54 million.

19. Oldhat Financial starts its first day of operations with $11 million in capital. A total of $120 million in checkable deposits is received. The bank makes a $30 million commercial loan and another $40 million in mortgages with the following terms: 200 standard, 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for $200,000.

Assume that required reserves are 8%. a. What does the bank balance sheet look like?

b. How well capitalized is the bank? c. Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day.

a.

Assets

Liabilities

Required Reserves Excess

$10 million $51

Reserves Loans

million

Checkable Deposits Bank Capital

$120 million $11 million

$70 b. The leverage million ratio is 8.40 %, and the bank is well capitalized. c. The risk-weighed assets after Oldhat's first day are $50 million; the risk-weighted capital ratio after Oldhat's first day is 22.00 %.

20. Early the next day, the bank invests $35 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 $99,838 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 actual balance sheet is: Assets Required Reserves Excess Reserves Loans

$10 million $49 million $55 million

Liabilities Checkable Deposits Bank Capital

$125 million −$11 million

Now, the true state of the bank’s position is realized; bank capital is now negative, so the bank is in a dire capital position.

21. To avoid insolvency, regulators decide to provide the bank with $27 million in bank capital. Assume that bad news about mortgages is featured in the local newspaper, causing a bank run. As a result, $40 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

Checkable Deposits

Excess Reserves Loans

$26 million

Bank Capital

$100 million $ 9 million

$75 million

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

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the number of commercial banks in the United States in each of the following categories: average assets less than $100 million (US100NUM), average assets between $100 million and $300 million (US13NUM), average assets between $300 million and $1 billion (US31NUM), average assets between $1 billion and $15 billion (US115NUM), and average assets greater than $15 billion (USG15NUM). Download the data into a spreadsheet. Calculate the percentage of banks in the smallest (less than $100 million) and largest (greater than $15 billion) categories, as a percentage of the total number of banks, for the most recent quarter of data available and for 1990:Q1.

What has happened to the proportion of very large banks? What has happened to the proportion of very small banks? What does this say about the ―too-big-to-fail‖ problem and moral hazard?

In 1990:Q1, there were 25 ‟very large‖ banks, and 9,529 ‟very small‖ banks, representing 0.2% and 76.5% of total commercial banks in the United States, respectively. For the most recent quarter of 2020:Q1, there were 95 ‟very large‖ banks, and 1,000 ‟very small‖ banks, representing 2.1% and 22.5% of total commercial banks in the United States, respectively. Thus, the proportion of very large banks in the banking system has increased substantially over this period while very small banks have shrunk dramatically; because of the proportional increase in these very large banks, the ―Too Big to Fail‖ problem has steadily worsened over this time. This implies that government safety nets, along with the increase in the number of very large banks, can increase moral hazard in the banking system.

2. Go to the St. Louis Federal Reserve FRED database and find data on the residual of assets less liabilities, or bank capital (RALACBM027SBOG), and total assets of commercial banks (TLAACBM027SBOG). Download the data from January 1990 through the most recent month available into a spreadsheet. For each monthly observation, calculate the bank leverage ratio as the ratio of bank capital to total assets. Create a line graph of the leverage ratio over time. All else being equal, what can you conclude about leverage and moral hazard in commercial banks over time?

See the graph below. In January 1990, the leverage ratio was 6.5%, and in the most recent month of June 2020, the leverage ratio was 9.9%. There are three distinct periods in the data. The first from 1990 to the end of 1995 indicates a gradually increasing leverage ratio. At the beginning of 1996, there was a significant dropoff in bank capital, thus the ratio declines to a much lower level at some point below 4%.

Beginning in 2009, as a result of the Global Financial Crisis a number of financial regulations were put into place to raise bank capital and hence the leverage ratio, thus the sharp increase. Overall, the increase in the leverage ratio from 1990 to now indicates that, holding everything else constant, moral hazard in the banking system should be lower now than in 1990.

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Chapter 11 ANSWERS TO QUESTIONS 1. Do you think that before the National Bank Act of 1863 the prevailing conditions in the banking industry fostered or hindered trade across states in the United States?

Two important conditions hindered trade across states before 1863: there was no national currency, and banknotes issued by state banks could become worthless any day. Given these two conditions, individuals interested in conducting their business across states had to use mostly gold as a mean of payment, with all the inconveniences attached to that particular type of money.

2. Why does the United States operate under a dual banking system?

Throughout most of the history of banking in the United States, there has been a fear of centralized banking power. As a result, all banks had been chartered locally by each state. Due to lax regulation by some states, banks regularly failed due to lack of sufficient capital or fraud. To stabilize the banking system, the federal government introduced the National Banking Act of 1863, which created a system of federally chartered banks that were subject to greater regulation and scrutiny. Since federally chartered banks were less prone to failure, they increased in number over the years.

However, the skepticism of centralized power in the banking system still allowed state banks to operate effectively. And although there have been attempts over the years to force all banks to be federally chartered, due to more uniformity in the chartering process, the distinctions between state and federally chartered banks have diminished, and so the two standards are still in operation today.

3. In light of the recent financial crisis of 2007–2009, do you think that the firewall created by the Glass-Steagall Act of 1933 between commercial banking and the securities industry proved to be a good thing or not?

Answers will vary. In general, one could say that the Glass-Steagall Act was a good choice in term of separating a risky industry (the securities industry) from traditional commercial banking. In this sense, the Act of 1933 proved to be a good thing, since the banking industry did not experience many crises during its life (it was repealed in 1999). One could also argue that this Act put U.S. banks at a disadvantage against its foreign competitors in terms of lost opportunities to make profits.

4. Which regulatory agency has the primary responsibility for supervising the following categories of commercial banks? a. National banks b. Bank holding companies c. Nonfederal Reserve member state banks d. Federal Reserve member state banks e. Federally chartered savings and loan associations f. Federally chartered credit unions a. Office of the Comptroller of the Currency

b. The Federal Reserve c. State banking authorities and the FDIC d. The Federal Reserve e. Federal Housing Finance Agency f. National Credit Union Administration.

5. How does the emergence of interest rate risk help explain financial innovation?

Large fluctuations in interest rates during the 1970s and 1980s led to a need for financial products that could help reduce risk related to unexpected interest rate fluctuations. Two examples of this type of innovation are adjustable-rate mortgages and financial derivatives, both developed during the 1970s.

6. Why did new technology make it harder to enforce limitations on bank branching?

Several banks frequently share new technologies such as electronic banking facilities, so these facilities are not classified as branches. Thus, they can be used by banks to escape limitations on offering services in other states and, in effect, to escape limitations from restrictions on branching.

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

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

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

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

9. How do sweep accounts and money market mutual funds allow banks to avoid reserve requirements?

With a sweep account, any account funds left at the end of the business day are technically transferred to another account, which is invested in overnight securities.

Since they are no longer classified as checkable deposits, the funds are not subject to reserve requirements. Money market mutual funds are set up such that deposits are used to invest in short-term money market securities. And although money market

mutual fund accounts have check writing functions like checkable deposits, they are also not subject to reserve requirements.

10. Securitization changes the systemic (system-wide) risks in the regulated and unregulated ―shadow‖ banking system. What is securitization? Does it pose a problem for effective banking systems?

Securitization, like a mortgage-back security (MBS), refers to the process of bundling illiquid financial assets into marketable capital market securities. Securitization is one of the main reasons why shadow banking systems are created—where typical lending is substituted by lending via the securities market; the system invests in long-term loans like auto loans and mortgages, and finances them by issuing short-term commercial papers or repos.

It does pose a problem, because on the one hand, shadow banking seems to be very profitable, performing the same functions as regular banks, and usually has lower transaction costs and fewer regulatory restrictions. On the other hand, its lack of regulations imply that it does not benefit from the same safety net as traditional banks do. For example, players in the shadow banking system will not be able to borrow from the Fed’s discount window as they are not federally insured. The role of securitization and shadow banking in the 2007-2009 financial crises is an example of how it affects effective banking systems.

11. Why is loophole mining so prevalent in the banking industry in the United States?

Since the banking sector is so heavily regulated, there is a strong incentive for banks to find ways to skirt regulations that restrict their ability to earn profits. Through loophole mining, banks can create new financial products that allow them to operate within existing regulations, but make (or increase) profits that were stifled due to regulation.

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

The rise in inflation and the resulting higher interest rates on alternatives to checkable deposits meant that banks had a big shrinkage in this low-cost way of raising funds.

The innovation of money market mutual funds also meant that the banks lost checking account business. The abolishment of Regulation Q and the appearance of NOW accounts did help decrease disintermediation, but raised the cost of funds for American banks, which now had to pay higher interest rates on checkable and other deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their cost of funds relative to American banks.

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

The growth of the commercial paper market and the development of the junk bond market meant that corporations were now able to issue securities rather than borrow from banks, thus eroding the competitive advantage of banks on the lending side.

Securitization has enabled other financial institutions to originate loans, again taking away some of the banks’ loan business.

14. According to Reuters, the People’s Bank of China has been using targeted increases in banks’ reserve requirement ratios (RRR) in recent months. Explain

why central banks impose reserve requirements for commercial banks. Why do commercial banks try to avoid this requirement?

Increasing reserve requirement ratios (RRR) is one of the main tools employed by the People’s Bank of China to keep inflation at bay and prevent asset price bubbles.

Usually, central banks impose reserve requirements on commercial banks to control money supply—banks need to hold a certain amount of reserves at the central bank (or other regulatory bodies) from their deposits. Holding reserves at central banks impose opportunity costs for these banks—they could have instead offered this fraction as loans and made a profit.

In certain countries, the central bank pays interests on the reserves (for example, the United States of America started doing so after 2008), which increases income taxes.

Thus, banks look to financial innovations to avoid reserve requirements and, hence, avoid paying higher income taxes.

15. Why are the number of traditional banking systems in industrialized and developed countries declining?

Answers may vary as students will be able to provide various examples for different countries. However, there are some common issues—expansion of securities market and shadow banking. Deregulation and information technologies have increased the availability of information about the securities market, so instead of just giving out loans and borrowing at the commercial bank, institutions and bodies may prefer to buy or sell securities. This tendency is more apparent in less developed countries that have weak securities markets. This is due to advanced technologies in those countries, which lets them trade in developed financial markets.

16. Unlike commercial banks, savings and loans, and mutual savings banks, credit unions did not have restrictions on setting up branches in other states. Why, then, are credit unions typically smaller than the other depository institutions?

Credit unions are small because they only have members who share a common employer or are associated with a particular organization.

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

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

18. Given the role of the loan originator in the securitization process of a mortgage loan described in the text, do you think the loan originator will be worried about the ability of a household to meet its monthly mortgage payments?

Given that the loan originator or mortgage broker is mostly worried about getting the household to accept the terms of the mortgage loan, so that the servicer can sell it to the bundler, then it is easy to see that he or she is not very worried about the financial constraints of this family. The loan originator is mostly worried about getting its fee, since he or she will not suffer any consequences if the household cannot repay its loan. This was one of the major problems at the origin of the global financial crisis of 2007–2009.

19. How did competitive forces lead to the repeal of the Glass-Steagall Act’s separation of the banking and securities industries?

Brokerage firms began to engage in the traditional banking business of issuing deposit instruments, while foreign bank activities in the United States further eroded the competitive position of U.S. banks. This led to the Federal Reserve’s allowing bank holding companies to enter the underwriting business through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999 was passed to repeal Glass-Steagall.

20. What has been the likely effect of the Gramm-Leach-Bliley Act on financial consolidation?

The Gramm-Leach-Bliley Act opened the door to consolidation, not only in terms of the number of banking institutions, but also across financial service activities.

Banking institutions have thus become larger and increasingly complex organizations, engaging in the full gamut of financial services activities.

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

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

22. What incentives have regulatory agencies created to encourage international banking? Why have they done this?

International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it will create more banking jobs in the United States.

23. How could the approval of international banking facilities (IBFs) by the Fed in 1981 have reduced employment in the banking industry in Europe?

IBFs encourage American and foreign banks to do more banking business in the United States, thus shifting employment from Europe to the United States.

24. If the bank at which you keep your checking account is owned by foreigners, should you worry that your deposits are less safe than if the bank were owned by Americans?

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

25. Implementing a structural separation of commercial banking and investment banking activities is a way to reduce systemic risks when a potential bank failure threatens an entire economic system. Do you think separating banking service industries from other financial service industries is a good idea? Explain your argument.

Answers will vary. Encourage students to do some research using the Internet or other resources regarding different systems. You could refer to the separation proposal

made by the OECD in 2009 (following the global financial crises). Those who argue in favor of separation will cite the economics of scope, greater utilization of scarce recourses, and getting rid of the too-big-to-fail system. It would get rid of unwarranted ―funding subsidies‖ for activities that should not require a Sgovernment guarantee. Those who argue against it could talk about the move resulting in the creation of large conglomerates, which will be difficult to control and supervise.

These conglomerates may gain huge economic and even political influence.

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

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

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

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

2. Go to the St. Louis Federal Reserve FRED database and find data on the level of money market mutual fund assets (MMMFFAQ027S). Download the data into a spreadsheet. a. When did assets start entering money market mutual funds? What was the total worth of assets in money market mutual funds at the end of 1970?

Assets started entering money market mutual funds at the beginning of 1974 (Q1). By the end of the decade in 1979:Q4 there were $45.2 billion in assets. b. For each decade period, calculate the total percentage change in assets from the beginning of the decade to the end of the decade: 1980:Q1–1990:Q1; 1990:Q1– 2000:Q1; 2000:Q1–2010:Q1; and 2010:Q1 – 2020:Q1. For each decade period, divide the total percentage change by 10 to get the average yearly percentage increase. Which decade had the largest average yearly growth in money market mutual funds?

1980 to 1990 1990 to 2000 2000 to 2010 2010 to 2020

Cumulative Decade % Change 659.8 264.2 46.6 45.4

Average Annual % Change 66.0 26.4 4.7 4.5

c. Calculate the growth rate from the most recent quarter of data available to the same quarter a year prior. How does this growth rate compare to the highest average yearly growth rate for the decades from part (b)?

For the most recent one year period from 2019:Q1 to 2020:Q1, money market mutual fund assets increased by 40.9%, which is close to the highest average yearly growth rate of about 66% per year in the 1980s.

Chapter 12 ANSWERS TO QUESTIONS 1. How does the concept of asymmetric information help to define a financial crisis?

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

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

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

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

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

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

Financial frictions are a set of conditions that prevent financial markets to effectively assign funds to the best investment opportunities. In general, they increase when information asymmetries worsen, preventing lenders from ascertaining the best potential borrowers. Financial frictions are a key element in financial crises because as the channeling of funds through the financial market is interrupted or limited, the economy slows down. This could trigger an asset-price decline, increase in uncertainty, and the deterioration in financial institutions’ balance sheets.

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

If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to a decline in investment spending, which slows economic activity. When there are simultaneous failures of

financial institutions, there is a loss of information production in financial markets and a direct loss of banks’ financial intermediation. In addition, a decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates, which increases asymmetric information problems and leads to a further contraction in lending and economic activity.

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

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

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

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

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

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

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

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

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

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

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

Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a deterioration in financial institution balance sheets, which then means that these institutions cut back lending and economic activity declines.

12. Identify two similarities and two differences between the Great Depression and the global financial crisis of 2007–2009.

Answers may vary. Both the Great Depression and the global financial crisis of 20072009 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 in many countries. The two episodes differ in the source of asset price increases: During the Great Depression, rising stock prices worldwide were the trigger, whereas in the financial crisis a housing bubble in the United States, but also in countries such as Spain or Ireland was the primary trigger. During the Great Depression, many bank failures lead to a bank panic, causing more banks to fail.

During the recent crisis, even though the banking system was hit hard and bank failures did occur, they were much less pronounced, and no bank panic occurred— apart from individual episodes and bank runs, such as in the case of Northern Rock in the United Kingdom. Finally, although both episodes resulted in significant declines in GDP and increases in unemployment in many countries, this was much more pronounced during the Great Depression, when, for instance, U.S. unemployment peaked at 25% (as opposed to the recent crisis, in which the U.S. unemployment rate reached 10.2%). In part, this is the result of central bank activism, with policymakers trying much more aggressively to contain the financial crisis and reverse the decline in economic activity during the recent crisis than was true during the Great Depression.

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

Answers may vary. In general, it is believed that the country as a whole probably learned from the experience of the Great Depression, and has put in place more sophisticated policy frameworks to help deal with severe economic downturns more

effectively. For instance, bank panics, which were widespread during the Great Depression, were virtually nonexistent during the 2007–2009 crisis; this is probably due to bank accounts now being insured by the FDIC, when they were not during the Great Depression. Another factor seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by instituting more aggressive, swifter policies to avoid any contagion effects that would unnecessarily deepen or lengthen the crisis.

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

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

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

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

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

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

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

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

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

The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial firms.

They are important because a large amount of funds flowed through the shadow banking system to support low interest rates, which fueled some of the housing bubble. Because of their large presence in financial markets, when credit markets

began tightening, funding from the shadow banking system decreased significantly, which further reduced access to needed credit.

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

During a financial crisis, asset prices fall, oftentimes very rapidly and unexpectedly.

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

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

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

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

Leverage cycles indicate that over business cycles, lending increases substantially in booms and decreases substantially in downturns. If countercyclical capital requirements were initiated, this would require more capital held at institutions during booms, which would reduce lending and help to mitigate credit bubbles that can be damaging later on. Likewise, when the economy goes into a downturn, capital requirements could be lowered, which would encourage more lending and facilitate faster economic growth.

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

The process of financial innovation is generally good for the economy: Its goal is to create new financial instruments as a response to the ever-changing preferences of financial system participants. One of its most beneficial effects is to increase the efficiency of the financial system. This process also can be risky at times. The creation of new financial instruments is often associated with their mismanagement.

Sometimes this can result in the creation of asset-price bubbles, as happened with mortgage-backed securities (or CDOs, or SIVs) in the 2007–2009 crisis. When these instruments are improperly priced, this can disrupt the financial system. Regulators can at best be one step behind in this process, since usually as a profitable opportunity is created (e.g., by trading MBSs, CDOs, etc.) many financial intermediaries will follow this path. Only after there is a thorough understanding of the structure and risk of new financial instruments can proper regulations be written and enforced. But this usually only happens after there is a disruption in the financial system.

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

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

24. Why is international regulatory cooperation important? What forms has it taken in the aftermath of the 2007–2009 financial crisis?

Given the global nature of the 2007-09 financial crisis, both in its causes and consequences, international supervisory cooperation was required to prevent largescale regulatory arbitrage by big financial institutions capable of taking advantage of loopholes in individual regulatory systems. Additionally, in the immediate aftermath of the crisis, policymakers have realized the importance of upgrading the global regulatory architecture to reduce the likelihood of similar global crises in future. G20 countries have established a Financial Stability Board to monitor systemic risk in crucial segments of global financial markets (such as derivative markets) and supervise inter-linkages between big financial institutions operating on a large scale, and a Mutual Assessment Process aimed at coordinating macroeconomic policy responses to the crisis.

25. What role can self-regulation play in the future to avert financial crises?

Self-regulation is an area where major improvements can help diffuse the risk of another financial crisis. Indeed, given the importance of risky business models and widespread reckless and unethical behavior on the part of top management within several financial institutions prior to the crisis, a new emphasis on financial education and monitoring of unethical behavior has been put in place in the aftermath of the crisis, especially in the banking industry.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on house prices (SPCS20RSA), stock prices (NASDAQCOM), a measure of the net wealth of households (BOGZ1FL192090005Q), and personal consumption expenditures (PCE).

For all four measures, be sure to convert the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For all four series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current period data minus the previous quarter data, and then divide by the previous quarter data. Multiply by 100 to change each result to a percent, and multiply by 4 to annualize the data. a. For the four series, calculate the average growth rates over the most recent four quarters of data available. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results.

See the table below. From the most recent available data from 2016:Q2 to 2017:Q1, all four data series are showing healthy gains, and are sensibly related to

each other. Since homeowner’s equity and retirement or stock portfolios are the two biggest sources of wealth for households, you would expect those to be closely related to net wealth of households. And since net wealth grew substantially, you would expect autonomous consumption to rise, which appears evident in the growth in consumption of almost 5%. b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results, before and during the crisis.

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

The most current data overall shows relatively strong growth in these household indicators somewhat similar to the pre-crisis period in 2005, although in the most recent period stock price growth is very high in comparison, while house price appreciation is very strong in the pre-crisis period. However, despite healthy stock price growth and modest home price appreciation, household net worth is relatively flat, and this translates to the relatively low consumption growth. The current data are significantly better than the crisis period.

NASDAQ CaseStock Shiller Price Home Price Household Consumption Growth Growth Net Worth Growth 2019:Q2 to 2020:Q1 18.2 3.4 –0.4 1.9 2008:Q3 to 2009:Q2 26.2 17.9 9.0 2.9 2005:Q1 to 2005:Q4 6.3 14.7 9.5 6.0

2. Go to the St. Louis Federal Reserve FRED database and find data on corporate net worth of nonfinancial businesses (TNWMVBSNNCB), private domestic investment (GPDIC1), and a measure of financial frictions, the St. Louis Fed financial stress index (STLFSI2). For all three measures, be sure to convert the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For corporate net worth and private domestic investment, calculate the annualized growth rates from quarter to quarter. To do this, take the current period data minus the previous quarter data, then divide by the previous quarter data. Multiply by 100 to change the results to percentage form, and then multiply by 4 to annualize the data. a. Calculate the average growth rates over the most recent four quarters of data available for the corporate net worth and private domestic investment variables.

Calculate the difference between the value of the stress index during the most recent quarter and the value of the stress index one year earlier. Comment on the relationships among financial stress, net wealth of corporate businesses, and private domestic investment.

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

See table below. During the pre-crisis period in 2005, financial frictions were essentially flat. However, net worth of corporations was increasing well over 10% on an annual basis, providing significant reassurance to lending institutions that strong corporate balance sheets would reduce lending risk. As a consequence, investment grew at 6.1% on average for the year.

During the crisis period, there was a strong increase in financial frictions (although the net change during the period was slightly negative); with asset prices declining, this lead to rapid deterioration of corporate balance sheets and net worth, and as a consequence, lending and investment contracted sharply by 28.9%. This is entirely consistent with the first stage of a financial crisis, where declining asset prices lead to lower net worth of firms, and lending contracts sharply. Moreover, financial frictions increased sharply during that time, which is indicative of asymmetric information problems rising. c. How do the current investment data compare to the data for the period prior to

the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

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

Average Change, Corporate Stress Net Worth Investment Index Growth Rate Growth Rate 2019:Q2 to 2020:Q1 1.5 11.1 –4.3 2008:Q3 to 2009:Q2 –0.4 10.7 28.9 2005:Q1 to 2005:Q4 0.2 10.7 6.1

Chapter 13 ANSWERS TO QUESTIONS 1. What are the two basic causes of financial crises in emerging market economies?

The two basic causes of financial crises in emerging market economies are, the mismanagement of financial liberalization and globalization, and severe fiscal imbalances.

2. Why might financial liberalization and globalization lead to financial crises in emerging market economies?

Financial liberalization and globalization in themselves do not lead to financial crises in emerging economies. Rather, it is the mismanagement of these two processes that might lead to financial crises. Because of financial liberalization and globalization, restrictions of financial institutions and capital flows across countries were eliminated. However, emerging economies lack the institutions that can supervise and manage these two processes effectively, especially in terms of screening and monitoring borrowers. Therefore, the two processes have led to a lending boom in emerging economies, and most funds were channeled towards high risk projects. The lending boom ultimately ends in a lending crash resulting in heavy losses and weakening of banks’ balance sheets. Another factor that would explain why the two processes might lead to financial crises is that in emerging economies, the existence of powerful business interests prevents the supervisory institutions from performing their job properly and weakens the regulations that restrict their banks from engaging in high-risk/high-payoff strategies.

3. Why might severe fiscal imbalances lead to financial crises in emerging market economies?

In emerging market economies, governments usually cajole or force banks to purchase their debts. Investors who lose confidence in the ability of the government to repay this debt, unload the bonds, causing their prices to plummet. Banks that hold this debt then face a big hole on the asset side of their balance sheets, with a huge decline in their net worth. With less capital, these institutions have fewer resources to lend and lending declines. The situation can be even worse if the decline in bank capital leads to a bank panic which causes the failure of many banks. The result of severe fiscal imbalances is therefore a weakening of the banking system, which leads to a worsening of adverse selection and moral hazard problems.

4. What other factors can initiate financial crises in emerging market economies?

Other factors that can initiate financial crises in emerging market economies include, a rise in interest rates from events abroad, a decline in asset price that causes a deterioration in banks’ balance sheets from asset write-downs, and an increase in uncertainty due to unstable political systems.

5. What events can ignite a currency crisis?

Events that can ignite a currency crisis are deterioration of banks’ balance sheet, and severe fiscal imbalances.

6. Why do currency crises make financial crises in emerging market economies even more severe?

Currency crises make financial crises in emerging market economies even more severe because both nonfinancial and financial firms in these countries have a massive amount of foreign currency debt. Emerging market economies denominate many debt contracts in foreign currency (usually dollars) leading to a problem of currency mismatch. With the fall of the local currency, all dollar denominated-debt will increase in local currency terms. Moreover, the deterioration in bank balance sheets has a greater negative impact on lending and economic activity, than in advanced countries, which tend to have more sophisticated securities markets and large nonbank financial sectors that can help pick up the slack when banks falter. So, as banks stop lending, there are no other players to solve the adverse selection and moral hazard problems.

7. How did the financial crises in South Korea and Argentina affect aggregate demand, short-run aggregate supply, and output and inflation in these countries?

The decline in lending by banks, in South Korea and Argentina, due to the increase in asymmetric information problems, led to a contraction of AD, as the AD curve shifted to the left. The collapse of the currency led to a further contraction of AD, and real GDP fell with a sharp rise in unemployment. However, due to the currency crisis, inflation rose: the collapse of the South Korean and Argentine currency after the speculative attack increased import prices and weakened the credibility of the central banks in both countries as an inflation fighter. These factors led to an upward shift in the short-run AS, resulting in a reduction in the output and an increase in inflation.

8. What can emerging market countries do to strengthen prudential regulation and supervision of their banking systems? How might these steps help avoid future financial crises?

To strengthen prudential regulation and supervision of their banking systems, emerging market economies need to ban commercial businesses from owning banking institutions such that risky lending behavior can be avoided. Prudential supervisors must also have adequate resources (more qualified personnel and better facilities, such as computers, etc.) so that they are able to perform their jobs effectively. The regulatory and supervisory agency also needs to be independent of any political pressure and influence. These steps are important as they promote a safer and sounder banking system by ensuring that banks have proper risk management procedures in place. These procedures include good risk measurement and monitoring systems, policies to limit activities that present significant risks, and internal controls to prevent fraud or unauthorized activities by employees.

9. How can emerging market economies avoid the problems of currency mismatch?

Governments can limit currency mismatch by implementing regulations or taxes that discourage the issuance of debt denominated in foreign currency by non-financial firms. Regulation of banks can also limit bank borrowing in foreign currencies.

Moving to a flexible exchange rate regime, in which exchange rates fluctuate, can also help discourage borrowing in foreign currencies since it is riskier. Monetary policy that promotes price stability also helps in making domestic currency less subject to decreases in its value because of high inflation, thus making it more desirable for firms to borrow in domestic currency.

10. Why might emerging market economies want to implement financial liberalization and globalization gradually rather than all at once?

Financial liberalization should be implemented gradually because there is a need to ensure that proper institutional infrastructures such as a strong prudential regulation, and supervision policies limiting currency mismatch and disclosure requirements are in place first, thereby avoiding any potential financial crises. If these infrastructures are not in place when liberalization occurs, the necessary constraints on risk-taking behavior will be far too weak. Moreover, since implementing these takes time, financial liberalization may have to be phased in gradually, with some restrictions on credit issuance imposed along the way.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the World Bank’s databank website at http://databank.worldbank.org/data/reports.aspx?source=2&country. Find the following annual data for South Korea (The Republic of Korea) and Thailand, for the past 25 years: (i) GDP at current US$ prices; (ii) Net foreign direct investment, in current US$; (iii) the current account balance, in current US$; (iv) the average official exchange rate. Download the data into a spreadsheet, and make sure the data align correctly with the appropriate date. Calculate annual GDP growth for each year over the period. (Hint: Follow the procedure indicated in Data Analysis Problem 1 at the end of Chapter 12.) Calculate the values of net foreign direct investment and current account balance as percentage of GDP. a. For both countries, for the period 1995 to 1999, compare and analyze the changes in net foreign direct investment to GDP, the current account balance, and the average official exchange rate. Do you see significant shifts, in line with what this chapter has discussed? Compare these data with the data on GDP growth. Comment on the relationship. What relationship do you see between the GDP growth rate, external account deterioration, and the exchange rate for both countries? b. For both countries, analyze the same data for the subsequent period, until the most recent year you could find. Comment on the effects of the 1997–1998 financial crisis on GDP. Compare the years before the 1997–1998 crisis, the crisis years, and the immediate aftermath, with the data you have for the most recent five years. What is the difference?

2. Go to the World Bank’s databank website at http://databank.worldbank.org/data/reports.aspx?source=2&country. Find the following annual data for Argentina, for the past 25 years: (i) GDP at current US$ prices; (ii) the general price level; (iii) the current account balance, in current US$; (iv) government debt in percentage of GDP; (v) the exchange rate. Download the data into a spreadsheet, and make sure the data align correctly with the appropriate date. Calculate annual GDP growth for each year over the period, following the procedure used in the previous question. Calculate the value of current account balance as percentage of GDP. Calculate the annual inflation rate in terms of annual changes in the general price level. a. Analyze the relationship between annual GDP growth, inflation rate, government debt, the current account balance, and the exchange rate in the two years prior to the 2001 crisis, during the crisis, and the two years after the crisis ended. Do you

find a different pattern from the Southeast Asian crisis? To what extent are government debt, inflation, and shifts in the exchange rate related? b. Analyze the same data for the subsequent period, until the most recent year you could find. Comment on the nature and the duration of the effects of the 2001 financial crisis on Argentinian GDP. Compare the years before the 2001 crisis, the crisis years, and the immediate aftermath, with the data you have for the most recent five years. What is the difference? To what extent would you say that Argentina finds itself in a better place now than it was 18 years ago?

Chapter 14 ANSWERS TO QUESTIONS 1. Should central banks be privately or publicly owned? Explain.

There are two different views concerning the ownership of central banks. While publicly-owned banks concentrate on public interest, privately-owned central banks are independent from the government and could potentially serve specific interests.

What is important is that central banks must ensure transparency and accountability.

In both cases, best governance practices are essential.

2. How will growth impact the structure of the European Central Bank’s (ECB) decision-making bodies?

If more countries join the European Union, the Governors of the national central banks of all EU member states will become full members of the General Council of the ECB, which is comprised of the President and Vice-President of the ECB. After new Member States adopt the euro, the Governors of the respective central banks will become members of the Governing Council of the ECB. However, the number of members with voting rights will be capped at 21. This includes six permanent voting rights for the members of the Executive Board, and 15 voting rights for the Governors of national central banks, to be exercised based on a rotation system. All members entitled to vote will have one vote, in line with the one-person-one-vote principle.

Members will also have the right to attend and speak at council meetings.

3. Why was the Federal Reserve System set up with twelve regional Federal Reserve banks rather than one central bank, as done in other countries?

Due to the traditional American hostility towards the concept of a central bank and centralized authority, the system of 12 regional banks was set up to diffuse power on a regional basis.

4. In what ways can the national central banks influence the conduct of monetary policy?

Central banks set up three interest rates based on the inflation rate target: deposit facility rate, refinancing rate, and marginal lending facility rate. They also use traditional monetary instruments such as open market operations, standing facilities, and reserve requirements. During a crisis, they can combine these with nonconventional monetary instruments such as emergency liquidity assistance and quantitative easing, including asset purchasing programs.

5. Why is the European Central Bank (ECB) governed by three different bodies?

The three bodies are the Governing Council, the Executive Board and the General Council. The General Council is a transitional body whose main task is to encourage cooperation. The body will be dissolved when integration of the single currency by all members is complete. The Governing Council and the Executive Board represent a two-tier governance structure corresponding to the separation of decision-making and day-to-day management as a rule of best governance practice.

6. Why have some countries rejected the single currency despite being full members of the European Union?

Non-Euro central banks do not belong to the single currency system, but still have some constraints due to a country’s EU membership, as they must coordinate their decisions with the ECB. Maintaining a floating exchange rate and having control over the monetary policy protects them from external shocks, and allows for independence in setting goals towards fiscal and monetary policies. However, EU rules regarding labor and competition cannot be bypassed by non-Euro countries.

7. Compare the structure and independence of the European System of Central Banks and the Federal Reserve System.

Both systems are independent and decentralized. They use the same conventional monetary tools. However, while the ECB’s focus is almost exclusively on price stability, the FED considers employment and economic growth equally important.

Due to the important role played by national central banks in the EU—in particular, the German Bundesbank—the ECB has lesser power in making budget decisions when compared to the FED. In the FED, monetary operations are centralized, while for the ECB, they are run by national central banks. This applies for the supervision and regulation of financial institutions as well, since within the Eurozone, each national central bank is doing it for its country’s financial system. Finally, local governments can use the ECB government bond repurchase programs to finance their fiscal deficits.

8. What are the main difficulties encountered by the newly established central banks in transition economies?

Prior to the 1990s, most transition nations possessed one state-owned bank that played the dual role of a commercial bank and a central bank, while a few others already had a separate central bank that regulated the operations of other state-owned banks. Moreover, the banking sector in transition economies had a huge debt portfolio owned by the inefficient public-sector firms, apart from the problems of inflation, the balance of payments, and devaluation. After 1989 and 1991, central banks were separated from commercial banks and the central bank’s independence has been gradually implemented.

9. What are the expected consequences of Brexit for the Bank of England?

The monetary policy conducted by the Bank of England is already independent from the ECB since the United Kingdom doesn’t belong to the Eurozone. However, one consequence is that financial services, being in a process of restructuring, are expected to lead to increased financial service costs. Depending on the type of Brexit, the Bank of England could also have the responsibility of regranting operating permissions in the United Kingdom to foreign organizations. This will impact the supervision and regulation of the financial system that is done by the Bank of England.

10. The structure and the policy of the People’s Bank of China (PBoC) differentiate it from traditional models of central banking systems. What are the main differences?

What are the consequences of the PBoC system for other economies?

The main goal of the PBoC is maintaining the stability of the value of the currency.

Other central banks usually focus on price stability. The People’s Bank of China requiresa reserve ratio from commercial banks that is mandatory and much higher than usual practices. The PBoC is not independent from the government, and the interest rate is strictly controlled. By doing so, the PBoC still contributes to economic growth through an external focus, while most other central banks center their decisions toward the domestic economy. This is aligned with the fact that Chinese economic growth is greatly dependent on exports, but this is slowly changing.

11. A central bank decides by how much an interest rate should be changed in order to restore equilibrium. What are the tools it uses to take such decisions?

There is no correct answer. The trend after the global financial crisis has been to develop formal approaches toward restoring economic equilibrium, which makes sense since decisions concerning interest rate levels require a high level of rationality.

However, it creates a risk for economic models that are related to the number and the complexity of the economic factors involved. Also, the increasing irrationality of investors and borrowers is a concern that is not captured well by all economic models. The judgement of highly experienced central bankers can be a determinant for restoring economic equilibrium.

12. People in general welcome actions that maintain effective communication and promote transparency, particularly when these involve public or quasi-public institutions. Can you think of a reason why a more transparent communication strategy might be detrimental to a central bank’s objectives?

There are at least two interconnected reasons. The first is the lack of financial literacy of the public. There is a risk in addressing an audience that is not able to understand the contents of the information provided to them. Second, publicly disclosed information is immediately scrutinized by different media bodies, which are not always neutral. Together, these reasons mean that elements of a highly transparent communication from a central bank can be misinterpreted both by the media and in public opinion, leading to irrational economic behavior.

13. Why might eliminating the central bank’s independence lead to a more pronounced political business cycle?

The lack of independence of a central bank means that instead of focusing on longterm public interest, central bank decisions are grounded in a political cycle. Board members are appointed based on their connections with the government instead of their expertise and performance. Accordingly, they are accountable for their decisions on a short-term perspective to the current government. Their decisions will not protect the economy against large long-term budget deficits. The expected consequence in democracies is a change of the party in power. It is usually believed that the increased long-term responsibilities of central banks need more independence to be successful, but there is no evidence against it.

14. William does not feel comfortable with the current level of the European Central Bank’s independence. Put yourself in William’s shoes and state an argument against the current level of the European Central Bank’s independence.

Examples of arguments that can be presented by students include: a. The ECB’s monetary policy is centered on a 2% inflation target. The previous ten years show that it has not been successful in reaching the target. b. ECB policy has demonstrated a lack of coherence among Eurozone members in several dimensions. Among others, a strong Euro policy doesn’t suit all countries’ economic policies at the same time. c. Regarding the reaction to the global financial crisis, the decision of a quantitative easing program arrived later than in other countries, and its effects are controversial (related to argument (b).

15. How would you argue in favor of the current trend of supporting the independence of central banks?

The most important argument in favor of the trend supporting the independence of central banks is the growing body of theoretical and empirical evidence which suggests that more independent central banks get better results (in general, lower inflation rates) than less independent central banks. However, this movement toward greater independence is resisted in some countries, precisely because it insulates the conduct of monetary policy from politics.

16. ―The independence of the central bank has meant that it takes the long view and not the short view.‖ Is this statement true, false, or uncertain? Explain your answer.

It is uncertain. Although independence may help the central bank take the long view because its personnel are not directly affected by the outcome of the next election, it can still be influenced through political pressure. In addition, the lack of accountability caused by its independence might make the bank irresponsible.

Therefore, it is not very clear whether a central bank might be more farsighted because of its independence.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate target (DFEDTAR, DFEDTARU, and DFEDTARL) and the discount, or primary credit rate (DPCREDIT). When was the last time the federal funds rate target was changed? When was the last time the primary credit rate was changed?

Did the rates increase or decrease?

As of July 30, 2020, the last time the federal funds rate target was adjusted was at an unscheduled FOMC meeting on Sunday, March 15, 2020. It decreased from a target range of between 1.25% and 1.00% to a range of between 0.00% and 0.25%. The last time the primary credit rate changed was at the same FOMC meeting, decreasing from 1.75% to 0.25%.

Chapter 15 ANSWERS TO QUESTIONS Unless otherwise noted, the following assumptions are made in all questions: the required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

1. Classify each of these transactions as an asset, a liability, or neither for each of the ―players‖ in the money supply process—the federal reserve, banks, and depositors. a. You get a $10,000 loan from the bank to buy an automobile.

Public: Assets rise by $10,000 due to automobile purchase, liabilities rise by $10,000 due to loan.

Banks: Assets rise by $10,000 due to loan; this is offset by a decrease in reserves assets of $10,000. b. You deposit $400 into your checking account at the local bank.

Public: Assets are unaffected ($400 increase in checking deposits is offset by a $400 decrease in currency holdings). Banks: Assets increase by $400 from reserves; liabilities increase by $400 due to checking account balance. Fed: Liabilities are unaffected (reserves increase by $400, currency decreases by $400). c. The Fed provides an emergency loan to a bank for $1,000,000.

Banks: Assets increase by $1,000,000 in reserves; liabilities increase by the same amount due to borrowing from the Fed. Fed: Assets increase by the $1,000,000 from the loan; liabilities increase by $1,000,000 due to the increase in reserves. d. A bank borrows $500,000 in overnight loans from another bank.

Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change due to the loan. e. You use your debit card to purchase a meal at a restaurant for $100.

Public: Assets rise by the value of the meal of $100, and are offset by a fall in assets due to lower checking account balances of $100. Assets and liabilities of the banking system as a whole are unaffected; however, individual banks’ balance sheets will change as funds are transferred from your bank account to the restaurant’s bank account.

2. The First National Bank receives an extra $100 of reserves but decides not to lend out any of these reserves. How much deposit creation takes place for the entire banking system?

None. Since there are no loans created from the new reserves, no additional deposit creation will occur.

3. Suppose the Fed buys $1 million of bonds from the First National Bank. If the First National Bank and all other banks use the resulting increase in reserves to purchase securities only and not to make loans, what will happen to checkable deposits?

Checkable deposits will remain the same.

4. If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable deposits, and the monetary base?

Reserves will decrease by $1,000, checkable deposits will decrease by $1,000, but the monetary base will be unchanged, since reserves decrease by the same amount as currency increases.

5. If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes, what is the effect on the level of checkable deposits?

None. The reduction of $10 million in discount loans and increase of $10 million of bonds held by the Fed leaves the level of reserves unchanged so that checkable deposits remain unchanged.

6. If you decide to hold $100 less cash than usual and therefore deposit $100 more cash in the bank, what effect will this have on checkable deposits in the banking system if the rest of the public keeps its holdings of currency constant?

The deposit of $100 in the bank increases its reserves by $100. This starts the process of multiple deposit expansion, leading to an increase in the money supply.

7. ―The Fed can perfectly control the amount of borrowed reserves in the banking system.‖ Is this statement true, false, or uncertain?

False. In general, The Fed will loan to banks when the need arises, and based on the desire to act as a lender of last resort. So in this sense, the Fed is at the mercy of banks’ needs for borrowed reserves when it arises and therefore cannot perfectly control the amount of borrowed reserves in the banking system.

8. ―The Fed can perfectly control the amount of the monetary base, but has less control over the composition of the monetary base.‖ Is this statement true, false, or uncertain?

Explain.

False. Since the Fed cannot control the amount of discount lending to financial institutions, it does not have perfect control over the amount of reserves, and hence does not have perfect control over the monetary base.

9. The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio. What will happen to the money supply?

When the Fed buys the $100 million of bonds from the public, this increases currency in circulation (or checkable deposits), leading to an increase in the money supply. The decline in the required reserve ratio would increase the multiplier, also leading to a higher money supply. Thus the effect of both actions unambiguously increases the money supply.

10. Describe how each of the following can affect the money supply: (a) the central bank; (b) banks; and (c) depositors. (a) The central bank can affect the money supply by affecting the amount of reserves or currency in circulation (hence changing the monetary base) through

open market operations, large-scale asset purchases, or discount loans. Additionally, it can affect the money multiplier by affecting the excess reserve ratio, either by changing the interest rate on excess reserves, or by large-scale asset purchases creating substantial excess reserves. (b) Banks can affect the money supply through their choice to hold excess reserves or not. This affects the excess reserve ratio, and thus changes the money supply through changes in the money multiplier. (c) Depositors affect the money supply through their choice to hold money in the form of currency or deposits. This affects the currency ratio, and thus changes the money supply through changes in the money multiplier.

11. ―The money multiplier is necessarily greater than 1.‖ Is this statement true, false, or uncertain? Explain your answer.

False. As the formula in Equation (4) indicates, if rr + e is greater than 1, the money multiplier can be less than 1. In practice, however, e is so small that rr + e is less than 1 and the money multiplier is greater than 1.

12. What effect might a financial panic have on the money multiplier and the money supply? Why? A financial panic would probably decrease the money multiplier and the money supply, for a given monetary base. In a financial panic, you would expect banks to want to make less risky loans, and have more liquidity on hand, which would increase the excess reserve ratio and decrease the money multiplier. In addition, depositors may get worried about the health of banks, and increase their holdings of currency, which also would decrease the money multiplier.

13. During the Great Depression years from 1930–1933, both the currency ratio c and the excess reserves ratio e rose dramatically. What effect did these factors have on the money multiplier?

Both of these factors worked to reduce the money multiplier. This can be seen in the figure in the fourth appendix to this chapter, which indicates a dramatically declining money supply, while the monetary base grew modestly, if at all.

14. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held by banks. How, if at all, might this affect the multiplier process and the money supply?

Paying interest on reserves gives banks incentive to hold more reserves rather than lend them out, which should raise the excess reserve ratio, reduce the money multiplier, and reduce the money supply, holding the monetary base constant.

15. The money multiplier declined significantly during the period 1930–1933 and also during the recent financial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the Depression period but increased by more than 20% during the recent

financial crisis. What explains the difference in outcomes?

The difference is that the monetary base increased dramatically during the recent financial crisis, which was more than enough to offset the fall in the multiplier.

During the Great Depression, the monetary base rose modestly, if at all.

ANSWERS TO APPLIED PROBLEMS Unless otherwise noted, the following assumptions are made in all of the applied problems: the required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s holdings of currency do not change.

16. If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Reserves and the monetary base fall by $2 million, as the following T-accounts indicate: First National Bank Assets

Liabilities

Reserves

–$2 million

Securities

+$2 million

Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

17. For the following operations, what happens to the central bank’s and commercial bank’s reserves and the monetary base? Use T-Accounts to show changes in balances. Assume that the amount is $10 million. a. Central bank provides loan to commercial bank; b. Central bank sells securities to commercial bank; c. Commercial bank repays the loan to central bank. a.

Central Bank Assets

Liabilities

Loans + 10 mln

Reserves +10 mln Banking system

Assets

Liabilities

Cash + 10 mln

Liabilities (borrowing from central

bank) + 10 mln

b.

Central Bank Assets Cash + 10 mln Securities – 10 mln

Liabilities

Banking system Assets Securities + 10 mln Cash –10 mln

Liabilities

c.

Central Bank Assets

Liabilities

Loans + 10 mln

Reserves –10 mln Banking System

Assets

Liabilities

Assets Cash – 10 mln

Liabilities (borrowing from central bank) –10 mln

18. If the Fed lends five banks a total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base?

Use T-accounts to explain your answer.

The initial effect of the loans on the banking system, Federal Reserve, and public are shown below.

Banking System (all five banks) Assets Reserves

Liabilities +$100 million

Loans (borrowings from the Fed)

+$100 million

Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed) Public

+$100 million Reserves

+$100 million

Assets

Liabilities

No change

No change

After the public withdraws $50 million in deposits to hold as currency, the Taccounts look like this: Banking System (all five banks) Assets Reserves

Liabilities +$50 million

Loans (borrowings from the Fed)

+$100 million

Checkable Deposits

–$50 million

Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed) million

+$100

Reserves

+$50 million

Currency

+$50 million

Public Assets

Liabilities

Checkable Deposits

–$50 million

Currency

+$50 million

19. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed lends $1 million to the First National Bank.

The initial effect of the loans provided by the Fed is shown in the T-accounts below: Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed)

+$1 million

Reserves

+$1 million

Banking System Assets Reserves

Liabilities +$1 million

Loans (borrowings from the Fed)

+$1 million

After the banks receive the reserves, those excess reserves are loaned out; through multiple deposit creation, the increase in reserves of the banking system will support $10 million in new loans and checkable deposits, increasing the money supply by $10 million. The final effect of the multiple deposit creation is shown in the Taccounts below:

Federal Reserve System Assets

Liabilities

Loans (borrowings from the Fed)

+$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Reserves

+$ 1 million

Loans (borrowings from the Fed)

+$1 million

Loans

+$10 million

Checkable Deposits

+$10 million

20. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed sells $2 million of bonds to the First National Bank.

The Fed sale of bonds to the First National Bank reduces reserves by $2 million. The net result is that checkable deposits in the banking system decline by $20 million. The initial effect on the Fed and the banking system is shown below: Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

Banking System Assets

Liabilities

Securities

+$2 million

Reserves

–$2 million

After the decline in bank reserves, the multiple deposit creation process works in reverse, so the final effect on the Fed and banking system balance sheets is shown below: Federal Reserve System Assets Securities

Liabilities –$2 million

Reserves

–$2 million

Banking System Assets

Liabilities

Securities +$ 2 million

Checkable Deposits –$20 million

Reserves

–$ 2 million

Loans

–$20 million

21. If the Fed buys $1 million of bonds from the First National Bank, but an additional 10% of any deposit is held as excess reserves, what is the total increase in checkable deposits? (Hint: Use T-accounts to show what happens at each step of the multiple expansion process.)

The total increase in checkable deposits is only $5 million, substantially less than the $10 million that occurs when no excess reserves are held. The reason is that banks now end up holding 20% of deposits as reserves and only lend out 80%, so that the increase in deposits found in the T-accounts is $1,000,000 + $800,000 + $640,000 + $512,000 + $409,600 + . . . = $5 million. The T-accounts below show the effect of the securities purchase: Federal Reserve System Assets Securities

Liabilities +$1 million Reserves

+$1 million

Banking System Assets

Liabilities

Securities

–$1 million

Reserves

+$1 million

After the increase in reserves and the multiple deposit creation process, the Fed and Banking system balance sheets are as follows: Federal Reserve System Assets Securities

Liabilities +$1 million

Reserves

+$1 million

Banking System Assets

Liabilities

Securities

–$1 million

Reserves

+$1 million

Loans

+$5 million

Checkable Deposits

+$5 million

22. If reserves in the banking system increase by $1 billion because the Fed lends $1 billion to financial institutions, and checkable deposits increase by $9 billion, why isn’t the banking system in equilibrium? What will continue to happen in the banking system until equilibrium is reached? Show the T-account for the banking system in equilibrium.

The banking system is still not in equilibrium because there continues to be $100 million of excess reserves (+$1 billion of reserves minus $900 million of required reserves, 10% of the $9 billion of deposits). The excess reserves will be lent out until equilibrium is reached with an additional $1 billion of checkable deposits. The 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 Fed)

Loans

+$10 billion

Checkable deposits +$10 billion

+$1 billion

23. Suppose the central bank of your country increases reserves by purchasing $1 million worth of bonds from banks and that the banking system in your economy is in equilibrium. The reserve requirement is 10%. What will happen to the level of checkable deposits? Use T-accounts to explain your answer.

We can use T-accounts to illustrate how the deposit level is affected. It will increase as follows Banking System Assets

Liabilities

Reserves

+$ 1 million

Securities

–$ 1 million

Loans

–$10 million

Checkable deposits +$10 million

24. If the Fed sells $1 million of bonds and banks reduce their borrowings from the Fed by $1 million, predict what will happen to the money supply.

The Fed’s sale of $1 million of bonds shrinks the monetary base by $1 million, and the reduction of borrowing from the Federal Reserve lowers the monetary base by another $1 million. The resulting $2 million decline in the monetary base leads to a decline in the money supply.

25. Suppose that the required reserve ratio is 9%, currency in circulation is $620 billion, the amount of checkable deposits is $950 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 = $620 billion + $950 billion = $1,570 billion; c = C/D = 620/950 = 0.653; e = ER/D = 15/950 = 0.016; m = (1 + c)/(rr + e + c) = 1.653/0.759 = 2.18. b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1,300 billion due to a sharp contraction in the economy.

The monetary base will increase to $620 + $950 + $15 + $1,300 = $2,885 billion; given the money multiplier calculated in part (a), this implies that the money supply should increase to $2,885 × 2.18 = $6289.3 billion. c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather

than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

ER = $1,315 billion; e = $1,315/$950 = 1.38; m = (1 + 0.653)/(0.09 + 1.38 + 0.653) = 0.78. The money supply is still $1,570 billion, since both the currency and deposit amounts have not changed. d. Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this scenario relate to your answer to part (c)?

The results from part (c) demonstrate that if large amounts of reserves enter the banking system but are held as excess reserves, it is possible for the money multiplier to fall below one.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find the most current data available on Currency (CURRNS), Total Checkable Deposits (TCDNS), and Excess Reserves (EXCSRESNS). a. Calculate the value of the currency deposit ratio c. c = CURRNS/TCDNS = 1857.0/3355.9 = 0.55 as of June 2020. b. Calculate the value of the excess reserve ratio e. e = EXCSRESNS/TCDNS = $3043.556/3355.9 = 0.907. c. Assuming a required reserve ratio rr of 11%, calculate the value of the money multiplier m.

Given the data above, m = 1.55/[0.55 + 0.907 + 0.11] = 0.99.

2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 Money Stock (M1SL) and the Monetary Base (BOGMBASE). a. Calculate the value of the money multiplier using the most recent data available and the data from five years prior.

The money multiplier for June 2020 is 5210.0/5002.0 = 1.04; for June 2015 the multiplier is 3020.4/3919.6 = 0.77. b. Based on your answer to part (a), how much would a $100 million open market purchase of securities affect the M1 money supply today and five years ago?

The $100 million open market purchase of securities will increase the monetary base by $100 million, and would hypothetically increase the M1 money supply by 1.04  $100 million = $104 million in June 2020, and the same open market operation would result in 0.77  $100 million = $77 million increase in M1 in June 2015.

Chapter 16 ANSWERS TO QUESTIONS 1. If the manager of the open market desk hears that a snowstorm is about to strike New York City, making it difficult to present checks for payment there and so raising the float, what defensive open market operations will the manager undertake?

The snowstorm would cause float to increase, which would increase the monetary base. To counteract this effect, the manager will undertake a defensive open market sale of securities using a reverse repo transaction.

2. During the holiday season, when the public’s holdings of currency increase, what defensive open market operations typically occur? Why? When the public’s holding of currency increases during holiday periods, the currency–checkable deposits ratio increases and the money supply falls. To counteract this decline in the money supply, the Fed will conduct a defensive open market purchase of securities.

3. If the Treasury pays a large bill to defense contractors and as a result its deposits with the Fed fall, what defensive open market operations will the manager of the open market desk undertake?

As we saw in Chapter 14, when the Treasury’s deposits at the Fed fall, the monetary base increases. To counteract this increase, the manager would undertake an open market sale of securities.

4. If float decreases to below its normal level, why might the manager of domestic operations consider it more desirable to use repurchase agreements to affect the monetary base, rather than an outright purchase of bonds?

Because the decrease in float is only temporary, the monetary base is expected to decline only temporarily. A repurchase agreement only temporarily injects reserves into the banking system, so it is a sensible way of counteracting the temporary decline in the monetary base due to the decline in float.

5. ―The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount rate.‖ Is this statement true, false, or uncertain? Explain your answer.

False. The Fed also can affect the level of borrowed reserves by directly limiting the amount of loans to an individual bank or the broader financial system.

6. ―The federal funds rate can never be above the discount rate.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the discount rate, it would never surpass the discount rate since banks would then borrow directly from the Fed, and not in the fed funds market, which would prevent the fed funds rate from ever rising above the discount rate. However, in practice, the fed funds rate can (and has) been above the discount rate. This may occur due to the stigma associated with banks borrowing directly from the Fed; that is, banks may prefer to pay a higher market rate than to borrow directly from the Fed and incur the perceived stigma. In addition, nonbank financial institutions, which do

not have access to the discount window, can and do participate in the federal funds market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is above the discount rate may not be arbitraged away.

7. ―The federal funds rate can never be below the interest rate paid on excess reserves.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate on excess reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower rate; this should prevent the fed funds rate from ever falling below the interest rate paid on excess reserves. However, in practice, the fed funds rate can (and has) been below the interest rate paid on excess reserves. This is because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds market and provide a significant amount of funding to the market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest rate on excess reserves may not be arbitraged away.

8. Why is paying interest on excess reserves an important tool for the Federal Reserve in managing crises?

During crises, the Fed may need to provide a large amount of liquidity to the banking and financial system, which would reduce the fed funds rate. If the Fed needs to sterilize these effects, it would need to conduct open market sales of securities to maintain a given fed funds rate target. If the liquidity provision is large, then offsetting the liquidity could eventually result in the Fed running out of securities to sell. In this case, the interest rate on excess reserves can be raised to push the fed funds rate up, without having to conduct offsetting open market sales that decrease the holdings of government securities by the Fed. 9. Why are repurchase agreements used to conduct most short-term monetary policy operations, rather than the simple, outright purchase and sale of securities?

Repurchase agreements are used because they are temporary, and allow the Fed to adjust open market operations relatively easy in response to day-to-day changes in conditions in the market for reserves.

10. Open market operations are typically repurchase agreements. What does this tell you about the likely volume of defensive open market operations relative to the volume of dynamic open market operations?

It suggests that defensive open market operations are far more common than dynamic operations because repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the monetary base.

11. Following the global financial crisis in 2008, assets on the Federal Reserve’s balance sheet increased dramatically, from approximately $800 billion at the end of 2007 to over $4.5 trillion in 2015. Many of the assets held are longer-term securities acquired through various loan programs instituted as a result of the crisis. In this situation, how could reverse repos (matched sale–purchase transactions) help the Fed reduce its assets held in an orderly fashion, while reducing potential inflationary problems in the future?

Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public. But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer maturity securities can be drawn off the balance sheet of the Fed. 12. ―Discount loans are no longer needed because the presence of the FDIC eliminates the possibility of bank panics.‖ Is this statement true, false, or uncertain?

This statement is false. The FDIC alone would likely be ineffective in eliminating bank panics without the Fed’s ability to provide discount loans to troubled banks to keep bank failures from spreading. In particular, the FDIC’s insurance only covers about 1% of total bank deposits. Since the Fed has unlimited ability to provide loans to the banking system, it can be much more effective in stabilizing the banking system in a panic.

13. What are the disadvantages of using loans to financial institutions to prevent bank panics?

Providing loans to financial institutions creates a moral hazard problem. If firms know that they will have access to Fed loans, they are more likely to take on risk, knowing that the Fed will bail them out if a panic should occur. As a result, banks that deserve to go out of business because of poor management may survive because of Fed liquidity provision to prevent panics. This might lead to an inefficient banking system with many poorly run banks.

14. Suppose your country is concerned about inflation and has set a target rate for the year. The government believes that targeting inflation is the most important role of monetary politics. The head of the central bank is responsible for targeting inflation.

What is the main tool that central banks can use for inflation targeting? Will this tool be enough?

In reality, some emerging countries really believe that targeted inflation is an important aspect of monetary policies. In situations where the government has set a target inflation rate, central banks can make use of required reserves, which directly affects money supply. If the central bank governor is responsible for overseeing this and expects inflation to increase, then the required reserve ratio will also increase and the required reserve increases. However, this is not the only tool available to the central bank. They can make use of open market operations and discount lending.

15. Following the coronavirus pandemic in March of 2020, the Federal Reserve

announced that it reduced the reserve requirement to zero as the size of the Fed’s balance sheet approached $6 trillion. What might be the rationale for implementing such a change?

In addition to helping encourage banks to lend during the coronavirus pandemic, there is a practical reason for reducing reserve requirements to zero. With a large balance sheet and excess reserves near $3 trillion dollars, the reserve requirement was essentially unnecessary. In an ample reserves framework, the amount of excess reserves dwarfs the amount of required reserves, thus the potential for banks to run out of needed reserves at any given time is quite low. The reduction in reserve requirements shifts the reserve demand curve to the left, however with a large balance sheet, the equilibrium interest rate is on the elastic portion of reserve demand, thus this change would not affect the equilibrium fed funds rate.

16. What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the effective lower bound?

Since short-term interest rates cannot be lowered much below the effective lower bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer-term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion.

17. Why is the composition of the Fed’s balance sheet a potentially important aspect of monetary policy during an economic crisis?

By purchasing particular types of securities, the Fed can impact interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision of liquidity where it may be needed the most (as opposed to typical open market purchases, which add reserves to the general banking system). For example, as a result of the global financial crisis the Fed purchased a significant amount of mortgage-backed securities from government sponsored enterprises, which helped to lower mortgage rates and support the housing market.

18. What is the main advantage and the main disadvantage of an unconditional policy commitment?

The main advantage to an unconditional policy commitment is that it provides a significant amount of transparency and certainty, which makes it easier for markets and households to make decisions about the future. The main disadvantage is that it represents a tacit commitment by the central bank; if conditions suddenly change where a change in the policy stance may be warranted, then holding to the commitment could be destabilizing. On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and the central bank could lose significant credibility.

19. In which economic conditions would a central bank want to use a ―forward-guidance‖

strategy? Based on your previous answer, can we easily measure the effects of such a strategy?

In general a central bank would use a strategy of ―forward guidance‖ when other types of conventional tools of monetary policy cannot affect the economy in the desired way. In practice, this strategy was followed by the Fed during the aftermath of the Great Recession to try to lower long-term interest rates (since the federal funds rate had hit the zero bound). As economic conditions are usually quite abnormal during the implementation of these strategies, it is in general difficult to ascertain their effects: during abnormal economic conditions standard models of agent’s behavior are not good representations of their decision making process and economists cannot therefore identify the reasons as to why one variable has changed.

20. How do the monetary policy tools of the European System of Central Banks compare to the monetary policy tools of the Fed? Does the ECB have a discount lending facility? Does the ECB pay banks an interest rate on their deposits?

In general the set of monetary policy tools available to the ECB is quite similar to the one at the Fed’s disposal. The ECB has a discount lending facility, called the marginal lending facility that is ready to supply funds to member banks at the marginal lending rate. This rate also acts as a ceiling for the overnight market rate, as in the United States does the discount rate. The ECB pays bank members an interest rate for their deposits at the ECB, thereby creating a floor for the overnight rate, as the Fed does in the United States.

21. What is the main rationale behind paying negative interest rates to banks for keeping their deposits at central banks in Sweden, Switzerland, and Japan? What could happen to these economies if banks decide to loan their excess reserves, but no good investment opportunities exist?

The rationale behind that idea is to encourage banks to create loans, as opposed to keeping their excess reserves idle at central banks. One can think that if banks are somewhat ―forced‖ to create loans when economic conditions are uncertain, it might result in funds being misallocated, and creating another sort of problem. For example, if banks create loans without the desirable mix of liquidity, term and risk, banks might be in trouble in the future, which also constitutes a problem for central bankers.

22. In early 2016 as the Bank of Japan began to push policy interest rates negative, there was a sharp increase in safes for homes in Japan. Why might this be, and what does it mean for the effectiveness of negative interest rate policy?

Negative policy interest rates have the effect of making deposit rates at banks negative. Thus, people can avoid negative returns on holding cash by simply pulling their money out of deposit accounts and keeping the cash in safes (with a zero return). This has two main implications for the effectiveness of negative interest rate policy. First, it has the potential side effect of decreasing liquidity in the banking sector as depositors pull their money from banks. This can destabilize the banking system, and reduce the amount of money in the

banking system available for lending. Second, the intended effect of negative interest rates is to penalize saving in the form of deposits, and thereby encourage consumption and borrowing, which can help stimulate the economy. However, if depositors are simply pulling their deposits and instead holding them as cash in safes, it does not increase spending and create the intended stimulus.

ANSWERS TO APPLIED PROBLEMS 23. If a switch occurs from deposits into currency, what happens to the federal funds rate? Use the supply and demand analysis of the market for reserves to explain your answer.

The switch from deposits into currency lowers the amount of reserves as was shown in the T-accounts of Chapter 14, and this lowers the supply of reserves at any given interest rate, thus shifting the supply curve to the left. The fall in deposits also leads to lower required reserves and hence a shift in the demand curve to the left. However, because the fall in required reserves is only a fraction of the fall in the supply of reserves (because the required reserve ratio is much less than one), the supply curve shifts left by more than the demand curve. Thus if the discount rate is initially above the fed funds target, the fed funds rate will rise (as shown in the graph below). However, if the fed funds rate is at the discount rate, then the fed funds rate will remain at the discount rate.

24. Why is it that a decrease in the discount rate does not normally lead to an increase in borrowed reserves? Use the supply and demand analysis of the market for reserves to explain.

In most cases, the discount rate is set far enough above the fed funds target rate such

that, even if there was a reduction in the discount rate with no change in the target fed funds rate, the equilibrium rate would still be below the discount rate, thus banks would still be better off borrowing at the market rate rather than the discount rate. In other words, even if the discount rate decreases, the amount of borrowed reserves may not change since the equilibrium will still fall below the discount rate, as shown in the graph below.

25. Using the supply and demand analysis of the market for reserves, indicate what effects the following situations would have on central bank interest rates and economies in general. a. The central bank eliminates interest paid on excess reserve.

Usually, central bank interest rates will decline. Hence it may cause a decline in interest rates in general and stimulate the economy b. The central bank introduces special interest rates (lower than usual) for commercial banks and sets special auction.

With this action, the central bank encourages additional borrowing, which decreases interest rates and stimulates the economy. c. The central bank conducts an open market sale of certain securities.

This action will increase the supply of securities and may increase interest rates, which has a negative impact on economic stimulation. d. The central bank sets negative interest rates on bank deposits.

Since the rates on deposits at central banks are negative, it will encourage banks to lend more rather than to deposit money, so that will stimulate the economy. e. The central bank increases reserve requirements.

In such cases, the money supply decreases, which makes borrowing more costly and has a negative impact on economic stimulation.

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database, and find data on nonborrowed reserves (NONBORRES) and the federal funds rate (FEDFUNDS). a. Calculate the percent change in nonborrowed reserves and the percentage point change in the federal funds rate for the most recent month of data available and for the same month a year earlier.

From June 2019 to June 2020, nonborrowed reserves increased by $1,344,656 million, or 84.0% and the federal funds rate decreased from 2.38% to 0.08%, or a decrease of 230 basis points. b. Is your answer to part (a) consistent with what you expect from the market for reserves? Why or why not?

Nonborrowed reserves increased significantly over the one-year period, while the federal funds rate decreased significantly. This is generally consistent with what you would expect in the market for reserves: as the supply of nonborrowed reserves decreases, the federal funds rate should increase (similar to what is shown in Figure 2, panel (a)). However, given the current ample reserves monetary policy environment, and that the federal funds rate is near the interest rate on excess reserves, it is more likely that decreases in the interest rate on excess reserves are decreasing the federal funds rate (the opposite of what is shown in Figure 5, panel (b)), rather than increases in nonborrowed reserves.

2. In December 2008, the Fed switched from a point federal funds target to a range target (and it’s possible that it will switch back to a point target in the future). Go to the St. Louis Federal Reserve FRED database, and find data on the federal funds targets/ ranges (DFEDTAR, DFEDTARU, DFEDTARL) and the effective federal funds rate (DFF). Download into a spreadsheet the data from the beginning of 2006 through the most current data available. a. What is the current federal funds target/range, and how does it compare to the effective federal funds rate?

As of July 30, 2020, the Fed’s current target is a range of between 0.0% and 0.25%. On this day, the effective federal funds rate was well within this range, at 0.10%. b. When was the last time the Fed missed its target or was outside the target range?

By how much did it miss?

The last time the Fed missed its target was when it switched from a target of between 1.50 and 1.75%% to a target of between 1.0% and 1.25% which occurred on March 3, 2020. At that time, the effective federal funds rate was 1.59% compared to the target of between 1.0% and 1.25%. This represents a miss of 34 basis points.

c. For each daily observation, calculate the ―miss‖ by taking the absolute value of the difference between the effective federal funds rate and the target (use the abs(.) function). For the periods in which the rate was a range, calculate the absolute value of the ―miss‖ as the amount by which the effective federal funds rate was above or below the range. What was the average daily miss between the beginning of 2006 and the end of 2007? What was the average daily miss between the beginning of 2008 and December 15, 2008? What is the average daily miss for the period from December 16, 2008, to the most current date available? Since 2006, what was the largest single daily miss? Comment on the Fed’s ability to control the federal funds rate during these three periods.

From the beginning of 2006 to the end of 2007, the average daily miss was 0.05, or 5 basis points. From the beginning of 2008 to December 15, 2008, the average daily miss was 0.22, or 22 basis points. From December 16, 2008 through July 30, 2020, the federal funds target was specified as a range, and the effective federal funds rate was outside of that range only a few times for brief periods by very small amounts, thus the average miss during that time is essentially zero. The largest single daily miss occurred on October 2, 2008, representing a miss of 1.33, or 133 basis points. In the earlier period, and the most recent period, the Fed has demonstrated relatively good precision in maintaining the federal funds rate close to target, but for somewhat different reasons. In the 2006–2007 period, reserve demand was relatively stable, so it was relatively easier to conduct defensive open market operations to keep the effective federal funds rate close to target. In the most recent period, because a range is specified, it is somewhat easier to keep the federal funds rate within target range. In addition, given the large size of the balance sheet, any variation in reserve demand won’t affect the effective federal funds rate much since it is pinned by the interest rate on excess reserves. The period in 2008 represented much more volatility where the Fed missed its target often, and sometimes by large amounts. Due to the effects of the global financial crisis and uncertainty in financial markets, large unpredictable swings in reserve demand meant greater fluctuations in the effective federal funds rate, and due to the unpredictable nature of these events, made it harder for the Fed to conduct defensive open market operations as effectively to maintain the federal funds rate at target.

Chapter 17 ANSWERS TO QUESTIONS 1. Francesco is considering going on vacation abroad, and the Australian Dollar has appreciated by 22% with respect to the Japanese Yen. Would he be more willing to visit Sydney or Tokyo?

Francesco will probably prefer to visit Tokyo, because the Australian dollar appreciation makes vacations more expensive in Sydney compared to Tokyo.

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. Describe what happens to exports and imports in the European Union (EU) when the euro appreciates.

Euro appreciation makes European domestic goods more expensive relative to foreign markets. Thus, both domestic and foreign consumers buy fewer EU-produced goods.

At the same time, imported goods become less expensive. Therefore, European Union exports will decrease and imports will increase.

4. You learn that the United Kingdom price level is rising by 3% compared to the price level in Germany. What does the theory of purchasing power parity predict will happen to the value of the British Pound in terms of euros?

It predicts that the value of the British pound will fall 3% in terms of euros.

5. ―A central bank with a dual mandate will achieve lower unemployment in the long run than a central bank with a hierarchical mandate in which price stability takes precedence.‖ Is this statement true, false, or uncertain? Explain.

False. There is no long-run tradeoff between inflation and unemployment, so in the long run a central bank with a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no more success at reducing unemployment than one whose primary goal is price stability.

6. Why is a public announcement of numerical inflation rate objectives important to the success of an inflation-targeting central bank?

The success of inflation targeting relies on its ability to credibly anchor inflation expectations at a low, desirable level. Without formal public announcements and reminders about the numerical inflation target, markets and the public may have less faith that policymakers are committed to maintaining the inflation target. And if a formal inflation target is not announced at all, market participants and the public may not know the exact target and be forced to infer or estimate the target, creating

uncertainty which can raise inflation expectations and unanchor inflation expectations from a low, desirable level.

7. How does inflation targeting help reduce the time-inconsistency problem of discretionary policy?

Inflation targeting increases the accountability of monetary policymakers, and is a mechanism of self-discipline that effectively ties the hands of policymakers to commit to a policy path. Because of the transparency of an inflation targeting framework, it is very easy to verify whether policymakers are faithful to a committed policy path. As a result, there is much less ability and incentive for policymakers to deviate to a discretionary policy which could increase output or raise the inflation rate, therefore mitigating the time-inconsistency problem.

8. What methods have inflation-targeting central banks used to increase communication with the public and to increase the transparency of monetary policymaking?

Inflation-targeting central banks engage in extensive public information campaigns that include the distribution of glossy brochures, the publication of Inflation Reporttype documents, making speeches to the public, and continual communication with the elected government.

9. Why might inflation targeting increase support for the independence of the central bank in conducting monetary policy?

Sustained success in the conduct of monetary policy as measured against a preannounced and well-defined inflation target can be instrumental in building public support for a central bank’s independence and for its policies. Also inflation targeting is consistent with democratic principles because the central bank is more accountable.

10. ―Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations.‖ Is this statement true, false, or uncertain? Explain.

False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targeters do worry about output fluctuations, and inflation targeting may even be able to reduce output fluctuations because it allows monetary policymakers to respond more aggressively to declines in demand because they don’t have to worry that the resulting expansionary monetary policy will lead to a sharp rise in inflation expectations.

11. What are the key advantages and disadvantages of the monetary strategy used by the Federal Reserve under Alan Greenspan, in which the nominal anchor was implicit rather than explicit?

This strategy has the following advantages: (a) it enables monetary policy to focus on domestic considerations; (b) underscoring the importance of price stability has helped it to mitigate the time-inconsistency problem, and (c) it has had a demonstrated success, producing low inflation with the longest business cycle expansion since World War II. However, it has the following disadvantages: (a) it is strongly dependent on the preferences, skills, and trustworthiness of individuals in the central bank and the government; and (b) it has some inconsistencies with democratic principles because the central bank is not highly accountable.

12. You learn through the newspaper that BMW in Germany is about to make a breakthrough in technology and is able to produce a car with very advanced artificial intelligence which will completely revolutionize driverless cars. What will happen to the euro exchange rate?

The euro will appreciate. The increase in European productivity raises the expected future exchange rate and thus raises the expected return on euro assets at any exchange rate. The resulting rightward shift of the demand curve leads to a rise in the equilibrium exchange rate.

13. If higher inflation is bad, then why might it be advantageous to have a higher inflation target rather than a lower target that is closer to zero?

The zero lower bound on nominal interest rates makes it harder to implement expansionary policy as actual inflation (and hence short-term interest rates) fall closer to zero. As a result, there is less room to use monetary policy as a stabilization tool in a low inflation environment. In this context, it is argued that a higher inflation target may be appropriate to give policymakers more flexibility. The downside of this of course is that in general higher inflation rates can be costly to society, posing a tradeoff for monetary policymakers in terms of flexibility versus efficiency of monetary policy.

14. Why might macroprudential regulation be more effective in managing asset-price bubbles than monetary policy?

There are several reasons why monetary policy may not be effective in eliminating asset-price bubbles. The main reason is that asset-price bubbles are extremely difficult to identify in real time; in many cases, by the time there is a consensus among policymakers and the public that a bubble exists, it is usually too late to implement policies to effectively deflate the bubble. And even if an asset-price bubble is identified in a timely manner, monetary policy is often thought of as too blunt an instrument to be able to deal effectively with most asset-price bubbles. In particular, interest rate changes may have some modest short-term effects on reducing the asset-price bubble, but the interest rate changes may have far more consequential effects on real economic activity and cause far worse collateral damage. Thus, because of the limitations of monetary policy, proactively identifying potential problems in advance and implementing safeguards in the banking and financial system can provide a more targeted and effective backstop against bubbles than monetary policy can.

15. In March 2020, in response to the COVID-19 pandemic, the ECB initiated a pandemic emergency purchase program (PEPP), which is a temporary asset purchase program of private and public sector securities. What effect would this have had on the euro exchange rate compared to major currencies?

The quantitative easing program should reduce the demand for euro-denominated assets and lead to an appreciation of the other currencies (resulting in a depreciation of the euro).

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 intermediary target.

Explain your answer. a. Long-term interest rates intermediary target—stands between short-term interest rates and stabilized longterm interest rates; b. Central bank interest rates Policy instrument—according to definition c. M2 Intermediary target—since central banks do not directly affect them by policy instruments, but they influence economic activities; d. Reserve requirements Policy instrument—according to definition 18. ―If the demand for reserves did not fluctuate, the Fed could pursue both a reserves target and an interest-rate target at the same time.‖ Is this statement true, false, or uncertain? Explain.

True. In such a world, hitting a reserves target would mean that the Fed would also hit its interest rate target, or vice versa. Thus the Fed could pursue both a reserves target and an interest rate target at the same time, but only if there were no variation in reserve demand.

19. What procedures can the Fed use to control the federal funds rate? Why does control of this interest rate imply that the Fed will lose control of nonborrowed reserves?

The Fed can control the federal funds rate by buying and selling bonds in the open market. When the fed funds rate rises above the target level, the Fed would buy bonds, which would increase nonborrowed reserves and lower the interest rate to its target level. Similarly, when the fed funds rate falls below the target level, the Fed would sell bonds to raise the interest rate to the target level. The resulting open market operations would of course affect the quantity of reserves and the money supply and cause them to change. The Fed would be giving up control of reserves and the money supply to pursue its interest rate target.

20. What are the main criteria for choosing a policy instrument? Why? Explain.

The main criteria are observability, measurability, controllability, and the predictable effect on goal. Observability and measurability are necessary since central banks must

see policy signals and measure policy instruments. Controllability is important as central banks must control their instruments—for example, central banks are able to measure and control short-term interest rates, unlike long-term rates, because expected inflation is hard to measure and control. Of course, policy instruments should be predictable and central banks should explain the expected results in purpose to achieve goal. Therefore, before using an instrument, a central bank needs to make sure that the effect will be positive and that it will actually take place.

21. ―Interest rates can be measured more accurately and quickly than reserve aggregates; hence an interest rate is preferred to the reserve aggregates as a policy instrument.‖ Do you agree or disagree? Explain your answer.

Disagree. Although nominal interest rates are measured more accurately and more quickly than reserve aggregates, the interest rate variable that is of more concern to policymakers is the real interest rate. Because the measurement of real interest rates requires estimates of expected inflation, it is not true that real interest rates are necessarily measured more accurately and more quickly than reserves. Interest rate targets are therefore not necessarily better than reserve targets.

22. How can forward guidance as a tool of the central bank affect the policy instrument, intermediate targets, and goals?

There are two main channels by which forward guidance can ultimately affect goal variables. First off, the central bank can communicate information about the expected path of future short-term interest rates (policy instrument). This can affect intermediate targets such as longer-term interest rates. Thus changes in borrowing costs such as longer-term interest rates can affect economic activity, and ultimately other related goals such as price or exchange rate stability. The second channel is through the expected holdings of reserves; as the central bank communicates about the expected path of its asset holdings, this impacts the expected reserve aggregates (policy instrument) which then can impact short-term and long-term interest rates (intermediate targets), and similarly affect goal variables.

23. What does the Taylor rule imply that policymakers should do to the fed funds rate under the following scenarios? a. Unemployment rises due to a recession.

If unemployment rises, this would lower the output gap, and trigger a lower fed funds rate according to the Taylor rule. b. An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%.

If inflation rises by 1%, this alone would prompt the fed funds rate to rise by 1.5 percentage points. The decrease in the output gap alone would imply the fed funds rate would fall by 0.5 percentage points. Thus, the two factors together imply a net effect of increasing the fed funds rate by one percentage point according to the Taylor rule. c. The economy experiences prolonged increases in productivity growth while actual output growth is unchanged.

Prolonged increases in productivity growth would increase potential output, and with the same rate of actual output growth this would cause the output gap to

decline, resulting in a decline in the fed funds rate according to the Taylor rule. d. Potential output declines while actual output remains unchanged.

If potential output declines, this is the opposite of (c) above, so the fed funds rate would rise according to the Taylor rule. e. The Fed revises its (implicit) inflation target downward.

If the inflation target is revised downward, this would increase the inflation gap at any given inflation rate. This would result in a higher fed funds rate according to the Taylor rule. f. The equilibrium real fed funds rate decreases.

If the equilibrium real fed funds rate decreases, all else equal, the Taylor rule would prescribe a decrease in the nominal fed funds rate.

ANSWERS TO APPLIED PROBLEMS 24. If the Fed has an interest rate target, why will an increase in the demand for reserves lead to a rise in the money supply? Use a graph of the market for reserves to explain.

An increase in the demand for reserves will raise the federal funds rate. In order to maintain the interest rate target, the Fed will buy bonds, thereby increasing the amount of nonborrowed reserves, which shifts the supply curve for reserves to the right, thereby keeping the fed funds rate from rising, as shown below. The open market purchase will then cause the monetary base and the money supply to rise.

25. Since monetary policy changes made through the fed funds rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate, rather than the current inflation rate.

Considering this, suppose that monetary policymakers employ the Taylor rule to set the fed funds rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the

inflation and output gaps are ½, the equilibrium real fed funds rate is 4%, the inflation rate target is 3%, and the output gap is 2%.

a. If the expected inflation rate is 7%, then at what target should the fed funds rate be set according to the Taylor rule?

Assuming the output gap and all other parameters remain constant, the Taylor rule is – , where the expected inflation is .

Thus, if , then the fed funds rate should be set to . b. Suppose half of the Fed economists forecast inflation to be 6%, and half of Fed economists forecast inflation to be 8%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then . In this case, the Taylor rule would again imply a setting of the fed funds rate of 12%. c. Now suppose half of the Fed economists forecast inflation to be 0%, and half forecast inflation to be 14%. If the Fed uses the average of these two forecasts as its measure of expected inflation, then at what target should the fed funds rate be set according to the Taylor rule?

If the measure of expected inflation is the average of the two forecasts, then In this case, = the Taylor rule would again imply a setting of the fed funds rate of 12%. 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. The Taylor rule doesn't take into account the possibility of a wide variation in forecasts.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the Bank of Albania’s exchange rate database (https://www.bankofalbania.org/Markets/Official_exchange_rate/), and find data on the exchange rate of Albanian Lek (ALL) per Euros (EUR). A Volkswagen Golf can be purchased in Frankfurt, Germany, for €18,000 or in Tirana, Albania, for ALL 2,268,000. a. Use the most recent exchange rate available to calculate the real exchange rate of the Frankfurt VW Golf per Tirana VW Golf. b. Based on your answer to part (a), are Volkswagen Golfs relatively more expensive in Frankfurt or in Tirana. c. What price in Albanian Lek would make the Volkswagen Golf equally expensive in both locations, all else being equal?

2. Go to the St. Louis Federal Reserve FRED database and find data on the personal

consumption expenditure price index (PCECTPI), real GDP (GDPC1), an estimate of potential GDP (GDPPOT), and the federal funds rate (FEDFUNDS). For the price index, adjust the units setting to ―Percent Change From Year Ago‖ to convert the data to the inflation rate; for the federal funds rate, change the frequency setting to ―Quarterly.‖ Download the data into a spreadsheet. Assuming the inflation target is 2% and the equilibrium real fed funds rate is 2%, calculate the inflation gap and the output gap for each quarter, from 2000 until the most recent quarter of data available. Calculate the output gap as the percentage deviation of output from the potential level of output. a. Use the output and inflation gaps to calculate, for each quarter, the fed funds rate predicted by the Taylor rule. Assume that the weights on inflation stabilization and output stabilization are both ½ (see the formula in the chapter). Compare the current (quarterly average) federal funds rate to the federal funds rate prescribed by the Taylor rule. Does the Taylor rule accurately predict the current rate?

Briefly comment.

For the most recent period in 2020:Q2, the federal funds rate is 0.06%, while the Taylor rule predicts –3.34%, underrepresenting actual policy by a gap of 3.4 percentage points. Compared to other significant deviations, this is a fairly large departure from the baseline Taylor rule. b. Create a graph that compares the predicted Taylor rule values with the actual quarterly federal funds rate averages. How well, in general, does the Taylor rule prediction fit the average federal funds rate? Briefly explain.

See the graph below. The Taylor rule since 2000 has periods in which they are fairly closely correlated, particularly from 2000 to 2002. However, there are significant gaps in other times, or periods in which they do not seem to move together, such as the period from 2002 to 2006. From 2008 onward, there are significant differences between the two, particularly the period late in 2008 through 2010, in which the Taylor rule predicts the federal funds rate should be negative by as much as almost –4%, which is not possible.

It also predicted a significant rise in the federal funds rate in 2011, which did not materialize, and generally speaking, the post-crisis Taylor rule has significantly overprescribed the actual fed funds rate. The coronavirus pandemic period beginning in 2020 created sharp declines in the actual fed funds rate and Taylor rule implied rate. c. Based on the results from the 2008–2009 period, explain the limitations of the Taylor rule as a formal policy tool. How do these limitations help explain the use of nonconventional monetary policy during this period?

Since the Federal funds rate was at the effective lower bound during that time, conventional monetary policy through adjustments in the federal funds rate was not possible, and highlights a limitation of the Taylor rule: under ‟normal‖ conditions the Taylor rule provides a good approximation to appropriate federal funds rate policy. However in extreme situations such as the financial crisis period and the coronavirus pandemic period, the Taylor rule is less useful, since other (nonconventional) monetary policy tools are needed to achieve stimulus. d. Suppose Congress changes the Fed’s mandate to a hierarchical one in which inflation stabilization takes priority over output stabilization. In this context,

recalculate the predicted Taylor rule value for each quarter since 2000, assuming that the weight on inflation stabilization is ¾ and the weight on output stabilization is ¼. Create a graph showing the Taylor rule prediction calculated in part (a), the prediction using new ―hierarchical‖ Taylor rule, and the fed funds rate. How, if at all, does changing the mandate change the predicted policy paths? How would the fed funds rate be affected by a hierarchical mandate? Briefly explain.

See the graph below. For the most part, the baseline Taylor rule and the hierarchical Taylor rule predict nearly the same federal funds paths. The only significant deviations are from 2008 to 2014, where the hierarchical version predicts a significantly higher federal funds rate due to the inflation spike during that time. And from about 2010 to 2014, it implied a federal funds rate around 2%, which is much higher than during that time and what the baseline rule predicts, and the actual fed funds rate was. For the most recent period of 2020:Q2, under such a hierarchical Taylor rule, the federal funds rate would be predicted to be about –1.1%, much lower than the current 0.06%. e. Assume again equal weights of ½ on inflation and output stabilization, and suppose instead that beginning after the end of 2008, the equilibrium real fed funds rate declines by 0.05 each quarter (i.e., 2009:Q1 is 1.95, then 1.90, etc.), and once it reaches zero, it remains at zero thereafter. How does it affect the prescribed fed funds rate? Why might this be important for policymakers to take into consideration?

A decline in the equilibrium real fed funds rate has the effect of reducing the implied Taylor rule fed funds rate lower. In fact, under this policy rule, it would have implied the fed funds rate to be negative during 2015, which also coincided with a period of low inflation. Of all three of the variations, the declining equilibrium real rate rule is the closest to the actual path of the fed funds rate since the financial crisis period. This may help explain why the actual path of the fed funds rate was lower than standard Taylor rules would imply. Moreover, if the real equilibrium fed funds rate did decline, but was not taken into account (for instance, by using the baseline rule in part (a)), this would imply that monetary policy would be overly contractionary. The graph below shows the distinction between the baseline Taylor rule and the declining natural rate Taylor rule.

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Chapter 18 ANSWERS TO QUESTIONS 1. Suppose you are a Japanese customer considering buying a bottle of French wine. If the euro appreciates by 15% with respect to the yen, are you more or less likely to buy a bottle of French wine rather than, say, sake?

Assuming you have to buy euros with yen before you use a credit card that automatically converts euros into Japanese yen at the new exchange rate, you would be less willing to purchase a bottle of French wine, since goods and services will be 15% more expensive to you.

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 Indian rupee depreciates, what happens to exports and imports in India?

The rupee depreciation makes domestic goods cheaper, thus both domestic and foreign consumers buy more goods produced in India. At the same time, imported goods become more expensive since they require more rupees per foreign currency to purchase. Thus, Indian exports will increase and imports into India will decrease.

4. If the British price level rises by 5% relative to the price level in India, what does the theory of purchasing power parity predict will happen to the value of British pounds in terms of rupees?

It predicts that the value of the British pound will fall 5% in terms of the Indian rupee.

5. If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will the country’s currency tend to appreciate or depreciate in the long run?

In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain.

6. When the Federal Reserve conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets?

The money supply increases, but this has an insignificant effect on the supply of dollar assets. Since dollar currency is a small part of total U.S. dollar-denominated assets, changes in the money supply are relatively small and therefore do not shift the supply curve.

7. From 2009 to 2011, the economies of Australia and Switzerland suffered relatively mild effects from the global financial crisis. At the same time, many countries in the euro area were hit hard by high unemployment and burdened with unsustainably high government debts. How should this have affected the euro/Swiss franc and euro/Australian dollar exchange rates?

This would reduce the demand for euro-denominated assets, resulting in a depreciation of the euro and an appreciation of the Swiss franc and Australian dollar.

8. In the mid-to-late 1970s, the yen appreciated in value relative to the dollar, even though Japan’s inflation rate was higher than America’s. How can this be explained by improvements in the productivity of Japanese industry relative to American industry?

Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese to continue to sell their goods at a profit at a high value of the yen.

9. Suppose the president of the United States announces a new set of reforms that includes a new anti-inflation program. Assuming the announcement is believed by the public, what will happen to the exchange rate on the U.S. dollar?

The dollar will appreciate. Because expected U.S. inflation falls as a result of the announcement, there will be an expected appreciation of the dollar and so the expected return on dollar assets will rise. As a result, the demand curve will shift to the right and the equilibrium value of the dollar will rise.

10. If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now, what will happen to the value of the Indian rupee today?

The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for rupee-denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises.

11. If nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. dollar exchange rate.

The dollar will depreciate. A rise in nominal interest rates but a decline in the real rate implies a rise in expected inflation that produces an expected depreciation of the dollar that is larger than the increase in the domestic interest rate. As a result, the expected return on dollar assets falls at any exchange rate, shifting the demand curve to the left and leading to a fall in the exchange rate.

12. If European car companies make a breakthrough in battery technology that will greatly increase the speed, reliability, and autonomy of electric cars, what will happen to the euro exchange rate?

The euro will appreciate. The increase in European productivity raises the expected future exchange rate and thus raises the expected return on euro 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 the spring of 2020, the european central bank announced a package of emergency measures designed to combat the economic impact of the covid-19 pandemic, comprising, inter alia, a pandemic emergency purchase program bound to further decrease long-term interest rates in the euro area. What effect could have such a policy have on the euro exchange rate?

The emergency covid-19 package should reduce the demand for euro-denominated assets, and lead to an appreciation of other currencies (a depreciation of the euro).

16. On June 23, 2016, voters in the United Kingdom voted to leave the European Union.

From June 16 to June 23, 2016, the exchange rate between the British pound and the dollar increased from 1.41 dollars per pound to 1.48 dollars per pound. What can you say about market expectations regarding the result of the referendum?

As noted in the text, a vote to leave the European Union would lower future UK Exports and thus lead to a lower long-run value of the British pound. The fact that the British pound rose in value prior to the vote suggests that the markets believed that the probability of an exit vote was declining, thus leading to a higher long-run value of the British pound than previously expected.

ANSWERS TO APPLIED PROBLEMS 17. A German sports car is selling for €65,000. What is the dollar price in the United States for the German car if the exchange rate is 0.80 euros per dollar?

65,000 euros × ($1/0.80 euros) = $81,250.

18. If the Canadian dollar to U.S. dollar exchange rate is 1.24 and the British pound to U.S. dollar exchange rate is 0.68, what must be the Canadian dollar to British pound exchange rate?

Spot exchange rate = 1.24 CAD/$ × ($1/£0.68) = 1.8235 Canadian dollars/pound

19. The New Zealand dollar to U.S. dollar exchange rate is 1.38, and the British pound to U.S. dollar exchange rate is 0.65. If you find that the British pound to New Zealand dollar is trading at 0.5, what would be the riskless profit per U.S. dollar invested?

Complete the following transactions simultaneously: i. Exchange $1.00 into 1.38 New Zealand dollars. ii. Exchange the 1.38 New Zealand dollars into £0.69. iii. Exchange the £0.69 into $1.06.

This yields a riskless $0.06 per U.S. dollar invested.

20. In 1999, the euro was trading at $0.90 per euro. If the euro is now trading at $1.18 per euro, what is the percentage change in the euro’s value? Is this an appreciation or depreciation? % change = (1.18 – 0.90)/0.90 = 31.11%; the euro has appreciated by 31.11%.

21. The Mexican peso is trading at 11 pesos per dollar. If the expected U.S. inflation rate is 1% while the expected Mexican inflation rate is 15% over the next year, given PPP, what is the expected exchange rate in one year?

Expected exchange rate = 11 × (1.15/1.01) = 12.525 pesos per dollar 22. If the price level recently increased by 19% in England while falling by 6% in the Canada, by how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.58 pound per dollar.

If prices rise relative to the United States by (19 + 6)% = 25%, then 25% more pounds will be required to buy the same Canadian goods. Thus, this will require the exchange rate to be 1.25 × £0.58/$ = £0.725/$.

For Problems 23–25, use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.

23. If expected inflation drops in Europe, so that interest rates fall there, what will happen to the exchange rate on the U.S. dollar?

The dollar will depreciate. The drop of expected inflation in Europe, which leads to a decline in the foreign interest rate (which is smaller than the drop in expected inflation), leads to a decline in the relative expected return on dollar assets, because the expected euro appreciation is greater than the decline in the foreign interest rate. The result of the decline in the relative expected return on dollar assets is a leftward shift of the demand curve, and the equilibrium U.S. dollar exchange rate falls. The graph is shown below.

24. If the European Central Bank decides to pursue a contractionary monetary policy to fight inflation, what will happen to the value of the U.S. dollar?

25. If a strike takes place in France, making it harder to buy French goods, what will happen to the value of the U.S. dollar?

Consider France to be the domestic country. Because it is harder to get French goods, people will buy more foreign goods and the value of the euro in the future will fall.

The expected depreciation of the euro lowers the expected return on euro assets at any exchange rate, so the demand for euros declines and the demand for dollars shifts to the right, as shown in the graph below. Thus, the dollar will appreciate.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the exchange

rate of U.S. dollars per British pound (DEXUSUK). A Mini Cooper can be purchased in London, England, for £17,865 or in Boston, United States, for $23,495. a. Use the most recent exchange rate available to calculate the real exchange rate of the London Mini per Boston Mini.

According to the exchange rate for July 31, 2020, the real exchange rate is $1.3133/£  [£17,865/London mini]/[$23,495/Boston mini] = 0.9986 Boston mini/London mini, or 1.001 London mini/Boston mini. b. Based on your answer to part (a), are Mini Coopers relatively more expensive in Boston or in London?

Since you can buy 1.001 minis in London for every one purchased in Boston, they are slightly relatively less expensive in London. c. What price in British pounds would make the Mini Cooper equally expensive in both locations, all else being equal?

If the real exchange rate equaled 1, this would imply 1 Boston mini/London mini = $1.31334/£  [X/London mini]/[$23,495/Boston mini]; solving for X yields a price of £17,890.05 for a London mini.

2. Go to the St. Louis Federal Reserve FRED database and find data on the daily dollar exchange rates for the euro (DEXUSEU), British pound (DEXUSUK), and Japanese yen (DEXJPUS). Also find data on the daily three-month London Interbank Offer Rate, or LIBOR, for the United States dollar (USD3MTD156N), euro (EUR3MTD156N), British pound (GBP3MTD156N), and Japanese yen ( JPY3MTD156N). LIBOR is a measure of interest rates denominated in each country’s respective currency.

31-Jul20 31-Jul19

USD LIBOR

EUR LIBOR

GBP LIBOR

JPY LIBOR

0.24875

−0.44471

0.08438

−0.05517

2.26563

−0.41971

0.77263

−0.07333

31-Jul-20 31-Jul-19 One Year Change

USD-EUR LIBOR 0.69346 2.68534 −1.99188

USD-GBP LIBOR 0.16437 1.49300 −1.32863

USD-JPY LIBOR 0.30392 2.33896 −2.03504

USD per EUR 1.1822 1.1130 EUR appreciated

USD per GBP 1.3133 1.2220 GBP appreciated

JPY per USD 105.78 108.58 JPY appreciated

31-Jul-20 31-Jul-19

a. Calculate the difference between the LIBOR rate in the United States and the LIBOR rates in the three other countries using the data from one year ago and the most recent data available.

See the table above for data from July 31, 2020. b. Based on the changes in interest rate differentials, do you expect the dollar to

depreciate or appreciate against the other currencies?

All three LIBOR rates for the euro currency area, United Kingdom, and Japan all increased relative to LIBOR rates in the United States. Thus, you would expect all three currencies should appreciate relative to the U.S. dollar. c. Report the percentage change in the exchange rates over the past year. Are the results you predicted in part (b) consistent with the actual exchange rate behavior?

See the table above. The British pound, the euro, and Japanese yen all appreciated according to prediction.

Chapter 19 ANSWERS TO QUESTIONS 1. If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting open market operation to 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 both international reserves and the monetary base decline equally, so the money supply falls. However, the offsetting open market purchase means that the monetary base and the money supply will remain unchanged. Then, there is 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 Reserve Bank of India buys rupees 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 rupees 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 rupee 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 in which part of the balance-of-payments account the transaction is recorded (current account, capital account, or net change in international reserves) and whether it is a receipt or a payment. a. A British subject’s purchase of a share of Johnson & Johnson stock A receipt in the capital account b. An American citizen’s purchase of an airline ticket from Air France A payment in the current account c. The Swiss government’s purchase of U.S. Treasury bills A negative change in net international reserves d. A Japanese citizen’s purchase of California oranges A receipt in the current account e. $50 million of foreign aid to Honduras A payment in the current account f. A loan from an American bank to Mexico A payment in the capital account g. An American bank’s borrowing of Eurodollars A receipt in the capital account 4. Suppose that you travel to Cali (Colombia), where the exchange rate is 1 USD to 3,617 Colombian pesos. As you enter a McDonald’s restaurant, you realize you need

11,900 Colombian pesos to buy a Big Mac. Assuming a Big Mac sells for $5.71 in the United States, would you say that the Colombian peso is over- or undervalued with respect to the U.S. dollar in terms of PPP? The purchase 5. Refer to the previous exercise. Which type of foreign market intervention must the central bank of Colombia conduct to keep the exchange rate at a level where the currency is not under- or overvalued in terms of PPP? To eliminate the overvaluation in terms of PPP, the exchange rate for the Columbian peso needs to decline. The central bank of Colombia should undertake an unsterilized foreign market intervention in which it will sell the domestic currency (COP) and buy foreign reserves, in order to increase reserves of its banking system, decrease the domestic interest rate, and shift the expected return on domestic currency denominated assets curve to the left.

6. What would be the effect of a devaluation on a country’s imports and exports? If a country imports most of the goods included in the basket of goods and services used to calculate the CPI, what do you think the effect will be on this country’s inflation rate?

When a country devalues its currency, the fixed exchange rate is set at a lower level, meaning that the central bank will no longer exchange domestic currency at the previous (higher) exchange rate. This means that foreigners with the same amount of foreign currency can get more units of domestic currency, thereby making that country’s exports cheaper for them, leading to an increase in the country’s exports.

On the other hand, domestic buyers of foreign products now need more units of domestic currency to buy the same amount of foreign currency, so imports become more expensive and will decrease. If many of the goods that are taken into consideration to measure the cost of living are imported, then the cost of living (as measured by the percentage change in the CPI) will most probably increase after the devaluation.

7. Under the gold standard, if Britain became more productive relative to the United States, what would happen to the money supply in the two countries? Why would the changes in the money supply help preserve a fixed exchange rate between the United States and Britain?

The increase in British productivity would create a tendency for the pound to appreciate relative to the dollar. The higher value of the pound would now cause Americans to exchange dollars for gold, ship the gold to Britain, and then buy British pounds with the gold. The result is that British holdings of gold (international reserves) would increase, which would raise the money supply because the monetary base would increase. The higher British money supply would then tend to lower the exchange rate back down to its par level because it would cause the price level to rise, which would lead to a depreciation of the pound.

8. What is the exchange rate between dollars and Swiss francs if one dollar is convertible into 1/40 ounce of gold and one Swiss franc is convertible into 1/25 ounce of gold?

0.63 francs per dollar (round off your response to two decimal places).

9. ―Inflation is not possible under the gold standard.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Inflation occurred when the world was under the gold standard before World War I. The gold discoveries in the Klondike and South Africa before World War I led to a continuing increase in the quantity of gold, which caused a more rapid growth in money supplies throughout the world. The result was worldwide inflation.

10. What are some of the disadvantages of China’s pegging the yuan to the dollar?

There are several disadvantages to China’s exchange rate strategy. First, diversification is a problem in that the Chinese own a very large amount of U.S. assets, including low-yielding U.S. treasuries. Second, it has created a backlash among trading countries that have threatened trade sanctions due to the cheap prices of Chinese exports due to the low yuan peg. Finally, having the undervalued yuan has resulted in the central bank selling large amounts of yuan currency and raising the domestic Chinese monetary base and money supply, which has the potential to create high inflation in the future.

11. If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange rate regime, what kind of intervention would that country’s central bank be forced to undertake, and what effect would the intervention have on the country’s international reserves and money supply?

The situation would be as depicted in Figure 2, Panel (b). The central bank would need to sell domestic currency and buy foreign assets, thus increasing its international reserves and the monetary base. The resulting rise in the money supply would then lead to a decline in the domestic interest rate, which would shift demand for domestic assets to the left so that the equilibrium exchange rate would be at par.

12. Why might a country that is suffering a recession not want to intervene in the foreign exchange market if its currency is overvalued? Assume this country participates in a fixed exchange rate regime.

When a country is engaged in a fixed exchange rate regime, it has a commitment to intervene in the foreign exchange market to maintain the system of fixed exchange rates. However, the combination of a recession and an overvalued currency is quite complicated to solve. The required unsterilized foreign exchange market intervention implies buying the domestic currency, decreasing reserves of the banking system and thereby increasing the domestic interest rate. This increase in domestic interest rates negatively affects the economy, reducing credit and expenditure on durable goods.

This is why countries engaged in fixed exchange rate regimes were sometimes reluctant to intervene in the foreign exchange market.

13. ―The abandonment of fixed exchange rates after 1973 has meant that countries have pursued more independent monetary policies.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although after 1973, countries must no longer intervene in the foreign exchange market to keep their currencies at par level and should pursue more independent monetary policies, they have chosen not to do so; instead, they have continued to engage in a substantial amount of intervention in the foreign exchange market. As a result, they continue to have considerable fluctuations in international reserves, which in turn affects their money supply.

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. What are the advantages and disadvantages of having the IMF as an international lender of last resort?

Central banks in emerging market countries can have limited ability to act as a lender of last resort since domestic liquidity provision can lead to higher inflation expectations and a depreciation of the currency. However, the IMF as an international lender of last resort can help avoid some of the political issues involved with liquidity provision and help stabilize the currency. Moreover, it can help prevent speculative attacks that can lead to contagion among other emerging market countries. A disadvantage to the IMF as an international lender of last resort is that it can encourage risky behavior by countries by increasing moral hazard, knowing that they will be bailed out by the IMF. In addition, countries are often required to adopt austerity measures as a condition to lending. However, many countries resist implementing the austerity measures, knowing that they will get bailed out anyway, creating a time-inconsistency problem.

18. How can the long-term bond market help reduce the time-inconsistency problem for monetary policy? Can the foreign exchange market also perform this role?

The long-term bond market can help reduce the time-inconsistency problem because politicians and central banks will realize that pursuing an overly expansionary policy will lead to an inflation scare in which inflation expectations surge, interest rates rise, and there is a sharp fall in long-term bond prices. Similarly, they will realize that overly expansionary monetary policy will result in a sharp fall in the value of the currency. Avoiding these outcomes constrains policymakers and politicians so timeinconsistent monetary policy is less likely to occur.

19. What are the key advantages of exchange rate targeting as a monetary policy strategy?

First, the exchange rate target directly keeps inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country to which its currency is pegged. Second, it provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem. Third, it has the advantage of simplicity and clarity.

20. When is exchange rate targeting likely to be a sensible strategy for industrialized countries? When is exchange rate targeting likely to be a sensible strategy for emerging market countries?

Exchange rate targeting is likely to be a sensible strategy for industrialized countries when domestic monetary and political institutions are not conducive to good monetary policymaking, and when there are other important benefits of an exchange rate target that have nothing to do with monetary policy. Exchange rate targeting is likely to be sensible for emerging market countries whose political and monetary institutions are weak so that it is the only way to break inflationary psychology and stabilize the economy.

21. What are the advantages and disadvantages of currency boards and dollarization over a monetary policy that uses only an exchange rate target?

22. Calculate the overvaluation of the Thai baht (THB) if you can get 34.6 THB per USD at the exchange counter, but a lunch menu that costs 25 USD in Boston sells for 948.25 THB in Bangkok.

The implicit exchange rate is 25 USD to 948.25 THB, or 1 USD to 37.93 THB. Using the THB as the domestic currency, the exchange rate is 0.0289 = 1/34.6 and the implicit exchange rate is 0.02636 = 1/37.93. The THB is thereby [(0.0289 / 0.02636) ‒ 1] × 100 = 9.64% overvalued.

ASWERS TO APPLIED PROBLEMS 23. Suppose the Reserve Bank of India (RBI) purchases ₹10,000,000 worth of foreign assets. a. If the RBI purchases the foreign assets with ₹10,000,000 in currency, show the effect of this open market operation, using T-accounts. What happens to the monetary base?

The RBI’s assets increase by ₹10 million, and it increases currency in circulation by ₹10 million. This results in the monetary base increasing by ₹10 million.

Reserve Bank of India (RBI) Assets

Liabilities

Foreign assets (international reserves)

₹10 million

Currency in circulation

₹10 million

b. If the RBI purchases the foreign assets by selling ₹10,000,000 in Indian government bonds, show the effect of this open market operation, using Taccounts. What happens to the monetary base?

The RBI’s assets increase by the increased foreign assets, but this is offset by a decrease in Indian government bonds of the same amount. Overall, the RBI’s assets are unchanged, and its liabilities and hence the monetary base are also unchanged.

Reserve Bank of India (RBI) Assets

Liabilities

Foreign assets (international reserves)

+₹10 million

Government bonds

–₹10 million

Currency in circulation

24. Suppose the Moroccan central bank chooses to peg the dirham to the euro and commits to a fixed dirham/euro exchange rate. Use a graph of the market for dirham assets (foreign exchange) to show and explain how the peg must be maintained if a shock in the eurozone forces the European Central Bank 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 Europe’s interest rates due to the contractionary monetary policy will increase the demand for euro assets and reduce the demand for dirham assets from D1 to D2, which will appreciate the euro and depreciate the dirham. This results in the dirham being valued below the peg; in order to maintain the peg, the Moroccan central bank must increase domestic interest rates by selling foreign assets, and buying domestic dirham currency. This results in the demand for dirham assets to increase back up to D1 as shown in the graph below. This demonstrates one of the main disadvantages to pegging the domestic currency in that domestic monetary

policy in the pegging country is dependent on foreign business cycles, meaning that there is no scope for domestic monetary policy stabilization. In this case, Morocco was forced to import a contractionary policy, which could create unexpected and undesirable contraction in the domestic economy. €/dirha m

Dirham Assets

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database, and find data on net exports (NETEXP), transfers (A123RC1Q027SBEA), and the current account balance (NETFI). a. Calculate net investment income for the most recent quarter available, and for the same quarter a year earlier.

See the table below. Net investment income is equal to the current account – transfers – net exports. b. Calculate the percentage change in the current account balance from the same quarter one year earlier. Which one of the three items making up the current account balance had the largest effect in percentage terms on the change of the current account? Which one had the smallest effect?

In percentage terms, the current account balance declined significantly (became more negative). Among the three items, net exports changed the most, decreasing by 19.7% (becoming more negative), while transfers changed the least, increasing by only 2.7%.

2020:Q1 2019:Q1 Percent Change

Current Account Balance ($Bil.) Transfers 423.4 316.7 532.0 308.4 0.4

2.7

Net Exports 494.3 615.5

Net Investment Income 245.8 224.9

19.7



2. Go to the St. Louis Federal Reserve FRED database and find data on the monthly U.S. dollar exchange rate to the Chinese yuan (EXCHUS), the Canadian dollar (EXCAUS), and the South Korean won (EXKOUS). Download the data into a spreadsheet. a. For the most recent five-year period of data available, use the average, max, min, and stdev functions in Excel to calculate the average, highest, and lowest exchange rate values, as well as the standard deviation of the exchange rate to the dollar (this is an absolute measure of the volatility of the exchange rate). b. Using the maximum and minimum values of each exchange rate over the last five years, calculate the ratio of the difference between the maximum and minimum values to the average level of the exchange rate (expressed as a percentage by multiplying by 100). This value gives an indication of how tightly the exchange rate moves. Based on your results, which of the three countries is most likely to peg its currency to the U.S. dollar? How does this country’s currency compare with the other two? c. Calculate the ratio of the standard deviation to the average exchange rate over the last five years (expressed as a percentage by multiplying by100). This value gives an indication of how volatile the exchange rate is. Based on your results, which of the three currencies is most likely to be pegged to the U.S. dollar? How does this currency compare with the other two? a. See table below for July 2015 to July 2020.

Average Maximum Minimum Standard Deviation

South Korean Won 1148.53 1228.13 1065.64 41.5

Chinese Yuan 6.73 7.11 6.30 0.24

Canadian Dollar 1.32 1.42 1.23 0.04

Max Min Difference/Average SD/Average

0.14 0.04

0.12 0.04

0.15 0.03

b. (b) See the table above. The Chinese yuan has a smaller band that it moves in relative to the average value; at only 12% of the average, this is slightly smaller than the South Korean won and the Canadian dollar bands that they fluctuated in over the last five years. Hence the Chinese yuan is the most likely to be pegged. c. The results are somewhat consistent with part (b) in that the fluctuations of all three currencies are somewhat similar, although Canada’s currency is slightly less volatile than China’s or South Korea’s.

Chapter 20 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. Hermann, your little brother, is wondering what would happen to the price level when the money supply in Eurozone increases from 4.5 trillion Euros to 9 trillion Euros over a decade. What would be your answer to him if you believe in the classical economist’s theory that velocity and aggregate output are reasonably constant?

The price level will double.

3. Suppose that due to a severe security hack, all credit cards in Australia become unusable for a month. What would happen to the velocity of money in Australia for that period?

The 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. Hans has his own economics blog. He has just written the following quote: "In the short run there is a strong positive relationship between inflation and money growth rates". Is this statement true, false, or uncertain? Explain your answer.

The statement is false. In the short run there is no strong positive relationship between inflation and money supply, according to empirical research.

5. Why would a central bank be concerned about persistent long-term budget deficits?

Persistent long-term budget deficits can lead to the perception or worry that policymakers will satisfy the government budget constraint by monetizing the debt in the future, leading to large increases in the monetary base that would be highly inflationary. Even if the central bank has no intention of monetizing the debt, the belief or appearance that the central bank may do this will increase inflation expectations, making it harder for monetary policymakers to keep inflation anchored at a low, stable level.

6. ―Persistent budget deficits always lead to higher inflation.‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. As long as a country (such as the United States) has reliable access to bond markets and bond holders are willing to accept and hold treasury debt, a country can continue to rely on borrowing to meet financial obligations. This relies on the perception that the government will be able to repay the debts in the future, and there is low risk of default. However, once bond holders believe that budget deficits have reached unsustainable levels, they may decide not to hold bonds anymore, and this could force the government to monetize the debt in order to meet financial

obligations. In this case, higher inflation may result.

7. Why might a central bank choose to monetize the debt, knowing that it could lead to higher inflation?

If the government is running large deficits, this could lead to higher interest rates, which could be contractionary to the economy or be misaligned from the central bank’s optimal policy interest rate to the point where the central bank may want to reduce interest rates. Thus, by purchasing bonds and monetizing the debt, even though it may be increasing the monetary base and raising inflation risk, it can be beneficial in reducing interest rates (or slowing the increase in interest rates) as a result of elevated debt issuance by the treasury. This is particularly useful in situations where output or employment goals may need to be prioritized over price stability objectives.

8. Consider two central banks: one with a history of maintaining price stability and low inflation, and the other with a history of high inflation and poor inflation management. All else equal, if the same level of government budget deficit is monetized in both countries, how is inflation likely to behave in each country?

Central banks with a poor history of inflation management can easily experience an unanchoring of (or sharp increase in) inflation expectations. So if the monetary base increases by the same amount in both countries as a result of the monetization of the debt, it is likely that inflation will increase much more in the country with poor inflation management than the one with a history of price stability.

9. Some payment technologies require infrastructure (e.g., merchants need to have access to credit card swiping machines). In most developing countries historically this infrastructure has either been nonexistent or very costly however recent mobile payment systems have expanded rapidly in developing countries as they have become cheaper. Everything else being equal, would you expect the transaction component of the demand for money to be increasing or decreasing in a developing country relative to a rich country?

In general the need for costly infrastructure to support new payment technologies would mean that cash would be used more in developing countries relative to rich countries. As a result, the transactions demand for money would be large in comparison. However with rapid improvements in mobile payments technology in developing countries, this would decrease the transactions demand for money relative to rich countries.

10. What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? On the basis of these motives, what variables did he think determined the demand for money?

The three motives are: precautionary, speculative, and transactions motives. From these three motives, Keynes believed that money demand was positively related to income and negatively related to the nominal interest rate.

11. In Keynes’s analysis of the speculative demand for money, what will happen to the demand for money if people suddenly expect that the normal level of the interest rate has fallen? Explain your answer.

As interest rates affect the money demand and velocity, since interest rates fluctuate a lot, velocity will fluctuate as well. Furthermore, changes in people’s expectations about what the normal level of interest rates are will cause money demand and hence the velocity to fluctuate. Thus, Keynes’s analysis of the speculative demand for money suggests that velocity will be far from constant; instead, it will undergo substantial fluctuations.

12. Why is Keynes’s analysis of the speculative demand for money important to his view that velocity will undergo substantial fluctuations and thus cannot be treated as constant?

Because it indicates that money demand and hence velocity is affected by interest rates, and since interest rates fluctuate a lot, velocity will as well. Furthermore, as the answer to problem 11 suggests, changes in people’s expectations about what the normal level of interest rates are will cause money demand and hence velocity to fluctuate. Keynes’s analysis of the speculative demand for money thus suggests that velocity will be far from constant; rather, it will undergo substantial fluctuations.

13. According to the portfolio theories of money demand, what are the four factors that determine money demand? What changes in these factors can increase the demand for money?

The four factors determining money demand under portfolio theory are: interest rates (decreases in interest rates increase money demand); wealth (higher wealth leads to higher money demand); risk of alternative assets (a higher risk of alternative assets increases money demand); and liquidity of other assets (a decrease in liquidity of alternative assets increases the demand for money).

14. Describe the effect of each of the following events on the demand for money in Turkey according to the portfolio theories of money demand: a. The Central Bank of the Republic of Turkey increased the base interest rate, which in turn increased the general interest rates in the country.

An increase in interest rates increases expected returns for bonds, therefore decreasing demand for money. b. The Banking Regulation and Supervision Agency approved a new electronic payment system which will make payments much more liquid and with a reduced cost.

Financial innovation lowers the demand for money. c. The stock market's main index in Borsa, Istanbul is getting more volatile in the recent months.

The stock market’s higher volatility, and hence the increase of risk in stocks, would increase the demand for money.

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. You learn that the new governor of the Central Bank of the Republic of Turkey is focusing on reducing inflation from the very high (double digit) levels seen in the last years. How do you think will this affect the demand for money in the country?

The expected decrease in inflation volatility and risk will increase the demand for money.

17. Both the portfolio choice and Keynes’s theories of the demand for money suggest that as the relative expected return on money falls, demand for it will fall. Why does the portfolio choice approach predict that money demand is affected by changes in interest rates? Why did Keynes think that money demand is affected by changes in interest rates?

In Keynes’s view, a rise in interest rates leads to a lower relative expected return of money and hence a lower demand for money. In the portfolio choice view, a rise in interest rates leads to an increase in the implicit interest paid on checkable deposits, so the relative expected return of money only falls by a small amount. Hence, in the portfolio choice view, the demand for money changes little when interest rates rise.

18. Why does the Keynesian view of the demand for money suggest that velocity is unpredictable?

In Keynes’s view, velocity is unpredictable because interest rates, which have large fluctuations, affect the demand for money and hence velocity. In addition, Keynes’s analysis suggests that if people’s expectations of the normal level of interest rates change, the demand for money changes. Keynes thought that these expectations moved unpredictably, meaning that money demand and velocity are also unpredictable.

19. What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand, and how has this conclusion affected monetary policymaking?

Velocity is used to indicate if the money demand function is stable. If velocity is predictable and stable, then the money demand function is also stable, and vice versa.

Up until the early 1970s, the money demand function was stable, but after that, financial innovation made velocity relatively unpredictable and hence implied a more unstable money demand function. Because of this, the Federal Reserve moved away from using the money supply as its main policy indicator, and moved to interest rates as its main monetary policy indicator.

20. Based on the empirical evidence on the weak relationship between money growth and inflation in the short run, what is the main insight regarding the flexibility of wages and prices?

The main insight is that wages and prices are not completely flexible in the short run,

so inflation pressures may not be as high when wages increase in a short amount of time.

ANSWERS TO APPLIED PROBLEMS 21. Oliver is looking at the data on money supply M and nominal GDP, PY in Australia in the last three years. The data are as follows (in billions of Australian dollars): Indicator

2018

2019

2020

M PY

1,150 1,434

1,250

1,230 1,450

1,500

Calculate the velocity for each year. At what rate is velocity changing in 2019? What about2020?

The velocity is 1.24 in 2018, 1.2 in 2019 and 1.18 in 2020. The velocity is changing at -3.2% in 2019 and -1.8% in 2020.

22. Calculate what happens to nominal GDP if velocity remains constant at 4 and the money supply increases from $250 billion to $375 billion.

Originally, the nominal GDP is $1 trillion. After the money supply increases, the nominal GDP is $1.5 trillion.

23. What happens to nominal GDP if the money supply grows by 17% but velocity declines by 24%?

The nominal GDP declines by approximately 7%. (Round off your response to the nearest integer.)

24. If velocity and aggregate output remain constant at 2 and A$1,450 billion respectively, what happens to the price level if the money supply declines from A$1,250 billion to A$1000 billion?

The price level declines from 1.72 (= 2,500/1,450) to 1.38 (= 2,000/1,450).

25.

Period Period Period Period Period Period Period 1 2 3 4 5 6 7 Y (in Interest billions) rate

Y (in

12,00 0.05 0

12,50 0.07 0

12,25 0.05 12,50 0.03 0 0

12,80 0.07 0

13,00 0.04 0

13,200 0.06

Period 1

Period 2

Period 3

Period 4

Period 5

Period 6

Period 7

12,000

12,500

12,250

12,500

12,800

13,000

13,200

billions) Interest Rate

0.05

0.07

0.03

0.05

0.07

0.04

0.06

L(i, Y)

1450

1492.5

1501.25

1512.5

1530

1585

1590

V = Y/L(i, Y)

8.28

8.38

8.16

8.26

8.37

8.20

8.30

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on the M1 Money Stock (M1SL), M1 Money Velocity (M1V), and Real GDP (GDPC1). Convert the M1SL data series to ―Quarterly‖ using the frequency setting, and for all three series, use the ―Percent Change from Year Ago‖ setting for units. a. Calculate the average percentage change in real GDP, the M1 money stock, and velocity since 2000:Q1.

From 2000:Q1 to 2020:Q2, average growth in real GDP is about 1.9%, average growth in velocity has been –2.5%, and the M1 money stock has grown about 6.9% per year. b. Based on your answer to part (a), calculate the average inflation rate since 2000 as predicted by the quantity theory of money.

Based on part (a), the average inflation rate should be about %ΔM + %ΔV – %ΔY = 6.9 – 2.5 – 1.9 = 2.5%. c. Next, find the data on the GDP deflator price index (GDPDEF), download the data using the ‟Percent Change from Year Ago‖ setting, and calculate the average inflation rate since 2000:Q1. Comment on the value relative to your answer in part (b).

Average inflation per year for the period using GDPDEF is 1.9%, which is lower than the implied inflation rate calculated above, so is not entirely consistent with the quantity theory of money.

2. Go to the St. Louis Federal Reserve FRED database and find data on the budget deficit (FYFSD), the amount of federal debt held by the public (FYGFDPUN), and the amount of federal debt held by the Federal Reserve (FDHBFRBN).

Convert the two ―debt held‖ series to ―Annual‖ using the frequency setting. Download all three series into a spreadsheet. Make sure that the rows of data align properly to the correct dates. Note that for the deficit series, a negative number indicates a deficit; multiply the series by –1 so that a deficit is indicated by a positive number. Manipulate the three series so that all data are given in terms of the same units (either millions or billions of dollars). To do this, if a series is in millions and you are converting it to billions, divide the series by 1,000. Finally, for each year, convert the two ―debt held‖ series into one ―changes in debt holdings by the public and the Federal Reserve‖ series by calculating,

for each year, the difference in bond holdings from the preceding year. a. Create a scatterplot showing the deficit on the horizontal axis and the change in bond holdings by the public on the vertical axis, using the data from 1980 through the most recent period of data available.

Insert a fitted line into the scatterplot, and comment on the relationship between the deficit and the change in public bond holdings. b. Create a scatterplot showing the deficit on the horizontal axis and the change in bond holdings by the Federal Reserve on the vertical axis, using the data from 1980 through the most recent period of data available. Insert a fitted line into the scatterplot, and comment on the relationship between the deficit and the change in Federal Reserve bond holdings. c. Now repeat part (b), but create separate scatter plots for the period of 1980 to 2007, and 2008 to the most recent year. Comment on how, if at all, the monetizing of the debt is exhibited in the data. Do you think the relationship between the deficit and the change in bond holdings of the Federal Reserve has changed since 2008?

Why or why not? a. See the graphs below. Not surprisingly, from 1980 to 2019, there appears to be a very strong relationship between deficits and the change in bond holdings by the public, as the fitted line is very steep (and has a high R-squared if using a regression line), and has close to a one-to-one relationship. Thus, from this data it appears that the public absorbs all of the new debt issued.

Deficit and Change in Public Bond Holdings 1980 to 2019 Change in Publically Held Debt

2000000

y = 1.0856x + 9171.3 R² = 0.9439

1500000 1000000 Series1 500000

Linear (Series1)

0

-500000 -500000

0

500000

1000000

1500000

Deficit - $ Mil.

b. See the graphs below. For the change in holdings by the Federal Reserve, there appears to be a positive relationship suggesting some monetization of the debt, but this is much less obvious (and using a fitted regression line

indicates a much smaller relationship, with less predictive power). In particular, for each $1 of deficit, the Fed absorbs about 16 cents of it in debt holdings.

Deficit and Change in Fed Bond Holdings 1980 to 2019 Change in Fed Bond Holdings

800000

y = 0.1589x + 2941.3 R² = 0.1229

600000 400000 Series1

200000

Linear (Series1)

0

-500000 0 -200000 -400000

500000

1000000

1500000

Deficit - $Mil.

c. See the graphs below. There appears to be some amount of debt monetization in the scatter plot data in the post-crisis period: in general, as the deficits get significantly larger during 2008 to 2019, the change in bond holdings by the Fed gets larger, indicating the central bank is facilitating higher deficits.

Looking separately at the period of 1980 to 2007 shows virtually no relationship between Federal Reserve debt holdings and deficits (see below; both the R-squared and the coefficient are close to zero). This is not surprising, since the Federal Reserve instituted several large-scale asset purchase programs during the post-crisis period, much of which was purchases of U.S. Treasuries, at a time when the United States was running very large deficits.

Deficit and Change in Fed Bond Holdings Pre- and Post-Crisis Change in Fed Held Debt

800000 y = 0.0142x + 21415 R² = 0.0184

600000 400000

1980 to 2007 2008 to 2019

200000

Linear (1980 to 2007)

0

-500000 0 -200000 -400000

500000

1000000

1500000

Linear (2008 to 2019) y = 0.1758x - 3658.9 R² = 0.0382

Deficit - $ Mil.

Chapter 21 ANSWERS TO QUESTIONS 1. ―Planned investment spending is equal to the total spending by businesses on new physical capital‖ Is this statement true, false, or uncertain? Explain your answer.

The statement is false. New homes should also be included in planned investment spending.

2. Why is inventory investment counted as part of aggregate spending if it isn’t actually sold to the final end user?

Since inventories of unsold goods are goods that have been produced, then in an accounting sense, they add to output and hence aggregate demand. However, since the final end user hasn’t purchased them yet, they are counted as inventory until they are sold.

3. ―Since inventories can be costly to hold, firms’ planned inventory investment should be zero, and firms should acquire inventory only through unplanned inventory accumulation.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although inventories are costly to hold, many firms prefer to have extra inventories of unsold goods on hand in the event that there is an unpredictable increase in demand for their goods, because this allows firms to satisfy customers’ demands. As a result, planned inventory investment may very well be positive.

4. During and in the aftermath of the financial crisis of 2007–2009, planned investment fell substantially despite significant decreases in the real interest rate. What factors related to the planned investment function could explain this?

During the height of the crisis, financial frictions f increased dramatically, which effectively raised the real cost of investment. In addition, firms’ planned autonomous investment I decreased dramatically as the prospects for economic growth and profits in the future weakened sharply. Both of these factors reduced planned investment, even though real interest rates may have decreased.

5. If households and firms believe the economy will be in a recession in the future, will this necessarily cause a recession, or have any impact on output at all?

These shifts in ―animal spirits,‖ according to Keynes, could very well create a recession. If the beliefs are strong enough, this could significantly reduce autonomous consumption and autonomous planned investment to the point where equilibrium output decreases substantially, leading to a recession.

6. Why do increases in the real interest rate lead to decreases in net exports, and vice versa?

When the real interest rate increases, this increases the demand for domestic assets, resulting in an appreciation of the domestic currency. As a result, imported goods become cheaper domestically, and exported goods become more expensive to foreigners. This reduces net exports, implying an inverse relationship between the real interest rate and net exports.

7. Why does equilibrium output increase as the marginal propensity to consume increases?

When the marginal propensity to consume (mpc) increases, this leads to a larger multiplier effect for any given change in spending, resulting in higher output. Put another way, when the mpc increases, this leads to a higher amount of consumption spending out of disposable income. This leads to more production, which leads to higher income, leading to further increases in spending.

8. If firms suddenly become more optimistic about the profitability of investment and planned investment spending rises by €150 billion, while consumers become more pessimistic and autonomous consumer spending falls by €150 billion, what happens to aggregate output?

Nothing. The €150 billion increase in planned investment spending is offset in full by the €150 billion decline in autonomous consumer expenditure, so autonomous spending and aggregate output remain unchanged.

9. If an increase in autonomous consumer expenditure is matched by an equal increase in taxes, will aggregate output rise or fall?

Rise. The fall in spending from an increase in taxes is always less than the change in taxes because the marginal propensity to consume is less than 1. By contrast, autonomous spending rises one-for-one with a change in autonomous consumer expenditure. If taxes and autonomous consumer expenditure rise by the same amount, autonomous spending must rise, and aggregate output also rises.

10. If a change in the interest rate has no effect on planned investment spending or net exports, what does this imply about the slope of the IS curve?

In this case, as interest rates fall, planned investment spending and net exports do not change, so equilibrium output remains unchanged. This means that the IS curve is vertical.

11. Inventories typically increase starting at the beginning of recessions, and begin to decline near the end of recessions. What does this say about the relationship between planned spending and aggregate output over the business cycle?

At the beginning of recessions, planned spending falls as consumers reduce spending and firms reduce investment, while production generally stays constant. As a result, an excess supply of goods is produced, leading to rising inventories. In the middle stages of recessions, firms may reduce production, but this may also be met with further decreases in planned spending leading to further buildup of inventories.

However, near the end of a recession, firms are slow to increase production, while

planned spending typically increases; this leads to reductions in inventories due to the excess demand for goods.

12. Why do companies cut production when they find that their unplanned inventory investment is greater than zero? If they didn’t cut production, what effect would this have on their profits? Why? Companies cut production when their unplanned inventory investment is greater than zero, because they are then producing more than they can sell. If they continue at current production, profits will suffer because they are building up unwanted inventory, which is costly to store and finance.

13. You read in a blog, that companies in India are becoming less confident about investment profitability, so they will decrease planned investment spending in the near future. What do you think will happen to aggregate demand?

Since this is an autonomous decrease in planned investment spending, it will decreases aggregate demand.

14. In each of the cases below, determine whether the IS curve shifts to the right or left, does not shift, or is indeterminate in the direction of shift. a. The real interest rate decreases in China.

This is a movement along the IS curve, so it does not shift the IS curve. b. The marginal propensity to consume by the population 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 in India.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. d. Autonomous consumption decreases.

Equilibrium output decreases at any given interest rate, which shifts the IS curve to the left. e. The new Italian government decreases both taxes and government spending 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 new Spanish 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. ―The fiscal stimulus package of 2009 caused the IS curve to shift to the left, since output decreased and unemployment increased after the policies were implemented.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Although the IS curved shifted to the left during the period of the financial crisis, this is because of external factors which caused a sharp decline in consumption and investment, such as financial frictions and sharp decreases in autonomous consumption and investment. If the stimulus package had not been in place, the IS curve would have shifted much farther to the left.

16. When the Reserve Bank of Australia reduced its policy interest rate in 2020, how, if at all, should the IS curve have been affected? Briefly explain.

The IS curve is not affected at all in theory, so it does not shift. Changes in the real interest rate represent movements along a given IS curve, but they do not shift the curve.

17. Suppose you read that prospects for stronger future economic growth have led the dollar to strengthen and stock prices to increase. a. What effect does the strengthened dollar have on the IS curve?

A more expensive dollar will result in fewer U.S. exports and more U.S. imports (everything else the same), therefore decreasing net exports. Graphically, this shifts the IS curve to the left, decreasing aggregate output at every interest rate. b. What effect does the increase in stock prices have on the IS curve?

Usually the increase in stock prices is interpreted as having a positive effect on autonomous planned investment, as investors become more confident about the future prospects of the economy. Therefore, we should expect autonomous planned investment to increase and the IS curve to shift to the right. c. What is the combined effect of these two events on the IS curve?

This is an example in which it is quite difficult to measure the net effect of these events. Depending on the relative magnitude of the shifts, the IS curve might end up shifting to the left, to the right, or not shifting at all. This problem arises because these events have opposite effects on the IS curve.

ANSWERS TO APPLIED PROBLEMS 18. Your sister Yennefer asks you to help her to calculate the value of the consumption function at each level of income in the table below if autonomous consumption = 200, taxes = 100, and mpc = 0.5.

Income Y Disposable Income YD Consumption C 0 100 200 300 400

Income Y Disposable Income YD Consumption C 0 –100 150 100 0 200 200 100 250 300 200 300 400 300 350 19. Assume that autonomous consumption is £1,625 billion and disposable income is £11,500 billion. Calculate consumption expenditure if an increase of £1,000 in disposable income leads to an increase of £750 in consumption expenditure.

If an increase of £1,000 in disposable income leads to an increase of £750 in consumption expenditure, then mpc = 0.75. Using this implies that C = 1,625 + 0.75 x 11,500 = 10,250. Consumption expenditure is therefore £10,250 billion.

20. Suppose that Dell Corporation has 20,000 computers in its warehouses on December 31, 2022, ready to be shipped to merchants (each computer is valued at $500). By December 31, 2023, Dell Corporation has 25,000 computers ready to be shipped, each valued at $450. a. Calculate Dell’s inventory on December 31, 2022.

Dell’s inventory on December 31, 2022, is the market value of the 20,000 computers at its warehouses. Therefore, Dell’s inventory equals 20,000 × $500 = $10,000,000 on December 31, 2022. b. Calculate Dell’s inventory investment in 2023.

Dell’s inventory spending is the change in the level of its inventory during the course of 2023. On December 31, 2023, Dell’s inventory equals 25,000 × $450 = $11,250,000. Therefore, Dell’s inventory spending in 2023 is $1,250,000 = $11,250,000 − $10,000,000. c. What happens to inventory spending during the early stages of an economic recession?

During the early stages of an economic recession, as soon as households’ income starts to fall, firms realize that their sales drop. This results in fewer orders by their dealers and therefore an increase in the number of goods they stock at their

warehouses (since they probably have already decided about production levels for that period). The consequence is that inventory spending will be positive for some time, but firms will quickly cut production and will try to sell their already manufactured goods before increasing production again.

21. Suppose that the consumption function in Argentina 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 200?

An equilibrium output of 2,000 occurs when Y = Yad and the aggregate demand function Yad = C + I + G + NX = 500 + 0.75Y. Solving for Y implies 0.25Y = 500, or Y = 2000. If government spending rises by 200, equilibrium output will rise by 800 to 2,800.

22. If the marginal propensity to in Italy consume is 0.75, by how much would government spending have to rise to increase output by €1,000 billion? By how much would taxes need to decrease to increase output by €1,000 billion?

The change in Output Y is given as the change in spending G, multiplied by 1/(1 − mpc). Thus €1000 = 4 × G, implying government spending would have to increase by €250 billion 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 =3xT, implying that taxes would have to decrease by €333.3 billion to increase equilibrium output by €1000 billion.

23. Assuming both taxes and government spending increase by the same amount, derive an expression for the effect on equilibrium output.

Formally, the effects on output from a change in government spending and a change in taxes are given, respectively, as YG = G/(1 – mpc) and YT = –T  mpc/(1 – mpc).

If both taxes and spending increase by the same amount, then G = T and the net effect on output is given as Y = YG + YT = G/(1 – mpc) – T  mpc/(1 – mpc) = G[1/(1 – mpc) – mpc/ (1 – mpc)] = G. Thus, if both taxes and government spending increase by the same amount, output will increase by exactly the amount of the increase in spending (or increase in taxes).

24. Consider an economy described by the following data: ̅

= $3.25 trillion

̅

= $1.3 trillion

̅

= $3.5 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= - $1.0 trillion

̅

=1

mpc

= 0.75

d

= 0.3

x

= 0.1

a. Derive simplified expressions for the consumption function, the investment function, and the net export function.

C = 3.25 + 0.75(Y – 3) = 1 + 0.75Y. I = 1.3 – 0.3(r + 1) = 1 – 0.3r. NX = –1 – 0.1r. b. Derive an expression for the IS curve.

The IS curve can be found by setting Y = Yad and solving: Y = 1 + 0.75Y + 1 – 0.3r + 3.5 –1 – 0.1r. This implies 0.25Y = 4.5 – 0.4r, or Y = 18 – 1.6r. c. If the real interest rate is r = 2, what is equilibrium output? If r = 5, what is equilibrium output?

At r = 2, equilibrium output is Y = 18 – 1.6(2) = $14.8 trillion; At r = 5, equilibrium output is Y = 18 – 1.6(5) = $10 trillion. d. Draw a graph of the IS curve showing the answers from part (c) above.

e. If government purchases increase to $4.2 trillion, what will happen to equilibrium output at r = 2? What will happen to equilibrium output at r = 5? Show the effect of the increase in government purchases in your graph from part (d).

An increase of government spending of $0.7 trillion will lead to an 0.7/(1 – 0.75) = $2.8 trillion increase in equilibrium output at any given interest rate. Thus, the IS curve will shift horizontally to the right by $2.8 trillion.

25. Consider an economy described by the following data: ̅

= $4 trillion

̅

= $1.5 trillion

̅

= $3.0 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=0

mpc

= 0.8

d

= 0.35

x

= 0.15

a. Derive an expression for the IS curve.

Using equation (12) in the chapter, the IS curve is given as Y = 35.5 – 2.5r. b. Assume that the Federal Reserve controls the interest rate and sets the interest rate at r = 4. What is the equilibrium level of output?

At an interest rate of Y = 35.5 – 2.5(4) = 25.5. c. Suppose that a financial crisis begins, and ̅ increases to ̅ = 3. What will happen to equilibrium output? If the Federal Reserve can set the interest rate, then at what level should the interest rate be set to keep output from changing?

The IS curve is now Y = 30.25 – 2.5r; at an interest rate of 4, equilibrium output is now Y = 20.25. In order to maintain the output level from part (b), the Federal

Reserve would have to set the interest rates such that 25.5 = 30.25 – 2.5r, implying the interest rate setting of to offset the increase in f of 3. Thus, the Federal Reserve will reduce d. Suppose the financial crisis causes ̅ to increase as indicated in part (c) and also causes planned autonomous investment to decrease to ̅ = $1.1 trillion. Will the change in the interest rate implemented by the Federal Reserve in part (c) be effective in stabilizing output? If not, what additional monetary or fiscal policy changes could be implemented to stabilize output at the original equilibrium output level given in part (b)? f I , Y = $25.5 trillion.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on Personal Consumption Expenditures (PCEC), Personal Consumption Expenditures: Durable Goods (PCDG), Personal Consumption Expenditures: Nondurable Goods (PCND), and Personal Consumption Expenditures: Services (PCESV). a. According to the most recent data: What percentage of total household expenditures is devoted to the consumption of goods (both durable and nondurable goods)?

For 2020:Q2, total personal consumption expenditures are $13,017.8 billion, nondurable consumption is $2875.7 billion, and durables consumption is $1474.2 billion. Thus, nondurables represent 100*2875.7/13,017.8 = 22.1%, and durables represents 100*1474.2/13,017.8 = 11.3%. Services is the largest part of consumption, at 100*8667.8/13,017.8 = 66.6% b. Given these data, which specific component of household expenditures would be most impacted by a reduction in overall household spending? Explain.

Since services are a much larger fraction of consumption than either nondurables or durable consumption, it would be reasonable to conclude a decline in household spending would most likely impact services spending. However, most of the services component is due to housing expenses, which do not change much over business cycles, thus it is more likely that nondurables, the second largest component, is affected most.

2. Go to the St. Louis Federal Reserve FRED database and find data on Real Private Domestic Investment (GPDIC1), a measure of the real interest rate; the 10-year Treasury Inflation-Indexed Security, TIIS (FII10); and the spread between Baa corporate bonds and the 10-year U.S. Treasury (BAA10YM), a measure of financial frictions. For (FII10) and (BAA10YM), convert the frequency setting to ―Quarterly,‖ and download the data into a spreadsheet. For each quarter, add the (FII10) and (BAA10YM) series to create ri, the real interest rate for investments for that quarter.

Then calculate the change in both investment and ri as the change in each variable from the previous quarter. a. For the eight most recent quarters of data available, calculate the change in investment from the previous quarter, and then calculate the average change over the eight most recent quarters.

From 2018:Q3 to 2020:Q2, the average change in investment was –$64.4 (billion) per quarter. b. Assume there is a one-quarter lag between movements in ri and changes in investment; in other words, if ri changes in the current quarter, it will affect investment in the next quarter. For the eight most recent lagged quarters of data available, calculate the one-quarter-lagged average change in ri.

From 2018:Q2 to 2020:Q1, the average change in ri was 0.01. c. Take the ratio of your answer from part (a) divided by your answer from part (b).

What does this value represent? Briefly explain.

The ratio of the changes is –64.4/0.01 = –6440; the absolute value of this represents the coefficient on the investment function; that is, for every one percentage point increase in ri, real private domestic investment decreases by about $6440 billion. Note that this is what you should expect in theory, as the real interest rate for investments and investment should be negatively related. d. Repeat parts (a) through (c) for the period 2008:Q3 to 2009:Q2. How do financial frictions help explain the behavior of investment during the financial crisis? How do the coefficients on investment compare between the current period and the financial crisis period? Briefly explain.

From 2008:Q3 to 2009:Q2, the average change in investment was –$166.0 (billion), and from 2008:Q2 to 2009:Q1, the average change in ri was 0.71. The coefficient on investment d during that period is the absolute value of – 166.0/0.71, or d = 233.8. Thus, for every one percentage point increase in ri, real private domestic investment would fall by about $233.8 billion. The financial frictions component partly helps explain the significant decline in investments during the financial crisis period despite real interest rates being relatively low; however, other factors are clearly at play that are affecting the value of the two coefficients that can’t be captured by the financial frictions data series.

Chapter 22 ANSWERS TO QUESTIONS 1.

2. Your brother Vihaan asks you what the main assumption that underlies the Reserve Bank of India’s ability to control the real interest rate. What would you tell him?

India’s central bank, the Reserve Bank of India, can control the nominal interest rate (the Repo rate), but what actually impacts economic activity are real interest rates.

The underlying assumption is that inflation is relatively sticky in the short run, so changes in the nominal interest rate also imply similar changes in the real interest rate.

3.

4. According to an economics blog, in Pakistan λ= 0.5. If the real interest rate is 6% and inflation is 8%, what is the nominal interest rate?

The nominal rate is 6% + 0.5 × 8% = 10% 5. How does an autonomous tightening or easing of monetary policy by the Fed affect the MP curve?

An autonomous tightening of policy results in r increasing, and the MP curve shifting upward; an autonomous easing of policy results in r decreasing, shifting the MP curve downward.

6.

7. During her speech at the ECB Forum on Central Banking, held virtually on November 11, 2020, the president of the ECB Christine Lagarde made the following statement in relation to the recession that resulted from the COVID pandemic: ―…the unusual recession has posed exceptionally high risks…. Not only has inflation fallen into negative territory, but we have already seen services inflation, which is normally the more stable part of the price index, drop to historic lows.‖ Lagarde also stated that they would launch a pandemic emergency purchase program (PEPP) to stabilize financial markets and ease the overall monetary policy stance. 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 ECB begins to pay less attention to the inflation rate, this would be equivalent to a reduction in λ, which would reduce the slope of the MP curve.

8. 

9. An analyst reports that the Lega Nord party will decrease taxes as soon as it comes into power after the elections, and this will shift the aggregate demand curve to the left. Is he correct?

The analyst is not correct. A decrease in taxes shifts the aggregate demand to the right (it increases aggregate demand).

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. "The main reason a central bank would lower interest rates when the economy is in recession is to increase inflation." Is this statement true or false?

False. The main reason would be to stimulate the economy, and to prevent inflation from falling.

12. How does an autonomous tightening or easing of monetary policy by the Fed affect the aggregate demand curve?

When an autonomous tightening occurs, the aggregate demand curve shifts left.

When an autonomous easing occurs, the aggregate demand curve shifts right.

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 in the Eurozone.

The IS curve shifts to the right; the MP curve does not shift; and the AD curve shifts to the right. b. An increase in taxes and an autonomous easing of monetary policy by the Reserve Bank of India.

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 in Turkey.

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, which reduces output and does not shift the AD curve. d. A decrease in autonomous consumption in Pakistan.

A decrease in autonomous consumption shifts the IS curve to the left; the MP curve does not shift; and the AD curve shifts to the left. e. Chinese firms become more optimistic about the future of the economy in China.

Autonomous investment increases, which shifts the IS curve to the right; the MP curve does not shift; and the AD curve shifts to the right. f. The new ECB chair begins to care less about fighting inflation This represents a decrease in λ, which does not affect the IS curve; the MP curve becomes flatter and the slope of the AD curve becomes steeper 14. Christina's manager has asked her to explain the effect a decrease in euro zone net exports would have on the aggregate demand curve. In addition, he asks Christina what the effect of this decrease would be on the monetary policy curve. How do you think Christina should respond?

A decrease in EU net exports directly affects the IS curve, since planned expenditure decreases at every real interest rate. Assuming the goods market is in equilibrium, aggregate output decreases, shifting the IS curve to the left. 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 left. This means that aggregate output decreases at every inflation rate.

15. Suppose the analyst mentioned in Question 9 states that if Lega Nord wins, the "animal spirits" in Italy will be unleashed and bring about economic growth. Do you think this implies that the aggregate demand curve will shift?

The aggregate demand curve shifts because a change in ―animal spirits‖ causes autonomous consumer expenditure or planned investment spending to change, which in turn causes the quantity of aggregate output demanded to change at any given inflation rate.

16. Suppose that government spending is increased at the same time that an autonomous monetary policy tightening occurs. What will happen to the position of the aggregate demand curve?

The effect on the aggregate demand curve is uncertain because increased government spending would shift the AD curve to the right while the autonomous policy tightening shifts the AD curve to the left.

17. If financial frictions increase, how will this affect credit spreads, and how might the central bank respond? Why? The increase in financial frictions, if left alone, will increase the cost of borrowing and result in higher credit spreads. This will lead to a decrease in planned investment, shifting the AD curve to the left and reducing aggregate output demanded. Thus if the central bank wants to avoid a recession, it needs to reduce the real interest rate for investments. It can do this through an autonomous easing of policy by reducing ̅ , which reduces the real policy interest rate r. This will help offset the negative effects of the financial frictions and shift the AD curve back to the right. Alternatively, as discussed in the upcoming Chapter 23, the central bank can pursue policies to directly reduce financial frictions by providing liquidity to key credit markets. This reduces financial frictions at the source and allows the policy real interest rate to remain the same, while directly reducing the real interest rate for investments and lowering credit spreads.

18. f f, f

ANSWERS TO APPLIED PROBLEMS 19. Your employer has calculated that the monetary policy curve in your country is r = 2.0 − 0.5. a. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%.

When the inflation rates are 2%, 3%, and 4%, the real interest rates are 1%, 0.5%, and 0%, respectively. b. Do you think the monetary policy curve calculated by your boss is downward or upward sloping?

The curve is downward sloping. c. Do you think the monetary policy equation calculated by your boss is correct?

No, the equation is incorrect, because the curve should be upward sloping.

d. After you talk with him, he says he made a small mistake and the curve is actually: r = 2.0 + 0.5. Calculate the real interest rate when the inflation rate is 2%, 3%, and 4%.

When the inflation rates are 2%, 3%, and 4%, the real interest rates are 3%, 3.5%, and 4%, respectively.

20. on your answer to part d of Problem 19, draw the MP curve r 4% 3.

5 3%

MP

π 2% 3% 21. Suppose the monetary policy curve is given by r = 1.5 + 0.75, and the IS curve is given by Y = 13 − r. a. Calculate an expression for the aggregate demand curve.

Y = 11.5 – 0.75. b. Calculate the real interest rate and aggregate output when the inflation rate is 2%, 3%, and 4%.

When the inflation rate is 2%, 3%, and 4%, the real interest rate is 3%, 3.75%, and 4.5%, respectively. Aggregate output is 10, 9.25, and 8.5, respectively. c. Draw graphs of the IS, MP, and AD curves, labeling the points from part (b) on the appropriate graphs.

Graphs are given below.

22. Consider an economy described by the following: ̅

= $4 trillion

̅

= $1.5 trillion

̅

= $3.0 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=0

mpc

= 0.8

d

= 0.35

x

= 0.15



= 0.5

r

=2

a. Derive expressions for the MP curve and the AD curve.



b. Calculate the real interest rate and aggregate output when  = 2 and  = 4.

 c. Draw a graph of the MP curve and the AD curve, labeling the points given in part (b).

23. Consider an economy described by the following: ̅

= $3.25 trillion

̅

= $1.3 trillion

̅

= $3.5 trillion

̅

= $3.0 trillion

̅​̅​̅​̅​̅

= $1.0 trillion

̅

=1

mpc

= 0.75

d

= 0.3

x

= 0.1



=1

r

=1

a.

 b. 

c. r r r d. r r.

24. a.

 b.  c. d.

25. that the MP curve of Argentina is given by r = 1 + 0.5 , the IS curve by Y = 10 – r. a. for the AD curveAD curve: Y = 9 − 0.5 b. Suppose that the MP curve of Chile is given by r = 2 + , the IS curve by Y = 20 – 4r.

AD curve: Y = 8 − 4 c. Based on your answers in parts (a) and (b), which central bank do you think is more averse to inflation?

The more a central bank cares about inflation, the higher the λ will be. Therefore, the bank of Chile is more averse to inflation

ANSWERS TO DATA ANALYSIS PROBLEMS 1. A measure of real interest rates can be approximated by the Treasury InflationIndexed Security, or TIIS. Go to the St. Louis Federal Reserve FRED database and find data on the five-year TIIS (FII5) and the personal consumption expenditure price index (PCECTPI), a measure of the price index. Choose ―Quarterly‖ for the frequency setting of the TIIS, and download both data series. Convert the price index data to annualized inflation rates by taking the quarter-to-quarter percent change in the price index and multiplying it by 4. Be sure to multiply by 100 so that your results are percentages. a. Calculate the average inflation rate and the average real interest rate over the most recent four quarters of data available, and the four quarters prior to that.

For the period of 2019:Q3 to 2020:Q2, average inflation was 0.58%, and the average real interest rate was –0.09%. For 2018:Q3 to 2019:Q2, inflation averaged 1.51% and the real interest rate averaged 0.76%.

b. Calculate the change in the average inflation rate between the most recent annual period and the year prior. Then calculate the change in the average real interest rate over the same period.

The change in average inflation was 0.58 – 1.51 = –0.94%. The change in average real interest rate was –0.09% – 0.76% = –0.85%. c. Using your answers to part (b), compute the ratio of the change in the average real interest rate to the change in the average inflation rate. What does this ratio represent? Comment on how it relates to the Taylor principle.

The ratio equals –0.94%/–0.85% = 1.11. This is an estimate of the coefficient λ, which represents the slope of the MP curve. Since λ = 1.11 is positive, this means that according to this data, monetary policy over the last couple years has adhered to the Taylor Principle.

2. A measure of real interest rates can be approximated by the Treasury InflationIndexed Security, or TIIS. Go to the St. Louis Federal Reserve FRED database and find data on the five-year TIIS (FII5) and the personal consumption expenditure price index (PCECTPI), a measure of the price index. Choose ―Quarterly‖ for the frequency setting for the TIIS, and choose ―Percent Change From Year Ago‖ for the units setting on (PCECTPI). Plot both series on the same graph, using data from 2007 through the most current data available. Use the graph to identify periods of autonomous monetary policy changes. Briefly explain your reasoning.

See the graphs below. Periods of autonomous monetary policy change are characterized by a decoupling of real rates and inflation rates. From the middle of 2007 to late 2008, inflation increased, while the real interest rate fell, indicating an autonomous easing of policy. The period from late 2008 through mid-2009 was consistent with a move along the MP curve, where policy was reacting to variation in inflation. From mid-2009 through mid-2011, inflation rose steadily, while the real interest rate continued to decline, suggesting autonomous easing of policy. From mid2011 to early 2013, both inflation and the real interest rate fell, again suggesting a movement along the MP curve as policy reacted to changes in inflation. From 2015 to 2019, inflation and the real interest rate largely moved together, indicating a movement along the MP curve. Through much of 2019, real interest rates declined while inflation increased modestly, indicating some autonomous easing during that period of time. By early 2020, both inflation and real interest rates were falling significantly, representing a movement along the MP curve.

-1.00

-2.00

2007-01-01 2007-10-01 2008-07-01 2009-04-01 2010-01-01 2010-10-01 2011-07-01 2012-04-01 2013-01-01 2013-10-01 2014-07-01 2015-04-01 2016-01-01 2016-10-01 2017-07-01 2018-04-01 2019-01-01 2019-10-01

Rate

Real Interest Rate and Inflation

4.00

3.00

2.00

1.00 Real Interest Rate

Inflation

0.00

Chapter 23 ANSWERS TO QUESTIONS 1. Explain why the aggregate demand curve slopes downward and the short-run aggregate supply curve slopes upward.

A rise in inflation causes monetary policymakers to raise the real interest rate. This reduces planned expenditures and lowers the level of output necessary for goods market equilibrium. The opposite occurs if inflation falls. Therefore, goods market equilibrium will occur at lower levels of output when the inflation rate rises and at higher levels of output when inflation falls. The downward slope of the aggregate demand curve reflects this. The short-run aggregate supply curve slopes upward to reflect the increase in the inflation rate that occurs when the economy’s aggregate output of goods and services exceeds the potential output level in the short run and the decrease in inflation that occurs when output is below potential output.

2. During the COVID-19 pandemic, most European governments increased government purchases and lowered some consumption taxes after the ECB increased monetary stimulus. What do you think the effect on the demand curve will be?

All these actions increase aggregate demand, shifting the curve to the right.

3. "The appreciation of the euro during 2020 had a negative effect on aggregate demand in the European Union." Is this statement true, false, or uncertain? Explain your answer.

The statement is correct. An appreciation of the Euro makes European exports more expensive for foreign consumers. At the same time, it makes imports into the EU cheaper. As a result, exports decrease, imports increase, and net exports decrease.

According to the aggregate demand and supply analysis, the aggregate demand curve shifts to the left.

4. What determines the unemployment rate at the natural rate of output?

The natural rate of output, also referred to as potential output, is considered the full employment level of output. The unemployment rate at potential output is not zero, since structural and frictional unemployment exists. Therefore, the factors that determine structural and frictional unemployment determine the natural rate of unemployment, which is also the unemployment rate that occurs when the economy is at potential.

5. If the labor force becomes more productive over time, how would the long-run aggregate supply curve be affected?

As labor productivity grows, the long-run aggregate supply curve shifts to the right.

This is because the existing labor force, along with a given amount of capital and other resources, can produce more output, indicating a greater amount of potential output.

6. Why are central banks so concerned with inflation expectations?

When inflation expectations rise, it shifts the short-run aggregate supply curve up, leading to higher actual inflation in the short run in addition to any inflationary effects

that may occur, for instance through negative price shocks. This illustrates the danger when inflation expectations become ―unanchored‖ from a low level, in that it is more difficult for the central bank to then stabilize inflation, particularly when a temporary inflation shock leads to higher expected inflation.

7. ―A supply shock affects the output gap and inflation both in the short and long run.‖ Is this statement true or false? Explain.

False. A supply shock only affects the output gap and inflation only in the short run, but not in the long run.

8. What factors shift the short-run aggregate supply curve? Do any of these factors shift the long-run aggregate supply curve? Why? Shifts in the short-run aggregate supply curve result from changes in expected inflation, price shocks, and persistent output gaps. None of these factors shift the longrun aggregate supply curve because price and wage flexibility ensures that in the long run the economy produces at its potential output level. Potential output depends not on actual or expected inflation but rather on the capital, labor, and technology available for producing goods and services. However, a change in potential output shifts the long-run aggregate supply curve and also the short-run aggregate supply curve because it changes the output gap at any given level of actual output.

9. If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the short-run aggregate supply curve when budget deficits rise?

The short-run aggregate supply curve will shift upward because wages and production costs rise, since workers and firms expect prices to be higher.

10. Internet sites that enable people to post their resumes online reduce the cost of job searches. How do you think the Internet has affected the natural rate of unemployment?

The Internet has reduced the amount of time and money spent looking for a job. It also has allowed for an increased flow of information between potential employees and employers (such as job descriptions, resumes, and other valuable information which are usually available online). This has resulted in a decrease in the natural rate of unemployment, as unemployed workers are matched with employment opportunities quicker.

11. When aggregate output is below the natural rate of output, what happens to the inflation rate over time if the aggregate demand curve remains unchanged? Why? When output is less than potential output, unemployment is above the natural rate and labor market slack causes wages to rise less rapidly. As the Phillips curve suggests, this causes firms to raise their prices less rapidly and thus decreases the inflation rate.

As a result, expected inflation will be lower in the following time period and the short-run aggregate supply curve will shift downward. This adjustment process in which inflation and expected inflation fall and the short-run aggregate supply curve shifts downward continues over time until output increases to the potential output level, the output gap increases to zero, and the economy reaches long-run equilibrium.

12. The ECB is adjusting its program and objective wording to increase public belief that inflation will rise from 1% to 2% in the future. Suppose the public has higher expectations of future inflation. What will happen to aggregate output and the inflation rate in the short run?

The inflation rate will be higher than it otherwise would be, and aggregate output will be lower. The higher expected inflation will cause the short-run aggregate supply curve to shift up, so that the intersection of the short-run aggregate supply curve with the aggregate demand curve will be at a lower level of output and a higher inflation rate.

13. If the unemployment rate in Spain is above the natural rate of unemployment, holding other factors constant, what will happen to inflation and output?

When the unemployment rate is above the natural rate of unemployment, there is slack in the labor market and output is below potential. This causes the short-run aggregate supply curve to shift downward, leading to lower inflation and higher output over time, until the Spanish economy reaches a long-run equilibrium.

14. What happens to inflation and output in the short run and in the long run when taxes decrease?

A decrease in taxes will lead to a rightward shift of the aggregate demand curve. In the short run, inflation and output will both rise. This leads to tightness in the labor market, which raises inflation expectations and shifts the short-run aggregate supply curve up; as this occurs, the economy moves to a new long-run equilibrium, output falls back to potential, and inflation increases.

15. If stagflation is bad (high inflation and high unemployment), does this necessarily mean low inflation and low unemployment is good?

Not necessarily. Even though low unemployment is desirable, if unemployment is too low relative to the natural rate of unemployment, future inflation risk could build even if the current inflation rate remains relatively low. In addition, as discussed in Chapter 16, having too low of an inflation rate could mean that an adverse shock could result in the conventional policy instrument hitting the effective lower bound and inflation turning negative, potentially triggering a deflationary episode which can be particularly damaging.

16. Are there any ―good‖ supply shocks?

Any type of positive supply shock (particularly permanent positive supply shocks) can be considered to be ―good‖, since it helps reduce both unemployment and inflation in the long run.

17. In what ways is the Volcker disinflation considered a success? In what ways is it considered a failure?

The Volcker disinflation is considered a success in that the Chair of the Federal Reserve, Paul Volcker, was finally able to bring inflation down to a permanently lower, stable level after a decade of high and volatile inflation through most of the 1970s. Unfortunately, the policies to get the economy on a path of low, stable longterm inflation required significantly contractionary policies. These policies resulted in

two recessions in the early 1980s, with unemployment rising above 12% at its peak.

So although the policies to reduce inflation from the high levels of the 1970s achieved their purpose, they did not come without some costs.

ANSWERS TO APPLIED PROBLEMS 18. Suppose the president gets Congress to pass legislation that encourages investment in research and the development of new technologies. Assuming this policy leads to a positive productivity change for the U.S. economy, use aggregate demand and supply analysis to predict the effects on inflation and output. Demonstrate these effects on a graph.

Technological change and infrastructure improvements affect the long-run aggregate supply curve. More fuel-efficient cars result in a decrease in the demand for gas at the same time that innovations in energy production make it possible to increase the supply of energy at any price level. Innovations in these fields result in a shift to the right in both the short- and long-run supply curves. Improvements in infrastructure make transportation of goods to market more efficient, and raise productivity in a variety of ways. In conclusion, inflation decreases and output increases in the long run.

19. Proposals advocating the implementation of a national sales tax have been presented before Congress. Predict the effects of such a tax on the aggregate supply and demand curves, showing the effects on output and inflation. Use a graph of aggregate supply and demand to demonstrate these effects.

Because goods would cost more, the national sales tax would raise production costs, and the short-run aggregate supply curve would shift to the left. The intersection of the short-run aggregate supply curve with the aggregate demand curve would then be at a higher inflation rate and a lower level of the aggregate output index; aggregate output would fall, and the inflation rate would rise.

20. Using the aggregate demand-aggregate supply model, explain and demonstrate graphically: a. Financial frictions increase.

In the short run. both inflation rate and real output increase. In the long run, wages adjust, decreasing short-run aggregate supply, to AS', raising prices further and reducing real output until the economy returns to the natural level of output. b. The long-run effects of an increase in the money supply.

The long-run result is to only increase inflation. The path is from 1 to 2 to 3.

See the following figure.

An increase in the money supply increases aggregate demand, from AD to AD'. The economy moves from point 1 to point 2.

21. Classify each of the following as a supply shock or a demand shock. Use a graph to

show the effects on inflation and output in the short run and in the long run. a. Financial frictions increase.

Negative demand shock. An increase in financial frictions reduces aggregate demand. The aggregate output index and inflation fall in the short run; in the long run, the aggregate output index rises back to potential, and inflation falls.

b. Households and firms become more optimistic about the economy.

This increases autonomous consumption and investment, which increases aggregate demand. The aggregate output index and inflation increase in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases.

c. Favorable weather produces a record crop of wheat and corn in the Midwest.

This shifts the short-run aggregate supply curve to the right (down). The aggregate output index increases and inflation decreases in the short run; in the long run, the aggregate output index falls back to potential, and inflation increases, returning to

the original level.

d. Auto workers go on strike for four months.

This shifts the short-run aggregate supply curve to the left (up). The aggregate output index decreases and inflation increases in the short run; in the long run, the aggregate output index increases back to potential, and inflation decreases, returning to the original level.

22. During 2017, some Fed officials discussed the possibility of increasing interest rates as a way of fighting potential increases in expected inflation. If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve? Use an aggregate demand and supply graph to illustrate your answer.

If the public assumes that the current Fed officials are not that worried about inflation, expected inflation will increase, shifting the short-run aggregate supply curve upward and to the left (as shown in the graph below). During 2017, Fed officials were in the difficult position of worrying when they might have to increase interest rates to fight inflation as the economy was largely recovered, but inflation remained low. Increasing interest rates too late could fuel expectations about higher inflation, while increasing interest rates too soon will slow down the recovery or even send the economy back into recession. It is quite difficult to make this decision, which is why most of the time the conduct of monetary policy is more an art than a science.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database, and find data on real GDP (GDPC1), potential GDP (GDPPOT), and the unemployment rate (UNRATE) from 1960 to the most recent period. For the unemployment rate data, convert the frequency to Quarterly. Download all of the data into a spreadsheet, and calculate the output gap and aggregate output index for each quarter. a. In which quarter is the output gap the most negative? What is the Aggregate Output Index for that quarter?

From the period of 1960 through the second quarter of 2020, the most negative output gap occurred during Q2 2020. During this quarter, the output gap was – 9.9%, or an AOI of 90.1. b. In which quarter is the unemployment rate highest?

The highest unemployment rate during this period occurred in Q2 2020, at 13.0%. c. Are these periods of time close to each other? What does this tell you about the relationship between output gaps and the unemployment rate?

Yes, since 1960, both the highest unemployment rate and most negative output gap coincide at the same time

in Q2 2020. This indicates that higher unemployment rates are consistent with more negative output gaps, and vice versa.

2. Go to the St. Louis Federal Reserve FRED database and find data on real government spending (GCEC1), real GDP (GDPC1), taxes (W006RC-1Q027SBEA), and the personal consumption expenditure price index (PCECTPI), a measure of the price level. Download all of the data into a spreadsheet, and convert the tax data series into real taxes. To do this, for each quarter, divide taxes by the price index and then multiply by 100. a. Calculate the level change in real GDP over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. b. Calculate the level change in real government spending and real taxes over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. c. Are your results consistent with what you would expect? How do your answers to part (b) help explain, if at all, your answer to part (a)? Explain using the IS and AD curves.

No, this is not entirely consistent with what would be expected for tax and spending changes. Over the most recent year period of 2019:Q1 to 2020:Q1, a mixed fiscal policy change took place with government spending increasing, while taxes decreased. With government spending much higher than taxes, you would expect this should increase output by shifting both the IS and AD curves to the right, which appears to be the case since output rose over that period. In the period from 2018:Q1 to 2019:Q1 the results are similar, but the magnitude of changes is reversed: government spending increases modestly, while tax receipts increases much more. In this case, you might expect the IS and AD curves to shift to the left and decrease output given the magnitude effects, however, output actually went up anyway. Clearly, there are other factors in the economy that are offsetting the contractionary tax effects to increase GDP overall in the economy.

Gov’t Spending Chg., $Bil.

Real Tax Chg., $Bil.

Real GDP Chg., $Bil.

2019:Q1 to 2020:Q1



9.3

60.5

2018:Q1 to 2019:Q1

55.7



419.9

3. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), a measure of the price level; real compensation per hour (COMPRNFB); the nonfarm business sector real output per hour (OPHNFB), a measure of worker productivity; the price of a barrel of oil (MCOILWTICO); and the University of Michigan survey of inflation expectations (MICH). Use the frequency setting to convert the oil price and inflation expectations data series to ―Quarterly,‖ and use the units setting to convert the price index to ―Percent Change from Year Ago.‖ Download all of the data into a spreadsheet, and convert the compensation and productivity measures to a single indicator. To do this, for each quarter, take the compensation number and subtract the productivity number. Call this difference ―Net Wages Above Productivity.‖ d. Calculate the change in the inflation rate over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. e. Calculate the changes in net wages above productivity, the price of oil, and inflation expectations over the four most recent quarters of data available, and the four quarters prior to that.

See summary table below. f. Are your results consistent with what you would expect? How do your answers to part (b) help explain, if at all, your answer to part (a)? Explain using the shortrun aggregate supply curve.

The data from part (b) move in somewhat different directions, so it is difficult to explain the inflation behavior consistent with what would be expected to explain part (a). In the most recent period, inflation expectations, oil prices, and net wages all decreased (which would shift the AS curve down). Despite this, inflation increased slightly during that time. In the previous period, the results are more consistent: inflation expectations fell slightly, oil prices declined, and net wages were flat. In this backdrop, inflation decreased modestly, and is consistent with a shift downward of the AS curve.

Inflation Chg.

Inflation Exp. Chg.

Oil Price Chg., $/Brl.

Net Wages Chg.

2019:Q1 to 2020:Q1

0.2

0.2

9.1

0.2

2018:Q1 to 2019:Q1

0.5

0.1

8.1

0.0

Chapter 24 ANSWERS TO QUESTIONS 1. You hear an analyst from Natixis say that the inflation gap is negative. What does it mean?

When the inflation gap is negative, this means that the current inflation rate is less than the target inflation rate.

2. How can the central bank eliminate both the output gap and inflation gap in the short run?

The central bank does this by autonomously easing monetary policy by cutting real interest rates at any given inflation rate.

3. For each of the following shocks, describe how monetary policymakers would respond (if at all) to stabilize economic activity. Assume the economy starts at a longrun equilibrium. a. Consumers in China 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 in Australia.

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 in Pakistan.

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 in Italy.

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 in the Eurozone.

An appreciation of the domestic currency leads to lower exports and higher imports, which reduces net exports and aggregate demand, so monetary policymakers would pursue an autonomous easing of monetary policy to stabilize economic activity.

4. During the global financial crisis, how was the Fed able to help offset the sharp increase in financial frictions without the option of lowering interest rates further?

Did the Fed’s plan work?

The Fed lowered the fed funds rate to zero during the crisis to offset falling aggregate demand; however, this was insufficient to stabilize aggregate demand and output. As a result, the Fed resorted to nonconventional monetary policy to help offset the financial frictions. This involved liquidity provision and asset purchases, which helped to lower medium and longer-term interest rates, and helped to increase

aggregate demand, despite having reached the effective lower bound on the federal funds rate. However, due to the severity of the crisis, these policies were insufficient to fully stabilize economic activity and bring output to potential.

5. Why does the divine coincidence simplify the job of policymakers?

The divine coincidence exists when policies that are appropriate to achieve price stability also stabilize economic activity. In this case, policymakers have easier jobs because there is no tradeoff between policy objectives and that they do not have to choose between them. They can, in other words, have their cake and eat it, too. The divine coincidence occurs when the economy is beset with aggregate demand shocks, but not when it experiences supply shocks. When faced with a demand shock, policymakers can stabilize both inflation and economic activity by enacting policies to shift the economy’s aggregate demand curve and return to long-run equilibrium at potential output. In the case of a supply shock, however, policies that shift the aggregate demand curve to achieve inflation stability will move the economy further away from potential output and those aimed at stabilizing economic activity at potential output will cause the inflation rate to move further away from the target rate.

6. Why do negative supply shocks pose a dilemma for policymakers?

With negative supply shocks, both inflation and the unemployment rate increase. In order to reduce the unemployment rate, an expansionary policy must be pursued, which further increases inflation. On the other hand, pursuing a policy to reduce the inflation rate requires a contractionary policy, which further increases the unemployment rate. Thus, with negative supply shocks stabilization policy requires a tradeoff between achieving the objectives of inflation stabilization and stabilization of real economic activity.

7. Suppose three economies are hit with the same negative supply shock. In country A, inflation initially rises and output falls; then inflation rises more and output increases. In country B, inflation initially rises and output falls; then both inflation and output fall. In country C, inflation initially rises and output falls; then inflation falls and output eventually increases. What type of stabilization approach did each country take?

In country A, policymakers chose a policy to stabilize output. In country B, policymakers chose a policy to stabilize inflation. In country C, policymakers chose no policy response, that is, left autonomous monetary policy unchanged.

8. Suppose three economies are hit differently from the coronavirus pandemic, but with the same negative supply shock during 2020. In Chile, inflation initially rises and output falls; then inflation rises more and output increases. In Paraguay, inflation initially rises and output falls, then both inflation and output fall. In Colombia, inflation initially rises and output falls; then inflation falls, and output eventually increases. What type of stabilization approach did each country take?

In Chile, policymakers chose a policy to stabilize output. In Paraguay, policymakers chose a policy to stabilize inflation. In Colombia, policymakers chose no policy response, i.e., left autonomous monetary policy unchanged.

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. In Europe, many analysts criticized the deadlock in the EU parliament to approve the Pan-European Guarantee Fund to tackle the economic consequences of the COVID19 pandemic. What type of policy lag does this describe?

This refers to the legislative lag (of fiscal policy).

12. ―If the data and recognition lags could be reduced, activist policy probably would be more beneficial to the economy.‖ Is this statement true, false, or uncertain? Explain your answer.

True. If the first parts of the statement could be achieved, the objection to activist policy would no longer be as serious. For instance, in response to aggregate demand shocks, the aggregate demand curve could be more quickly shifted to potential output, resulting in less variation in both inflation and output, and making an activist policy more desirable.

13. If the economy’s self-correcting mechanism works slowly, should the government necessarily pursue discretionary policy to eliminate unemployment? Why or why not?

Not necessarily, because an activist policy to eliminate unemployment could lead to the demand-pull and cost-push inflations depicted in Figure 7 and Figure 8 in the chapter. In addition, the activist policy might lead to a higher probability that workers will push up their wages, which results in episodes of high unemployment.

14. Why do activists believe that the economy’s self-correcting mechanism works slowly?

Activists argue that wages are inflexible, and that they are not likely to fall as would be needed for the self-correcting mechanism to adjust to a long-run equilibrium if the economy suffers from low output and high unemployment. Wages and prices may be prevented from changing by existing contractual agreements, for example, those between employers and workers. Expected inflation may be slow to adjust, which will delay the upward or downward shifts of the short-run aggregate supply curve that are part of the self-correcting mechanism.

15. You just read in an economics blog that the Japanese Yen is appreciating beyond its intrinsic value. How are policymakers likely to respond if this is true?

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.

16. Suppose one could measure the welfare gains derived from eliminating output (and unemployment) fluctuations in the economy. Assuming these gains are relatively small for the average individual, how do you think this measurement would affect the activist/nonactivist debate?

Evidence showing that the welfare gains from stabilizing output and unemployment are relatively small supports the nonactivist case. This is actually a major topic in macroeconomics, which was addressed by the Nobel Prize-winning economist Robert Lucas. Lucas developed a theoretical model meant to represent the U.S. economy after World War II and used to measure how well off the average individual would be if the government followed a stabilization policy agenda. He concluded that there is only a tiny increase in the well-being of the average individual resulting from stabilization policy. On the contrary, monetary and fiscal policies focused on the long run resulted in much bigger welfare gains for the average individual, making them a better option over stabilization policy.

17. ―The existence of long policy lags makes activism a very efficient way of adjusting the economy‖. Is the statement correct?

The statement is incorrect. Long policy lags decrease the case for activism.

18. How can monetary authorities target any inflation rate they wish?

Monetary policymakers can target any inflation rate they want to simply by implementing autonomous monetary policy easing (to target a higher inflation rate) or tightening (to target a lower one). However, although they can exert this control over inflation in the long run, they have no control over real interest rates or potential output in the long run, so the classical dichotomy and monetary neutrality hold just as they do in the classical framework.

19. What will happen if policymakers erroneously believe that the natural rate of unemployment is 7% when it is actually 5% and therefore pursue stabilization policy?

If policymakers believe that the natural rate of unemployment is 7% when it is actually 5%, then once the unemployment rate begins to drop below 7%, they are likely to pursue contractionary policy to avoid a perceived potential demand-pull inflation problem. In actuality, this would represent a situation where policymakers are contracting the economy when it is already in recession. The result of these policies is that this could create a downward spiral in inflation, which could lead to deflation and a severe economic downturn.

20. How can demand-pull inflation lead to cost-push inflation?

When inflation increases due to demand-side conditions, this could prompt workers to demand higher wages (which are greater than the growth in labor productivity) in anticipation of future higher inflation. This results in the aggregate supply curve shifting upward, and creating cost-push inflation (which was initiated by a demandpull inflation source).

21. How does the policy rate hitting a floor a little below zero lead to an upward sloping aggregate demand curve?

When the effective lower bound is hit, a lower inflation rate leads to a higher real

interest rate because the nominal interest rate is fixed at zero, and this higher real interest rate then causes planned expenditure and therefore aggregate output to decline. The fall in aggregate output as inflation falls, then results in an upward sloping aggregate demand curve.

22. Why does the self-correcting mechanism stop working when the policy rate hits the effective lower bound?

Because a negative output gap, which leads to a fall in the short-run aggregate supply curve, which lowers inflation, which then causes aggregate output to fall along the lines outlined in the answer to question 13, then leads to an even more negative output gap. The result is then a downward spiral where inflation keeps falling and output does as well, so the self-correcting mechanism is not operational.

23. In what ways can nonconventional monetary policy affect the real interest rate for investments when the economy reaches the effective lower bound? How are credit spreads affected?

There are a number of ways the central bank can reduce the real interest rate for investments at the effective lower bound. By providing liquidity to key credit markets, the central bank can directly reduce financial frictions, which lowers the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The second way is by purchasing private assets. This has the effect of reducing financial frictions in specific asset classes, and therefore reducing the real interest rate for investments in those markets (Mortgage-Backed Securities and the housing market, for instance). The result of this is to lower the real interest rate for investments at any given safe policy interest rate. In this case, credit spreads are reduced directly as financial frictions are reduced. The central bank can also purchase long-term government securities, which directly lowers the longer-term real interest rate at any given level of financial frictions. This results in a decline in the real interest rate for investments, but does not affect (at least directly) financial frictions or credit spreads. Finally, through forward guidance, information about the future path of policy can lower longer-term real interest rates, thereby lowering the real interest rate for investments.

ANSWERS TO APPLIED PROBLEMS 24. What nonconventional monetary policies shift the aggregate demand curve, and how do they work?

All nonconventional policies work by lowering the interest rate for investments and so stimulate investment spending and shift the aggregate demand curve to the right.

Liquidity provisions help heal impaired financial markets, thereby lowering financial frictions and consequently the real interest rate for investments. Asset purchases of private securities raise the price of these securities, thereby lowering the credit spread and the real interest rate for investments. Asset purchases of long-term bonds raises the price of these bonds and therefore lowers long-term interest rates, which lowers the real interest rate for investments. The management of expectations by committing to keep interest rates low for a long period of time again lowers long-term interest rates, which lowers the real rate for investments.

25. Suppose the current Italian administration decides to decrease government expenditures as a means of cutting the existing government budget deficit. a. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.

According to the aggregate demand and supply analysis, the decrease in government expenditure results in a shift to the left in the aggregate demand curve, as aggregate expenditure decreases at every inflation rate. As a result, the new intersection point with the short-run aggregate supply curve determines a lower inflation rate and output level 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 output level if the European Central Bank decides to stabilize the inflation.

If the ECB 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 πT and the output is at potential output 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.

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 2011, as the Eurozone economy was coming from a low growth and inflation environment and the risk of a breakup in the Eurozone being discussed from many analysts, the ECB proactively lowered the deposit rate from 0.75% in late 2011 to 0% by mid-2012. In addition, the ECB committed to keeping the deposit rate at this level for a considerable period. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary. a. How might fears of a zero 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 zero lower bound. At that point, conventional monetary policy would be ineffective. Policymakers viewed the risk of economic damage in the event of a deflationary spiral to be significant enough to overcome any potential inflation risk in implementing the policy. Thus, policymakers chose to err on the side of attempting to eliminate the deflationary threat. b. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.

With the economy starting out at point A, an adverse shock would push the economy into a destabilizing deflation. An autonomous easing of policy would shift the MP curve down, and in the short-run the economy would end up at point B. Note that even though the economy is not at a long-run equilibrium, at that point, the self-correcting mechanism can move the economy to a stable long-run equilibrium since the ZLB inflection point lies to the right of the LRAS curve.

28. Suppose that f is determined by two factors: financial panic and asset purchases. a. Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the effective lower bound and into a destabilizing deflationary spiral.

A financial panic will increase f , thus raising the real interest rate on investments at any given inflation rate. A sufficiently large panic will push the economy to point B, where the self-correcting mechanism will lower inflation, and real rates will rise since the economy is beyond the ELB. This results in a deflationary spiral in which the economy will move toward (and past) a point such as point C.

b. Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases can reverse the effects of the financial panic depicted in part (a).

A sufficient enough asset purchase will lower f , reversing the effects of the panic, and lower the real interest rate on investments at any given inflation rate.

This moves the economy from point A, to a point such as point B, where the economy is no longer at risk of a deflationary spiral. At point B, the selfcorrecting mechanism can move the economy to a stable long-run equilibrium since the ELB inflection point lies to the right of the LRAS curve along that AD curve.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. On January 24, 2020, the Federal Reserve released its amended statement on longerrun goals and monetary policy strategy. It stated: ―The Committee reaffirms its judgment that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.‖ and that ―the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.4%.‖ Assume this statement implies that the natural rate of unemployment is believed to be 4.4%. Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), real GDP (GDPC1), and real potential gross domestic product (GDPPOT), an estimate of potential GDP. For the price index, adjust the units setting to ―Percent Change From Year Ago.‖ For the unemployment rate, adjust the frequency setting to ‟Quarterly.‖ Download the data into a spreadsheet.

a. For the most recent four quarters of data available, calculate the average inflation gap using the 2% target referenced by the Fed. Calculate this value as the average of the inflation gaps over the four quarters. b. For the most recent four quarters of data available, calculate the average output gap using the GDP measure and the potential GDP estimate. Calculate the gap as the percentage deviation of output from the potential level of output. Calculate the average value over the most recent four quarters of data available. c. For the most recent four quarters of data available, calculate the average unemployment gap, using 4.4% as the presumed natural rate of unemployment. Based on your answers to parts (a) through (c), does the divine coincidence apply to the current economic situation?

Why or why not? What does your answer imply about the sources of shocks that have impacted the current economy? Briefly explain. a. From 2019:Q3: 2020:Q2, the average inflation gap was –0.7%. b. From 2019:Q3: 2020:Q2, the average output gap was –2.2% c. From 2019:Q3: 2020:Q2, the average unemployment gap was 1.6%. Yes, the divine coincidence applies based on the current data. Expansionary policy would close a negative inflation gap, a positive unemployment gap, and a negative output gap. Given that the divine coincidence applies and based on the data, the economy would seem to be characterized by somewhat weak demand-side conditions over the period of 2019:Q3: 2020:Q2.

2. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI), the unemployment rate (UNRATE), and an estimate of the natural rate of unemployment (NROU). For the price index, adjust the units setting to ―Percent Change From Year Ago.‖ For the unemployment rate, adjust the frequency setting to ‟Quarterly.‖ Select the data from 2000 through the most current data available, download the data, and plot all three variables on the same graph. Using your graph, identify periods of demand-pull or cost-push movements in the inflation rate. Briefly explain your reasoning.

See the graphs below. The period from around early 2001 to around the end of 2003 appears to be influenced by demand-pull inflation conditions, since inflation is a bit lower than what appears to be normal at the time (2.5%), and the unemployment rate rises and remains above the estimated natural rate during this time. For a brief time from the middle of 2007 to the middle of 2008, the economy appears to be hit by a cost-push inflation episode, since the inflation rate spikes, and the unemployment rate rises above the natural rate of unemployment. From the middle of 2008 to about early 2014, inflation remains mostly at or below the 2% target, while the unemployment rate is well above the natural rate, suggesting that demand-pull forces are at work.

From 2015 to 2019, inflation generally increased, while

unemployment declined, indicating demand-pull factors. In late 2019 into 2020 with the coronavirus pandemic resulting in an economic lockdown, inflation fell and the unemployment rate spiked, indicative of severe adverse demand-pull conditions.

Inflation and Unemployment 14.0

Unemployment Rate

12.0 10.0

Natural rate of Unemployment Unemployment Gap

6.0 4.0

2% Inflation Target

2.0 PCE Inflation Rate 2019-11-01

2018-09-01

2017-07-01

2016-05-01

2015-03-01

2014-01-01

2012-11-01

2011-09-01

2010-07-01

2009-05-01

2008-03-01

2007-01-01

2005-11-01

2004-09-01

2003-07-01

-4.0

2002-05-01

-2.0

2001-03-01

0.0 2000-01-01

Rate

8.0

Inflation Gap

Chapter 25 ANSWERS TO QUESTIONS 1. What does the Lucas critique state about the limitations of our current understanding of the way in which the economy works?

The Lucas critique says that policymakers’ priors about the effects of a given policy will generally be wrong, since it is difficult for policymakers to accurately take into account the reaction by people to changes in policies. This points out the limitation to our understanding of how the economy works in that current research cannot fully explain and model accurately the behavior of individuals, and therefore policymakers have to rely on fundamentally flawed models to estimate the effects of policies on the economy.

2. The Lucas critique implies that a particular monetary policy doesn’t depend on the public expectations about the policy. Is this statement true or false?

False. Public expectation is critical for long-term rates. If the public believes an increase in interest rate is permanent, the response of the long-term rate is far greater.

3. Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate.

Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth. a. Discuss the implications of the econometric model’s predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

According to the rational expectation theory, individuals might interpret this increase in the federal funds rate target as a signal that the Fed will commit to fight inflation. The increase in the federal funds rate determines an increase in real interest rates in the short run and results in a higher user cost of capital. Although this might reduce investment, it is possible that individuals recognize the Fed’s intentions and therefore decide to increase investment in anticipation of a low inflation economic environment that encourages investment. b. What would be Lucas’s critique of this model?

Lucas’s critique will point out the fact that the model was probably constructed by using past data in which domestic investment decreased after interest rates increased. But that model does not take into consideration that individuals might revise their expectations quite quickly and might decide to alter the way in which they respond to changes in economic variables, like the interest rate.

4. Suppose that the public expects the ECB to pursue a policy that will probably lower the short-term interest rates to permanently −0.8%, but the ECB doesn't go through with this policy change, what will happen to long-term interest rates? Explain your answer.

The long-term interest rates will increase because the market had already priced in a decrease of interest rates.

5. In what sense can greater central bank independence make the time-inconsistency problem worse?

When central banks are more independent, there is less formal accountability by them to pursue stable inflation policies. In this sense, it is easier for central banks to give the appearance of desiring to pursue low inflation policies, while in actuality pursuing more expansionary policies to lower the unemployment rate and increase output. However, even with greater central bank independence, the time-inconsistency problem can be somewhat alleviated through greater transparency and communication, which means that there is less ability for the public to be fooled into false expectations, and therefore less ability for the central bank to pursue overly inflationary policies to increase output and lower unemployment in the short run.

6. Outline the benefits and costs of sticking to a set of rules in each of the following cases. How does each of these situations relate to the conduct of economic policies? a. Going on a diet The benefit of sticking to a set of rules when following a diet include reaching a given goal, probably defined in terms of a desired weight. The costs can be measured in terms of the lost opportunities to savor tasty food or desserts. In this case, costs are short lived, although it is quite easy to succumb to such temptations. This could be compared to a central bank pursuing an excessively expansionary policy to surprise market participants and temporarily decrease unemployment. Even if that pays off in the short run, it will most likely reduce the central bank’s credibility and make it more difficult to attain the long-run goal. b. Raising children The benefit of sticking to a set of rules in this case might be considered a little more controversial. Giving children a clear set of rules and making every possible effort to enforce them seems to have positive effects in the long run. However, this might be quite difficult, as many parents can confirm. Also, it might not be that clear that excessive rules have a positive effect on children. In any event, parents who decide to set up rules will eventually face the problem that giving in will decrease their reputation and compromise the credibility of future rules. The cost of following rules when raising children is that one cannot possibly think of all the situations that might arise in a child’s life, and it is therefore impossible to set a rule for everything. On top of that, enforcing every rule might create severe problems in the short run, as the lack of discretion might hurt the economy if fiscal policy is designed to follow strict rules (e.g., like forcing governments to balance their budget every year).

7. Francesco just learned that Lega Nord, an Italian political party, might win the elections in a surprise victory. The party has an inflationary policy in its political overview. What do you think might happen to the level of output and inflation even before the new administration comes to power?

The rise in expected inflation due to 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 as a result of the huge fiscal stimulus by the different governments to support the economies during the COVID-19 pandemic, the

high level of budget deficits may lead to inflationary monetary policies in the future.

Could these budget deficits have an effect on the current rate of inflation?

Yes, if budget deficits are expected to lead to an inflationary monetary policy and expectations about monetary policy affect the short-run aggregate supply curve. In this case, a large budget deficit would cause the short-run aggregate supply curve to shift upward because expected inflation would be higher. The result is that the increase in the current inflation rate would be higher.

9. In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

When a president has the authority to nominate or lay off the head of the central bank, it is quite plausible that the conduct of monetary policy would be discretionary.

Adherence to monetary policy rules involves imposing some hardship on the economy sometimes. If the president can pressure the head of the central bank, then most likely monetary policy will be discretionary and follow the dictates of the president or his/her political party. This is actually what happened in many South American countries in the 1970s and 1980s. Not surprisingly, most of these countries could not reach long-run goals such as price stability during this period. Also, frequent changes in monetary policy (and fiscal policy) resulted in increased output volatility and low growth. Although most central banks are still subject to pressure from politicians, it is widely understood that some independence is desirable.

10. How would an unexpected change in the equilibrium real fed funds rate be an argument against using a Taylor rule for monetary policy implementation?

One of the criticisms of using rules is that often times, once implemented, structural changes in the economy necessitate updating the rule regularly to reflect appropriate policy outcomes. However, in this case, if the equilibrium real fed funds rate changes and policymakers do not know it has changed, are uncertain of the magnitude or direction of change, or recognize the change but simply fail to update the policy rule, it is likely that monetary policy will be either too tight, or too loose relative to what it should be. As a result, rather than relying solely on a mechanical rule, policymakers may be better off using discretion which can much more flexibly account for these types of frequent and unexpected structural changes in the economy.

11. How is constrained discretion different from discretion in monetary policy? How are the outcomes of these policies likely to differ?

Constrained discretion is a more transparent and disciplined type of discretion in which the general objectives and tactics of the policymaker are committed to in advance. This allows for some flexibility in policy actions (as in a purely discretionary regime), but somewhat limits the ability of policymakers to pursue overly expansionary policies as

long as they are committed to the general objectives and tactics laid out. The difference in outcomes is that under constrained discretion, since policymakers are likely to have more credibility through commitment and transparency, inflation and inflation expectations are likely to be lower than under pure discretion, without giving up much flexibility to address changes in the real economy.

12. Why does a central bank’s independence and credibility affect its ability to pursue its objectives?

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 shortrun aggregate supply curve. This results in higher actual inflation and lower output, which is obviously less desirable an outcome than if the central bank were to have full credibility.

13. In Japan, the government and central bank have enacted policies recently to raise inflation permanently from persistently low levels, however inflation continues to remain near zero. How, if at all, might credibility of the central bank explain the low inflation persistence?

Normally, expansionary fiscal or monetary policies (especially when implemented together) should result in higher inflation and consequently raise inflation expectations to permanently higher levels. However, in the case of Japan since inflation has been near zero for many years, this has anchored inflation expectations near zero as well. More specifically, it has created a mindset among market participants and the public in Japan that even if the central bank or government acts, it may be less likely to be successful in raising inflation.

Because of the lack of credibility by the central bank in its efforts to raise inflation, this is reflected in permanently low inflation expectations, and low actual inflation.

14. As part of its response to the global financial crisis, the Fed lowered the federal funds rate target to nearly zero by December 2008 and quadrupled the monetary base between 2008 and 2014, a considerable easing of monetary policy. However, surveybased measures of five- to ten-year inflation expectations remained low throughout most of this period. Comment on the Fed’s credibility in fighting inflation.

This is a clear sign that the Fed enjoys a high level of credibility. This credibility was probably earned over the last three decades. Although the Fed never explicitly stated an inflation target until 2012, many people believe that Fed officials had an inflation target in their minds during this period. Even though it was not announced, this target was assumed to be above zero, and (here is where opinions differ) around 1.5% to 2.5% annual inflation rate. Even if the Fed had not announced an inflation target, and can therefore not be held accountable for missing it, it is quite clear that individuals believe that the Fed is and has been concerned about keeping inflation at low and stable levels. Finally, even more impressive is the fact that the monetary base

increased significantly as a consequence of the Fed’s actions to support the U.S. financial system, but this did not result in high expected inflation, either.

15. The more the president of the country tries to influence the central bank policies, the less credible the policies of the bank will become. Is this statement true or false?

Explain.

True. The more the president interferes (with objectives different than the central bank), the higher the probability of the central bank to lack credibility and faith by the public. 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 as an outcome than if the central bank were to have full credibility.

16. Why did the oil price shocks of the 1970s affect the economy differently than the oil price shocks of 2007?

As Figure 3 in the chapter demonstrates, the oil price shocks in the 1970s resulted in significantly higher inflation and unemployment as compared to the shock that affected the economy beginning in 2007. The main distinction between the two episodes is the role of policy credibility. In the case of the 1970s, the Federal Reserve’s commitment to keeping inflation low was weak, so the oil price shocks shifted the aggregate supply curve upward not only due to the shock itself, but also due to higher inflation expectations as a result of weak Fed credibility. In contrast, the Federal Reserve’s commitment to keep inflation low and stable in the last couple of decades has created strong Fed credibility. This kept inflation expectations from rising very much as a result of the 2007 shock, so the effects on actual inflation and the unemployment were more subdued than in the 1970s episodes.

17. Central banks that engage in inflation targeting usually announce the inflation target and time period for which that target will be relevant. In addition, central bank officials are held accountable for their actions (e.g., they could be fired if the target is not reached), and their success or lack thereof is also public information. Explain why transparency is such a fundamental ingredient of inflation targeting.

Announcements about the inflation targets and potential punishments for central bank officials are crucial for inflation targeting. It is very important for the public to be able to check whether the target has been reached or not. When central bank officials know that the public can easily check their performance, they have an extra incentive to do everything in their power to attain their goals, as their reputation is at stake.

Even if their reputation is not that important to them, they have an incentive to do their job, since they might be fired otherwise. When the central bank officials and the general public know ―the rules of the game,‖ there is a higher probability that monetary policy will be more credible. In conclusion, transparency could be a good ingredient in the conduct of any specific type of monetary policy. This was recognized by the Federal Reserve some time ago. Even if the Fed is not engaged in inflation targeting (or any monetary policy with an explicit nominal anchor), it recognized the need to communicate with the public its decisions about the federal funds rate target some years ago.

18. Suppose the statistical office of a country does a poor job in measuring inflation and reports an annualized inflation rate of 4% for a few months, while the true inflation rate has been around 2.5%. What will happen to the central bank’s credibility if it is engaged in inflation targeting and its target is 2%, plus or minus 0.5%?

The statistical office’s mistake will obviously hurt the central bank’s credibility and will mean that the inflation target was missed. Depending on the set of rules governing the central bank, some officers might be dismissed. When pursuing an inflation target, accurate inflation measurement is critical. It could technically happen that a couple of prices might artificially pull up the price index, therefore increasing inflation measures more than necessary. This is true for some important prices—like the price of oil and gas—in most industrialized countries. To avoid this problem, other price indices which do not consider the price of oil and gas are constructed. When evaluating the performance of the central bank engaged in inflation targeting, more than one price index is analyzed. In addition, effective and clear communication with the public and government authorities is crucial for everyone to understand the limits of these measures and the limits to the central bank’s actions. If this limitation is not properly understood, the central bank’s credibility will be hard to earn and maintain.

19. What are the purposes of inflation targeting, and how does this monetary policy strategy achieve them?

Inflation targeting has two basic purposes, to keep inflation under control and to increase the credibility of monetary policymakers’ commitment to price stability.

These are achieved by announcing a numerical target for inflation and a commitment to price stability as the primary long-run goal of monetary policy, increasing communications with the public and financial market participants about the goals and processes of monetary policy making, and holding policymakers accountable for achieving the inflation target that has been set.

20. How can the establishment of an exchange rate target bring credibility to a country with a poor record of inflation stabilization?

Tying its domestic currency to another country’s currency is an easy way for a country with a poor inflation record to establish credibility. This is because a formal exchange rate target provides a simple and clear rule for monetary policymakers to follow, which is easily verifiable. Thus, commitment to the exchange rate target significantly reduces the time-inconsistency problem by limiting discretionary policy.

Moreover, committing to an exchange rate target with a country that has a good record of low, stable inflation means that the domestic economy will import that low inflation environment, as long as it maintains its commitment to the target.

21. Would you characterize Murat Uysal, former president of the Central Bank of Turkey

who lowered interest rates on double digit inflation during 2019 and 2020, as 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. In the case of Uysal, with inflation in double digit levels, it was expected that he and the central bank would increase the interest rate. Uysal did the contrary, so he is certainly not a conservative central banker.

ANSWERS TO APPLIED PROBLEMS 22. Suppose the central bank is following a constant-money-growth-rate rule and the economy is hit with a severe economic downturn. Use an aggregate supply and demand graph to show the possible effects on the economy. How does this situation reflect on the credibility of the central bank if it maintains the money growth rule? How does it reflect on the central bank’s credibility if it abandons the money growth rule to respond to the downturn?

A severe downturn would result in the aggregate demand curve shifting sharply to the left to AD2 below. With a strict constant money growth rule, this would result in a limited expansionary effect on aggregate demand, shifting aggregate demand back to AD3. However, this would be inadequate to fully stabilize output, and a recessionary condition would still persist. This could reflect poorly on the central bank in the sense that, by failing to stabilize output, it may be viewed by the public as not doing its job.

The central bank could abandon the constant money growth rule and expand aggregate demand enough to move the economy back to potential output (at AD1), however this would be moving away from a rules-based policy, which helps keep credibility high and inflation expectations low, to a more discretionary framework in which credibility would be lower and inflation expectations higher.

23. Suppose country A has a central bank with full credibility, and country B has a central bank with no credibility. How does the credibility of each country’s central bank affect the speed of adjustment of the aggregate supply curve to policy announcements? How does this result affect output stability? Use an aggregate supply and demand diagram to demonstrate.

In country A, the public is more likely to believe announcements about future policy changes, and therefore adjust inflation expectations in anticipation of changes in future policy. As a result, aggregate supply will adjust more quickly to policy announcements compared to country B in which the central bank has no credibility. If the central banks both announce an autonomous tightening policy to reduce the target inflation rate, the aggregate supply curve will shift down much quicker in country A than country B. With no credibility, country B would likely have to contract aggregate demand first and let expectations adjust after the policy is implemented to achieve the same lower long-term inflation rate as country A. The implication is that output will be more stable in country A than in country B, and the adjustment process is faster in country A than country B.

24. Suppose that Venezuela and Argentina have identical aggregate demand curves and potential levels of output, and  is the same in both countries. Assume that in 2017, 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.

2016 2017 2018 2019 2020

Venezuel a 3.0

Argentin a 3.0

% % 3.8 5.5 % % 3.5 5.0 % % 3.2 4.3 % % 3.0 3.8 % % Since the aggregate demand curve, the potential output, the parameter , and the price shock are identical in both countries, the only factor that can explain the difference in inflation between the two countries is expected inflation. Argentina’s inflation rate increased far more and stayed elevated for much longer than Venezuela’s inflation rate, which must be reflective of higher inflation expectations in Argentina. The implication is that the central bank in Argentina B has less credibility at maintaining low, stable inflation than Venezuela. Therefore, 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 Argentina.

25. How does a credible nominal anchor help improve the economic outcomes that result from a positive aggregate demand shock? How does a credible nominal anchor help if a negative aggregate supply shock occurs? Use graphs of aggregate supply and demand to demonstrate.

Positive aggregate demand shocks shift the aggregate demand curve to the right, causing both inflation and the aggregate output index to rise. Without a credible nominal anchor, the increase in inflation causes expected inflation to rise, which shifts the short-run aggregate supply curve upward and causes the inflation rate to increase further to 3. With a credible nominal anchor, however, expected inflation does not change, so there is no upward shift in the short-run aggregate supply curve.

Thus, with a credible nominal anchor, inflation is more stable following the demand shock.

The outcome is similar when a negative aggregate supply shock occurs. Inflation increases and the aggregate output index falls as the short-run aggregate supply curve shifts upward, but with a credible nominal anchor, expected inflation does not increase. As a result, no further upward shifts of the short-run aggregate supply curve occur and the increase in inflation and decrease in the aggregate output index are not as great as they otherwise would be. Thus the credible nominal anchor brings about better outcomes for both inflation and output when a negative supply shock occurs, as shown in the graph below.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the personal consumption expenditure price index (PCECTPI). Convert the units setting to ―Percent Change from Year Ago,‖ and download the data. Beginning in January 2012, the Fed formally announced a 2% inflation goal over the ―longer-term.‖ a. Calculate the average inflation rate over the last four and the last eight quarters of data available. How does it compare to the 2% inflation goal?

From 2019:Q3 to 2020:Q12 inflation averaged 1.3%, which is below the current 2% target. Over the two-year horizon from 2018:Q3 to 2020:Q2, inflation averaged 1.6%, which is still below the 2% target. b. What, if anything, does your answer to part (a) imply about Federal Reserve credibility?

Over both the one-year and two-year horizons the Fed missed its target by a meaningful amount. Consistently missing the target, all else equal, may lead the public to believe that the Fed has lost its ability to keep inflation stable, which can potentially unanchor inflation expectations and lead to a decline in credibility.

This is a concern in this case since falling inflation expectations in a very low inflation environment can eventually lead to falling actual inflation, and at a relatively low rate of inflation, can turn into deflation.

2. Go to the St. Louis Federal Reserve FRED database and find data on the core PCE price index (PCEPILFE) and the spot price of a barrel of oil (WTISPLC). For both variables, convert the units setting to ―Percent Change from Year Ago,‖ and download the data from 1960 to the most recent available data. a. Identify periods in which oil price inflation is 80% or higher. b. In the periods identified in part (a), for how many months was oil price inflation 80% or higher? What was the average core inflation rate during each of those episodes? c. Based on your answers to parts (a) and (b) above, what can you conclude about the credibility of more recent monetary policy compared to its credibility in the earlier periods?

a. See the graphs below. Oil price inflation was 80% or higher during the periods of January 1974–December 1974; September 1979–July 1980; July 1987; November 1999–March 2000; May 2008–June 2008; and December 2009–February 2010.

Oil and Core Inflation

Core PCE Inflation (Left Axis)

2018-07-01

2016-05-01

2014-03-01

2012-01-01

2009-11-01

2007-09-01

2005-07-01

2003-05-01

2001-03-01

1999-01-01

1996-11-01

1994-09-01

1992-07-01

1990-05-01

1988-03-01

-100.0 1986-01-01

0.0 1983-11-01

-50.0 1981-09-01

2.0 1979-07-01

0.0

1977-05-01

4.0

1975-03-01

50.0

1973-01-01

6.0

1970-11-01

100.0

1968-09-01

8.0

1966-07-01

150.0

1964-05-01

10.0

1962-03-01

200.0

1960-01-01

12.0

Oil Price Inflation (Right Axis)

b. For the 1974 episode, it lasted 12 months, and average inflation during that time was 7.9%. The 1979–1980 episode was 11 months long, with average core inflation of 8.5%. The 1987 episode was only one month long, with average core inflation of 3.2%. The 1999–2000 episode was five months long, with average core inflation of 1.6%. The 2008 episode was only two months long, and average core inflation was 2.3%. The 2009–2010 episode was three months long, and average core inflation was 1.7%. c. Clearly, the recent monetary policy has been much more credible in keeping inflation low and stable. In particular, looking at the average inflation during each episode, it is clear that sharp increases in oil prices in the 1970s led to much bigger changes in the inflation rate. More recent episodes of similar magnitude left inflation rates relatively low and stable, suggesting an anchoring of expectations inherent with high credibility.

Chapter 26 ANSWERS TO QUESTIONS 1. During 2012, as the ECB moved to avert and credit squeeze and bank failures, the financial departments of many European car manufacturers borrowed billions of euros to avail of cheap, three-year loans. In turn, the car manufacturers lent the money to customers to buy cars. Do you think this is a normal and intended mechanism of ECB's monetary policy?

Even though monetary policy is mainly targeted at banks, and their interest rates on loans and deposits, the presence of financial units from cars and other machinery producers makes them important players in this market. By lowering interest rates on car loans, the customers increase investment and expenditure, so this was an important mechanism of monetary policy transmission, even though maybe not initially intended by the ECB. 2. ―Considering that consumption accounts for nearly 56% of total GDP, this means that the interest rate, wealth, and household liquidity channels are the most important monetary policy channels in India‖ Is this statement true, false, or uncertain? Explain your answer.

Uncertain. Although consumption is the largest part of overall 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 33% of Indian GDP, investment fluctuations are much more pronounced over the business cycle than changes in consumption, leading to the possibility that interest rate effects on investment could be potentially more important. In addition, proponents of the credit view believe that credit market effects are much more important than interest rate effects, and since the credit view primarily impacts investment, credit effects on investment could be potentially more powerful than consumption effects from monetary policy changes.

3. How can the interest rate channel still function when short-term nominal interest rates are at the effective lower bound?

If the central bank commits to a higher inflation policy while maintaining low nominal interest rates, this will raise inflation expectations and therefore lower real interest rates, even if the nominal interest rate is near zero. In addition, the central bank can commit to keeping short-term interest rates low for a long time, which can have the effect of lowering longer-term nominal interest rates, which also reduces real longer-term interest rates.

4. Lars Svensson, a former Princeton professor and deputy governor of the Swedish central bank, proclaimed that when an economy is at risk of falling into deflation, central bankers should be ―responsibly irresponsible‖ with monetary expansion policies. What does this mean, and how does it relate to the monetary transmission mechanism?

Part of the problem with deflation is that lower (negative) inflation raises the real interest rate, which raises the cost of capital and lowers investment and consumption through the interest rate channel, creating further deflationary pressure. In addition,

short-term nominal interest rates reach the effective lower bound, meaning traditional monetary policy is rendered ineffective. Thus, by being ―responsibly irresponsible,‖ central banks can commit to creating strong but temporary inflationary policies that are designed to raise inflation expectations (and hence lower real interest rates) enough to create stimulus through the interest rate channel and expand aggregate demand safely and surely to get out of a deflationary spiral.

5. Describe an advantage and a disadvantage of the fact that monetary policy has so many different channels through which it can operate.

An advantage to monetary policy having so many channels through which it can impact the economy is that if policy is rendered ineffective through any one particular channel, it doesn’t mean the policy is entirely ineffective, as there are other channels and other sectors of the economy in which the same policy can still impact the economy. On the other hand, having so many different channels through which monetary policy operates can increase uncertainty over the effects of any given policy.

6. Suppose that Argentina fixes its exchange rate. Does this mean that the exchange rate channel of monetary policy does not exist? Explain your answer.

True. When countries fix their exchange rate, they must use monetary policy to affect the interest rate in order to maintain the exchange rate. In other words, the central bank must change the real interest rate to maintain the exchange rate, which means net exports and aggregate demand will be unaffected as long as the exchange rate peg is maintained.

7. During the 2007–2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.

There are four main mechanisms through which the decline in stock prices could have reduced aggregate demand and contributed to the severity of the recession. First, the decline in stock prices lowered Tobin’s q and might have reduced investment spending.

Second, the decline in financial wealth, as a result of the stock price decline, could have caused a drop in consumption because consumers’ lifetime resources were reduced. Third, the decline in stock prices lowered the value of financial assets, which increased the public’s probability of financial distress, and so they cut back on their purchases of consumer durables and housing. Fourth, the decline in stock prices lowers the net worth of business firms, which increases adverse selection and moral hazard problems in lending and might have resulted in a reduction in lending and less investment spending.

8. ―The costs of financing investment are related only to interest rates; therefore, the only way that monetary policy can affect investment spending is through its effects on interest rates.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Monetary policy can affect stock prices, which affect Tobin’s q and adverse selection and moral hazard problems in lending, thereby affecting investment spending. In addition, monetary policy can affect loan availability, which may influence investment spending.

9. The Melbourne Institute and Westpac Bank Consumer Sentiment Index for Australia jumped 4.1% in December 2020, while the stock market increased by more than 20%.

Explain how this relates to the monetary transmission mechanisms.

Monetary policy can lower financial frictions by lowering credit spreads and stimulating investment spending. A commitment to future expansionary policy helps revive the economy by raising inflation expectations and by reflating other asset prices.

10. From February to March 2020, the FTSE 100 declined by more than 15%, 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 were so large, investment spending fell dramatically during this period.

11. Nobel Prize winner Franco Modigliani found that the most important transmission mechanisms of monetary policy involve consumer expenditure. Describe how at least two of these mechanisms work.

There are three mechanisms involving consumer expenditure. First, an expansionary monetary policy that lowers interest rates and reduces the cost of financing purchases of consumer durables, and consumer durable expenditure rises. Second, an expansionary monetary policy that causes stock prices and wealth to rise, leading to greater lifetime resources for consumers and causing them to increase their consumption. Third, an expansionary monetary policy that causes stock prices and the value of financial assets to rise and also lowers people’s probability of financial distress, so they spend more on consumer durables.

12. In the late 1990s, the stock market was rising rapidly, the economy was growing, and the Federal Reserve kept interest rates relatively low. Comment on how this policy stance would affect the economy as it relates to the Tobin’s q transmission mechanisms.

This situation is consistent with Tobin’s q and the wealth effects of expansionary monetary policy. With lower interest rates, stock prices rise. Tobin’s q predicts that investment will increase, stimulating aggregate demand. In addition, with the higher stock prices, this will raise wealth, and lead to higher consumption and increased aggregate demand.

13. During and after the global financial crisis, the Fed reduced the fed funds rate to nearly zero. At the same time, the stock market fell dramatically and housing market values declined sharply. Comment on the effectiveness of monetary policy during this period with regard to the wealth channel.

The wealth channel suggests that this type of monetary policy would raise stock prices and increase house prices, which would raise homeowners’ equity, and hence wealth through housing and stock markets. However, even though real interest rates were low, stock values and housing wealth declined sharply, which ultimately

decreased consumption and aggregate demand, suggesting monetary policy effects through the wealth channel were ineffective during the global financial crisis.

14. From 2008 to 2009, the ECB continued to lower interest rates. At the same time, the stock market fell dramatically and housing market values declined sharply. Comment on the effectiveness of monetary policy during this period with regard to the wealth channel.

The wealth channel suggests that this type of monetary policy would raise stock prices and increase house prices, which would raise homeowners’ equity, and hence wealth through housing and stock markets. However, even though real interest rates were low, stock values and housing wealth declined sharply, which ultimately decreased consumption and aggregate demand, suggesting monetary policy effects through the wealth channel were ineffective during that period.

15. Why does the credit view imply that monetary policy has a greater effect on small businesses than on large firms?

Since small businesses are more dependent on bank loans than large firms, monetary policy changes that impact the availability of credit will disproportionately affect small businesses more than large firms.

16. Do you think the banking channel is more important in a developing country with no active financial markets or a developed country with a very active financial market?

The banking channel will be more important in the developing country, as the banking system takes a larger share in financing of firms and corporations.

17. If adverse selection and moral hazard increase, how does this affect the ability of monetary policy to address economic downturns?

It would make it more difficult for the central bank to stimulate the economy. The credit view indicates that adverse selection and moral hazard play an important part in affecting investment behavior and ultimately the economy. However, during downturns, asymmetric information problems increase, meaning that monetary policy must be more powerful to offset the contractionary effects of increases in adverse selection and moral hazard.

18. How does the Great Depression demonstrate the unanticipated price level channel?

During the Great Depression, the fall in the price level led to a significant decrease in consumer wealth and a sharp decline in consumption. The decline in prices led to an increase in real debt of more than 20%, and overall, the effect on consumers was to reduce expenditure more than 50%, and housing expenditures fell 80%.

19. How are the wealth effect and the household liquidity effect similar? How are they different?

The two channels are similar in that increases in real interest rates lead to lower asset prices, which lead to lower spending on consumption and housing. The difference is in how changes in asset prices lead to lower spending. Under the wealth effect, people are simply less willing to spend when wealth is lower (due to lower overall lifetime resources), leading to a reduction in spending. The household liquidity effect instead

indicates a substitution effect between more liquid assets (such as cash or stocks) and less liquid assets (such as consumer durables or housing). Thus, with lower asset values, households use their resources to purchase safer, more liquid assets rather than consumption or housing, leading to lower aggregate demand.

20. After the coronavirus pandemic hit the economy, mortgage rates reached record-low levels in 2020. a. What effect should this have had on the economy according to the household liquidity effect channel? b. As unemployment soared and the global economy went into full recession, a lot of banks became reluctant to lend. How does this information alter your answer in part (a)? a. 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. While interest rates were extremely low, if banks are afraid to lend because of the extreme economic situation it would not have an appreciable effect on raising the value of household’s financial assets (i.e housing wealth). Thus, the likelihood of financial distress would remain elevated, and not improve consumer durable and housing expenditure.

21. “If the fed funds rate is at zero, the Fed can no longer implement effective accommodative policy.” Is this statement true, false, or uncertain? Explain.

False. Even though conventional monetary policy tools may be ineffective, the Fed can implement a number of nonconventional monetary policy tools to help provide accommodation if needed. The recent financial crisis of 2009 is a good case in point where the Fed was able to effectively implement large-scale asset purchase programs, liquidity provision to key credit markets, and use forward guidance all to effectively (if not slowly) generate a sustained recovery away from the effective lower bound.

22. In 2019, Riksbank, Sweden's central bank raised its benchmark repo rate from 0.25% to 0%, after five years of holding the rate in negative territory. The central bank said in a statement that it expected the repo rate would remain unchanged through 2021, and the stance of monetary policy would remain accommodative.

Explain this seeming contradiction.

Even though Riksbank increased the base rate from negative to zero, mainly because of the effect negative interest rates were having on asset prices and pension funds, it still didn't want to tighten financial conditions too much. By giving a promise of no further interest rate increases for the next two years, it is reassuring the public with forward guidance that monetary policy will still be on the accommodative side.

23. In a local newspaper, Rasa reads that stock prices in Lithuania are falling and unemployment is high and consumption is slowing. Would she classify monetary policy as tight or easy?

The low inflation environment, lowering consumption, and the increasing unemployment would suggest that monetary policy is tight.

24. How does the experience of Japan during the ―two lost decades‖ lend support to the four lessons for monetary policy outlined in this chapter?

The experience of Japan directly supports the four lessons of monetary policy discussed in this chapter. First, short-term interest rates in Japan were near zero; however, due to deflation, real interest rates remained elevated, suggesting a contractionary monetary policy stance. Second, if Japanese policymakers would have paid more attention to the collapse of stock and housing markets, this could have led to earlier and swifter action to shore up the economy. Third, Japan took no steps to stimulate the economy other than pushing short-term rates to zero. However, they could have done more to push longer-term rates down through asset purchases and raising inflation expectations. Finally, Japan allowed the economy to go into a deflationary period, leading to unanticipated and undesirable fluctuations in the price level.

ANSWERS TO APPLIED PROBLEMS 25. Suppose the economy is in recession and the monetary policymakers lower interest rates in an effort to stabilize the economy. Use an aggregate supply and demand diagram to demonstrate the effects of a monetary easing when the transmission mechanisms are functioning normally and when the transmission mechanisms are weak, such as during a deep downturn or when significant financial frictions are present.

When the transmission mechanisms are functioning normally (and predictably), policymakers can ease monetary policy with reasonable precision, so that the aggregate demand curve shifts to the right from AD1 to AD3 and eliminates the output gap. Under periods in which the monetary transmission mechanisms are not functioning normally, such as during a financial crisis, some channels may not work as effectively, or at all. As a result, for a given monetary policy prescription, the effects on aggregate demand may be muted or nonexistent. In this case, aggregate demand may only shift to the right to AD2 and an output gap may still remain at Y2. This illustrates the limitations of monetary policy to stabilize the output gap in such situations.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. A ―rate cycle‖ is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), real business fixed investment (PNFIC1), real residential investment (PRFIC1), and consumer durable expenditures (PCDGCC96). Use the frequency setting to convert the federal funds rate data to ―quarterly,‖ and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy. b. Calculate the percentage change in business fixed investment, residential (housing) investment, and consumer durable expenditures over this rate cycle.

Over this period, business fixed investment decreased by 9.2%, residential investment decreased by 6.3%, and consumer durable spending decreased by 2.9%. c. Based on your answers to parts (a) and (b), how effective was the traditional interest rate channel of monetary policy over this rate cycle?

Based on the expansionary nature of the rate cycle, and the declines in all three components of the traditional interest rate channel, this transmission mechanism was not very effective in having the impact the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

2. As defined in Exercise 1, a ―rate cycle‖ is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database and find data on the federal funds rate (FEDFUNDS), bank reserves (TOTRESNS), bank deposits (TCDSL), commercial and industrial loans (BUSLOANS), real estate loans (REALLN), real business fixed investment (PNFIC1), and real residential investment (PRFIC1). Use the frequency setting to convert the federal funds rate, bank reserves, bank deposits, commercial and industrial loans, and real estate loans data to ―quarterly,‖ and download the data. a. When did the last rate cycle begin and end? (Note: If a rate cycle is currently in progress, use the current period as the end.) Is this rate cycle a contractionary or an expansionary rate cycle?

The last rate cycle, as of July 2020, was the period from 2019:Q3 to 2020:Q2 (the most recent quarter of data in the current rate cycle). The federal funds rate decreased from 2.40% to 0.06%, an expansionary policy.

b. Calculate the percentage change in bank deposits, bank lending, real business fixed investment, and real residential (housing) investment over this rate cycle.

Over this period, bank reserves increased by 97.3%, bank deposits increased by 45.5%. As a result, business fixed investment decreased by 9.2%, C&I loans increased by 25.4%, while real estate loans increased by 3.4% and residential investment decreased by 6.3%, c. Based on your answers to parts (a) and (b), how effective was the bank lending channel of monetary policy over this rate cycle?

The results are somewhat mixed with the data. Based on the expansionary nature of the rate cycle, we would expect all of these variables to increase when the policy rate decreases, according to the bank lending transmission mechanism.

However, with the exception of business fixed investment and residential investment, all of the variables increased. Thus, it appears that this transmission mechanism was modestly effective in having some impacts the transmission mechanism predicts on the economy over this rate cycle. However, often times in expansionary rate cycles, monetary policy is designed to slow the declining growth in the economy, rather than to reverse growth altogether, so the data may be consistent with this.

Web Chapter 1 ANSWERS TO QUESTIONS 1. Why do people choose to buy insurance even if their expected loss is less than the payments they will make to the insurance company?

People carry insurance because they are risk-averse and prefer to know their wealth with certainty.

2. How do insurance companies protect themselves against losses due to adverse selection and moral hazard?

Insurance companies protect themselves by requiring inspections and medical examinations, insuring groups rather than individuals, and insisting on a deductible.

3. What is the difference between term life insurance and whole life insurance?

Term life insurance pays a death benefit if the policyholder dies; no other benefit is paid. Whole life policies pay a death benefit but also include a savings program that pays out if the policyholder lives.

4. What is the purpose behind reinsurance?

Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium.

5. Why do property and casualty insurance companies have large holdings of municipal bonds, whereas life insurance companies do not?

Property and casualty insurance companies are taxed on their interest income, so they hold municipal bonds that are tax exempt. This tax-exempt feature is of no benefit to life insurance companies, who are not taxed on their interest income, so they do not hold municipal bonds.

6. Why did the Federal Reserve and the government intervene to bail out AIG? As a result of AIG’s dealings in credit default swaps, the global financial crisis led to a sharp decrease in AIG’s net worth and its access to credit. But because AIG was one of the largest companies in the world and integrally tied to the financial system, the government believed letting AIG fail would be catastrophic. In particular, banks and mutual funds held a large portion of AIG debt, so letting AIG fail would also pressure these companies, who were already severely liquidity-constrained due to the crisis. As a result, the U.S. government along with the Federal Reserve created a credit facility to provide $85 billion in liquidity to keep AIG from failing.

7. ―In contrast to private pension plans, government pension plans are rarely underfunded.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Government pension plans are often underfunded. Many pension plans for both federal and state employees are not fully funded.

8. Why is Social Security in danger of eventually going bankrupt?

The demographics suggest that more people will be retiring than will be entering the workforce in the future. With fewer people paying into the plan and more taking out,

it could go bankrupt.

9. What are the three main proposals for privatizing Social Security? What are their advantages and disadvantages?

The three main proposals to privatize Social Security are (a) to invest the current assets in corporate securities. The advantage is that it would improve the trust fund’s overall return and minimize transaction costs. The disadvantage is that it could lead to more government intervention in the private sector. (b) To shift trust fund assets into individual accounts. This has the advantage of increasing returns on assets and doesn’t involve government ownership of assets. The disadvantage is that it could expose individuals to greater risk and higher transaction costs. (c) To provide individual accounts in addition to those in the trust fund. The advantages and disadvantages are similar to (b) above.

10. What is ERISA, and why was it established?

The Employee Retirement Income Security Act establishes minimum standards for reporting and disclosure, sets rules for vesting and the degree of underfunding, places restrictions on investment practices, and assigns oversight responsibility to the Labor Department. In addition, the Pension Benefit Guarantee Corporation was created, similar to the role that the FDIC plays for banks. ERISA was established to safeguard pension systems by protecting them from mismanagement, underfunding, fraudulent practices, and other abuses.

11. If you needed to take out a loan, why might you first go to your local bank rather than a finance company?

Because interest rates on loans are typically lower at banks than at finance companies.

12. How are securities brokers/dealers, investment banks, and organized exchanges different from financial intermediaries?

They are different from financial intermediaries in that they do not perform the intermediation function of acquiring funds by issuing liabilities and then using the funds to acquire assets.

13. What problems or concerns do sovereign wealth funds present? Are they valid?

There are several concerns that have been raised. For one, they have grown in size, and so changes in the asset positions of these funds can mean large movements of capital, which could cause market instability. There have also been concerns that sovereign wealth funds may use their investments and assets for political purposes.

Finally, most sovereign wealth funds provide little public information about their holdings or investment practices. To some extent, these concerns may be valid, but many believe they are overblown and that the concerns stem primarily from xenophobia and fear of the unknown.

14. Why can a money market mutual fund allow its shareholders to redeem shares at a fixed price while other mutual funds cannot?

Because a money market mutual fund holds high-quality, short-term debt instruments

that do not fluctuate much in value, it can allow shareholders to redeem shares at a fixed price. In contrast, other mutual funds hold assets that have large fluctuations in value, so their share values must also fluctuate.

15. What features of mutual funds and the investment environment have led to mutual funds’ rapid growth in the last three decades?

Liquidity intermediation, denomination intermediation, ease of diversification, cost advantages, and the growth of defined contribution pension plans have led to rapid growth in mutual funds.

16. Is investment banking a good career for someone who is afraid of taking risks? Why or why not?

No. Investment banking is a risky business, because if the investment bank cannot sell a security it is underwriting for the price it promised to pay the issuing firm, the investment bank can suffer substantial losses.

17. How do hedge funds differ from mutual funds?

In contrast to mutual funds, hedge funds have a minimum investment requirement of $100,000 and must have no more than 99 investors (limited partners) who have steady annual incomes of more than $200,000 or a net worth of at least $1 million, excluding their homes. They are also set up as partnerships rather than with shareholders as in mutual funds.

18. ―Hedge funds are not risky because, as their name indicates, they hedge risks.‖ Is this statement true, false, or uncertain? Explain.

False. Despite their name, hedge funds do not hedge risks. Indeed because they frequently have a lot of leverage and invest in very risky assets, they can be far riskier than investing in many other institutions.

19. What are the four advantages of private equity funds? How do they help alleviate the free-rider problem?

First, as private companies they are not subject to the controversial and costly regulations included in the Sarbanes-Oxley Act. Second, managers of private companies do not feel under pressure to produce immediate profits, as do those at publicly traded companies, and thus can manage their company with their eyes on longer-term profitability. Third, because private equity funds give managers of these companies larger stakes in the firm than is usually the case in publicly traded corporations, they have greater incentives to work hard to maximize the value of the firm. Fourth, private equity overcomes the free-rider problem. In contrast to publicly traded companies, which have a diverse set of owners who are happy to free-ride off of each other, venture capital and capital buyout funds are able to garner almost all the benefits of monitoring the firm and therefore have the incentives to make sure the firm is run properly.

20. How have GSEs exposed taxpayers to large losses?

The implicit government backing of GSE debt leads to the same moral hazard problem that led to the S&L and banking crises in the 1980s and early 1990s

discussed in Chapter 11. Because GSE debt is in effect guaranteed by the government, market discipline to limit excessive risk-taking by GSEs is quite weak.

The GSEs, therefore, have incentives to take on excessive risk, and this is exactly what they have done, with the taxpayer exposed to large losses.

ANSWERS TO APPLIED PROBLEMS 21. Your rich uncle dies, leaving you a life insurance policy worth $100,000. The insurance company offers you the option of receiving $8,225 per year for 20 years, with the first payment due today, or a lump sum. Which option should you choose?

It depends on the interest rate, as well as many other factors. Since the options are either $100,000 immediately or $8,225/year, you can calculate the present value of the yearly payment as: $8225  [1 + 1/(1 + r) + 1/(1 + r)2 + . . . + 1/(1 + r)19], where r is the rate of return (or interest rate). If the present value of the yearly payments is less than $100,000, you should take the $100,000 up front. The interest rate that equates the two is about 6%, so if the interest rate is greater than 6%, the present value of the yearly payments will be less than the $100,000 immediately, so the upfront payment would be more desirable (and vice versa). With this information, the answer for each individual depends on many factors. Do you ―need‖ the $100,000 today? Can you personally invest the $100,000 at a higher rate with the same level of risk? Is there any risk that the insurance company will not pay in the future?

22. Kio Outfitters estimated the following probabilities of loss from past experience: Loss

Probability (%)

$30,000

0.25

$15,000

0.75

$10,000

1.50

$5,000

2.50

$1,000

5.00

$250

15.00

$0

75.00

What is the probability that Kio will experience a loss of $5,000 or greater? If an insurance company offers a loss policy with a $1,500 deductible, what is the most that Kio will pay if it files a claim?

Losses of less than $5,000 occur 95% of the time. So, 5% of the time, losses will be $5,000 or greater.

With a $1,500 deductible, Kio’s expected losses are: Loss $28,500

Probability (%) 0.25

$13,500 $ 8,500 $ 3,500 $ 1,000 $ 250 $ 0

0.75 1.50 2.50 5.00 15.00 75.00

The expected (mean) loss is $475, which is the fair price of insurance.

23. Paul’s car slid off an icy road, causing $2,500 of damage to his car. He was also treated for minor injuries that cost $1,300. His car insurance has a $500 deductible, after which the full loss is paid. His health insurance has a $100 deductible and covers 75% of medical costs (total). What were Paul’s out-of- pocket costs from the incident?

The car will cost Paul $500. The remaining $2,000 is covered. Paul will pay $400 of the medical expenses—the $100 deductible plus 25% of the remaining $1,200 of expense. Thus, the total out-of-pocket expenses for Paul are $900.

24. An employee contributes $200 a year (at the end of the year) to her pension plan.

What will be the total value of the account after five years? Assume the plan earns 15% per year over the period.

The total contributions are $200  5 = $1,000. The future value of the plan at the end of five years is equal to 200  [1 + 1.152 + 1.153 + 1.154] = $1348.48.

25. Suppose that you contribute $20,000 at the beginning of each year into your defined benefit pension plan, and the interest rate is 10%. a. After 8 years, what will be the total value of the account?

The total contributions will be worth $20,000  8 = $160,000. The account will be worth $20,000  [1.10 + 1.102 + . . . + 1.108] = $251,589.54. b. Suppose that after eight years you are eligible to receive benefits of $250,000. Is the pension plan underfunded or fully funded?

It is fully funded, since the amount of benefits you are eligible for are less than the account’s value. c. Suppose the pension plan takes a 2% management fee at the time each contribution is made. How does this change your answer to parts (a) and (b), if at all?

If the pension plan takes a 2% management fee right off the top of gross contributions, then the net contribution each year will be 0.98  $20,000 = $19,600. In this case, total contributions will then be $19,600  8 = $156,800; the account will be worth $19,600  [1.10 + 1.102 + . . . + 1.108] = $246, 557.75.

Now the pension plan will be slightly underfunded, since the eligible benefits are larger than the account value.

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database and find data on the amount of mutual fund shares held by households and nonprofit organizations (HNOMFAQ027S) and the amount of mutual fund shares held by financial businesses (FBMFT-TQ027S). Which of the two categories currently holds the most assets?

Which of the two categories has grown the most in percentage terms over the past five years? (Use the most recent five years of data available.)

As of 2014:Q1, households and nonprofits held the most mutual fund assets at $7,058,871.1 million, more than twice as much as financial businesses at $3,389,318.9 million. Over the last five years from 2009:Q1 to 2014:Q1, household and nonprofit mutual fund assets held grew by 123.6%, slightly more than the 121.7% growth by mutual fund assets held by financial businesses.

2. Go to the St. Louis Federal Reserve FRED database and find data on the amount of mortgages held by Ginnie Mae (MDOTHFRAGNMA), Fannie Mae (MDOTHFRAFNMA), and Freddie Mac (MDOTHFRAFHLMC). Which of the three companies currently holds the largest dollar amount of mortgages? Which holds the smallest? How do the current volumes of mortgages held by Fannie Mae and Freddie Mac compare to the volumes before 2010?

As of 2014:Q1, Fannie Mae held the largest amount of mortgages, at $3,028,727.0 million, and Ginnie Mae held the smallest amount at $5,996.7 million. Fannie Mae and Freddie Mac as of 2014Q1 hold a combined $4,714,034 million in mortgages.

However, there is a significant dropoff in mortgages held by the two prior to 2010.

For instance, in 2009:Q4, they held a combined $555,359 million in mortgages, which was fairly consistent to this amount for much of the time prior to 2010.

Web Chapter 2 ANSWERS TO QUESTIONS 1. What are the advantages and disadvantages of using forward contracts to hedge?

The big advantage of forward contracts is their flexibility, as they can be designed in any way that the counterparties would like them to be. The two main disadvantages are first, that it may be difficult for one party to find a counterparty to enter into the forward contract, as they can be quite specific. Because of this, there may be a lack of liquidity in certain forwards markets, leading to less favorable terms on forward contracts to attract counterparties. The second main disadvantage is that forward contracts are subject to default risk, and the only recourse for a counterparty defaulting on its contract is to take legal action, which can be expensive and lengthy.

2. What advantages do futures contracts have over forward contracts?

There are several advantages of futures over forward contracts. For instance, quantities and delivery dates of futures are standardized to improve liquidity and limit the ability of someone to corner the market. Futures can be traded at any time up to the delivery date, which is not possible with forward contracts. And in contrast to forwards, futures contracts are cleared through a clearinghouse, limiting default risk.

Finally, in a futures contract, physical delivery of the underlying asset can be avoided, thus lowering the costs of trading in futures.

3. In the July 2017 FOMC meeting, governors and voting presidents of the Federal Reserve System agreed not to increase the federal funds rate target, but somewhat let the markets know that there could be a rise in the near future. How do you think that financial managers will react to this news? Which instruments can they use to hedge against a change in interest rates?

Financial managers should be prepared for an increase in interest rates somewhere in the near future. The fact that the FOMC announced a possible increase in interest rates as the economy recovers does not mean that interest rates will increase immediately, but they should be considering this scenario with higher probability.

The instruments used by each financial manager will depend on the characteristics of their business and the portfolio they manage. In essence, they should be prepared for a price decrease in securities (as the discount factor increases) and will have to find the specific instrument that better helps them to hedge this risk (forwards contracts, financial futures contracts, options, and so on).

4. What are the advantages and disadvantages of using an options contract rather than a futures contract?

The advantages of using options contracts are that the buyers of options are not obligated to take action (i.e., buy or sell the underlying asset) at a disadvantageous price when the option is ―out of the money‖ and that their potential losses are limited to the premium paid for the option. There is also no need to maintain a margin account and make daily settlement payments into or out of that account, as is the case with futures contracts. The disadvantage of an options contract is that you have to pay a premium that you would not have to pay with a futures contract.

5. Explain why greater volatility or a longer term to maturity leads to a higher premium on both call and put options.

Because an option has the feature that you win big if the price has a large change in one direction but don’t lose big if the price has a large change in the other direction.

More volatility of the price means that on average you will have a larger profit because you are more likely to win big with either a call or a put option and thus their premiums will be higher.

6. Why does a lower strike price imply that a call option will have a higher premium and a put option a lower premium?

Because for any given price at expiration, a lower strike price means a higher profit for a call option and a lower profit for a put option. A lower strike price makes a call option more desirable and raises its premium and makes a put option less desirable and lowers its premium.

7. What are the advantages and disadvantages of using interest rate swaps?

Advantages of interest rate swaps are that they allow institutions to convert fixed rate assets into rate-sensitive assets without affecting their balance sheets (which otherwise may be quite difficult), at relatively low cost. Another advantage of interest rate swaps is that they can be written over long horizons, whereas futures and options are typically of much shorter duration. The main disadvantages of interest rate swaps are that they may lack liquidity, and are subject to default risk similar to forward contracts.

8. If the finance company you manage has a gap of +$5 million (rate-sensitive assets greater than rate-sensitive liabilities by $5 million), describe an interest rate swap that would eliminate the company’s income gap.

You would swap interest on $5 million of variable rate assets for the interest on $5 million of fixed rate assets, thereby eliminating the income gap.

9. If the savings and loan you manage has a gap of −$42 million, describe an interest rate swap that would eliminate the S&L’s income risk from changes in interest rates.

You would swap the interest on $42 million of fixed rate assets for the interest on $42 million of variable rate assets, thereby eliminating the income gap.

10. How can financial derivatives create excessive risk in the financial system?

Derivatives allow financial institutions to increase their leverage, in essence making huge bets with a limited ability to pay up if they are on the wrong side of the bet, which can quickly and unexpectedly bring down large financial institutions. In addition, banks hold significant notional amounts of derivatives many times larger than their bank capital, exposing them to serious risk of failure. These factors present significant risk in the financial system, and the failure of one large institution that is systemically important can jeopardize the entire financial system.

ANSWERS TO APPLIED PROBLEMS 11. If the pension fund you manage expects to have an inflow of $120 million six months

from now, what forward contract would you seek to enter into to lock in current interest rates?

You would like to enter into a contract that specifies you will purchase $120 million of bonds with an interest rate equal to the current interest rate six months from now.

12. If the portfolio you manage is holding $25 million of 6s of 2035 Treasury bonds with a price of 110, what forward contract would you enter into to hedge the interest rate risk on these bonds over the coming year?

You would enter into a contract that specifies that you will sell the $25 million of 6s of 2035 at a price of 110 one year from now.

13. Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 105. If the price of the Treasury bond is 115 at expiration, is the option at the money, in the money, or out of the money? Determine the premium if the profit equals $8,000.

The call option is ―in the money‖ because you would want to exercise the right to buy the Treasury bonds at $105 and then sell them at $115, for a profit. If the profit equaled $8,000 this means that the premium was (115 – 105) × 100,000 – 8,000 = $2,000.

14. Jason bought a put option on a $100,000 Treasury bond futures contract with an exercise price of 105 for a premium of $2,000. If on expiration the futures contract sells for 110, determine Jason’s profits and explain if he will exercise the right to sell the futures contract.

How would your answer change if the futures contract sells for 95 on expiration?

If price on expiration is 110: The option is ―out of the money‖ and Jason does not exercise his right to sell the futures contract. His profit is: – $2,000. If price on expiration is 95: The option is ―in the money‖ and Jason exercises his right to sell the futures contract. His profit is: (105 – 95) × 100,000 – $2,000 = $8,000.

15. If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125,000 euro futures contracts?

You would buy 200 million euro of futures contracts that mature one year from now.

With a contract size of 125,000 euros, you would buy 200 million/125,000 = 1,600 contracts.

16. If your company has to make a 10 million euro payment to a German company three months from now, how would you hedge the foreign exchange risk in this payment with 125,000 euro futures contract?

You would hedge the risk by buying 80 euro futures contracts that mature three months from now.

17. Suppose your company will be receiving 30 million euros six months from now, and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract should you enter into?

You would want to enter into a contract in which you agree to deliver 30 million euros six months from now in exchange for U.S. $30 million.

18. Suppose the pension fund you are managing is expecting an inflow of funds of $100 million next year, and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

You would buy $100 million worth, that is, 1,000 contracts, of long-term bond futures contracts with an expiration date of one year in the future. This means that you would be entitled to delivery of the long-term bond at today’s price so that the current rate would be locked in.

19. If you buy a put option on a $100,000 Treasury bond futures contract with an exercise price of 95 and the price of the Treasury bond is 120 at expiration, is the contract in the money, out of the money, or at the money? What is your profit or loss on the contract if the premium was $4,000?

The put option is out of the money because you would not want to take the option to sell the futures at 95 when the price at expiration is 120. Since the premium is $4,000 and you did not exercise the contract, your loss on the contract is $4,000.

20. Suppose that you buy a call option on a $100,000 Treasury bond futures contract with an exercise price of 110 for a premium of $1,500. If, upon expiration, the futures contract has a price of 111, what is your profit or loss on the contract?

You have a profit of 1 point ($1,000) when you exercise the contract, but you have paid a premium of $1,500 for the call option, so your net profit is –$500, a loss of $500.

21. Chicago Bank and Trust has $100 million in assets and $83 million in liabilities. The duration of the assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures contracts does this bank need to fully hedge itself against interest rate risk? The available Treasury bond futures contracts have a duration of 10 years, have a face value of $1,000,000, and are selling for $979,000.

This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the duration of the liabilities, so the bank will take a short position, effectively increasing its liabilities. Assume that the dollar amount of the position is Y.

DURgap = 5  83100Y   8383Y 1.8  83YY 10  0 500 = 149.40 + 10Y, Y = 35.06, or a position in $35,060,000 futures. At the current price, this requires $35,060,000/979,000 = 35.812 contracts, or 36.

22. Futures are available on three-month T-bills with a contract size of $1 million. If you take a long position at 96.22 and later sell the contracts at 96.87, what is the total net gain or loss on this transaction?

Gain = (96.87 – 96.22)  10,000 = $6,500 per contract.

23. A bank customer will be going to London in June to purchase £100,000 in new inventory. The current spot and futures exchange rates are as follows: Exchange Rates (dollars/pound) Period

Rate

Spot

1.5342

March

1.6212

June

1.6901

September

1.7549

December

1.8416

The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

She paid an actual rate of $1.6901 per pound, or $169,010. Had she simply taken the spot rate at the time, the cost would have been $172,500. She saved $3,490.

24. Consider a put contract on a T-bond with an exercise price of 101 12/32. The contract represents $100,000 of bond principal and has a premium of $750. The actual T-bond price falls to 98 16/32 at the expiration. What is the gain or loss on the position?

The gain per contract is (101 12/32  98 16/32)  1,000 = $2,875. If you include the premium paid, the gain is $2,125 per contract.

25. A swap agreement calls for Durbin Industries to pay interest annually, based on a rate of 1.5% above the one-year T-bill rate, currently 6%. In return, Durbin receives interest at a rate of 6% on a fixed rate basis. The notional for the swap is $50,000.

What is Durbin’s net interest for the year after entering into the agreement?

Durbin pays 7.5%  $50,000 and receives 6%  $50,000, or net, pays 1.5%  $50,000 = $750.

ANSWERS TO DATA ANALYSIS PROBLEMS 1. Go to the St. Louis Federal Reserve FRED database and find data on the dollar/euro exchange rate (DEXUSEU). Suppose that one month ago you entered into a forward contract to sell 10 million euros at the forward rate equivalent to the spot rate one month ago. What exchange rate was specified on the forward contract? (Find the

most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 11, 2017, the spot exchange rate was $1.1811/€, and on July 11, 2017, when the forward contract was entered into, the exchange rate was $1.1430/€. Thus, locking in the forward contract exchange rate (assumed at the July 11 spot rate) would mean you receive €10,000,000  $1.1430/€ = $11,430,000 one month later on August 11.

Had the forward contract not been entered into, the €10,000,000 would be worth €10,000,000  $1.1811/€ = $11,811,000. In this case, since the dollar depreciated, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a risk-neutral world, you are worse off with utilizing the forward contract.

2. Go to the St. Louis Federal Reserve FRED database, and find data on crude oil prices (DCOILWTICO). Suppose that one month ago you entered into a forward contract to sell 1 million barrels of oil at the forward rate equivalent to the spot rate one month ago. What price was specified on the forward contract? (Find the most recent data available, and then use the data from one month prior.) What will be the payment in dollars when the contract is executed? In hindsight, would you have been better off or worse off by not entering into the forward contract?

On August 14, 2017, the spot price of WTI oil was $47.59/barrel, and on July 14, 2017, when the forward contract was entered into, the price was $46.53/barrel.

Thus, locking in the forward contract exchange rate (assumed at the July 14 spot rate) would mean you receive 1,000,000 barrels  $46.53/barrel = $46,530,000 one month later on August 14. Had the forward contract not been entered into, the 1,000,000 barrels would be worth 1,000,000 barrels  $47.59/barrel = $47,590,000. In this case, since the price of oil increased, the dollar payment at the current spot rate is more than what the forward contract pays out. So in a risk-neutral world, you are worse off with utilizing the forward contract.

Web Chapter 3 ANSWERS TO QUESTIONS 1. How does the provision of several types of financial services by one firm lead to a lower cost of information production for the firm?

Because one information resource can be used in providing the several services, thus lowering the cost for each.

2. How does the provision of several types of financial services by one firm lead to conflicts of interest?

Conflicts of interest arise because higher profits might arise in providing one kind of service if the service provider misuses information, provides false information, or conceals information when providing another kind of service.

3. How can conflicts of interest make financial markets less efficient?

Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric information problems become worse, which prevent financial markets from channeling funds into productive investment opportunities. The result is that financial markets become less efficient.

4. How can conflicts of interest lead to unethical behavior?

Unethical behavior can arise because conflicts of interest generate incentives for service providers to lie or conceal information, thereby hurting the customers they work for.

5. Describe two conflicts of interest that occur when underwriting and research are provided by a single investment banking firm. 

Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business.



Investment banks might engage in spinning, a form of kickback in which they allocate hot but underpriced IPOs to executives in return for their companies’ future business.

6. How does spinning lead to a less efficient financial market?

Spinning makes financial markets less efficient because it might influence executives to not use the lowest-cost investment bank when issuing securities. The result would be a higher cost of capital and hence lower efficiency.

7. Describe three conflicts of interest that occur in accounting firms. 

Clients may be able to pressure auditors into skewing their opinions in order to get fees for other accounting services.



Auditors may be auditing information systems or structuring (tax and financial) advice put in place by their nonaudit counterparts within the firm, and thus may be reluctant to criticize this advice or systems.



Auditors may provide overly favorable opinions in order to solicit or retain

business.

8. Some commentators have attributed the demise of Arthur Andersen to the combination of auditing and consulting activities provided by the firm. Is this assessment correct?

The source of Arthur Andersen’s demise was not that the company combined its auditing and consulting activities, but rather that the Houston office succumbed to tremendous pressure to give favorable opinions about Enron because Enron was such a large client and the Houston office could not afford to lose Enron’s business.

9. Describe three conflicts of interest that occur in credit-rating agencies. 

Rating agencies might provide more favorable ratings to a firm in order to obtain its consulting business.



Rating agencies may bias their ratings because they are auditing their own work if they have been involved in advising the firm in their consulting business.



Rating agencies might provide more favorable ratings to firms to get firms to hire them to do their rating.

10. Describe two conflicts of interest that occur in universal banks.

The underwriting department may aggressively sell bad securities to the bank’s customers; the bank may use its underwriting department to sell bonds of a troubled firm so that the firm can pay off its loans to the bank; a bank may make loans at overly favorable terms to get the firm’s underwriting business; or a bank may lean on its customers to purchase insurance that they may not need from the bank.

11. ―Conflicts of interest always reduce the flow of reliable information.‖ Is this statement true, false, or uncertain? Explain your answer.

False. Conflicts of interest only reduce the flow of reliable information if they are exploited. If the incentives to exploit the conflict are low, say because exploiting the conflict hurts the reputation of the firm and reduces its future business, then the conflict is unlikely to be exploited and the flow of reliable information will not be reduced.

12. Give two examples of conflicts of interest that do not seem to have been exploited and thus have not led to a reduction of reliable information in the financial markets. 

Credit-rating agencies seem to have given accurate appraisals of credit risk on plain vanilla corporate bonds even though they are paid by the firms that are issuing these securities.



Commercial banks that underwrote securities before the Glass-Steagall Act was enacted did not seem to push bad securities they had underwritten onto their customers.



The market can often figure out which research analysts not to trust if they are subject to strong conflicts of interest.



Clients of accounting firms limit the use of nonaudit services if the conflicts of

interest lead to a decrease in trust of the audit.

13. When is it more likely that conflicts of interest will be exploited?

When the market cannot get information about whether an exploitation of a conflict of interest is occurring, the reputation of firms exploiting conflicts of interest is not damaged and so they have incentives to exploit the conflicts of interest.

14. How can poorly designed compensation schemes in financial service firms lead to conflicts of interest?

If the compensation scheme for one activity is very high relative to the compensation scheme for another activity, then employees might conceal or misuse information when engaging in the lower-paying activity to get more business in the higher-paying activity.

15. What are ―reputational rents‖ and how are they significant?

Reputational rents refer to the value of a firm’s reputation, as reflected by customers’ purchases from the firm because it is trusted in the marketplace with high-quality, reliable products or services. They are significant here in that conflicts of interest can arise where individuals within an institution may have short-term incentives to produce results or meet goals which generate revenue for the company, but are not aligned with the principles or long-term strategies of the company, and may harm the reputation of the company in the long run.

16. ―Sarbanes-Oxley significantly raises compliance costs for firms. Since it dramatically decreases market efficiency, it should be abolished.‖ Do you agree with this statement? Why or why not?

Although many believe the standards set forth in the Sarbanes-Oxley legislation are onerous and make compliance costly, there are benefits to the laws which reduce conflicts of interest and help to avoid the accounting scandals illustrated by the Arthur Anderson and Enron cases. In this sense, it should probably not be abolished, but some might agree that an overhaul or streamlining of the legislation should occur.

17. Which provisions of the Sarbanes-Oxley Act do you think are beneficial and which do you think are not?

Sarbanes-Oxley requires CEOs and CFOs to certify the financial statements and disclosures of the firm and requires disclosure of off-balance-sheet transactions and relationships with special purpose entities. This mandatory disclosure improves the quality of information, but has the disadvantage of being costly. Sarbanes-Oxley also substantially increases supervisory oversight with the PCAOB that can help stop conflicts of interest in the accounting industry. Also by making the audit committee independent of management, audits are likely to be more reliable, an important benefit. However, Sarbanes-Oxley may reduce economies of scope available to accounting firms by preventing them from providing auditing and consulting services to the same client.

18. Which provisions of the Global Legal Settlement do you think are beneficial and which do you think are not?

The Global Settlement has increased disclosure of analysts’ recommendations, which can help increase information in financial markets. Also, it required increased disclosure of potential conflicts of interest, which can help the market to constrain them. The Global Settlement bans spinning, which might otherwise encourage executives to choose high-cost investment banks to underwrite their securities: Banning spinning makes it more likely that lower-cost and more efficient underwriting will take place. The fines imposed by the Global Settlement also provide incentives for investment banks to avoid exploiting conflicts of interest in the future. The negative side of the Global Settlement is that it separates activities and so may mean that economies of scope in information production are lost. The Global Settlement also requires that part of the $1.4 billion fine be used to fund independent research, but it is not clear that the quality of this research will be high.

19. Why might the market be the best mechanism for minimizing conflicts of interest?

There are several reasons why a self-regulating market mechanism may work best.

First of all, it requires no explicit regulation by the government. In addition, markets can penalize offending firms in the form of higher funding costs, or lower demand for their services. This has the effect of impacting offending firms with lower profits and helps to avoid excessive reactionary responses, which can occur in the politicized regulatory process.

20. What are the advantages and disadvantages of mandatory disclosure when dealing with conflicts of interest?

Mandatory disclosure has the advantage of providing information to help markets assess whether a conflict of interest exists, thus enabling the markets to discipline firms that exploit conflicts of interest. It has the disadvantage that it might reveal proprietary information or have a high cost, thereby making it hard for the financial institution to make money from engaging in information production. Also it might not work if financial firms can get around the regulations and continue to hide information about conflicts of interest.

21. How can supervisory oversight help reduce conflicts of interest?

Supervisory oversight can reduce conflicts of interest because the supervisor might have better access to information about whether a conflict of interest exists and is being exploited and can then take actions to stop it.

22. What are the disadvantages of separating financial activities into different firms in an effort to avoid conflicts of interest?

Separating financial activities can reduce synergies, thereby preventing financial firms from taking advantage of economies of scope, thereby raising the cost of information production and reducing the flow of reliable information.

23. What are the advantages and disadvantages of governmental provision of information as a solution to the problems created by conflicts of interest?

The government agency is less likely to have the conflict of interest than the private sector. In addition, information may be a public good that is undersupplied, so government provision of this information might make the markets more efficient.

Conversely, the government may not have as good incentives as the private sector to

provide good-quality information. Also, government agencies have trouble paying high salaries to get the best people, so the quality of information they provide might not be very good.

24. Why is a conflict of interest present when compliance officers are involved in the production of credit ratings?

This represents a conflict of interest in that compliance officers are tasked with ensuring that an institution is conforming to all applicable laws and regulations, as well as internal firm protocols. In order for them to be credible and effective in this role, it is vital that they do not put themselves in a situation where conflicts of interest can arise. This can occur in particular when producing credit ratings, since the companies that are being rated can benefit tremendously from favorable ratings, and can lobby the raters to improve those ratings. Compliance officers involved in this process may then face a conflict between ensuring compliance with internal and formal regulations and improving client relations and better bonus checks.

25. In what ways is the Dodd-Frank legislation designed to reduce conflicts of interest?

The Dodd-Frank legislation helps reduce conflicts of interest by prohibiting compliance officers from working on producing credit ratings, and prohibits firms issuing asset-backed securities from shopping around for the highest ratings. It also authorizes investors to sue credit-rating agencies for reckless failure to produce accurate ratings.