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Definitions |
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RISK PREMIUM
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INTEREST RATE SPREAD BETWEEN DEFAULT AND DEFAULT FREE BONDS
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INFLATION
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RATE OF INCREASE IN PRICES OF GOODS AND SERVICES
Measured by GDP Deflator, PCE deflator, and Consumer Price Index
Phillips Curve
Currently inflation is up as a result of increase in crude oil, agricultural products, & other commodities, & a decline in US dollar
Overly expansionary monetary policy leads to high inflation.
Increase rates slows down growth in inflation
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3 factors that move LRAS line
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1. Amount of Labor Force
2. Capital Invested in the Economy
3. Available Technology
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Fisher Equation
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in=ir+pie(e)
Nominal interest rate =real interest rate +expected inflation
Real =adjusted by subtracting expected changes in the price level to reflect true cost of borrowing
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RATIONAL EXPECTATIONS
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DECISIONS REFLECT OPTIMAL FORCASTS USING ALL DATA.
Leads to an efficient capital market.
Changes are fast.
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Easing
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Push interest rates down
Use when output falls short of growth potential but produces a slack in resources
Stock prices go up
Dollar depreciates
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Factors that cause shift in the SRAS curve
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1. Output is above or below natural level
2. Expected Price
3. Wage Push
4. Change in Production Cost unrelated to wage costs
5. (Productitivity)
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Sovereign Weath Funds
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Gov't run investment fund.
Ex: China's investment in Morgan Stanley, Abu Dhabi investment in City Group, Singaport investment in UBS.
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TIPS Spread
(Treasury Inflation Protection Spread)
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Spread between yield on nominal 10 year Treasury Issues and yield on TIPS.
Direct measure of long term inflation rates.
Watch 5 & 10 years maturities.
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GDP
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MARKET VALUE OF ALL FINALS GOODS AND SERVICES PRODUCED IN A YEAR
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Tightening
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Push interest rates up
Used when excess in output growth but produces strains on labor market
Stock prices will fall
Dollar will appreciate
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Irrational Exuberance
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Coined by Greenspan.
Catch phrase of the stock market boom of the 1990's.
Heighted state of speculation.
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Recession
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According to NBER (Nat'l Bureau of Economic Research)
- Significant decline in economic activity
- Spread across the economy
- Lasting more than a few months
- Normally visible in Real GDP, real income, emplyment, industrial production & wholesale/retail sales
Conventional Definition - at least 2 consecutive quarters of declining Real GDP
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OUTPUT GAP
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MAXIMUM LEVEL OF OUTPUT - ACTUAL OUTPUT
Wider gap, greater slack in resource.
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Credit Default Swap
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Over-the-counter derivatives where buyer who wants to hedge a company's credit risk pays seller a periodic fee in exchange for a contingent payment triggered by a credit event (i.e. bankruptcy, downgrading of credit rating).
Transfer of credit risk between counterparties.
A bet someone is going to default on credit.
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FIAT MONEY
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PAPER CURRENCY BACKED BY GOV
NOT EXCHANGE FOR GOLD
Started in U.S. in 70's. First time for U.S. exchange rate fluctuation.
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Fiscal Policy
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Must be:1. Timely 2. Targeted 3. Temporary
Automatic stabilization Feature
It's better than monetary policy, felt by families bearing the brunt of recession.
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MONETARIST
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MONEY SUPPLY PRIMARY SOURCE OF PRICE LEVEL CHANGES
ECONOMY INHERENTLY STABLE
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Purchase Power Parity
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Exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. Assume all goods are identical & transportation & trade costs are low. However, all goods are not identical. Also, many goods are not traded across national borders.
Factors affecting exhange rates in the long and short run.
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T - Accounts
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Fed Reserves
Assets Liabilities
Securities Reserves
Discount Loans Currency in circulation
Banking System
Assets Liabilities
Reserves Checkable Deposit
Securities
Nonbank Public
Assets Liabilities
Securities
Checkable Deposits
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CARRY TRADE
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BORROW IN CURRENCIES WITH LOW INTEREST RATES SUCH AS YEN INVEST IN "Commodity" CURRENCIES THAT PAY HIGH INTEREST RATES, LIKE NEW ZEALAND & CANADIAN DOLLAR
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Efficient Market Hypothesis
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Expectations are not only rational but also prices reflect the real value of securities being traded.
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DISINFLATION
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SLOWING IN THE RATE OF GROWTH IN PRICES OF GOODS AND SERVICES
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Most Recent Fiscal Packages
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1. Fixed spending allowance - $600 per adult
2. Tax Rebates
3. Increase in FHA insurance to mortgage companies
4. Increase in ceiling for comforming mortgages purchased by Fannie Mae & Freddie Mac up to $729,750 from $417,000
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Fed Fund Rate
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Bank reserves held at the Fed, loaned and borrowed between banks, usually overnight.
Since September through April, this rate has been cut from 5.25% to 2.25% - 300 basis points.
2.25 % Nominal FFR - 2% Core PCE = .25% Real FFR (room for futher rate cuts)
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Factors affecting Demand for Bonds
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1. Wealth - increase causes increase in demand.
2. Expected interest rates - increase cause decrease in demand.
3. Expected inflation - increase cause decrease in demand.
4. Riskiness - increase cause decrease in demand.
5. Liquidity - increase cause increase in demand.
6. Expect return - increase cause increase in demand.
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Financial Stimulus
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Stimulants to induces households and businesses to spend.
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How can you pump emergency liquidity into the system?
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1. Fed supply of reserves
2. Cutting Rates
3. TAF, TSLF & PDCF
4. Capital infusion by foreign sovereign wealth funds
5. Fiscal Policy packages
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Deriaviatives
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A Financial Instrument
-Transfer of risk to those who want to take it at a profit
- Types: Option Contract, Foward Contracts, Future contracts, Swaps.
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TIME INCONSISTENCY TRAP
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CENTRAL BANKS SEEKING TO BOOST OUTPUT AND EMPLOYMENT IN THE SHORT RUN BY EXPANSIONARY MONETARY POLICY.
BUT ONLY THING THEY CAN DO IN THE LONG RUN IS CONTROL INFLATION, and to do this effectively, they must avoid overly expansionary policies in the short run.
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INDIRECT FINANCE
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BANKS MOVE FUNDS INDIRECTLY FROM
SAVERS TO BORROWERS
Banks borrow short-term funds and loan these funds long term
Direct Finance - Issuance of debt or stock
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Financial Multiplier
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1. Decline in asset prices
2. Reduction in value of collateral
3. Banks become more restrictive in leaning
4. Increasing severity of economic downturn
5. Increasing credit losses
6. Cycle starts all over again
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Monetary Policy
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Direct Effect on banking system and capital markets
Indirect impact on aggregate demand and output growth
Longer to take effect (6 to 12 months) than fiscal policy
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Opportunity Costs
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Amount of interest sacrificed by not holding an alternative asset.
Ex: Holding money and not putting it into a money market account.
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CAPITAL MARKET
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TRADING OF LONG TERM DEBT / EQUITY
(MATURITY OF MORE THAN 1 YEAR)
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New Regulation
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Feds say it is critical in knowing what banks are doing to come up with innovative ideas.
Although it may help smooth the curve, it will not eliminate peaks and trenches because human nature never changes.
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4 types of Credit Market Instruments
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1. Simple Loans - business loans
2. Fixed Payment - car/home
3. Coupon Bond - Treasury/Corp Bonds
4. Discount Bond/Zero Coupon-Treasury Bills/Bonds
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Present Value
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PV = CF/(1+i)n
A dollar paid to you today is worth more than a dollar paid a year from now.
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RICARDIAN EQUIVALENCE
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PEOPLE UNDERSTAND THAT BOND ISSUES FROM GOV'T MEAN THAT THEY WILL PAY HIGHER TAXES
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NAIRU
(Non-accelerating inflation rate of unemployment)
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LOWEST RATE OF UNEMPLOYMENT AT WHICH THERE IS NO TENDENCEY FOR INFLATION TO CHANGE
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Aggregate Supply/Output
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GDP -Total production of all final goods & services.
Sustainable Growth potential = productivity growth plus labor force growth
Natural output - max output at full employment
Output Gap = Diff between max level & actual level
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REAL BILLS DOCTRINE
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LOANS MADE TO SUPPORT PRODUCTION OF GOODS AND SERVICES WILL NOT BE INFLATIONARY
BAD THEORY
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3 Factors Affecting Exchange Rates
in the Short Run
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1. Price levels - when prices go up, demand goes down, and currency value goes down.
2. Trade Barriers - cause a country's currency to appreciate.
3. Productivitity - higher productivity reduces unit labor costs & prices leading to currency to appreciate.
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Expectations Theory
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The interest rate on a long-term bond will equal the average of the short-term interest rates expected over the life of the long-term bond.
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Off-Balance Sheet Activities
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Trading financial instruments and generating income from fees (servicing mortgages) and loan sales (at higher rates).
If issuer of security defaluts, the bank is responsible.
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Shift in Supply of Bonds
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1. Expected Profitability of investments
2. Expected inflation
3. Gov't budget
All have a direct relations to supply.
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Balance of Payments
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Book keeping system for recording all receipts and payments that have a direct bearing on movement of funds between a nation and foreign currencies.
Key items in the balance of payment:
1. Current Accounts
2. Capital accounts
3. Sum of 1 and 2 = Net change in gov't international reserves
4. Sovereign wealth funds - up to 3.5 trillion
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OPPORTUNISTIC DISINFLATION
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WHEN INFLATION IS LOW BUT NOT YET TO DESIRED LEVEL
FED KEEPS ECONOMY PRODUCING AT SUSTAINABLE GROWTH UNTIL RECESSION
THEN EASE TO CORRECT SHORTFALL IN DEMAND
ACCEPTING LOST OUTPUT AND CEMENTING IN LOWER INFLATION FROM RECESSION
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PDCF (Primary Dealer Credit Facility)
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Infinite amount of funds
Open to depository institutions plus investment banks
Extended to 90 days
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4 Factors that Fuel Inflation
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1. Rising inflation expecations
2. Decling economic slack
3. Increase in energy prices (oil)
4. Decline in U.S. dollar in foreign exchange markets
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GREAT MODERATION
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TENDENCY OVER PAST 25 YEARS HAS BEEN LOW INFLATION ECONOMIC GROWTH WITH REDUCED FLUCTUATIONS & LOW VOLATILITY.
GOOD JOB FED WITH COUNTER-CYCLICAL EFFECTS!
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Inside Lag
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Time between major shock & initial response to monetary or fiscal policy
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YIELD CURVE
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UPWARD SLOPING = STRONGER ECONOMIC GROWTH =
Short term interest rates expected to rise
DOWNWARD SLOPING = SLOWER GROWTH =
Short term interest rates expected to fall
Flating yield curve - short term rate hikes lead to longer term increase but then investors become increasing convined that inflation will be contained.
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GDP Deflator
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Nominal GDP (current prices)/Real GDP (fixed prices)
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GREENSPAN CONUNDRUM
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FED'S 325 BASIS POINT RATE HIKE CAUSED LONG TERM RATES TO DECLINE BY 40 POINTS
NORMALLY INCREASE IN FED FUND RATE IS ACCOMPAINED BY SYMPATHETIC INCREASES IN LONG-TERM INTEREST RATES RATHER THAN DECLINES.
CAUSES: GLOBAL SAVINGS GLUT, JAPANASE CARRY TRADE, LOW INFLATION EXPECTATIONS
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Update on Credit Crisis
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Explain
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Liquidity Premium Theory
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The interest rate on a long-term bond will equal an average of short-term interest rates expected over the life of the long-term bond plus a liquidity premium which increases as the term to maturity increases.
Key assumption: Bonds of different maturities are close though not perfect substitutes. Expected return on one bond influences the return on another. Nevertheless, investers prefer shorter-term bonds.
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ADAPTIVE EXPECTATIONS
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DECISIONS BASED ON PAST VALUES.
Changes in expectation are slow.
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Factors Affecting Supply of Bonds
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1. Profitabliity of investments - increase cause increase in supply in bonds
2. Expect inflation - increase cause increase in supply in bonds
3. Gov't deficit - increase cause increases supply in bonds
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CDO
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Off balance sheet conduits or Structured Investment Vehicles that buy risky longer-term securities and sell matching liabilities in the form of high and low risk tranches.
Problem: NO LIQUIDITY & HARD TO VALUE
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Term Auction Facility (TAF)
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- Introduced Dec 2007 injecting $40 Billion
- On March 7 increased injection to $100 billion in emergency liquidity
- through a series of auctions
- at a rate below the discount rate, closer to FFR
- with an extension from 28 days to 6 month terms
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Fed's Monetary Policy Tools
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Management of Short-term interest rates
1. Discount Rate
2. Fed Fund Rate target through open market operations
3. Required Reserves
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FUTURES
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AT EXPIRATION DATE, PRICE OF THE CONTRACT IS THE SAME AS THE PRICE OF THE UNDERLYING ASSET
Sale on a future date.
More liquid
Types: U.S. Treasury Sec., currency contracts, Euro dollar contracts, etc.
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PHILLIPS CURVE
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TRADE OFF BETWEEN PRODUCTIVE CAPACITY AND INFLATION
IF UNEMPLOYMENT RATE IS PUSHED TOO LOW, WAGES AND PRICES WILL BE PUSH UP.
ECONOMIC SLACK
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Yield to Maturity
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Interest rate that equates the present value of cash flow payments on a debt with its value today.
PV = CF/(1 + i)n
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Shifts in SRAS
(Short run aggregate supply)
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When output exceed natural level, demand for labor exceed supply, higher labor costs, reduced profits - shift to left.
When output falls below natural level, demand for labor falls short of supply, lower labor costs, increased profits - shift to the right
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FINANCIAL INTERMEDIATION
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BANKS MOVE FUNDS FROM
SAVERS-LENDERS TO BORROWERS-SAVERS
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ASSET PRICE BUBBLE
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SHARP SURGE IN ASSET PRICES SUSTAINED BY IRRATIONAL EXUBERANCE through the wealth effect on spending and output.
Bernanke Rule: If a bubble has not caused inflation, then the Feds should not respond.
If a bubble causes inflation the Feds should move with tightening measures.
Once a bubble burst, the Fed should respond immediately with easing in its policy
stance.
Difficult to identify until after it bursts.
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Intended Saving
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Almost never equals intended investments. If intended savings exceeds intended investments, interest rates decline.
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Who makes up the FOMC ?
(Fed Open Market Committee)
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7 Fed Governors + 5 Reserve Bank Pres. = 12
Meet 8 times a year.
Buys and sells gov't securities which effects interest rates and reserve amounts in the banking system.
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Effects on Globalization & Outlook of Dollar
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1. Foreign Exchange Rates
2. Purchase Power Parity
3. International Reserves
4. Balance of Payments -
current account,
capital aacount,
sum of current and capital = net change in gov't int'l reserves,
Sovereign wealth fund
5. Outlook of US dollar -
trade deficits,
domestic demand,
locomotive role,
US-Euro interest rate diff
6. Outlook of China -
Rapid growth,
export led,
mercantilist style build up in int'l reserves (sell, sell, not buy)
expansion seeking sources for oil & indust mat
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Factors affecting exchange rates in the short run.
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1. Domestic Intestest Rates - increase in rates causes demand, dollar appreciates.
2. Foreign Interest Rates -increase in rates causes decrease in demand for domestic assets and causes domestic currency to depreciate.
3. Expected increase in future exchange - rate increases demand for domestic assets and cuase the domestic currency to appreciate.
4. When domestic real interest rates rise, the demand for domestic assets increases and the domestic currency appreciates.
5. Domestic interest rates rise due to an increase in expected inflation the demand for domestic assets decrease ad the domestic currency depreciates.
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FORWARD CONTRACTS
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ENGAGE IN A TRANSACTION AT A FUTURE POINT IN TIME.
Sale of a debt at a future date at a set price.
Lacks liquidity.
Default risk on part of counterparty.
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Transmission Mechanism
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Explain
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Factor Affecting Exchange Rates
in the Long Run
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Demand for domestic assets
Increase in interest rates increase demand for domestic assets, currency appreciates.
Increase in foreign interest rates decreases demand for domestic assets, currency depreciates.
Increase in expected future exchange rate increases deman for domestic assets, currency appreciates.
When interest rates rise due to inflation, the demand for domestic assets decrease, currency depreciates. Fisher Equation.
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Aggregate Demand Components
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70% PCE (Personal Consumption Expenditures)
4% FRI (Residential Fixed Investments)
10.8% BFI (Business Fixed Investments)
19.6% Government Spending
-5.1% Net Exports (12.3% Exports-17.4 Imports)
Effected 6 months after transmission channels are put into place.
When dollar goes down, exports go up, deficit goes down
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Primary transmission channel of monetary policy
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1. Interest Rates
2. Asset prices, through wealth effect
3. Foreign exchange value of dollar, which influences net exports.
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CONTRACTUAL SAVINGS INSTITUTIONS
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ACQUIRE FUNDS AT PERIODIC INTERVALS
Benefit: CAN PREDICT HOW MUCH PAYOUT IS
Examples: LIFE INSURANCE, PENSION FUNDS, ETC
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Sources of Liquidity
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1.Capital infusion by foreign sovereign wealth funds 2. Central banks creation of new money
3. Global carry trades
4. Global saving glut
5. Home equity appreciate
6. Feds supply of reserves
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BANK RESERVES
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BORROWED RESERVES (BANKS BORROWINGS AT DISCOUNT WINDOW)
AND
NONBORROWED RESERVES (INFLUENCED BY PURCHASES OR SALES OF GOV'T SECURITIES)
PURCHASES ADD NON-BORROWED RESERVES. SALES SUBTRACT NON-BORROWED RESERVES.
BANK CAN HOLD RESERVES AT FED OR IN VAULT.
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MORAL HAZARD
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SAFETY NET INDUCES MORE RISK THAN NORMAL
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Global Crisis Triggers
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July 25 - Countrywide reveals sub-mortgage market problems
August 3 - Bear Stearn closes 2 funds with heavy holdings of sub-prime mortgage backed securites.
August 9 - BNP Paribas halts redemption of asset backed securities because it could not determine market value
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PRIMARY CHANNELS OF MONETARY POLICY
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INTEREST RATES
EQUITY PRICES
DOLLAR VALUE
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SUSTAINABLE GROWTH POTENTIAL
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PRODUCTIVITY GROWTH + LABOR FORCE GROWTH
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Perfect Storm
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1. Investor complacency & overconfidence
2. Decling inflation expectations
3. Unusually low interest rates
4. Abnormally narrow credit risk spread in debt mkt
5. Investors seking "enhanced" returns.
6. Housing boom 2003-2006
7. Home price appreciation
8. Housing credit bubble
9. Housing bust 2006-2008
10. Recession
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Global Credit Crisis
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1. Housing buble burst in U.K. & Spain
2. Decrease exports by Germany because of soaring euro.
3. U.K.'s largest mortgage lender had to be rescued by gov't
4. Two German Banks same fate
5. China suppressing unsustainable double digit growth
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Factors that effect Options
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1. Strike Price
2. Stock Price
3. Volitilaty
4. Interest Rates
5. Duration
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1997-1998 Asian Contagion
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Extremely depression impact on growth in a string of mostly Asian economies, while U.S. growth remained strong.
Asian market not effected today by our credit crisis.
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WAREHOUSE PERIOD
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TIME BETWEEN WHEN A BANK UNDERWRITES LOAN AND WHEN LOAN IS SOLD TO INVESTORS
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CREDIT DEFAULT SWAP
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HEDGE AGAINST CREDIT DEFAULT RISK IN BOND
TRIGGERED BY CREDIT EVENT
Over-the-counter deriviative
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Shift in the Demand for Bonds
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1. Wealth
2. Expected return
3. Risk
4. Liquidity
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Tobin's "q" ratio
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Ratio of stock prices to replacement cost of capital.
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Lessons of the 1970's
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Inflation expections must be well anchored if supply side oil price shocks are to be kept from spilling over into core consumer inflation.
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Economic Slack
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Unemployment rate above NAIRU
Aggregate output below maximum potential output at full employment
Output gap
Greater ecomonic slack, lower inflation
Declining ecomomic slack, higher inflation
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Term Securities Lending Facility (TSLF)
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- Announced March 11
- Injections of $200 billion in lending liquid Treasury securities
- Exchange for illiquid mortgage backed sec.
- Available to Primary Dealers (20 banks)
- Weekly auctions
- 28 day periods
- Problem because they were limited
- Secured by collateral
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Two Track Fed Reserve Approach
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1. Inject emergency liquidity to stabilize financial markets.
2. Increase in reserve availability through Fed outright purchases of Treasury securities accompanied by cut in Fed fund rates.
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WEALTH EFFECT
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IMPACT OF CHANGE IN WEALTH ON HOUSEHOLD SPENDING
$1 INCREASE IN NET WORTH
= 4 CENT CHANGE IN SPENDING
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Fiscal Policy Measures
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Government spending component of aggregate demand may be influenced by fiscal countercyclical policies.
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Average Duration of Expansion
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57 months
Our recent expansion was 72 months
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STAGFLATION
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HIGH INFLATION
LOW GROWTH
HIGH UNEMPLOYMENT
1970 WITH OIL SHOCK
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Options
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Right to buy or sell at an exercise/strike price within a specific time/before an expiration date.
You can never loose more than you paid for the option.
Examples: stock options & futures options.
Call: right to buy at set price before term date
Put: right to sell at set price before term date
Example: Bears Stearns - Bearish (puts) bets
outnumbered bullish (call)bet by 2.5 to 1.
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Hierarchical Mandate
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Price Stability
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Discount Rate
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Cost of borrowing from the Fed
Available to deposity institutions
Usually 100 basis points above Fed funds rate
Stigma associated with discount window because of perception of financial weakness
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Financial Restraints
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Restraints to curtail households and businesses frin spending.
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Non-bank Financial Entities
Shadow Banking System
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1. Finance companies
2. Insurance Companies
3. Mutual Funds
4. Hedge Funds
5. Private Equity Industries
6. Pension Funds
7. GSE
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Factors that affect the exchange rates in the long run.
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1. Relative Price Levels compared to other countries
2. Trade Barriers - on incoming goods
3. Productivity - more goods at less cost
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Bears Sterns Bail Out
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Occured March 14
Use of Discount Window
28 day loan to J.P. Morgan to buy B.S.
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6 Indicatiors of the Credit Crisis
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1. Corporate Credit Risk Spreads-widening spread of interest rate on bonds of diff. credit risk
2. TED Spreads- cost of short term borrowings relative to costs of US Treasury (I.e. 3 month US Treasury Bills vs 3 month euro dollars rate)
3. LIBOR spreads - rate on interbank lending relative to dollar(Fed fund rate vs. euro vs. sterling)
4. Credit Default Swaps -protection on credit event. Crisis causes higher premium.
5. VIX Index - volatility measure for S&P 500. Seen mostly in demand for options due to fear.
6. 30 year Fannie Mae mortgage backed securities vs. 5 or 10-year U.S. Treasury Securities Spread
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Credit Crunch
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"An environment in which quality borrowers find credit either unavailable or available only on very expensive terms." Minneapolis Fed Pres. Gary Stern
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Exchange Rate Targeting
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Advantage:
1. Keeps inflation under control.
2. Automatic rule for monetary policy
Tightening when currency depreciates
Easing when currency appreciates
Disadvantage:
1. Inability to pursue independent monetary policy
2. Open to attacks against currency
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SECURITIZATION
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TURN ILLIQUID ASSET INTO MARKETABLE SECURITIES TRADE IN CAPITAL MARKETS
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SOFT LANDING
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OUTPUT BELOW MAXIMUM (FULL EMP) LEVEL & GROWTH ABOVE POTENTIAL
FED TIGHTENS JUST ENOUGH TO SLOW OUTPUT GROWTH TO SUSTAINABLE POTENTIAL AS THE LEVEL OF OUTPUT REACHES MAXIMUM LEVEL(FULL EMPLOYMENT)
Examples: Succeeded in 1994/95
Failed in 1988/89 and 1999/2000 leading to recession
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Core PCE (Personal Consumption Expenditures)
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Feds favorite short-term indicator of the underlying trend in inflation.
Core PCE - less food & energy
Headline-everything/best long run inflation indicator
Currently curtailed by higher credit costs, declining home prices, rising energy prices, volatile stock , prices, soft employment conditions
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MONEY MARKET
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TRADING OF SHORT TERM LIQUID SECURITIES WITH MATURITY OF ONE YEAR OR LESS
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Disadvantages of Official Inflation Target
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Bernanke favors. Greenspan did not because it reduces flex. in achieving major objective of sustainable growth
1. Too much weight on stable prices
2. Tendency to fight inflation at expense of all else
3. Loss of credibility when target is missed
4. Congress will want an unemployment target
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Shifts in the Demand for Money
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1. Income Effect
Income up, demand for money up, interest rates up
2. Price Level Effect
Prices up, demand for money up, interest rate up
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Average Duration of a Recession
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10 months
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Random Walk
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Stock prices follow a random walk. Future prices are unpredictable. Past stock prices cannot predict future prices.
Extreme version of Efficient Market Hypothesis
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Fed's Dual Mandate
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1. Stable Prices
2. Maximum Employment
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Factors that affect the US Dollars
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1. Trade deficits
2. Domestic demand
3. Locomotive role - our consumer pulls the world along but it is unstatainable
4. U.S. vs European interest rate differential - Feds need to stop cutting
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KEYNESIAN
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GOVERNMENT AND FISCAL POLICY AFFECT OUTPUT
ECONOMY IS NOT INHERENTLY STABLE
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Liquidity
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Financial asset that can be converted into cash cheaply and quickly.
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2007-2008 Credit Crisis
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Triggered by a sudden collapse in the housing market and the rapid increase in defaults on subprime mortgages. An abrupt shift from abundant liquidity to scarce liquidity, and sudden investor risk aversion as reflected in a flight to US Treasury Securities. Crisis has seen a dramatic shift favoring deleveraging of risk and the re-pricing of risk especially in the mortgage market. A large portion of the credit bubble was extended indirectly through a shadow banking system consisting of highly leverage nonbank financial interemediaries as well as off-balance sheet conduits such as CDO. Problem created:
1. The underlying assets could not be valued accurately because real estate values were declining and foreclosures were increasing and
2. There are no secondary markets for these assets.
3. Some of these funds were closed due to an impossibility to determine their values.
4. Some banks and other financial instituiton wrote huge write-downs of mortgage-related asset holdings.
5. Banks hoarding liquidity, increased costs for credit.
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Shifts in the Supply of Money
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1. Changes in Income
Income up, supply up, int. rates up
2. Changes in prices
Prices up, supply up, int. rates up
3. Changes in money supply
Money supply up, supply up, int. rates down
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Signals of excess liquidity
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1. Declining short term interest rates
2. Sharp steepening in yield curve.
3. Stock market rally
4. Asset price bubbles
5. Booming housing market
6. Speculation in commodity markets
7. Decline in US dollar
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