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1- Financial Crisis & Intro

1- Financial Crisis & Intro - Monetary Economics Winter...

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Monetary Economics, Winter 2010 Introduction We will start with a description of various interest rates, financial instruments, and financial institutions to get us grounded in the real world before we start to discuss the current financial/housing crisis and to develop economic models. Examples of interest rates and financial instruments : If you flip through the financial pages of a newspaper you will see many different interest rates and their associated financial instruments. Interest rates usually are expressed in percentage points per annum (e.g., 6.25% per annum); sometimes they are expressed in basis points where each basis point is 1/100 th of a percentage point (e.g., 6.25% per annum converts to 625 basis points per annum). Interest rates and associated financial instruments related to personal saving : for example, rates on Certificates of deposit (CDs) and on checking deposits. Interest rates and associated instruments related to personal borrowing (for example, on home mortgages, student loans, auto loans, and credit cards): The most common type of fixed-rate home mortgage is one with 30 years to maturity; “fixed rate” means that the interest rate remains the same over the 30 years. The home itself serves as collateral for the loan, meaning that if the borrower defaults on the loan, the lender gets the house. ARMs are an alternative type of mortgage. The mortgage with a 1-year adjustable rate, for example, is a home loan that is paid off typically over 30 years but for which the interest rate is adjusted annually. Usually the interest rate is tied to some measure of market interest rates, such as the average yield on a 1-year U.S. Treasury security. There often is a maximum amount by which the rate can adjust or “re-set”each year. People borrow to buy motor vehicles, using the vehicle as collateral for the loan. The car can be repossessed and resold by the lender. Credit card loans, by contrast, involve no collateral , and the lender has to incur significant legal expenses to force repayment. These costs tend to exceed those associated with repossessing collateral and thus helps explain why the interest rate on credit cards is so much higher than rates on auto loans. There are other reasons as well. The expected loss on credit cards is relatively high in the absence of very high interest rates because, in the absence of those high rates, it has been found that people who are very bad credit risks apply for credit cards and default at high rates. The opportunism revealed by such people is an example of adverse selection .
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2 Interest rates and associated instruments related to government borrowing : In terms of government borrowing, there are rates on U.S. Treasury bills (with maturities up to 1 year), rates on U.S. Treasury notes (with maturities between 1 year and 10 years), rates on U.S. Treasury bonds (with maturities greater than 10 years), and rates on local or municipal government bonds. To finance its budget
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1- Financial Crisis & Intro - Monetary Economics Winter...

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