Unformatted text preview: Money and Banking 01:220:301 Sec.01 Instructor: Carl Shu‐Ming Lin Name: Final May 6, 2010 Q1. 20pts 1. The amount of borrowed reserves is ________ related to the discount rate, and is ________ related to the market interest rate. A) negatively; negatively B) negatively; positively C) positively; negatively D) positively; positively 2. The discount rate is ________ kept ________ the federal funds rate. A) always; below B) typically; below C) typically; equal to D) typically; above 3. High unemployment is undesirable because it A) results in a loss of output. B) always increases inflation. C) always increases interest rates. D) reduces idle resources. 4. The case for Federal Reserve independence does not include the idea that A) political pressure would impart an inflationary bias to monetary policy. B) a politically insulated Fed would be more concerned with long‐run objectives and thus be a defender of a sound dollar and a stable price level. C) policy is always performed better by an elite group such as the Fed. D) a Federal Reserve under the control of Congress or the president might make the so‐called political business cycle more pronounced. 5. Under monetary targeting, a central bank announces an annual growth rate target for ________. A) a monetary aggregate B) a reserve aggregate C) the monetary base D) GDP 6. The monetary policy strategy that provides the least accountability is A) exchange‐rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. 7. Using Taylor's rule, when the equilibrium real federal funds rate is 2 percent, there is no output gap, the actual inflation rate is zero, and the target inflation rate is 2 percent, the 1 nominal federal funds rate should be A) 0 percent. B) 1 percent. C) 2 percent. D) 3 percent. 8. The majority of members of the Federal Open Market Committee are A) Federal Reserve Bank presidents. B) members of the Federal Advisory Council. C) presidents of member banks. D) the seven Federal Reserve governors. 9. Which of the following is NOT an entity of the Federal Reserve System? A) Federal Reserve Banks B) The Comptroller of the Currency C) The Board of Governors D) The Federal Open Market Committee 10. Purchases and sales of government securities by the Federal Reserve are called A) discount loans. B) federal fund transfers. C) open market operations. D) swap transactions. Q2. 20pts 1. If the Fed decides to reduce bank reserves, it can A) purchase government bonds. B) extend discount loans to banks. C) sell government bonds. D) print more currency. 2. The theory that monetary policy conducted on a discretionary, day‐by‐day basis leads to poor long‐run outcomes is referred to as the A) adverse selection problem. B) moral hazard problem. C) time‐inconsistency problem. D) nominal‐anchor problem. 3. Even if the Fed could completely control the money supply, monetary policy would have critics because A) the Fed is asked to achieve many goals, some of which are incompatible with others. B) the Fed's goals do not include high employment, making labor unions a critic of the Fed. C) the Fed's primary goal is exchange rate stability, causing it to ignore domestic economic conditions. D) it is required to keep Treasury security prices high. 4. Which of the following is not an advantage of inflation targeting? A) There is simplicity and clarity of the target. B) Inflation targeting does not rely on a stable money‐inflation relationship. 2 C) There is an immediate signal on the achievement of the target. D) Inflation targeting reduces the effects of inflation shocks. 5. The ratio that relates the change in the money supply to a given change in the monetary base is called the A) money multiplier. B) required reserve ratio. C) deposit ratio. D) discount rate. 6. Assuming initially that r = 10%, c = 40%, and e = 0, a decrease in r to 5% causes the M1 money multiplier to _____, everything else held constant. A) increase from 2.8 to 3.11 B) decrease from 3.11 to 2.8 C) increase from 2 to 2.22 D) decrease from 2.22 to 2 7. Both ________ and ________ are monetary liabilities of the Fed. A) government securities; discount loans B) currency in circulation; reserves C) government securities; reserves D) currency in circulation; discount loans 8. The monetary base minus currency in circulation equals A) reserves. B) the borrowed base. C) the nonborrowed base. D) discount loans. 9. When the Fed buys $100 worth of bonds from First National Bank, reserves in the banking system A) increase by $100. B) increase by more than $100. C) decrease by $100. D) decrease by more than $100. 10. The discount rate is A) the interest rate the Fed charges on loans to banks. B) the price the Fed pays for government securities. C) the interest rate that banks charge their most preferred customers. D) the price banks pay the Fed for government securities. 3 Q3. Credit Crisis (20pts) Recipe for Disaster: The Formula That Killed Wall Street A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize‐winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide. For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored. Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full‐fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril. David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees. How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion‐dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers. 4 A bond, of course, is just an IOU, a promise to pay back money with interest by certain dates. If a company—say, IBM—borrows money by issuing a bond, investors will look very closely over its accounts to make sure it has the wherewithal to repay them. The higher the perceived risk—and there's always some risk—the higher the interest rate the bond must carry. Bond investors are very comfortable with the concept of probability. If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time. Bond investors also invest in pools of hundreds or even thousands of mortgages. The potential sums involved are staggering: Americans now owe more than $11 trillion on their homes. But mortgage pools are messier than most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default. Wall Street solved many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk‐free triple‐A credit rating. Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double‐A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on. The reason that ratings agencies and investors felt so safe with the triple‐A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time. But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage‐pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are. 5 Investors like risk, as long as they can price it. What they hate is uncertainty—not knowing how big the risk is. As a result, bond investors and mortgage lenders desperately want to be able to measure, model, and price correlation. Before quantitative models came along, the only time investors were comfortable putting their money in mortgage pools was when there was no risk whatsoever—in other words, when the bonds were guaranteed implicitly by the federal government through Fannie Mae or Freddie Mac. Yet during the '90s, as global markets expanded, there were trillions of new dollars waiting to be put to use lending to borrowers around the world—not just mortgage seekers but also corporations and car buyers and anybody running a balance on their credit card—if only investors could put a number on the correlations between them. The problem is excruciatingly hard, especially when you're talking about thousands of moving parts. Whoever solved it would earn the eternal gratitude of Wall Street and quite possibly the attention of the Nobel committee as well. To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Let's call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price. But something important happens when we start looking at two kids rather than one—not just Alice but also the girl she sits next to, Britney. If Britney's parents get divorced, what are the chances that Alice's parents will get divorced, too? Still about 5 percent: The correlation there is close to zero. But if Britney gets head lice, the chance that Alice will get head lice is much higher, about 50 percent—which means the correlation is probably up in the 0.5 range. If Britney sees a teacher slip on a banana peel, what is the chance that Alice will see it, too? Very high indeed, since they sit next to each other: It could be as much as 95 percent, which means the correlation is close to 1. And if Britney wins the class spelling bee, the chance of Alice winning it is zero, which means the correlation is negative: ‐1. If investors were trading securities based on the chances of these things happening to both Alice and Britney, the prices would be all over the place, because the correlations vary so much. But it's a very inexact science. Just measuring those initial 5 percent probabilities involves collecting lots of disparate data points and subjecting them to all manner of statistical and error analysis. Trying to assess the conditional probabilities—the chance that Alice will get 6 head lice if Britney gets head lice—is an order of magnitude harder, since those data points are much rarer. As a result of the scarcity of historical data, the errors there are likely to be much greater. In the world of mortgages, it's harder still. What is the chance that any given home will decline in value? You can look at the past history of housing prices to give you an idea, but surely the nation's macroeconomic situation also plays an important role. And what is the chance that if a home in one state falls in value, a similar home in another state will fall in value as well? a. Analyze the effects of this Gaussian copula formula on the risk premium of Treasury bonds and triple‐B corporate bonds when this formula broke down. b. One key factor leading up to the housing bubble is the U.S. economy was experiencing a low interest rate environment. Two reasons can explain this: 1. Large capital inflows from abroad, especially from Asian countries. 2. The Federal Reserve had adopted a lax interest rate policy. Provide the economic intuitions for the two reasons, respectively. c. What is “Liquidity Effect”? Use the Liquidity Preference Framework to show it and briefly discuss the argument by Milton Friedman. In part b, we know the U.S. economy had a low interest rate environment, do you think this is the result of “Liquidity Effect”? Provide your reason. d. Before the crisis, banks offload risk typically by creating “structured” products often referred to as collateralized debt obligations (CDOs). The first step is to form diversified portfolios of mortgages and other types of loans, corporate bonds, and other assets like credit card receivables. The next step is to slice these portfolios into different tranches. These tranches are then sold to investor groups with different appetites for risk. The safest tranche—known as the “super senior tranche”—offers investors a (relatively) low interest rate, but it is the first to be paid out of the cash flows of the portfolio. Buyers of these tranches or regular bonds can also protect themselves by purchasing credit default swaps (CDS), which are contracts insuring against the default of a particular bond or tranche. Anyone who purchased an AAA‐rated tranche of a collateralized debt obligation (CDO) combined with a credit default swap (CDS) had reason to believe that the investment had low risk because the probability of the CDS counterparty defaulting was considered to be small. However, as we all have seen last year (or in the video), the super senior tranche product (sold as a kind of bonds) issued by the Lehman Brothers defaulted and caused a catastrophic impact on the global financial market. In fact, Lehman went into bankruptcy in September last year. Now, analyze the effects of this Lehman Brothers incident on the risk premium between 7 Treasury bonds and corporate bonds (similar credit rating but not issued by the Lehman Brothers). Q4. The Great Depression (20 pts) To understanding the Great Depression, the best way is to look at its evolution by phases 1. Booming Strong Economy in 1920s 2. Beginning Shocks, 1928‐1929 3. Aggravating Shocks, 1930‐1933 4. Rock Bottom and Recovery, 1933‐1936 5. The 1937‐1938 Recession 6. The Recovery, 1939‐1941 We know there were bank panics during 1930‐1933 which aggravated the economic recession into a depression. The first bank panic, from October 1930 to January 1931, when there was a rise in the amount of deposits at failed banks. Because there was no deposit insurance at the time, when a bank failed, depositors would receive only partial repayment of their deposits. Therefore, when banks were failing during a bank panic, depositors knew that they would be likely to suffer substantial losses on deposits and thus the expected return on deposits would be negative. The theory of asset demand predicts that with the onset of the first bank crisis, depositors would shift their holdings from checkable deposits to currency by withdrawing currency from their bank accounts. Also, our earlier analysis of the banking management suggests that the resulting surge in deposit outflows would cause the banks to protect themselves by substantially increasing their excess reserves. a. According to the fact described above, use what you have learned (money supply model and the money multiplier) to analyze why the money supply fell by 25% during the bank 8 panics 1930‐1933. b. The monetary base increased by 20% during the contraction of 1929‐1933, but the money supply fell by 25%. Explain why this occurred. How can the money supply fall when the base increases? c. Make your comments on each of the four Fed’s monetary policies right before and during the Great Depression. (i.e., do you agree or disagree with the Fed’s actions? Why or why not?) 1. In 1928, the Fed raised the discount rate from 3 ½ to 5%. 2. In July 1929, the Fed raised the discount rate again from 5 to 6%. 3. In August 1931, Federal Open Market Committee voted 11 to 1 against $300 million open market purchase of bonds. 4. In 1937, the Fed doubled the required reserve ratio. d. Here are some basic numbers of the Great Depression. Real GDP falls 39%. Real Consumption falls 29%. Prices (GDP deflator) falls 23%. Unemployment Jumps: 3.2% in 1929, 25% in 1933, 17% in 1939. Now, use an AD‐AS model to show these results. e. The Industrial Policy during the Great Depression raised the nominal wages (in particular the minimum wage) for workers. Hence, it helped people to have more income. Do you agree or disagree with this policy? Please explain and use a simple labor market model to support your answer. f. 9 Federal Deficit as Percentage of GDP
10 8 6 4 Percent 2 0 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
-2 -4 -6 -8 -10 Actual GDP Full Employment GDP (1) What does this graph tell you about the fiscal policy during the Great Depression? (2) Do you agree with this fiscal policy? Explain. (3) If you were the policymaker in the Federal Government during the Great Depression, what would you do? (Here you need to show a graph) Q5. Market for Reserves (20pts) (1) Sovereign‐debt worries ‐ Rate and see FOR years, Dubai strove to capture the imagination of the financial world, projecting its young financial centre as a “global gateway” for capital. Last week it succeeded in grabbing attention. Its announcement that it would delay repayment of the debts ($59 billion) of Dubai World, a vast government‐owned conglomerate, swept through global markets like one of the blinding sandstorms that occasionally afflict the emirate, obscuring the gleam of its skyscrapers. Like those storms, Dubai’s announcement was so damaging because it reduced visibility. Investors had assumed that the Dubai government was willing to rescue the indebted conglomerates it sponsors, and that Abu Dhabi, its well‐heeled neighbouring emirate, was willing, in turn, to rescue Dubai. In particular, they had looked forward to the full and timely repayment of a $3.5 billion Islamic bond issued by Nakheel, a Dubai World subsidiary, on December 14th. Dubai’s failure re‐awakened a number of dormant fears in investors. Some worried about banks that had lent heavily to the region. Others wondered if Dubai was carrying far more than the $80 billion or so in debt that it has owned up to. The announcement reminded investors that tacit sovereign guarantees may be worthless. Earlier in November, for 10 example, Ukraine’s state railway firm, Ukrzaliznytsya, failed to repay part of a syndicated loan, and its energy firm, Naftogaz, restructured its debt. a. If you were the chairperson of the UAE, what is the most effective monetary policy you can do to prevent or avert a financial panic? Explain your answer with a theory (graph). b. Besides this monetary policy, what should you do immediately? (2) Discuss: the difference between the central banks in U.S. and Canada in controlling the overnight interest rates (ex, Fed funds rate in U.S.) in the market for reserves (you need to show the graphs and explain what the major problem of U.S. system is). (3) Simple deposit model a. If reserves in the banking system increase by $100, then checkable deposits will increase by $500 in the simple model of deposit creation when the required reserve ratio is? b. If the required reserve ratio is 20 percent, the simple deposit multiplier is? c. What are the two problems (critique) in the simple model of multiple deposit creation? d. So, does the simple deposit multiplier overstate or understate the true money multiplier? Why? e. How do economists fix the two problems? (4) M3 money multiplier The M2 definition is M2= C + D + T + MMF and the definition of M3 is M3 = M2 + LCD + RPO + EURO, where C= currency in circulation, D=checkable deposits, T=time and savings deposits, MMF=primarily money market mutual fund shares and money market deposit accounts, LCD= large certificate of deposits, RPO= overnight repurchase agreements and EURO= overnight Eurodollars. Let c = C/D be the currency ratio, e =ER/D be the excess reserve ratio as before. a. Derive the formula which implies the M3 money multiplier. (Define your symbols clearly and show your derivation.) Hint: R (total reserves) = RR (required reserves) + ER (excess reserves) and MB (monetary base) = R (total reserves) + C (currency in circulation) b. Assume r=required reserve ratio=5%, C=$500 billion, D=$1000 billion, ER=$0.8 billion, T=$2400 billion, MMF=$200 billion, LCD=$100 billion, RPO=$60 billion, and EURO=$40 billion. Compute the money multiplier for M3. 11 ...
View Full Document
- Fall '10
- Federal Reserve, Federal Reserve System, Federal Open Market, discount rate, Great Depression