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midtermanswers - Econ 111, Winter Quarter 2008 Midterm...

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Econ 111, Winter Quarter 2008 Midterm Answers 1. There were two versions of this question, one asking for the direct channels through which higher interest rates affect aggregate demand and the other asking for the channels through which lower rates affect aggregate demand. I’ll focus on higher rates here and give brief answers. (i) Higher interest rates lower consumption demand by raising the real cost of borrowing for consumer durables; by lowering the real value of financial wealth; by boosting the incentive to save (assuming that the substitution/incentive effect outweighs the income effect). (ii) Higher rates lower business and residential investment demand by increasing the real cost of borrowing for plant and equipment and for new homes. (iii) Higher rates boost the exchange value of the dollar (i.e., lead to an appreciation of the dollar) which in turn reduces our exports and increases our imports. For extra credit you needed to say a couple of things about the “credit channel,” which isn’t really a separate channel but a set of factors that amplify and propagate conventional interest rate effects. When interest rates rise, such factors include a decline in the value of collateral that is put up by the borrower to back a loan and a decline in corporate cash flow from higher interest payments. 2. Securitization is the process of packaging existing financial instruments (e.g., home loans) into a new one with its own interest rate. Investors receive principal and interest (as on any bond) generated by the underlying collateral. In short, MBSs are created as the originating home mortgage lender sells the mortgages to another public (Fannie or Freddie) or private company (e.g., investment bank); in turn, these institutions package the mortgages into interest-bearing securities (backed by the cash payments made by homeowners on their mortgages) which they sell to investors worldwide. In terms of balance sheets (I will not draw them here, but talk about them instead), in the first stage, households (HH) have houses as assets and mortgages as liabilities; banks hold the mortgage loans as assets on their balance sheets (of course banks and HH have many other assets and liabilities, but we focus on the housing related items here). In the
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midtermanswers - Econ 111, Winter Quarter 2008 Midterm...

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