Financial Terms - David Jones Flashcards

Terms Definitions
GDP
MARKET VALUE OF ALL FINALS GOODS AND SERVICES PRODUCED IN A YEAR
INFLATION
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
FINANCIAL INTERMEDIATION
BANKS MOVE FUNDS FROM
SAVERS-LENDERS TO BORROWERS-SAVERS 
ASSET PRICE BUBBLE
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.  
CAPITAL MARKET
TRADING OF LONG TERM DEBT / EQUITY
(MATURITY OF MORE THAN 1 YEAR)
MONEY MARKET
TRADING OF SHORT TERM LIQUID SECURITIES WITH MATURITY OF ONE YEAR OR LESS
INDIRECT FINANCE
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 
CONTRACTUAL SAVINGS INSTITUTIONS
ACQUIRE FUNDS AT PERIODIC INTERVALS
 
Benefit:  CAN PREDICT HOW MUCH PAYOUT IS
Examples:  LIFE INSURANCE, PENSION FUNDS, ETC 
FIAT MONEY
PAPER CURRENCY BACKED BY GOV
NOT EXCHANGE FOR GOLD 
 
 
Started in U.S. in 70's.  First time for U.S. exchange rate fluctuation.
 
ADAPTIVE EXPECTATIONS
DECISIONS BASED ON PAST VALUES. 
 
Changes in expectation are slow.
RATIONAL EXPECTATIONS
DECISIONS REFLECT OPTIMAL FORCASTS USING ALL DATA.
 
Leads to an efficient capital market.
 
Changes are fast.
 
REAL BILLS DOCTRINE
LOANS MADE TO SUPPORT PRODUCTION OF GOODS AND SERVICES WILL NOT BE INFLATIONARY
BAD THEORY 
RICARDIAN EQUIVALENCE
PEOPLE UNDERSTAND THAT BOND ISSUES FROM GOV'T MEAN THAT THEY WILL PAY HIGHER TAXES 
RISK PREMIUM
INTEREST RATE SPREAD BETWEEN DEFAULT AND DEFAULT FREE BONDS
NAIRU
(Non-accelerating inflation rate of unemployment)
LOWEST RATE OF UNEMPLOYMENT AT WHICH THERE IS NO TENDENCEY FOR INFLATION TO CHANGE
SUSTAINABLE GROWTH POTENTIAL
PRODUCTIVITY GROWTH + LABOR FORCE GROWTH
OUTPUT GAP
MAXIMUM LEVEL OF OUTPUT - ACTUAL OUTPUT
 
Wider gap, greater slack in resource.
KEYNESIAN
GOVERNMENT AND FISCAL POLICY AFFECT OUTPUT
 
ECONOMY IS NOT INHERENTLY STABLE 
MONETARIST
MONEY SUPPLY PRIMARY SOURCE OF PRICE LEVEL CHANGES
 
ECONOMY INHERENTLY STABLE 
OPPORTUNISTIC DISINFLATION
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 
CARRY TRADE
BORROW IN CURRENCIES WITH LOW INTEREST RATES SUCH AS YEN INVEST IN "Commodity" CURRENCIES THAT PAY HIGH INTEREST RATES, LIKE NEW ZEALAND & CANADIAN DOLLAR
MORAL HAZARD
SAFETY NET INDUCES MORE RISK THAN NORMAL
WEALTH EFFECT
IMPACT OF CHANGE IN WEALTH ON HOUSEHOLD SPENDING
 
$1 INCREASE IN NET WORTH
= 4 CENT CHANGE IN SPENDING 
YIELD CURVE
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.
BANK RESERVES
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.
DISINFLATION
SLOWING IN THE RATE OF GROWTH IN PRICES OF GOODS AND SERVICES
PHILLIPS CURVE
TRADE OFF BETWEEN PRODUCTIVE CAPACITY AND INFLATION
 
IF UNEMPLOYMENT RATE IS PUSHED TOO LOW, WAGES AND PRICES WILL BE PUSH UP.
 
ECONOMIC SLACK 
 
GREENSPAN CONUNDRUM
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
CDO 
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 
SOFT LANDING
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
FORWARD CONTRACTS
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.
FUTURES
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.
PRIMARY CHANNELS OF MONETARY POLICY
INTEREST RATES
EQUITY PRICES
DOLLAR VALUE 
WAREHOUSE PERIOD
TIME BETWEEN WHEN A BANK UNDERWRITES LOAN AND WHEN LOAN IS SOLD TO INVESTORS
STAGFLATION
HIGH INFLATION
LOW GROWTH
HIGH UNEMPLOYMENT
 
1970 WITH OIL SHOCK  
SECURITIZATION
TURN ILLIQUID ASSET INTO MARKETABLE SECURITIES TRADE IN CAPITAL MARKETS
TIME INCONSISTENCY TRAP
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.
CREDIT DEFAULT SWAP
HEDGE AGAINST CREDIT DEFAULT RISK IN BOND
TRIGGERED BY CREDIT EVENT 
 
Over-the-counter deriviative
GREAT MODERATION
TENDENCY OVER PAST 25 YEARS HAS BEEN LOW INFLATION ECONOMIC GROWTH WITH REDUCED FLUCTUATIONS & LOW VOLATILITY.  
 
GOOD JOB FED WITH COUNTER-CYCLICAL EFFECTS!
Lessons of the 1970's
Inflation expections must be well anchored if supply side oil price shocks are to be kept from spilling over into core consumer inflation.
Credit Crunch
"An environment in which quality borrowers find credit either unavailable or available only on very expensive terms." Minneapolis Fed Pres. Gary Stern
Fed Fund Rate
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)
Discount Rate
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
Intended Saving
Almost never equals intended investments.  If intended savings exceeds intended investments, interest rates decline. 
TIPS Spread
(Treasury Inflation Protection Spread)
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.
Global Crisis Triggers
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
 
Irrational Exuberance
Coined by Greenspan. 
 
Catch phrase of the stock market boom of the 1990's. 
 
Heighted state of speculation.
Recession
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
Deriaviatives
A Financial Instrument
 
-Transfer of risk to those who want to take it at a profit
 
- Types: Option Contract, Foward Contracts, Future contracts, Swaps.
Term Securities Lending Facility (TSLF)
- 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
Term Auction Facility (TAF)
- 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
Core PCE (Personal Consumption Expenditures)
 
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
4 Factors that Fuel Inflation
1.  Rising inflation expecations
2.  Decling economic slack
3.  Increase in energy prices (oil)
4.  Decline in U.S. dollar in foreign exchange markets
Who makes up the FOMC ?
(Fed Open Market Committee)
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.
Perfect Storm
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
 
Two Track Fed Reserve Approach
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.
   Bears Sterns Bail Out
Occured March 14
Use of Discount Window
28 day loan to J.P. Morgan to buy B.S.
PDCF (Primary Dealer Credit Facility)
Infinite amount of funds
Open to depository institutions plus investment banks
Extended to 90 days
Options
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. 
Credit Default Swap
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.
Hierarchical Mandate
Price Stability
6 Indicatiors of the Credit Crisis
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
Fed's Dual Mandate
1.  Stable Prices
2.  Maximum Employment
Average Duration of a Recession
10 months
Average Duration of Expansion
57 months
 
Our recent expansion was 72 months
2007-2008 Credit Crisis
 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.
Aggregate Demand Components
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
 
Aggregate Supply/Output
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
 
 
Shifts in SRAS
(Short run aggregate supply)
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
Purchase Power Parity
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.
3 Factors Affecting Exchange Rates
in the Short Run
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.
Factor Affecting Exchange Rates
in the Long Run
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.
Fisher Equation
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
Exchange Rate Targeting
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
Effects on Globalization & Outlook of Dollar
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
GDP Deflator
Nominal GDP (current prices)/Real GDP (fixed prices)
 
 
4 types of Credit Market Instruments
1.  Simple Loans - business loans
2.  Fixed Payment - car/home
3.  Coupon Bond - Treasury/Corp Bonds
4.  Discount Bond/Zero Coupon-Treasury Bills/Bonds
Yield to Maturity
Interest rate that equates the present value of cash flow payments on a debt with its value today.
 
PV = CF/(1 + i)n
Present Value
PV = CF/(1+i)n
 
A dollar paid to you today is worth more than a dollar paid a year from now.
Expectations Theory
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.
Shift in the Demand for Bonds
1.  Wealth
2.  Expected return
3.  Risk
4.  Liquidity
Shift in Supply of Bonds
1.  Expected Profitability of investments
2.  Expected inflation
3.  Gov't budget
 
All have a direct relations to supply. 
Liquidity Premium Theory
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.
Shifts in the Demand for Money
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
Shifts in the Supply of Money
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
Efficient Market Hypothesis
Expectations are not only rational but also prices reflect the real value of securities being traded.
Random Walk
Stock prices follow a random walk.  Future prices are unpredictable. Past stock prices cannot predict future prices.
 
Extreme version of Efficient Market Hypothesis
Opportunity Costs
Amount of interest sacrificed by not holding an alternative asset. 
 
Ex:  Holding money and not putting it into a money market account.
Off-Balance Sheet Activities
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. 
Non-bank Financial Entities
Shadow Banking System
1.  Finance companies
2.  Insurance Companies
3.  Mutual Funds
4.  Hedge Funds
5.  Private Equity Industries
6.  Pension Funds
7.  GSE
Financial Stimulus
Stimulants to induces households and businesses to spend.
Financial Restraints
Restraints to curtail households and businesses frin spending.
Tobin's "q" ratio
Ratio of stock prices to replacement cost of capital.
Fiscal Policy Measures
Government spending component of aggregate demand may be influenced by fiscal countercyclical policies.
3 factors that move LRAS line
1.  Amount of Labor Force
2. Capital Invested in the Economy
3.  Available Technology
Factors that cause shift in the SRAS curve
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)
 
Factors that affect the exchange rates in the long run.
1.  Relative Price Levels compared to other countries
2. Trade Barriers - on incoming goods
3.  Productivity - more goods at less cost
Factors affecting exchange rates in the short run.
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. 
Sovereign Weath Funds
Gov't run investment fund.  
 
Ex:  China's investment in Morgan Stanley, Abu Dhabi investment in City Group, Singaport investment in UBS.
Balance of Payments
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
Factors that affect the US Dollars
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
Factors that effect Options
1. Strike Price
2.  Stock Price
3.  Volitilaty
4.  Interest Rates
5.  Duration
T - Accounts
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                          
              
Fed's Monetary Policy Tools
Management of Short-term interest rates
1.  Discount Rate
2.  Fed Fund Rate target through open market operations
3.  Required Reserves
Global Credit Crisis
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
How can you pump emergency liquidity into the system?
1.  Fed supply of reserves
2.  Cutting Rates
3.  TAF, TSLF & PDCF
4.  Capital infusion by foreign sovereign wealth funds
5.  Fiscal Policy packages
Most Recent Fiscal Packages
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
Fiscal Policy
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. 
Disadvantages of Official Inflation Target
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
 
Tightening
Push interest rates up
 
Used when excess in output growth but produces strains on labor market
 
Stock prices will fall
 
Dollar will appreciate
Easing
Push interest rates down
 
Use when output falls short of growth potential but produces a slack in resources
 
Stock prices go up
 
Dollar depreciates
Inside Lag
Time between major shock & initial response to monetary or fiscal policy
Monetary Policy
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
 
 
New Regulation
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.
Factors affecting Demand for Bonds
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.
Factors Affecting Supply of Bonds
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
Economic Slack
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
Primary transmission channel of monetary policy
1.  Interest Rates
2.  Asset prices, through wealth effect
3.  Foreign exchange value of dollar, which influences net exports.
1997-1998 Asian Contagion
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.
Liquidity
Financial asset that can be converted into cash cheaply and quickly.
 
 
Sources of Liquidity
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
Signals of excess liquidity
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
Financial Multiplier
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
Update on Credit Crisis
Explain
Transmission Mechanism
Explain
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