Exam 2 Money and Banking

The Loanable Funds Theory

①The interest rate on debt securities (Treasury securities/corporate bonds) is determined by supply and demand of securities. ②The issuers of bonds such as the U,S. government are the borrowers of funds, and the buyers of bonds are the lenders of funds.

The Demand for Bonds

① The demand for bonds increases when the interest rate on bonds rises. The demand curve for bonds is upwardly-sloped with the interest rate measured on the vertical axis.②The demand curve for bonds is downwardly sloped when the price of bonds is measured along the vertical axis, and the quantity of bonds is measured horizontally.

The Supply of Bonds

①The supply of bonds by private firms increases as the interest rate falls. The supply curve for corporate bonds is downwardly sloped on a graph with the interest rate measured vertically.② The supply of bonds by the U.S. governments is independent of the interest rate.The supply curve for government bonds is vertical.③the total supply curve is downwardly sloped.④The supply curve for bonds is upwardly sloped when the price of bonds is measured along the vertical axis, and the quantity of bonds is measured along the horizontal axis.

Changes in the Equilibrium Interest Rate

① The equilibrium interest rate is determined in the securities market at the point where the demand for bonds equals the supply of bonds② Excess demand for bonds: When the market interest rate is higher than the equilibrium interest rate, the demand for bonds exceeds the supply of bonds (why?), which pushes the price of bonds upwardly. Because there is an inverse relationship between the price of bonds and the interest rate, the market interest rate begins to fall until it reaches the equilibrium interest rate. ③ Excess supply of bonds: When the market interest rate is lower than the equilibrium interest rate, the supply of bonds exceeds the demand for bonds (why?), which pushes the price of bonds downwardly. Thus the market interest rate begins to rise until it reaches the equilibrium interest rate. ④ Changes in Equilibrium Interest Rates: If there is a shift in the demand for bonds (for example, wealth, expected returns on bonds relative to alternative assets, risk of bonds relative to alternative assets, liquidity of bonds relative to alternative assets) and/or a shift in the supply of bonds (for example, expected profitability of investment opportunities, expected inflation, government budget deficits), the equilibrium interest rate will change.

The interest rate on debt securities (such as Treasury securities or corporate bonds) is determined by

the demand for and supply of securities in the securities market.

The issuers (suppliers) of bonds such as the U,S. government are

the borrowers of funds, and the buyers (demanders) of bonds are the lenders of funds.

The demand for bonds increases when

the interest rate on bonds rises. The demand curve for bonds is upwardly-sloped on a graph with the interest rate measured on the vertical axis.

The demand curve for bonds is downwardly sloped when

the price of bonds is measured along the vertical axis, and the quantity of bonds is measured along the horizontal axis.

The supply of bonds by private firms increases

as the interest rate on the bonds falls. The supply curve for corporate bonds is downwardly sloped on a graph with the interest rate measured on the vertical axis.

The supply of bonds by the U.S. governments is

independent of the interest rate. ⇒The supply curve for government bonds is vertical.

When we add the supply curve for corporate bonds and the supply curve for government bonds

we obtain the total supply curve that is downwardly sloped.

The supply curve for bonds is upwardly sloped when

the price of bonds is measured along the vertical axis, and the quantity of bonds is measured along the horizontal axis

The equilibrium interest rate is determined in the securities market at

the point where the demand for bonds equals the supply of bonds, that is the supply of loanable funds equals the demand for loanable funds

Excess demand for bonds

When the market interest rate is higher than the equilibrium interest rate, the demand for bonds exceeds the supply of bonds (why?), which pushes the price of bonds upwardly. Because there is an inverse relationship between the price of bonds and the interest rate, the market interest rate begins to fall until it reaches the equilibrium interest rate.

Excess supply of bonds

When the market interest rate is lower than the equilibrium interest rate, the supply of bonds exceeds the demand for bonds (why?), which pushes the price of bonds downwardly. Thus the market interest rate begins to rise until it reaches the equilibrium interest rate.

Changes in Equilibrium Interest Rates

If there is a shift in the demand for bonds (for example, wealth, expected returns on bonds relative to alternative assets, risk of bonds relative to alternative assets, liquidity of bonds relative to alternative assets) and/or a shift in the supply of bonds (for example, expected profitability of investment opportunities, expected inflation, government budget deficits), the equilibrium interest rate will change.

Transactions demand for money

People want to hold (or demand) money to carry out their transactions. The transactions demand for money is positively related to income.

Precautionary demand for money

People want to hold money to meet unforeseen contingencies such as illness, accidents, etc. The precautionary demand for money is positively related to income.

Speculative demand for money

Some people want to hold money to speculate in assets such as bonds and stocks whose prices and returns vary. The speculative demand for money is negatively related to the interest rate.

Total demand for money

Given the level of income, the total demand for money is negatively related to the interest rate.

The supply of money is mainly determined by

the Fed.

The Fed determines

the amount of money available in the economy as a way of conducting its monetary policy

The supply of money is not affected by

the interest rate, and thus the supply curve for money is given by a vertical line

The equilibrium interest rate is determined in the money market

at the point where the demand for money equals the supply of money

The interest rate determined by

the interaction of the demand for money and supply of money in the money market is equivalent to the interest rate determined by the demand for and supply of bonds in the securities market if there are only two kinds of assets in the economy: money and bonds, and the economy is general equilibrium (This is known as the Equivalence Theorem.)

The interest rate determined in the money market

can be viewed as a policy interest rate such as the federal funds rate. The federal funds rate is the overnight interest rate on inter-bank loans, and market interest rates are determined on the basis of the federal funds rate (= benchmark interest rate).

Equivalence Theorem

The interest rate determined by the interaction of the demand for money and supply of money in the money market is equivalent to the interest rate determined by the demand for and supply of bonds in the securities market if there are only two kinds of assets in the economy: money and bonds, and the economy is general equilibrium

benchmark interest rate

The interest rate determined in the money market can be viewed as a policy interest rate such as the federal funds rate. The federal funds rate is the overnight interest rate on inter-bank loans, and market interest rates are determined on the basis of the federal funds rate

Market interest rates equals

Federal funds rate + Demand and supply forces in the market

Shifts in the demand for money Income effect

When the economy is in a boom, the interest rate tends to rise, and when the economy is in a recession, the interest rate tends to fall

Shifts in the demand for money Inflation effect

Higher interest rate leads to a higher interest rate, and lower inflation leads to a lower interest rate = The Fisher effect

The Fisher effect

Higher interest rate leads to a higher interest rate, and lower inflation leads to a lower interest rate

Shifts in the supply of money

An increase in the money supply (expansionary monetary policy) lowers interest rates, and a decrease in the money supply (contractionary monetary policy) raises interest rates.

it = 3.6%, iet+1 = 3.2%, iet+2 = 3.1%, iet+3 = 3.3%

Liquidity premiums = 0.2% for a 2-year maturity, 0.4% for a 3-year maturity, and 0.5% for a 4-year maturity.

According to the Pure Expectations Theory (PET), what is today's annual interest rate on 2 year, 3year, and 4-year bonds, respectively?

(1) 𝑖2𝑡 = (3.6% + 3.2%)/2 = 3.4%; 𝑖3𝑡 = (3.6% + 3.2% + 3.1%)/3 = 3.3%; 𝑖4𝑡 = (3.6% + 3.2% + 3.1% + 3.3%))/4 = 3.3% (2) The yield curve is slightly upwardly sloped.

According to the Liquidity Preference Theory (LPT), what is today's annual interest rate on 2 year, 3-year, and 4-year bonds, respectively?

(1) 𝑖2𝑡 = (3.6% + 3.2%)/2 + 0.2% = 3.6%; 𝑖3𝑡 = (3.6% + 3.2% + 3.1%)/3 + 0.4% = 3.7%; 𝑖4𝑡 = (3.6% + 3.2% + 3.1% + 3.3%))/4 + 0.5% = 3.8% (2) The yield curve is upwardly sloped.

Suppose the interest rate on a 1 year bond (𝑖𝑡) is 3.6% and the average of the expected future short

term interest rates over the next five years is 3.2%. If the liquidity premium for the 5-year bond is 0.8%, what is the annual interest rate on the 5-year bond (according to LPT)? Draw the yield curve for the interest rates- Answers: (1) 𝑖5𝑡 = 3.2% + 0.8% = 4.0% (2) The yield curve is slightly upwardly sloped.

Segmented Markets Theory (SMT)

It will be beneficial for the city to finance its long-term debt by rolling over 1-year munis. Upwardly-sloping yield curves have been most prevalent in post-WWII data in the U.S. this pattern indicates that investors predominantly prefer short-term securities to long-term securities

Suppose that the interest rate on a 3

year Treasury note is 3.2%, and the risk premium for a 3-year IBM bond is 0.5%- You should expect the interest rate on the 3-year IBM bond to be 3.2% + 0.5% = 3.7%

Suppose that the interest rate on a 3

year Treasury note is 3.2%, and the liquidity premium for a 3-year Office Depot bond is 0.6%- You should expect the interest rate on the 3-year Office Depot bond to be 3.2% + 0.6% = 3.8%

Term spread

Interest rate on 10-year Treasury notes minus nterest rate on 3-month Treasury bills

The Term Spread

(1) The larger the term spread, the higher is the likelihood that the economy will grow faster. (2) If the term spread is negative (= inverted yield curve), the likelihood that the economy will slip into a recession increases

Total assets equals

Total liabilities + Net worth

Bank Assets Uses of Funds

① Reserves: Reserve deposits at the Fed + Vault cash ② Cash items in process of collection ③ Securities: Government securities (Treasury securities), municipal bonds (state and local government bonds), other securities (highly rated corporate bonds, securities issued by government enterprises such as Fannie Mae and Freddie Mac), mortgage-backed securities (MBS) ④ Loans: Loans account for 55% of total assets.

Bank Liabilities Sources of Funds

① Checkable deposits: Non-interest-bearing demand deposits, interest-bearing other checkable deposits such as NOW accounts ② Non-transaction deposits: savings deposits, MMDA (money market deposit accounts), time deposits (CDs) ⇒ Non-transaction deposits account for 59% of total liabilities. ③ Borrowings: Borrowing in the federal funds market, borrowing from the Fed (discount loans), borrowing from a bank's foreign branches (Euro-dollars), and repurchase agreements (RPs) ④ Net worth: Profits (or losses) + par value of a bank's stock

Adverse Selection

① Adverse selection refers to asymmetric information existing between lenders and borrowers before the transaction occurs. ② Adverse selection occurs when the potential borrowers (bad credit risks) who are the most likely to produce an undesirable (adverse) outcome are the ones who most actively seek out a loan and thus are the most likely to be selected. ③ Adverse selection makes it more likely that loans will be made to bad credit risks

Moral Hazard

① Moral hazard refers to asymmetric information existing between lenders and borrowers after the transaction occurs. ② Moral hazard occurs because once borrowers obtain a loan, they are more likely to engage in high-risk business. ③ Moral hazard makes it more likely that loans will not be paid back to the lender.

The Nature of Interest Rate Risk

① Direct effect of changes in interest rates: Some loans and deposits have variable interest rates that change at least once a year. Thus, interest rate earnings from variable-rate loans and interest payments on variable-rate deposits are directly affected by changes in interest rates. ② The market value of interest-earning assets and interest paying liabilities is affected by changes in interest rates, regardless of whether they have variable interest rates or fixed interest rates.

∆ in earnings equals

(Amount of variable-rate assets) x (∆ in interest rate)

∆ in payments equals

(Amount of variable-rate liabilities) x (∆ in interest rate)

∆ in net earnings equals

∆ in earnings minus ∆ in payments

∆ in net earnings equals

(Amount of variable-rate assets - Amount of variable-rate liabilities) x (∆ in interest rate)

∆ in net earnings equals

Gap x (∆ in interest rate)

% ∆ in the market value of interest

earning assets equals- negative(% point ∆ in interest rate)𝑥 (𝐷𝐴)

% ∆ in the market value of interest

paying liabilities equals- negative(% point ∆ in interest rate)𝑥 (𝐷𝐿)

% ∆ in the market value of net assets equals

% ∆ in the market value of interest minus earning assets minus % ∆ in the market value of interest minus paying liabilities = negative(% point ∆ in interest rate)𝑥 [𝐷𝐴 − 𝐷𝐿]