Money, Banking, and Financial Markets: Bond Pricing, Financial Crises, and Monetary & Macroprudential Policy

Comprehensive review flashcards covering bond demand and supply, the Fisher effect, risk and term structures of interest rates, the anatomy of financial crises, central bank balance sheet operations and reserve markets, and macroprudential policy frameworks.

How does the bond market adjust to reach the equilibrium bond price ($P^*$) when there is excess supply or excess demand?

When there is excess supply ($B^s > B^d$), the bond price falls to $P^*$, which increases the interest rate ($i$). When there is excess demand ($B^d > B^s$), the bond price rises to $P^*$, which decreases the interest rate.

Why does an increase in expected inflation ($\pi^e$) cause the bond demand curve ($B^d$) to shift to the left?

An increase in expected inflation reduces the expected real return on bonds, making them less attractive to lenders and investors.

Why does an increase in expected inflation ($\pi^e$) cause the bond supply curve ($B^s$) to shift to the right?

An increase in expected inflation lowers the real cost of borrowing, which encourages borrowers to issue and sell more bonds.

What is the net effect of higher expected inflation ($\pi^e$) on the equilibrium bond price and interest rate (the Fisher effect)?

Because bond demand shifts left and bond supply shifts right, the equilibrium price of bonds falls (from $P_1$ to $P_2$) and the equilibrium interest rate rises.

Under what condition will the equilibrium quantity of bonds decrease when expected inflation ($\pi^e$) rises?

The equilibrium quantity will decrease if the bond demand curve ($B^d$) shifts leftward by a larger amount than the bond supply curve ($B^s$) shifts rightward.

How does an increase in default risk on corporate bonds affect both the corporate bond and default-free Treasury bond markets?

It shifts corporate bond demand ($D^c$) to the left (lowering corporate bond prices $P^c$ and raising yields $i^c$), while shifting default-free Treasury bond demand ($D^T$) to the right (raising Treasury prices $P^T$ and lowering yields $i^T$).

What happens to the risk premium when the default risk of corporate bonds increases?

The risk premium increases because the interest rate on corporate bonds rises ($i^c \uparrow$) while the interest rate on default-free Treasury bonds falls ($i^T \downarrow$).

Why do municipal bonds typically have lower interest rates than Treasury bonds despite possessing default risk?

Municipal bonds are exempt from federal income taxes, making them more attractive to investors, which shifts municipal bond demand ($D^m$) rightward and Treasury bond demand ($D^T$) leftward, lowering the interest rate on municipal bonds relative to Treasuries.

According to the Expectations Theory of the term structure, what do a flat yield curve and an inverted yield curve indicate?

A flat yield curve indicates that short-term rates equal long-term rates (rates are expected to stay constant), whereas an inverted yield curve indicates that short-term rates are higher than long-term rates (short-term rates are expected to decline in the future).

How does the Liquidity Premium (Preferred Habitat) Theory explain why the yield curve is almost always upward sloping?

It posits that long-term bonds carry greater interest-rate risk, so investors require a positive liquidity premium ($l_{nt}$) that increases with maturity ($n$) to incentivize them to hold longer-term debt.

According to the provided diagram, what are the three sequential stages of a financial crisis in advanced economies?

Stage One is the Initial Phase (deterioration in balance sheets, asset-price decline, and uncertainty leading to worsening adverse selection and moral hazard), Stage Two is the Banking Crisis (economic contraction leading to bank failures and further lending contraction), and Stage Three is Debt Deflation (an unanticipated price level decline that deepens the contraction).

According to the provided diagram, what characterizes Stage Two of a financial crisis in an emerging market economy?

Stage Two is a Currency Crisis initiated by fiscal imbalances that trigger a foreign exchange crisis, which severely worsens adverse selection and moral hazard problems.

What are the primary assets and liabilities listed on the central bank's balance sheet?

Assets include Government Securities ($S$) and Loans to banks ($LB$); liabilities include Currency in circulation ($C$) and Reserves ($R$).

What are the T-account entries when the central bank conducts an open market purchase of $100$ in securities from commercial banks?

For the Central Bank: Assets change by Securities $+100$, Liabilities change by Reserves $+100$. For the Banking System: Assets change by Securities $-100$ and Reserves $+100$.

How does a $100$ discount loan granted by the central bank to the banking system affect their respective balance sheets?

For the Central Bank: Assets change by Loans $+100$, Liabilities change by Reserves $+100$. For the Banking System: Assets change by Reserves $+100$, Liabilities change by Loans $+100$.

Under a $10\%$ reserve requirement, how does Bank A initiate the deposit expansion process after receiving an initial deposit of $100$?

Bank A retains $10\%$ ($10$) as required reserves and lends out the remaining $90$; when deposited into Bank B, Bank B keeps $9$ and lends out $81$, continuing the multiple deposit creation process.

Based on the provided reserves market graph, how do central banks set the ceiling and floor for the overnight interbank rate ($i$)?

The lending/discount rate ($i_l$) sets the ceiling where reserve supply ($R^s$) becomes perfectly elastic, while the deposit rate ($i_d$) paid on reserves sets the floor where reserve demand ($R^d$) becomes horizontal.

Based on the provided graph, what is the market effect of an increase in the required reserve ratio on the overnight interbank rate ($i$)?

Demand for reserves increases, shifting the demand curve from $R_1^d$ to $R_2^d$, which raises the equilibrium overnight interbank rate from $i^1$ to $i^2$.

How are tailor-made macroprudential policy instruments categorized by target, scope, and underlying problem?

By target: capital, liquidity, leverage ratio, mortgage financing, credit growth. By scope: general credit growth limits, sectoral limits. By underlying problem: addressing moral hazard at large banks (G-SIBs, R-SIBs, D-SIBs).

What are the five essential characteristics of effective macroprudential instruments?

1. Effective at preventing systemic risk build-up; 2. Limited arbitrage opportunities (avoiding 'international leakage'); 3. Aimed at roots, not symptoms; 4. Minimally distortionary; 5. Generating few cross-border effects.

What are the two primary dangers associated with implementing macroprudential policy?

1. Inaction bias: costs are short-term and visible while benefits are long-term and uncertain (countered by central bank independence). 2. Waterbed effect: capping credit to one sector merely redistributes excessive lending into another sector.

What role does the European Systemic Risk Board (ESRB) play, and how can national central banks in the euro area offset 'one-size-fits-all' ECB monetary policy?

Created in 2011, the ESRB sets macroprudential guidance that national regulators adapt. If ECB interest rates are too low for an overheating domestic market, a national central bank can require dynamic provisioning (extra provisions for expected losses) or enforce lower Loan-to-Value (LTV) ratios.