Exam 3 Study Guide – ECON3311

Chapter 14: Regulating the Financial System

·         The Sources & Consequences of Bank Runs, Panics & Crises

o   Bank Runs

§  Sources

·         Banks promise to satisfy depositors' withdrawal requests on a first-come first served basis.

o   If a bank cannot meet this promise because of insufficient liquid assets, it will fail.

·         What matters during a bank run is not whether a bank is solvent, but whether it is liquid. 

o   Solvency: the bank assets > bank liabilities. Positive net worth.

o   Liquidity: the bank has sufficient reserves and immediate marketable assets to meet depositors' demand for withdrawal.

o   Solvent banks with liquidity problems can be fixed. Insolvent banks, not so much

§  Consequences  

·         Primary concern: a single bank's failure might cause a small-scale bank run that could turn into a system-wide bank panic

§  How do bank runs start, why are they bad? How can they lead to panics?

·         Reports that a bank is insolvent can spread fear that it will run out of cash

o   Insolvent: when bank's assets < bank's liabilities.

o   Mindful of the first-come, first-served policy, people run to the bank to get their money first.

·         Contagion: phenomenon of spreading panic on the part of the depositors

o   Panics

§  Sources

·         Information asymmetries are the reason that a run on a single bank can turn into a bank panic.

§  Consequences

·         People see another bank failing, fear their bank may fail (asymmetric information), and withdraw their funds. This can continue on and on!

o   Crisis

§  Sources

·         Decline in housing prices increased mortgage defaults in 2006, leading to financial crisis of 2007 - 2009

·         This lowered value of mortgages and mortgage backed securities, which are assets to banks nationwide.

§  Consequences

·         Example: Those wanting to refinance their mortgage (change interest rate) couldn't any longer

·         House is collateral. An increase in house value = A better interest rate. Opposite true]

·         Bank capital decreased (capital = assets - liabilities), and some banks became insolvent. 

·         Fewer loans = less investment = amplifies downturn.

·         The Government Safety Net

o   Lending

§  Government employs strategies to protect investors and ensure stability:

§  Lender of last resort: Making loans to banks that face sudden deposit outflows.

§  Deposit insurance: Guaranteeing depositors receive the full value of their accounts if the institution fails.

§  Make loans to prevent the failure of solvent banks

§  Provide liquidity in sufficient quantity to prevent or end a financial panic.

§  Significantly reduces but does not eliminate contagion.

o   Consequences and Failures

§  This safety net causes bank managers to take on too much risk

§  Flaw in lender of last resort: must be able to distinguish an illiquid from an insolvent institution.

·         During a financial crisis, computing the market value of a bank's assets is almost impossible.

·         Gov. wants to lend to illiquid banks, not necessarily insolvent.

§  Officials are likely to be generous in their evaluations.

§  Knowing the government will be there, gives bank managers the incentive to take on too much risk (Creates a moral hazard.)

§  In the crisis of 2007-2009, we learned U.S. lender of last resort mechanism has not kept pace with the evolution of financial system.

·         Many shadow banks did not have the option to borrow from the Fed.

§  Government officials are worried about largest banks, they can pose a threat to entire financial system if they fail.

§  Some of these institutions are treated as too-big-to-fail

§  In most cases, deposit insurer quickly funds a buyer for a failed bank (or acts as lender of last resort).

§  Following Lehman failure, governments in Europe and US guaranteed all of the liabilities of their largest banks.

·         Also bailed out many shadow banks

§  During the crisis, governments also recapitalized some intermediaries to prevent a run by their creditors

·         The government gave them public money in return for partial ownership rights.

§  FDIC shut down 297 banks in 2009 and 2010.

§  Problem of time consistency

·         Not costless way to solve this

·         Regulations & Supervision of The Financial System

o   Regulatory Requirements

§  Designed to minimize the cost failure of public banks:

1.      New banks must obtain a charter

2.      Once open, regulations:

a.       Restricts competition

b.      Specifies what assets the bank can/can't hold

c.       Minimum level of capital

d.      Makes public information about the bank's balance sheet.

o   Supervision

§  Gov. enforces banking regulations through supervision.

·         Relies on monitoring and inspection: both remotely and on-site examination.

§  All chartered banks must file quarterly reports, known as call reports.

§  Every depository institution insured by FDIC is examined at least annually. o Examines things like if loans actually exist, bank accounts are correct.

·         At large institutions, examiners are on site all the time.

§  Supervisors use what is called CAMELS criteria to evaluate the health of banks:

·         Capital Adequacy

·         Asset Quality

·         Management Earnings

·         Earnings

·         Liquidity

·         Sensitivity to Risk

§  CAMELS rating not made public

·         Used by gov. to decide whether to take formal action against the bank or even close it.

§  Stress Tests: (Think of Bar Rescue)

·         Stress tests evaluated the prospective capital needs of 19 largest U.S banks in light of the recession that was underway.

·         Results were sufficient to reassure gov/market that most institutions were solvent.

·         Dodd-Frank Act requires the Fed to conduct annual stress tests.

Chapter 15: Central Banks in the World Today

·         Function of The Central Bank

o   Financial institution which manages gov' finances, controls the availability of money and credit in economy, and serves as the bank to commercial banks

§  Government's Bank

·         Fed began operation in 1914

·         As the government's bank, Fed has privileged position:

o   The central bank creates money: monopoly on the issuance of currency.

·         Central bank can control amount of money and credit in economy.

·         Most central banks do this by adjusting short-term interest rates:

·         monetary policy.

o   They use it to stabilize economic growth and information.

§  Banker’s Bank

·         Provide loans during times of financial stress

o   Ability to create money = can make loans when no one else can (lender of last resort).

·         Manage the payment system

o   Every country needs a secure and efficient payments system.

o   Banks needs reliable ways to transfer funds from each other. $3.2 trillion per dav transferred over Fedwire in 2020.

·         Oversee commercial banks and financial system

o   Monitor banks

·         Fed does not control securities markets (though may monitor and participate in securities market with open market operations).

·         Does not control the government's budget.

o   Gov. budget controlled through congress/president: fiscal policy.

o   The Fed acts as the Treasury's bank.

·         Objectives of The Central Bank

o   Stable Inflation

§  Many central banks take price stability as primary job

·         Primary consensus is that too high or too low) inflation for extended periods is due to central banks.

§  Maintaining price stability: money efficiency, better unit of account and store of value.

§  High inflation or hyperinflation is bad for growth.

·         Prices contain no information - real resources spent on changing prices

§  Zero inflation probably too low:

·         Risks deflation: debts more difficult to repay, increasing default.

·         If wages needed to decrease, would have to cut nominal wages.

o   High & Stable Real Growth

§  Potential Output: some long-run normal level of production. Depends on:

·         Technology, size of capital stock, number of workers, working hours

§  Growth in these inputs leads to growth in potential output - sustainable growth!

§  Periods of above-average growth have to be followed by a period of below-average growth.

§  Job of central bank is to change interest rates is to adjust growth.

§  More stability = higher growth

·         More uncertainty = more caution = less investments

o   Financial System Stability

§  Fed was founded to stop financial panics that plagued US during 19th and 20th century.

§  Financial system stability: eliminate financial system volatility. (Integral part of iob.)

§  If people lose faith in financial system, will rush to low-risk alternatives

·         Savers will not lend, borrowers can't borrow.

·         Type of systematic risk.

§  Newer measures of risk seek to quantify the impact of the failure of important intermediaries could have on the stability of the financial system as a whole.

o   Interest Rate & Exchange Rate Stability

§  Why stabilize interest rates?

·         Low interest rates = more borrowing and spending (in general)

·         More interest rate volatility = higher risk = risk premiums

§  Why stabilize exchange rates?

·         Stable exchange rates = dollar prices of goods predictable, easier planning for everyone.

·         For emerging market countries, exports/imports are central to the structure of economy (so stable exchange rates important)

·         Dual Mandate

o   Dual mandate of price stability and maximum sustainable employment; "balanced approach" to tradeoffs between goals; price stability defined numerically

·         The Importance of Independence

o   Central Bank Independence: central banks should be independent of political pressures.

o   Independence has two operational components: 

§  Central bankers must be free to control their own budgets.

§  Central bank's policies must not be reversible by people outside the central bank. 

§  Successful monetary policy requires a longtime horizon 

§  To forsake long-term goals for short-term gains is always a temptation for politicians.

§  Therefore, governments have given monetary policy to central banks, largely apolitical.

Chapter 16: The Structure of Central Banks: The Federal Reserve

·         Buy & Sell Securities

o   By buying or selling securities in the market through an open market operation (OMO), the Fed could increase or decrease the supply of reserves (shifting the supply curve to the right or the left) in order to lower or raise the market federal funds rate.

·         Federal Funds Rate

o   Interest rate banks charge each other for unsecured overnight loans

§  FOMC does not engage in financial transactions to target federal funds rate or to manage the Fed's portfolio (system open market account [SOMA])

Chapter 17: The Central Bank Balance Sheet and The Monetary Supply Process

·         Types of Assets Held

o   Securities: Primary assets

§  Mostly Treasury securities, also other assets (MBS)

§  The quantities of securities held is controlled through open market operations.

o   Foreign Exchange Reserves: Gov’s balance of foreign currency

§  Held through foreign bonds (denominated in foreign currency)

§  Foreign exchange interventions: attempt to change market value of various currencies.

o   Loans: Usually for commercial banks.

§  Discount loans: loans made when commercial banks need short-term liquidity.

·         Monetary Policy

o   Reserve Banks play a major role in this

§  They do it primarily through their representation on the Federal Open Market Committee (FOMC), which makes interest rate decisions and determines the size and composition of the Fed's balance sheet, and less importantly through their participation in setting the discount rate, the interest rate charged on loans to commercial banks

o   Not spoken about publicly

§  Spoken in meetings w/ Chair of the Board of Governors

o   Chair of Governors controls it, President of the Federal Reserve Bank of New York carries out operations

Chapter 18: Monetary Policy: Stabilizing the Domestic Economy

·         Taylor Rule

o   Fed sets a specific target using HUGE amounts of information

o   We can approximate it using the Taylor Rule:

o   Target Fed Funds Rate = Natural Rate of Interest + Current Inflation + .5 (Inflation Gap) + .5 (Output)

§  Natural Rate of Interest: The real short-term interest rate when the economy is using resources efficiently. About 2%

§  Inflation Gap: Current inflation minus inflation target (both are %). Notice when inflation exceeds the target, the inflation gap is higher

§  Output Gap: The % deviation of current output from potential

o   Tells us that when inflation is above target, Fed will increase interest rates (or when output is higher than potential)

§  Similarly, when output and inflation is too low, the Fed decreases interest rate

o   The one-half in front of the inflation and output gap says the Fed cares about each equally (dual mandate)

§  If the Fed started to care about the inflation gap more, the multiplier term on the inflation gap would increase

·         Forward Guidance, Quantitative Easing, and Targeted Asset Purchasing

o   Forward Guidance

§  Definition: Central bank communicates intentions regarding the future path of monetary policy

§  The central bank expresses the intent to keep interest rates low in the future, influencing long-term interest rates if it is credible.

§  Simplest Unconventional Approach

·         Examples: Announces to keep inflation low for an extended period of time

o   Remember, long-term interest rates depend on expected future interest rates

§  Aims at lowering long-term interest rates that affect private spending

·         People switch from saving to spending. However, it must be credible

·         Example: In 2008, Fed announced "weak economic conditions are likely to warrant exceptionally low levels of the fed funds rate for some time"

o   Sets future expectations lower

§  Downsides:

·         What's the best announcement to reach a goal? No consensus

·         Could make unintended consequences (such as asset prices bubbles)

o   Quantitative Easing

§  Definition: Central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually 0 or lower)

§  Involves open-market purchases and lending that increase bank reserves beyond the level necessary to keep the policy rate at its target (typically near zero), expanding the size of the central bank’s balance sheet.

§  QE occurs when the central bank expands the supply of aggregate reserve beyond the level needed to maintain its policy rate target

·         Buys assets, expanding its balance sheet

§  When market federal funds rate = IOER, an addition to aggregate reserves no

§  longer reduces the federal funds rate

§  Mechanism by which QE affects economic prospects is not clear

·         QE may simply lead banks to hold more of them, rather than make loans

§  However, may add credibility to Fed keeping interest rates low

·         QE is implemented at low interest rates. Therefore, QE being implemented means expected low interest rates. Reinforces forward guidance

§  Increased total reserves to over 300 times their 2007 average; and excess reserves were 1,400 times larger

o   Targeted Asset Purchasing

§  Definition: Central bank alters the mix of assets it holds on to its balance sheet to change their relative prices in a way that stimulates economic activity

§  Involves buying different assets than usual, such as longer-term Treasury bonds and mortgage-backed securities issued by government agencies, thereby altering the composition of the central bank’s balance sheet.

§  TAP shifts the composition of Fed's balance sheet toward selected asset to boost their relative price and stimulate economic activity

§  Influences both the cost and availability of credit

·         Increases demand of targeted asset, increasing prices and lowering yields

·         When private demand is absent, TAP creates credit when there is none.

§  TAP impact greater in illiquid markets

·         Adds confidence into markets

§  Financial Crisis: Fed purchased $1.8 trillion in mortgage-backed securities and $2 trillion in long-term Treasury debt. Goal: lower their yields

§  In normal times, central bank avoids TAP

·         They promote competition rather than picking winners

§  Exiting TAP is probably more difficult than unwinding QE. TAP assets are harder to sell than short-term treasuries

·         Generally, less liquid, may cause large price discounts

·         Political Issues: may lobby to stop banks from selling assets in fear of raising costs

·         Discount Lending and Financial Crisis Prevention

o   Discount Lending

§  Discount lending is the Fed's primary tool for:

·         Ensuring short-term financial stability

·         Eliminating bank panics

·         Preventing the sudden collapse of institutions experiencing financial difficulties

§  The central bank is the lender of last resort:

·         Making loans to banks when no one else will

§  The Fed will make three types of loans:

·         Primary Credit Loan

o   Extended on a very short-term basis to sound institutions

o   Most post collateral

o   The interest rate charged is the primary discount rate: set above IOER/IORB rate

o   Puts a cap on federal funds rate. Banks can borrow from Fed if it's cheaper

·         Secondary Credit Loan

o   Available to institutions that are not sufficiently sound to quality for primary credit

o   The secondary discount rate is set above the primary discount rate

o   Banks may do this if they have a shortfall in reserves, or can't borrow from anyone else

o   Signals that the bank is in trouble: Before the Fed will make the loan, has to believe there is a good chance the bank will survive

·         Seasonal Credit

o   Used by small agricultural banks in the Midwest to help manage the cyclical nature of farmers' loans and deposits

o   Federal Crisis Prevention

§  To steady the economy after the financial crisis, Fed used conventional policy tools:

·         The target range for the federal funds rate

·         Interest rate on excess reserves (IOER rate) - replaced with IORB

·         The rate for discount window lending.

§  By December 2008, the Fed had lowered the federal funds target rate to essentially zero percent.

§  The Fed then turned to extraordinary measures when it began making massive loans to banks and buying large amounts of risky assets.

·         IORB – Know how it works with numeric examples.

o   How It Works

§  Interest on Reserve Balances (IORB) is the primary tool

·         Interest rate that banks earn from the Fed on the funds they deposit in their reserve balance accounts.

·         Risk free investment option for banks

·         Rate set by the Fed (not determined by markets)

o   Examples

§  Reservation Rate

·         The lowest rate that banks are likely willing to accept for lending out their funds.

·         ORB serves as the reservation rate

§  Arbitrage

·         The simultaneous purchase and sale of funds (or goods) to profit from a difference in price

·         Arbitrage ensures that the federal funds rate does not fall far below the interest on reserve balances rate.

o   Short-term rates are closely linked to federal funds rate

o   Makes interest on reserve balances an effective tool to guide the federal fund rate.

§  Young Sheldon

·         Federal Reserve Supplemental Module (Work through the questions via the link below)

o   https://www.econlowdown.org/monetary_policy_tools?module_uid=1669&section_uid=3557&page_num=17695&p=yes

Chapter 23: Modern Monetary Policy and The Challenges Facing Central Bankers

·         Quantitative Easing & Forward Guidance in Practice

o   Used to compensate for the collapse of intermediation and the fragility of financial markets.

o   Actively employed by central bankers in the financial crisis of 2007-2009, by the CB in the euro-area crisis and by the Bank of Japan in its battle against deflation.

§  Quantitative Reasoning

·         Used to control the size of their balance sheet and the mix of assets that they hold

·         During normal times, policymakers control the supply of their reserve liabilities in order to meet a target interest rate.

o   Even if the short-run target rate drops to the lower bound, monetary policymakers retain their ability to expand their balance sheet.

o   They can continue to purchase securities or make loans to banks to increase the size of the monetary base.

§  Forward Guidance

·         Over time, expressions of central bank intent to keep interest rates low over an extended period

·         Influenced the willingness of investors to purchase other important assets, like equities and private-sector debt

·         Central bankers use forward guidance to influence long-term bond yields, which depend in part on expectations about future policy rates

·         Policies Related to Bubbles

o   "Leaning Against Bubbles"

§  Stabilizing inflation and real growth means raising interest rates to discourage bubbles from developing in the first place.

§  If successful, this policy would reduce the credit booms that accompany bubbles, along with the busts that inevitably follow.

o   Opponents of this interventionist view argue that bubbles are too difficult to identify when they are developing.

o   Opponents of leaning against bubbles used to argue that central banks should simply wait until the bubble bursts and only then react aggressively to limit the fallout on the economy by cleaning up the mess.

§  They point to the debate about U.S. housing prices in 2004 and 2005 as evidence that views were not unanimous.

§  They pointed to the Great Depression and the 1990s in Japan as examples of what can happen if the central bank attempts to prick a bubble with interest rate policy.

o   HW Questions

§  Considering the role of the U.S. house price bubble in the financial crisis of 2007−2009, how do you think monetary policymakers should respond to bubbles in asset markets?

·         Answer: It can be difficult to identify bubbles when they are emerging and how severe the required interest rate response would be, it might be more appropriate to focus on macro-prudential regulatory policy actions than to try to use interest rate policy

·         Traditional vs Unconventional Monetary Policy

o   Traditional

§  Interest Rates and Exchange Rates

·         Interest Rate Channel: As real interest rates fall, financing becomes cheaper and firms increase investments. Households increase financed spending.

o   Data shows this effect is not powerful, company finance decisions already decided and household spending based on long-term interest rates.

·         Exchange Rate Channel: A decrease in interest rates lead to a depreciation of the dollar.

o   Less demand for US assets abroad with lower yields, makes dollar less valuable.

o   Increases the cost of importing goods and services from abroad, reducing imports

o   Makes U.S. goods cheaper, so foreigners will buy more goods from U.S

§  Also no powerful effect, demand for U.S goods mainly based on other factors

§  Easing monetary policy - a decrease in target nominal interest rate, which decreases real interest rates

o   Unconventional

§  We have seen that most central banks set a target for the overnight interbank lending rate in an effort to stabilize the economy and keep inflation low

§  However, there are two circumstances when additional policy tools can play a useful stabilization role:

·         When lowering the target interest rate to zero (or to the ELB is not sufficient to stimulate the economy

·         When an impaired financial system prevents conventional interest rate policy from supporting economic growth.

o   In both cases, unconventional monetary policy can add to the stimulus already coming from conventional policy.

§  When these circumstances arose during the financial crisis of 2007-2009, in the euro-area crisis that followed

§  Japan's long battle against deflation, central banks used a variety of unconventional policy tools to supplement conventional interest rate policy.

§  With continued use by many central banks, these tools have become less and less “unconventional,” but we continue to categorize them in this way to simplify matters.

·         Lower Bound & Zero Lower Bound

o   Lower Bound

§  Investors can always hold cash, so bonds must have yields to attract investment.

§  Deflation is a concern at ELB: policy cannot fully respond to adverse shocks.

·         Deflation increases the real interest rate, reducing spending.

·         Becomes harder for businesses to obtain financing.

o   Increases the real value of a firm’s liabilities, without affecting the real value of assets

·         Traditional policy cannot respond to ease credit conditions: i = 0!

·         People see deflation, keep expecting it to decrease. Result: deflationary spiral. 

§  The difficulties posed by the ELB arise only when central bankers have achieved their objective of low, stable inflation.

·         Policymakers can minimize the changes of this sort of catastrophe:

o   Set inflation target higher because of perils of deflation

o   If inflation is high, so is the interest rate, giving a cushion against ELB.

o   They can act boldly at the hint of deflation. Preemptive strike.

o   Monetary early so problems aren’t realized as heavily.

o   Unconventional monetary policy.

o   Zero Lower Bound

§  The idea that a nominal interest rate cannot fall below zero.

§  For nominal interest rates has been in common use for some time because of the widespread belief that commercial banks could always hold cash in lieu of reserves

·         Central banks could not reduce policy rates below zero.

§  Recent experience shows that, due to the transaction costs of holding cash-which include storage, transportation, and insurance it’s possible to lower rates below zero

·         There is still an effective lower bound (ELB) at which intermediaries and their customers will switch to holding cash

Questions from HW that could be SAR Questions

Suppose in an election year, the economy was benefiting from consumer optimism. At the same time, clear signs of inflationary pressures were apparent. How might the central bank with a primary goal of price stability react?  How might members of the incumbent political party who are up for reelection react?

Answer: In this case, the appropriate monetary policy is to tighten monetary policy, increasing interest rates to curb the emerging inflationary pressures in pursuit of the long-run goal of price stability. In contrast, it is likely that the politicians due for reelection would be more concerned with the consumer optimism in the economy and be in favor of an increase in interest rates. In the absence of influence over an independent central bank, they may push for immediate decreases in government spending or increases in taxes.

Suppose you examine the central bank’s balance sheet and observe that since the previous day, reserves had risen by $300 million. In addition, on the asset side of the central bank’s balance sheet, securities had risen by $300 million. What activity did the central bank carry out earlier in the day to lead to these changes in the balance sheet? Do you think by carrying out this activity the central bank was aiming to increase, decrease, or maintain the size of the money supply?

Answer: The central bank conducted an open market purchase of $300 million with a commercial bank. This transaction would involve $300 million of securities being added to the central bank’s balance sheet. There would be an increase of $300 million in reserves to reflect the related payment to the commercial bank into its reserve account. By carrying out this activity, the central bank was aiming to increase the size of the money supply.

You read a story reporting a major scandal about the Federal Deposit Insurance Corporation that is likely to undermine the public’s confidence in the banking system. What impact, if any, do you think this scandal might have on the relationship between the monetary base and the money supply?

Answer: The scandal is likely to increase the public’s desire to hold currency and so the currency-to-deposit ratio is likely to rise. In addition, banks are likely to hold a higher level of excess reserves in anticipation of the public’s reaction, thus Increasing the excess reserve-to-deposit ratio.  The changes in both these ratios would reduce the money multiplier, thus reducing the stock of money for a given monetary base.

Explain how the Federal Reserve would implement a rise in the target range for the federal funds rate.

Answer: The Federal Reserve would increase the interest rate on excess reserves (IOER), an interest rate that it controls directly. This raises the minimum rate at which banks would be willing to lend to other institutions because they can earn the IOER rate risk-free by depositing these funds with the Fed. How does its action influence the market federal funds rate? This change in the IOER rate raises the rate at which banks would be willing to borrow in the money markets from nonbank participants that cannot earn interest on deposits at the Fed. This therefore puts upward pressure on the market federal funds rate to bring it into the new higher target range.

Federal Reserve buying of mortgage-backed securities is an example of a targeted asset. Explain how the Fed’s actions are intended to work.

Answer: By purchasing mortgage-backed securities (MBS), the Fed sought to lower mortgage rates in order to increase home sales, raise house prices, and promote housing construction.

Suppose you examine the central bank’s balance sheet and observe that since the previous day, reserves had fallen by $100 million. In addition, on the asset side of the central bank’s balance sheet, securities had fallen by $100 million. Do you think the size of the banking system’s balance sheet would be affected immediately by these changes to the central bank’s balance sheet?

Answer: No because reserves appear on the asset side and securities appear on the liability side of the banking system's balance sheet and so the changes would affect the size of its balance sheet.