Definitions and Basic Concepts

Transcription

1 Definitions and Basic Concepts 1. Compare and contrast the federal funds rate with the discount rate. How does the discount rate influence the effective federal funds rate? Federal funds rate: the interest rate at which banks borrow from and lend to each other so that they can satisfy the reserve requirement. Discount rate: the interest rate at which banks can borrow from the Federal Reserve to satisfy the reserve requirement. Under normal conditions, the discount rate puts a ceiling on the effective federal funds rate. If the federal funds rate goes above the discount rate, then banks simply obtain discount loans from the Fed rather than borrowing from other banks. This increases the amount of reserves in the banking system. 2. Define debt deflation and then explain how it can make financial crises worse. Debt deflation: A situation in which a substantial decline in the price level sets in, leading to a further deterioration in firms net worth because of the increased burden of indebtedness. As aggregate prices decrease, then debtors must pay back dollars that have more purchasing power than when they borrowed. If wages do decline, then the debt service ratio might increase. If the borrowed money were used to purchases assets, the value of those assets might also decline. If firms become insolvent because of the increase in real indebtedness, then this could cause banks balance sheets to also deteriorate. They would cut back on lending and increase interest rates because of increased risk. This decrease in economy activity would cause adverse selection and moral hazard to both increase. This further decreases commercial bank lending which adds momentum to the downward spiral in the economy. 3. Compare and contrast the risk structure and term structures of interest rates. How can you use these concepts to explain why Five Year Treasury Notes currently yield 1.9% and Ten Year Muni Bonds yield 4.7%. Risk structure of interest rates: The relationships among the interest rates on various bonds with the same term to maturity Interest rates can differ because of default risk, liquidity, and tax treatment. Term structure of interest rates: The relationships among interest rates on bonds with different terms to maturity. This compares bonds with the same default risk, liquidity, and tax treatment. Five Year Treasury Notes would have a lower interest rate than Ten Year Muni Bonds because of default risk which is part of the risk structure of interest rates. The Ten Year

2 Muni Bond would also have a higher interest rate because of the term structure of interest rates. The Muni has five more years to maturity than the Treasury Notes and are not default free. For these two reasons, the yield to maturity on the Muni Bond is higher. 4. Define the Fisher Equation and then use it to explain how you can calculate expected inflation by using the yields on Treasury Bonds and Treasury Inflation Protected Securities (TIPS). The Fischer Equation is nominal rates equal real rates plus expected inflation or expected inflation equals the nominal rate minus the real rate. The yield to maturity of Treasury Bonds is a nominal rate. The yield to maturity of TIPS is a real interest rate. Therefore, expected inflation is simply the ytm on Treasury Bonds minus the ytm on TIPS. 5. Compare and contrast Federal Reserve Notes with US Treasury Notes. Your explanation should use the balance sheets of the nonbank public, commercial banking, Federal Reserve and US Treasury. Federal Reserve Notes are paper currency and are a liability to the Federal Reserve and assets to the nonbank public, commercial banks, and the US Treasury. The US Treasury issues US Treasury Notes in order to borrow because the US Government spends more that it receives in taxes. US Treasury Notes are a liability to the US Treasury and assets to the nonbank public, commercial banks, and the Federal Reserve. Federal Reserve Notes held by commercial banks are vault cash and count as part of banks reserves.

3 Problems and Essays 1) In July 1995, as President Bill Clinton was looking towards his re-election campaign, he was faced with the following set of indicators: Economic Indicator Indicator Value GDP Growth 2.4% Leading Indicators Yield Curve Capacity Utilization 83.3% Productivity Growth 3.5% Core Inflation 2.4% Inflation Rate 1.5% Unemployment Rate 5.6% NonAg Employment Growth 230,000 Target Federal Funds Rate 6.0% Flat Flat a) Assess and evaluate the macro economic situation that existed in July 1995 as measured by the above variables. Organize your discussion of the indicators by evaluating growth, inflation, and labor markets. Consider the Taylor Rule as you anticipate an appropriate monetary policy. How well was the Fed achieving its goals and objectives? The economy is expanding but there are some indicators that the economy might slow into a recession. Growth A 2.4% growth rate is below the potential of 3% to 3.5% capacity utilization is high and in the range that could cause inflation (within range of full utilization of 80% plus) leading indicators are forecasting neither an increase or decline in the economy flat yield curve indicates declining interest rates and that the economy could slip into a recession Labor market unemployment is at approximately the natural rate or NAIRU 5.0% to 5.5% economy adding jobs at 230,0000 or a very rapid rate (should be adding 100,000 to 150,000 jobs per month) productivity growth is above the average Inflation above target of 2%

4 possible inflationary pressure because of high capacity utilization and an unemployment rate close to the natural rate or NAIRU The Taylor Rule indicates the target federal funds rate should be approximately 4.1%, which is lower than the current target. The target federal funds rate was undoubtedly high because of the high rate of inflation. Evaluation The Fed did a decent job of having low inflation, low unemployment, and high economic growth. Inflation was a little too high and growth a little too slow. If the high target federal funds rate had caused a recession this could have complicated President Clinton s reelection bid. b) Given the state of the economy described previously, determine an appropriate dynamic monetary policy. Suggest changes for current monetary policy tools. Use the Federal Reserve balance sheet and a market for reserves diagram to show how your suggested monetary policy would affect the market for reserves and the monetary base. Make sure that you draw and correctly label the diagram and balance sheet. Policy can either address the problem of high inflation or low growth. The slow economy could possibly cause inflation to naturally decline. To bring down inflation, it should raise rates. Alternatively, to stimulate the economy, the Fed should lower rates. If the Fed decides to focus on the recession, it could lower the target rate towards 4.1%. This would require open market purchases, decreases in the discount and deposit rates, and a decrease in the required reserve ratio. Because the Fed, usually doesn t change the required reserve ratio, it doesn t need to be shown on the diagrams.

5 The purchase of securities increases the amount of reserves and the monetary base. Whenever, the FOMC changes the target federal funds rate, it usually also changes the discount and deposit rates. The increase in the monetary base shifts the supply of reserves to the right. This will cause the federal funds rate to decrease. The decrease in the discount rate will also move the kink on the supply curve downwards. The decrease in the interest rate paid on reserves will cause the kink on the demand curve to move down. The discount rate and the deposit rate place limits on the movements of the effective federal funds rate

6 c) Use the money supply equation, commercial bank balance sheets, and loanable funds diagram to explain how your prescribed monetary policy would affect interest rates, reserve aggregates, and monetary aggregates. Make sure that you include diagrams and explain your answer using equations and balance sheets. By buying securities, the Fed increases the monetary base (reserve aggregate) which then increases the money supply (monetary aggregate) with a multiplier effect. Buying Treasuries from commercial bank would cause reserves to increase and the bank's holdings of securities decrease. With more reserves, the banks would be able to make more loans and checkable deposits would increase. By the multiplier effect checkable deposits increase. The increase in the money supply causes the supply of loanable funds to increase and the interest rate to fall.

7 d) Draw a supply and demand diagram for loanable funds and use it to explain why interest rates (especially longer term maturities) might eventually have increased if the FOMC had lowered the target federal funds rate. Lowering interest rates could cause expected inflation to increase. Higher inflation would cause the supply of loanable funds to decrease and the demand for loanable funds to increase. Expected inflation is likely the dominant effect. The decrease in the target federal funds rate would accelerate the economy. This would increase wealth and cause the supply of loanable funds to increase. The expected return and risk of loanable might change differentially from those in equity markets as the economy grows faster. It might be that the expected return in equity markets increases relative to that in the loanable funds market. This would cause the supply for loanable to decrease. More risk relative to equity markets will likely also cause a decrease in the supply of loanable funds The effect of the government deficit is difficult to predict. A lower target federal funds rate would encourage growth. If the economy were to grow faster, then tax revenues would increase and government expenditures would decrease. If the deficit were to decrease, this would cause the demand for loanable funds to decrease. Better business conditions with a lower target federal funds rate could cause the demand to increase. If we observe a decrease in the interest rate, it must mean that either supply increased or demand decrease. If the expected inflation effects dominate, then we would see a decrease in supply and an increase in demand. This would cause the supply for loanable funds to decrease and this in turn would cause the yield to maturity to increase.

8 2) Use the loanable funds and Treasury workspaces (where appropriate) to explain how you think the following events will cause interest rates in the United States to change. a) The Trump Administration lowers taxes and increases spending. This would cause an increase in the deficit which the US Treasury would need to finance by issuing more bonds. This increases the supply of Treasuries which causes the price to fall and interest rates to rise. b) The Federal Reserve gradually reduces the size of its $4.5 trillion balance sheet by not replacing Treasury Securities as they mature. The Federal Reserve is decreasing its holdings of US Treasury securities. This means that demand has declined. The lower demand means that prices fall and the yield to maturity increases.

9 c) Trump successfully eliminates the trade deficit which causes the capital account surplus to disappear. Elimination of the current account deficit and capital account surplus means that foreign investors and governments have fewer dollars to invest in the US. This causes the supply of loanable funds to decrease which causes interest rates to rise. d) Commercial banks increase lending by reducing their excess reserves, which causes the total amount of excess reserves to decrease from the current $2 trillion.

10 If the excess reserves ratio declines then the money multiplier will expand. This causes the money supply to increase which in turn causes the supply of loanable funds to increase. The increased supply in loanable funds drives down the interest rate. 3) As the turn of the century approached, the Federal Reserve was worried that the population would convert a significant amount of their bank deposits into cash as part of the Y2K scare. a) Use balance sheets of the nonbank public, commercial banks, and the Federal Reserve to explain why a large number of withdrawals would cause the amount of reserves in the banking system to decrease but the monetary base to remain unchanged. Reserves in the banking system are the total of vault cash and deposits at the Federal Reserve. When depositors withdraw cash from the bank, then the bank s reserves decline and the amount of Federal Reserve Notes held by the nonbank public will increase. This causes the reserves in the banking system to decline. The monetary base is the sum of Federal Reserve Notes held by the nonbank public plus reserves. Reserves decline by the same amount as the increase in the Federal Reserve notes held by the nonbank public. The increase in FRN s and decrease in reserves exactly cancel each other out so the monetary base stays the same. b) Explain why the Fed would need to use a defensive open market operation to keep the effective federal funds rate from rising. Use the market for reserves workspace as part of your answer. The decrease in reserves in the banking system causes the supply of reserves to decrease as shown in the diagram below. This causes the effective federal funds rates to rise above the target rate. To keep this from happening, the Open Market Desk in New York would need to buy Treasuries to just offset the decrease in reserves caused by the withdrawals by the nonbank public.

11 4) Identify and explain the trend and seasonality conditions in which the exponential smoothing implementation in Excel will be appropriate. The Excel implementation of the ETS exponential smoothing model is an ETS(A, A, A). From this framework it is possible to have the following models: ETS(A, N, N) which is a horizontal pattern with constant variance ETS(A, A, N) which is a linear trend with constant variance and no seasonality ETS(A, A, A) which is a linear trend with constant variance and seasonality If the trend is exponential or if the seasonality and error terms are expanding, then multiplicative models are the most appropriate. Unfortunately, when nonlinear trends and nonconstant variance, Excel can t give match the pattern in the data.