Finance 101: Understanding Money, Financial Markets, and Monetary Policy - Prof. S. Filiz, Study notes of Economics

Download Finance 101: Understanding Money, Financial Markets, and Monetary Policy - Prof. S. Filiz and more Study notes Economics in PDF only on Docsity! Chapter 1 & 2 Chapter 1-2  Maturity- number of years (term) until instruments expiration date  Short term if debt instrument reaches maturity in one year or less  Long term has a maturity of 10 years or longer  Intermediate term is anything from more than one year to less than 10 years  Liquidity is how fast something can be transferred to cash  Money Market- financial market in which only short-term debt instruments are traded o Money market instruments  U.S. Treasury bills- short term debt instruments that U.S. government issues in one, three, and six month maturities to finance federal government  Capital market- the market in which longer term debt and equity are traded Financial Intermediaries  Financial intermediation- process of indirect finance, primary route for moving funds from lenders to borrowers. They are the banks o They provide risk sharing between investors and borrowers o Adverse selection- occurs when the potential borrowers who are the most likely to produce an o undesirable (adverse) outcome, are the ones most actively seeking out loans  Types of Intermediaries o Depository institutions- (banks) accept deposits from individuals and institutions and make loans o Commercial Banks- raise funds primarily by issuing checkable deposits, savings deposits, and time deposits. And then use funds to make commercial, consumer, and mortgage loans and to buy U.S. government securities and municipal bonds Regulation of Financial System  To increase available information to investors to reduce adverse selection and insider trading  Include the SEC, FDIC, Federal Reserve, more  Ensure soundness of financial system by controlling risky assets, with deposit insurance, and putting limits on competition Chapter 3 What is money?- money is different from currency and income, money is NOT wealth o Money is "anything" that is generally accepted as payment for goods and services or in the settlements of debts o Barter economy-  People trade goods and services directly with other services  Its inefficient  Double coincidence- when you have to find someone who has a good or service you want and you have a good or service they want  Hard to accumulate wealth  Lack of standardization o Functions of Money  Medium of exchange- money in the form of currency and checks used to pay for goods and services  Promotes economic efficiency  Characteristics  Easily standardized  Widely accepted  Divisible  Carried easily  Must be durable  Unit of account- measures value in economy  Store value- transfers purchasing power into the future and allows for accumulation of wealth  If prices increase => Purchasing power decreases => value of money decreases o Evolution of the payments system  Payments system- method of conducting transactions in economy  Commodity money- money made up of precious metals or another valuable commodity. Used from ancient times until several hundred years ago  Fiat money- paper currency decreed by governments as legal tender but not convertible into coins or precious money. Not backed by physical commodity  Checks  Electronic payment- debit card, credit card, EFT o Measuring Money  Monetary aggregates- measures quantity of money that are broader than currency  M1- + Currency + Travelers checks + Demand deposits + Other checkable deposits o M2= M1 + Small-denomination time deposits + Savings Deposits and money market deposit accounts + Money market mutual fund shares (retail) = Total M2 Chapter 4 PT+1 Understanding interest rates o Compounding- process of earning interest on payments as saving accumulate over time  Taxation o Municipal bonds-  Income tax free  Not as liquid as treasury bonds  Are not default free o Treasury bonds-  Default free  Taxed Term structure of interest rates  How maturity effects interest rates  Term structure: relationship between interest rates and maturity for a particular type of bond  Yield curve (Yc): shows this relationship o Upward sloping: occurs when short term interest rates are LOWER than long term notes (i- increases as maturity increases) o Downward sloping: occurs when short term rates are GREATER than long term rates o Flat: when short term rates are equal to long term rates Three Empirical facts 1. Interest rates on bonds of different maturities move together over time 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short term interest rates are high, yield curves are more likely to slope downward and be inverted 3. Yield curves are almost always sloped upward Three Theories explaining the slope of yield curve 1. Expectations theory- proves fact 1,2 2. Segmented Markets Theory- proves fact 3 3. Liquidity Premium Theory- proves facts 1,2,3 Expectations Theory  States: The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long term bond  Key assumption: buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with different maturity. Investors view bonds with different maturities as "perfect substitutes"  Implications: o Upward Yc: Investors expect that short term interest rates are going to rise o Flat Yc: investors expect interest rates to remain the same o Downward Yc: Expected interest rates to fall Segmented Markets Theory  States: Interest rates on a bond of a particular maturity is determined by the demand and supply of bonds of that maturity  Key assumption: Investors to NOT see bonds of different maturities as "perfect substitutes" => NO perfect substitutes o Return of bond with x maturity will affect bond with y maturity. X≠Y  Proves fact 3 that Yc is typically upward sloped. *can't explain facts 1 & 2  Implications: o Compared to Short term bonds, long term bonds are subjected to higher interest rate risk; often less liquid o Therefore=> there will be more investors in the short term market => price of s.t. will be higher => i- of s.t. bonds decrease => s.t. rates will be lower than l.t. rates => Yc is upward sloping Liquidity Premium Theory  States: The interest rate on long term bond is average of interest rates expected to occur on short term bonds over the life of long term bond PLUS a liquidity premium (term premium) o It is the additional interest investors require to be willing to hold a long term bond (subject to interest note risks) o Liquidity premium increases with increasing maturity  Key assumptions: Bonds of different maturities are substitutes BUT NOT perfect substitutes.  Preferred habitat theory: assumes investors have a preference for bonds of one maturity over another, a particular bond maturity (preferred habitat) in which they like to invest. Chapter 7- Stock Market  Stockholder has legal claim on firms profits  Dividends- payment cooperation makes to stockholders  Price of financial asset = PV of all future payments to be received from owning it Computing price of common stock 1. One-period valuation model a. Value of a share of stock today depends upon the present value of both dividends and the expected sales price b. Current stock price increases if the expected price increases c. Required rate of return on investment (Ke)- rate of return households require to compensate for the risk(Ke) of investing d. Formula- 2. Generalized Dividend Valuation Model a. The price of the stock is determined only by the dividend payments b. If expected sales price is in distant future, it does not affect current stock price i. Because present value is almost 0 b. Sum of present value of future dividend stream 2. Gordon Growth Model (GGM) a. Uses current dividend(Do), required rate of return on investment (Ke), and dividend growth rate (g) to calculate price of stock b. c. Key assumptions i. Ke is always greater than g 1. Decrease in risk => stock price will increase ii. (g) is always constant 1. If g increases => stock price will increase How the market sets stock prices  Asset's price is set by the buyer willing to pay the highest price o Information allows buyer to more accurately judge risk o An expected decrease in level of future dividends decreases asset price  Change in perceived risk of a stock changes the required rate of return  Stock's price falls if there is an increase in required rate of return  Monetary expansion increases stock prices because decrease in required rate of return and increase in dividend growth rate Theory of Rational Expectations 1. Adaptive expectations- people make forecasts of future values of the variable by ONLY the past values of the variable. 2. Rational Expectations- people make forecasts of future value of a variable by using "all" information available a. Doesn’t require accuracy, just BEST forecast with available information b. XE = XO (E is expectation)(O is optimal forecast) Implications of rational Expectations 1. When there is a change in the way a variable moves, how the expectations are formed will change as well 2. There will be forecasting errors which cannot be predicted ahead of time The Efficient Market Hypothesis  Theory of rational expectations, when applied to financial markets = efficient market hypothesis o Assumption- that prices in the financial market fully reflect all available info. o Current price of financial asset will be set so that the equilibrium rate of return equals expected rate of return. Rationale Behind hypothesis  Financial Arbitrage- market participants eliminate unexploited profit opportunities.   R* is equilibrium Behavioral Finance  Behavioral Finance- field of study that applies concepts from social sciences such as psychology and sociology to help to understand the behavior of security prices 8.3 Exchange rates in the short run: supply and demand analysis. theory of asset demand: the most important factor affected the demand for domestic and foreign assets is the expected return on theses assets relative to one another Real Exchange Rate - 0 NCO © supply is fixed b/c quantity supplied at any exchange rate is the same co excess demand = increase value of dollar (exchange rate goes down from eq.) o excess supply = decrease value of dollar (exchange rate goes up from eq.) 8.4 Explaining changes in exchange rates Chapter 9 (22 in full text) Aggregate Demand and Supply Analysis 9.1 Aggregate demand © agg demand curve: total quantity of an economy's final gaods and services demanded at diff price Ils © slopes downward b/c decrease in the price M = increase real money supply = increase real spending : o quantity theory of money derived from equation of exchange = agg demand also am increase money supply = increase agg dernand © four component parts: m@ consumer expenditures planned investment spending m@ gov't spending = net exports ©. consumption expenditure I: investment, g: gov't purchases t taxes nx: net exports ms: money supply 9.2 Aggregate supply * agg supply curve: total quantity of final goods and services offered for sale at diff price levels © shows relationship bfn price lvl and Iv of agg output supplied © long run agg supply curve o natural rate of unemployrment where economy gravitates in the long run © vertical line through the natural rate Ivl of output ° factors that shift curve to right am increase in total amt of capital m@ increase in total amt of labor supplied am increase in available technology m@ decline in natural rate of unemployment © short run agg supply curve 10.2 How actively should policymakers try to stabilize economic activity? lags prevent policies fram being immediately implemented © data lag: time it takes for policymakers to obtain data indicating what is happening in the economy © recognition lag: time it takes for policymakers to be sure of what the data is signaling about the future course of the economy legislative lag: time it takes to pass legislation to implement policy implementation lag: time it takes for policymakers to change policy instruments once they have decided on new policy © effectiveness lag: time it takes for policy to actually have an impact on economy 10.3 Inflation: always and everywhere a monetary phenomenon © monetary authorities can target any inflation rate in the long run with autonomous monetary policy adjustments © potential output is independent of monetary policy 10.4 Causes of inflationary monetary policy © high employment targets and inflation © high employment can bring high inflation = cost push inflation: from temporary negative supply shock or push by workers for wage hikes beyond what productivity gains can justify © temp negative supply shock shifts short run agg supply curve up ¢ output falls and unemployment increases © policy makers increase agg demand ® inflation rises dramatically m= demand pull inflation: policymakers pursuing policies that increase agg demand © policy makers increase agg demand to reach higher output © short run agg supply shifts up b/c rising wages e inflation rises dramatically o ° Chapter 11- Central Banks & FED Federal Reserve Banks  12 Federal Reserve districts  12 main federal reserve banks o Most important bank in New York  Quasi- public institution that is part private and part government o Member banks- private commercial banks that are members of Federal Reserve System  All national banks are required to be member banks, Required to keep reserve deposits  Board of Governors o 7 member board o Headquartered in Washington o Each appointed by president of U.S. serving 14 year terms  Chairman of board is chosen from 7 and serves 4 year terms. Advises President of U.S. o Sets reserve requirements o Controls discount rate o  Federal Open Market Committee (FOMC) o Consists of 12 Members  7 members of Board of Governors (7)  President of NY Fed Bank (permanent member) (1)  Presidents of 4 other Fed banks (4)  Rotate annually  Meets 8 times a year o Directs Open Market Operations  Federal Funds Rate- interest rate on overnight loans from one bank to another  Tightening of monetary policy- rise in fed funds rate  Easing of monetary policy- lowering in fed funds rate  Functions of Federal Reserve Banks o Clear Checks o Issue new currency & withdraw damaged o Administer discount loans o Evaluate mergers o Act as liaisons between business community and Fed o Collect data on local business conditions o Examine banking holding companies o Research to conduct monetary policy The Fed and independence  Instrument independence- the ability of the central banks to set monetary policy instruments  Goal independence- ability of central banks to set goals of monetary policy Should the Fed be Independent?  For: o Yes to keep it from political pressures o Yes to control of monetary policy is too important to leave up to politicians  Against: o No- current lack of accountability of the committee is having negative consequences o No- the public holds Congress and President accountable for economy, when in reality, they have no control over it. o No- in the past, the Fed hasn’t always used its freedom successfully/efficiently o No- Fed is not immune to political powers Central Bank Behavior  Theory of bureaucratic behavior- objective is to maximize its own welfare o 1st prediction of Fed- they will fight vigorously to preserve its autonomy(independence) o 2nd prediction- Fed will try to avoid conflict with powerful groups that might threaten to reduce power and/or autonomy Chapter 12- Money Supply Process 3 players  Central Bank- conducts monetary policy  Banks- (Depository Institutions) are the intermediaries that accept deposits from individuals & make loans  Depositors- Individuals and institutions that hold deposits in banks Federal Reserve System  Monetary Base- the sum of Feds monetary liabilities and the US treasury's Liabilities o Currency in circulation- amount of currency in hands of the public o Reserves- deposits at the Fed plus the currency that is physically held by banks  Required reserves- amount bank is required to hold by Fed  Excess reserves- Any additional reserves that banks decide to hold o Required Reserve Ratio  Assets o Securities o Loans to financial institutions made at the discount rate Control of Monetary Base  MB = C + R  Open Market Operations o Purchase- MB increases by amount of purchase. (always the same for MB)  Effect on reserves depends on which form proceeds from sale is in  Currency has no effect on reserves  Deposits cause an increase equal to amount of purchase o Sale- MB decreases by an equal amount.  Effect on MB is more certain than the effect on reserves o Float- temporary net increase in total amount of reserves in the banking system due to Feds check clearing process. (Fed credits account before debiting)  o Discount window- facility at which banks can borrow reserves from the Fed  Primary credit- discount lending that plays important role in monetary policy  Standing lending facility- healthy banks borrow all they want at very short maturities(overnight)  Interest rate set at discount rate  Amount of primary credit discount lending is very small  Kept more so as a backup for liquidity for sound banks  Secondary Credit- given to banks that are in financial trouble and are experiencing severe liquidity problems  Interest set at .5% higher than discount rate. Used as a penalty rate to reflect the less sound condition of the bank  Seasonal Credit- given to meet needs of limited small number of small banks in vacation or agricultural areas that have seasonal patterns of deposits  Interest rate set to the average of FFR and certificate of deposit rates o Lender of Last resort- When Fed was created, its most important role was to be the lender of last resort  To prevent bank failures from spinning out of control  To provide reserves to banks when no one else would  To prevent band and financial panics  ** Discounting is a particularly effective way to provide reserves to the banking system  Reserve Requirements (slanted part of Rd) o Changes in reserve requirements affect the money supply by causing the money supply multiplier to change o When required reserve ration increases => required Reserves increase => FFR increases o  Interest on Reserves o Non-conventional Monetary Policy Tools  Sometimes the conventional tools are not enough to stabilize the economy o Zero-lower-bound problem- Central bank is unable to lower short term interest rates any further because they have hit floor zero  Three Forms o Liquidity Provisions  Discount window expansion  Term auction facility- opened in 2007, makes loans at rate determined through competitive auctions  New lending programs- Fed began lending to investment banks as well as lending to promote purchases of commercial paper, mortgage backed securities, and other asset backed securities o Asset Purchases  In 2008- Fed purchased 1.25 trillion of mortgage backed securities to stimulate housing market. Lowered interest rate on houses  In 2010- Fed purchased 600 billion of long term treasuries securities @ rate of 75 billion per month. Stimulated investment spending  Quantitative easing- expansion of Feds balance sheet  Credit easing- altering the composition of Feds balance sheet in order to improve the functioning of particular segments of credit markets o Commitment of future policy actions  Management of expectations- committing a future policy action by keeping FFR at zero for an extended period, the Fed could lower the markets expectations of future short term interest rates, thereby causing long term interest rates to fall . Chapter 14- Conduct Monetary Policy 6 Goals of Central Banks 1. Practice stability- low and stable inflation and is viewed as most important goal a. Nominal Anchor- a nominal variable such as inflation rate or money supply, which ties down the price level to achieve price stability. i. Keeping the nominal variable within a narrow range promotes stability ii. Limits time inconsistency problem- monetary policy is conducted on a discretionary day to day basis that leads to poor long run outcomes 2. High employment and output stability a. The goal is not zero unemployment, but a level above zero consistent with full employment=> natural rate of employment=> potential output 2. Economic Growth 3. Stability of financial markets 4. Interest rate stability- fluctuations in interest rates can create uncertainty and make it hard to plan for the future 5. Stability in Foreign Exchange Markets Hierarchical Mandates- Mandates that put the goal of price stability first, and then say that as long as it is achieved, other goals will be pursued.  European Central Bank, Bank of Canada, and Bank of England use this directive Dual Mandates- to achieve two co-equal objectives, price stability and maximum employment Fed Reserve uses this directive Inflation Targeting- Economic policy in which central bank estimates and makes public, projected target inflation rate, then attempts to steer inflation towards target through interest rate changes and other monetary tools  New Zealand was first country to do this  Advantages o Makes Central bank accountable therefore potentially reducing time inconsistency problem o Can reduce political pressures on central bank, because they have the power to do it o It is readily understood by the public o Has had relatively high performance  Disadvantages o Delayed signaling- Inflation not easily controlled and can have long lags General principles of Bank Management o Liquidity Management  Deposit outflows- holding excess reserves allows the bank to escape the costs of  Borrowing from other banks  Selling securities  Borrowing from Fed  Calling in or selling off loans  Asset management  When bank has insufficient reserves, it calls in loans  Banks would rather acquire funds quickly by borrowing from Fed  Goal: purchasing securities with high return and low risk  Liability management  Banks will most likely meet reserve shortfall by borrowing Fed Funds  Leads to increased sales of CD's to raise funds  Insolvency- liabilities exceed assets  Capital adequacy management  How the bank prevents failures  Can be used to absorb losses resulting from bad loans => lessens chance of insolvency  How amount of bank capital affects returns to equity holders  The lower the bank capital, the higher the return to owners of the bank  Trade off between safety and returns  Bank capital requirement- banks hold capital because they have to due to regulations o Managing Credit Risk  Screening and Monitoring  Screening- screen out bad credit risks from good ones so that loans are profitable; avoiding adverse selection  Specialization Monitoring- easier for banks to collect credit info on local firms than far away ones  Monitoring and enforcing restrictive covenants to reduce moral hazard  Long term customer relationships  Keeps banks from having to redo the screening and monitoring process  Loan Commitments- banks commitment to provide a firm with loans up to a given amount at an interest rate tied to the market  Collateral and Compensating balances  Collateral if loanee defaults  Compensating balances  Loanee must keep certain amount of money in bank account at bank in order to receive loan. This amount can be taken if loanee defaults  Credit rationing- refusing to make loans even though borrowers are willing to pay stated rate or higher  Lender refuses to make loans of any mount to a borrower  Lender is willing to make a loan but restricts the size of loan to less that what borrower wants o Managing Interest Rate  If a bank has more rate sensitive liabilities than assets, a rise of interest rates will reduce bank profits  Gap analysis- amount of rate sensitive liabilities is subtracted from amount of rate sensitive assets  Maturity bucket approach- measure gap for several maturity sub intervals  Duration analysis- examines sensitivity of market value of the banks total assets and liabilities to changes in interest rates o Off balance sheet objectives  Loan sales- a contract that sells all or part of the cash stream from a specific loan and thereby removes the loan so that it no longer is an asset on balance sheet  Generation of Fee income- by offering personalized services for customers  Trading activities and risk management techniques Chapter 16- Financial Crisis Ch 9 Financial Crisis- Occurs when there is a particularly large disruption to information flows in financial markets  Result- Financial Frictions increase sharply and financial markets stop functioning o Financial friction- asymmetric information problems that act as a barrier to efficient allocation of capital Dynamics of Financial Crisis in Advanced economies  STAGE 1 : Initiation of financial crisis o Mismanagement of financial innovation/liberalization  Fin. Innovation- when economy introduces new types of loans or other financial products  Fin. Liberalization- the elimination of restrictions on financial markets and institutions o Leads to deterioration of financial institutions balance sheets  Asset price decline o Increased uncertainty o Adverse selection problem and moral hazard  STAGE 2 : Banking Crisis o Economic activity declines o Banking crisis- deteriorating balance sheets can lead to bank insolvency and cause some banks to fail  Bank panic- multiple bank fail simultaneously  Fire sales- runs on banks can cause banks to quickly sell off assets to raise necessary funds o Adverse selection problem and moral hazard  STAGE 3 : Debt Deflation o Unanticipated drop in price level o Adverse selection problem and moral hazard o Economic activity declines Causes of 2007-2009 Financial Crisis  Financial innovation in mortgage rates  Agency problems in mortgage markets o Agencies often times did not make strong enough effort to evaluate whether borrower could pay off the loan o Broker wanted to make money by giving out more loans and gaining commission, disregarding whether or not they could pay it off  Asymmetric information in Credit agency's o Rating agencies were conflicts of interest because they would get paid to advise clients on products that they were in control of the rating. Reduced the need for accurate ratings Effects of Financial Crisis  Residential housing prices: boom and bust  Deterioration of financial institutions balance sheets  Run on the shadow banking system o Shadow banking system- composed of hedge funds, investment banks, and other non- depository financial firms which are not as tightly regulated  Global financial market issues  Failure of high profile banks like: Bear Sterns, Lehman Brothers, Fannie Mae & Freddie Mac, and AIG Dynamics of financial crisis in emerging markets  STAGE 1 : Initiation of financial crisis o Deterioration of bank balance sheets o Increase in interest rate o Asset price decline o Increased uncertainty o Adverse selection problem and moral hazard  STAGE 2 : currency Crisis o Economic activity declines o Financial imbalances o Foreign exchange crisis o Adverse selection problem and moral hazard  STAGE 3 : full blown financial crisis o Banking crisis o Adverse selection problem and moral hazard o Economic activity declines