The price stability goal and the nominal anchor
-price stability: low and stable inflation; high inflation = lower economic growth; creates uncertainty
1. The role of a nominal anchor
-a nominal variable such as inflation rate or the money supply ties down price level to achieve price stability; adherence to nominal anchor promotes low inflation
-limits time-inconsistency problem
2. The time-inconsistency problem
-tempted to pursue discretionary monetary policy that is more expansionary than expected becauses boost economic output in the short run
-best policy is not to purue expansionary policy because decisions about wages and prices relect workers' and firms' expectations about policy; when they see an expansionary policy, they expect inflation driving wages and prices up --> higher inflation but not higher output
-best policy is to keep inflation under control
-nominal anchor is a behavior rule; prevent the time-inconsistency problem in monetary policy by providing an expected constraint on discretionary policy.;
Other goals of monetary policy
1. Higher employment: the alternative situation: high unemployment causes misery; high ue = idle workers and resources = loss of output
-frictional ue: searches to find suitable matchups; beneficial to economy
-structural ue: mismatch between job requirements and skills or availability of local workers; undesirable
-natural rate of ue: demand for labor equals the supply of labor
2. Economic growth
-related to high employment;encouraging firms to invest or encouraging people to save
-supply-side economics polcies: intended to spur economic growth by tax incentives for businesses to invest and for taxpayers to save.
3. Stability of financial markets
4. Interest rate stability
-fluct can create uncertainty
-reduce upward movements: generate hostility toward central banks and lead to demands that their power be curtailed
-increase in interest rate: large capital losses on long-term bonds and mortgages
5. Stability in foreign exchange markets
-rise in value eof dollar makes american industries less competitive; declines in value stimulate inflation in us.
Should price stability be the primary goal of monetary policy?
1. in long-run, no trade-off between price stability and other goals
-short run price stability conflicts with goals of high employment and interest-rate stability
2. Hierachical vs. dual mandates
-hierachical mandates: primary goal is price stability then other goals
dual mandate: price stability and max employment
-price stability should be the primary, long-run goal of monetary policy
Monetary targeting
1. central bank announces certain vaule of annual growth rate of a monetary agggregate such as 5% growth rate of M1 or 6% growth rate of m2.
2. US: kept missing target
-shocks that made monetary aggregates control difficult
-smokescreen: free to manipulate interest rates to dampen inflation; won't be blame for high interest rates
no longer use monetary aggregates as guide for monetary policy
3. Germany: success
-focus on narrow monetary aggregate called central bank money: sum of currency in circulation and bank deposits
-more transparent to the public; not rigid; more accountable
4. Advantages of monetary targetiing
-info on whether central bank is achieving its target is known immediately; fix inflation expectations and produce less inflation
-allow immediate accountability for monetary policy to keep inflation low --> help precent from falling into the time-inconsistency trap
5. Disadvantage sof monetary targeting
-there must be strong and reliable relationship between goal variable (inflation or nominal income) and the targeted monetary aggregate
Inflation targeting
1. public announcement of medium-term numerical targets for inflation;
-an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal;
-an information-inclusive approach in which many variables (not just monetary aggregates) are used in making decisions about monetary policy;
-increased transpareny of monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers;
-increased accountability of the central bank for attaining its inflation objectives
2. New Zealand was first to adoptt inflation targeting
3. Canada: inflation dropped but ue soared
4. UK: inflation fell and there was growth and reduction in ue
Advantages of inflation targeting
1. does not rely on relationship of money and inflation
2. can use all information and not just one variable
3. understood by public and highly transparent
4. increase accountability of central bank; prevent time-inconsistency trap
Disadvantages
1. delayed signaling; too much rigidity; potential for increased output fluctuations; and low economic growth
2. delayed signaling: inflation not easily controlled; unable to send immediate signals to public
3. too much rigidity: limits ability to respond to unforseen circumstances
-flexible inflation targeting in practice
4. potential for increased output fluctuations: does not require sole focus on inflation
-choose inflation targets above 0 to prevent deflation; concerned about output and ue too.
Tuesday, December 11, 2007
Chapter 15: Tools of Monetary Policy
The market for resesrves and the federal funds rate
Supply and Demand in the market for reserves
1. Demand curve: quantity of excess reserves demanded = required reserves + quantity of excess reserves demanded
-excess reserves are insurance against deposit outflow and the cost of holding er is the interest rate that could have been earned on lending it out which is the federal funds rate.
-fund funds rate decreases --> cost of holding er falls --> quan of reserves rises
2. Supply curve:
-two components: amount of reserves supplied by fed's open market operations called nonborrowed reserves; and the amount of reserves borrowed from the fed, the borrowed reserves
-cost of borrowing from fed is the interest rate fed charges on these loans, the discount rate (id)
-bowworing from other banks at the fed funds rate; as long as iff is less than id, banks will not borrow from fed; vertical line until id
How changes in the tools of monetary policy affect the federal funds rate
1. open market operations: an open market purchase causes the fed funds rate to fall, whereas an open market sale causes the fed funds rate to rise
-open market purchase leads to greater quan of reservess supplied; shirts the sc to the right
2. discount lending: effect depends on whether dc intersects the supply curve in its vertical section or flat section
-when intersect at vertical section - most changes int eh discount rate have no effect on the fed runds rate
-intersect at flat section; some discount lending; iff moves with id
3. reserve requirements: when required reserve ratio increases, quan of resreves demanded increases for any given interest rate --> shift demand curve to the right --> raises the fed funds rate
-when the fed raises reserve requirements, the fed funds rate rises
Open market operations (t-bills)
-most useful monetary policy tool; primary determinants of changes in interest rates and monetary base --> change in money supply
-open market purchases expand reserves and monetary base and money supply lowering short-term interest rates
-open market sales shrink reserves and monetary base decreasing money supply and increasing short-term interest rates.
-two types of open market operations: dynamic open market operations: change the level of reserves and monetary base
-defensive omo: offset movements in other factors that affect reserves and the monetary base
-repurchase agreement: fed purchases securities with an agreement that the seller will repurchase them; temp open market purchase
-matched sale-purchase transaction (reverse repo): temp open market sale; fed sells securities and buyer agrees to sell them back to fed
Advantages of open market operations
1. fed has complete control over it
2. flexible, precise and used to any extent
3. easily reversed
4. implemented quickly; no administrative delays
Operation of the discount window
1. three types of discount loans:
a. primary credit: most important; healthy banks allowed to borrow all they want for short maturities --> standing lending facility
-lent at discountr ate which is 100 basis points (1%) higher than fed funds rate
b. secondary credit: banks taht are in financial trouble and experiencing severe liquidity problems
-interest set at 50 basis points above the discount rate
c. seasonal credit: small banks in vacation and agricultural areas that ahve seasonal pattern of deposits
-interest rate is average of fed funds rate and certificate of deposit rates
Lender of last resort
1. fed as lender of last resort to prevent bank panics
2. moral hazard problems
Advantages and disadvantages of discount policy
1. ad: lender of last resort
2. dis: decisions to take out discount loans are made by banks and are not controlled by the fed
Reserve requirements
-affect money supply by changing money supply multiplier
-rise in reserve requirements reduces the amount of deposits that can be supported by level of monetary base and lead to contraction of ms.
-rise in rr also increases the demand for reserves and raises the fed funds rate
1. disadvantages of reserve requirements
-no longer binding for most banks
-raising requirements can cause immediate liquidity problems for banks where reserve requirements are binding; create more uncertainty for banks
Application: Why have reserve requirements been declining worldwide?
-makes banks less competitive
ApplicationThe channel/corridor system for setting interest rates used in other countries
-central banks ets up a standing lending facility; commonly called a lombard facility; interest rate charged is called lombard rate
-overnight interest rate is always between ir and il
Monetary policy tools of the european central bank
1. set target financing rate which sets target for overnight cash rate
2. Open market operations: main refinancing operations are predominant form of open market operations and are similar to the fed's repo; they involve weekly reverse transactions
-longer-term refnancing operations: similar to fed's outright purchases or sales
3. lending to banks: marginal lending facility; borrow overnight loans from national central banks at the marginal lending rate which is 100 basis points above target financing rate; similar to discount rate; ceiling
-deposit facility: banks are paid fixed interest rate that is 100 basis points below target financing rate; floor for overnight market interest rate
4. Reserve requirements: pays interest on required reserves
Supply and Demand in the market for reserves
1. Demand curve: quantity of excess reserves demanded = required reserves + quantity of excess reserves demanded
-excess reserves are insurance against deposit outflow and the cost of holding er is the interest rate that could have been earned on lending it out which is the federal funds rate.
-fund funds rate decreases --> cost of holding er falls --> quan of reserves rises
2. Supply curve:
-two components: amount of reserves supplied by fed's open market operations called nonborrowed reserves; and the amount of reserves borrowed from the fed, the borrowed reserves
-cost of borrowing from fed is the interest rate fed charges on these loans, the discount rate (id)
-bowworing from other banks at the fed funds rate; as long as iff is less than id, banks will not borrow from fed; vertical line until id
How changes in the tools of monetary policy affect the federal funds rate
1. open market operations: an open market purchase causes the fed funds rate to fall, whereas an open market sale causes the fed funds rate to rise
-open market purchase leads to greater quan of reservess supplied; shirts the sc to the right
2. discount lending: effect depends on whether dc intersects the supply curve in its vertical section or flat section
-when intersect at vertical section - most changes int eh discount rate have no effect on the fed runds rate
-intersect at flat section; some discount lending; iff moves with id
3. reserve requirements: when required reserve ratio increases, quan of resreves demanded increases for any given interest rate --> shift demand curve to the right --> raises the fed funds rate
-when the fed raises reserve requirements, the fed funds rate rises
Open market operations (t-bills)
-most useful monetary policy tool; primary determinants of changes in interest rates and monetary base --> change in money supply
-open market purchases expand reserves and monetary base and money supply lowering short-term interest rates
-open market sales shrink reserves and monetary base decreasing money supply and increasing short-term interest rates.
-two types of open market operations: dynamic open market operations: change the level of reserves and monetary base
-defensive omo: offset movements in other factors that affect reserves and the monetary base
-repurchase agreement: fed purchases securities with an agreement that the seller will repurchase them; temp open market purchase
-matched sale-purchase transaction (reverse repo): temp open market sale; fed sells securities and buyer agrees to sell them back to fed
Advantages of open market operations
1. fed has complete control over it
2. flexible, precise and used to any extent
3. easily reversed
4. implemented quickly; no administrative delays
Operation of the discount window
1. three types of discount loans:
a. primary credit: most important; healthy banks allowed to borrow all they want for short maturities --> standing lending facility
-lent at discountr ate which is 100 basis points (1%) higher than fed funds rate
b. secondary credit: banks taht are in financial trouble and experiencing severe liquidity problems
-interest set at 50 basis points above the discount rate
c. seasonal credit: small banks in vacation and agricultural areas that ahve seasonal pattern of deposits
-interest rate is average of fed funds rate and certificate of deposit rates
Lender of last resort
1. fed as lender of last resort to prevent bank panics
2. moral hazard problems
Advantages and disadvantages of discount policy
1. ad: lender of last resort
2. dis: decisions to take out discount loans are made by banks and are not controlled by the fed
Reserve requirements
-affect money supply by changing money supply multiplier
-rise in reserve requirements reduces the amount of deposits that can be supported by level of monetary base and lead to contraction of ms.
-rise in rr also increases the demand for reserves and raises the fed funds rate
1. disadvantages of reserve requirements
-no longer binding for most banks
-raising requirements can cause immediate liquidity problems for banks where reserve requirements are binding; create more uncertainty for banks
Application: Why have reserve requirements been declining worldwide?
-makes banks less competitive
ApplicationThe channel/corridor system for setting interest rates used in other countries
-central banks ets up a standing lending facility; commonly called a lombard facility; interest rate charged is called lombard rate
-overnight interest rate is always between ir and il
Monetary policy tools of the european central bank
1. set target financing rate which sets target for overnight cash rate
2. Open market operations: main refinancing operations are predominant form of open market operations and are similar to the fed's repo; they involve weekly reverse transactions
-longer-term refnancing operations: similar to fed's outright purchases or sales
3. lending to banks: marginal lending facility; borrow overnight loans from national central banks at the marginal lending rate which is 100 basis points above target financing rate; similar to discount rate; ceiling
-deposit facility: banks are paid fixed interest rate that is 100 basis points below target financing rate; floor for overnight market interest rate
4. Reserve requirements: pays interest on required reserves
Monday, December 10, 2007
Chapter 14: Determinants of the Money Supply
The money supply model and the money multiplier
1. fed can control monetary base better than reserves: money supply = money multiplier X monetary base
2. desired level of currency and excess reserves grow proportionally with checkable deposits
-currency ratio = currency/deposit
-excess reserves ratio = excess reserves/deposits
-total reserves = required reserves + excess reserves
-required reserves = required reserve ratio X deposits
-R=(rXD) + ER
-MB = R + C = (rXD) + ER + C ; the amount of monetary base needed to support the existing amounts of checkable deposits, currency, and excess reserves
-an increase in the monetary base that goes into currency is not multiplied, whereas an increase that goes into supporting deposits is multiplied
-MB = (r X D) + (e X D) + (c X D) = (r + e + c) X D ; D = [1/(r + e +c) ] X MB
-M = [(1+c)/(r+c+e)] X MB ; currency ratio set by depositors, excess reserves ratio set by banks, and required reserve ratio set by Fed
-money multiplier is less than teh simple deposit multiplier; although there is multiple expansion deposits, there is no such expansion for currency
Factors that determine the money multiplier
1. the money multiplier and money supply are negatively related to the required reserve ratio
2. the money multiplier and money supply are negatively related to the currency ratio
3. negatively related to the excess reserves ratio
4. banking system's excess reserves ratio is negatively related to the market interest rate; as market interest rate increases, the expected return on loans and securities rises relative to the zero return on excess reserves and the excess reserves ratio falls
5. excess reserves ratio is positively related to expectedd deposit outflows
Additional factors that determine money supply
1. monetary base into two components: one that the Fed can control and one that it can't
-less tightly controlled is the amount of the base that is created by discount loans (borrowed reserves)
- the tightly controlled is the nonborrowed monetary base which results from open market operations
-(nonborrowed monetary base) = (monetary base) + (borrowed reserves from the Fed
-M = m X (MBn + BR)
-money supply is positively related to the nonborrowed monetary base
-money supply is positively related to the level of borrowed reserves fromt eh fed
Application: movements in money supply
1. over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base which controlled by fed open market operations
Application: bank panics
1. cause substantial reduction in the money supply by increasing in c and e.
1. fed can control monetary base better than reserves: money supply = money multiplier X monetary base
2. desired level of currency and excess reserves grow proportionally with checkable deposits
-currency ratio = currency/deposit
-excess reserves ratio = excess reserves/deposits
-total reserves = required reserves + excess reserves
-required reserves = required reserve ratio X deposits
-R=(rXD) + ER
-MB = R + C = (rXD) + ER + C ; the amount of monetary base needed to support the existing amounts of checkable deposits, currency, and excess reserves
-an increase in the monetary base that goes into currency is not multiplied, whereas an increase that goes into supporting deposits is multiplied
-MB = (r X D) + (e X D) + (c X D) = (r + e + c) X D ; D = [1/(r + e +c) ] X MB
-M = [(1+c)/(r+c+e)] X MB ; currency ratio set by depositors, excess reserves ratio set by banks, and required reserve ratio set by Fed
-money multiplier is less than teh simple deposit multiplier; although there is multiple expansion deposits, there is no such expansion for currency
Factors that determine the money multiplier
1. the money multiplier and money supply are negatively related to the required reserve ratio
2. the money multiplier and money supply are negatively related to the currency ratio
3. negatively related to the excess reserves ratio
4. banking system's excess reserves ratio is negatively related to the market interest rate; as market interest rate increases, the expected return on loans and securities rises relative to the zero return on excess reserves and the excess reserves ratio falls
5. excess reserves ratio is positively related to expectedd deposit outflows
Additional factors that determine money supply
1. monetary base into two components: one that the Fed can control and one that it can't
-less tightly controlled is the amount of the base that is created by discount loans (borrowed reserves)
- the tightly controlled is the nonborrowed monetary base which results from open market operations
-(nonborrowed monetary base) = (monetary base) + (borrowed reserves from the Fed
-M = m X (MBn + BR)
-money supply is positively related to the nonborrowed monetary base
-money supply is positively related to the level of borrowed reserves fromt eh fed
Application: movements in money supply
1. over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base which controlled by fed open market operations
Application: bank panics
1. cause substantial reduction in the money supply by increasing in c and e.
Chapter 13: Multiple Deposit Creation and the Money Supply Process
Multiple deposit creation: a simple model
1. when fed supplies banking system with $1 of additional reserves, deposits increase by a multiple of this amount
Deposit creation: The banking system
1. A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan
2. whether a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on deposit expansion is the same
3. multiple increase in deposits generated from an increase in the banking system's reserves is called the simple deposit multiplier: (change in checkable deposits in the banking system) = (required reserve ratio)(change in reserves for the banking system)
4. Critique: fed has no complete control over the level of checkable deposits
1. when fed supplies banking system with $1 of additional reserves, deposits increase by a multiple of this amount
Deposit creation: The banking system
1. A bank cannot safely make loans for an amount greater than the excess reserves it has before it makes the loan
2. whether a bank chooses to use its excess reserves to make loans or to purchase securities, the effect on deposit expansion is the same
3. multiple increase in deposits generated from an increase in the banking system's reserves is called the simple deposit multiplier: (change in checkable deposits in the banking system) = (required reserve ratio)(change in reserves for the banking system)
4. Critique: fed has no complete control over the level of checkable deposits
Chapter 12: Structure of Central Banks and the Federal Reserve System
Structure of the Federal Reserve System
1. Diffusion of power: the Fed Reserve banks, Board of Governors of the Federal Reserve System, Federal Open Market Comittee (FOMC), Fed Advisory Council and member commercial banks.
2. Federal Reserve Banks: for 12 district; largest are New York, Chicago, and SF
-quasi-public (part private, part government)
-each with nine directors who appoint president and other officers of the FRB
-The twleve Fed Reserve banks perform the following functions:
a. clear checks, issue new currency, withdraw damaged currency, administer and make discount loans to banks, evaluate mergers, liaisons between the business communitry and FRS, examine bank holding companies and state-chartered member banks, collect data, use staffs of prof economists to research topics related to monetary policy.
-Involved in monetary policy:
a. establish discount rate; which banks can obtain discount loans; directors select banker to serve on Fed Advisory Council; 5 of 12 presidents have vote in the FOMC
3. Special role of the FRB of NY
-contains many large banks in the US; bond and foreign exchange markets; only FRB to be a member of the Bank for International Settlements (BIS); president is the only permanent member of FOMC serving as vice-chairman of the committee.
Member Banks
1. all national banks are members of Fed Reserve System; required all banks to have required reserves; all banks can borrow from fed
Board of Governors of the Fed Reserve System
1. seven members, including the chairman, appointed by the president of the US and confirmed by the Senate
2. head of the fed; monetary policy; FOMC; set reserve requirements; control discount rate; mergers; bank holding companies; supervises the activities of foreign banks in US
Federal Open Market Committee
1. influence money supply and interest rates
2. open market operations
The FOMC Meeting, Why the Chairman of the Board of Governors Really Runs the Show
How Independent is the Fed?
1. instrument iindependence: the ability of the central bank to set monetary policy instruments
2. Goal independence: the ability of central bank to set the goals of monetary policy
3. The fed has both types of independence
4. factor that contribue to independence: income from Fed
5. Congress can change fed structure; president can appoint governors
Structure and Independence of the European Central Bank
1. conducts monetary policy for countries that are members of the European Monetary Union
2. The central banks for each country has similar role to that of the Federal Reserve Banks
Differences Between the European System of Central Banks and the Federal Reserve System
1. budgets of fed controlled by board of governors, while national central banks control their own budgets and the budget of the ECB in Frankfurt; ECB has less power than does the BoG
2. monetary operations of teh ECB are conducted by the NCB in each country so monetary operations are not centralized as Fed.
3. ECB not involved in supervision and regulation of financial institutions
Governing Council
1. concensus but no votes; fed releases statement of fomc; ECB have news conference
How independent is the ECB?
1. most independent central bank in the world; long-term goal is price stability
2. ecb's charter cannot be changed by legislation
Structure and independence of other foreign central banks
1. Bank of Canada
-gave monetary policy to the government; on paper, BoC is not as instrument-independent as the fed.; in practice, does control monetary policy
-goal for monetary policy, a target for inflation, is set jointly by the bank of canada an the government so the bank of canada has less goal independence than the fed.
2. Bank of England
-least independent of the central banks because the decision to raise or lower interest rates is controlled by the chancellor
-makes it monetary policy independently from the ECB.
-inflation target is set by chancellor so less goal-independent than fed
3. Bank of Japan
-price stability, granted greater instrument and goal independence
-Ministry of Finance has control over budget --> limit independence
4. The trend toward greater independence
-greater independence produce better monetary policy
Explaining central bank behavior
1. factor affecting central bank behavior is its attempt to increase its power and prestige
2. fed maintain autonomy; avoid conflict with powerful groups
3. hide actions from public and politicians to avoid conflicts with them
Should the fed be independent?
1. favor
-inflationary bias to monetary policy; politicians are short-sighted; politically insulated fed is more likely to be concerned with long-run objectives
-political business cycle: just before election, expansionary policies are pursued to lower unemployment and interest rates.
2. against
-undemocratic to have monetary policy controlled by elite troup that is responsible to no one.; lack of accountability; only by placing monetary policy under the control of politicians who also control fiscal policy can these two policies be prevented from working at cross-purposes.
-fed has not always used its greedom sucessfully.
1. Diffusion of power: the Fed Reserve banks, Board of Governors of the Federal Reserve System, Federal Open Market Comittee (FOMC), Fed Advisory Council and member commercial banks.
2. Federal Reserve Banks: for 12 district; largest are New York, Chicago, and SF
-quasi-public (part private, part government)
-each with nine directors who appoint president and other officers of the FRB
-The twleve Fed Reserve banks perform the following functions:
a. clear checks, issue new currency, withdraw damaged currency, administer and make discount loans to banks, evaluate mergers, liaisons between the business communitry and FRS, examine bank holding companies and state-chartered member banks, collect data, use staffs of prof economists to research topics related to monetary policy.
-Involved in monetary policy:
a. establish discount rate; which banks can obtain discount loans; directors select banker to serve on Fed Advisory Council; 5 of 12 presidents have vote in the FOMC
3. Special role of the FRB of NY
-contains many large banks in the US; bond and foreign exchange markets; only FRB to be a member of the Bank for International Settlements (BIS); president is the only permanent member of FOMC serving as vice-chairman of the committee.
Member Banks
1. all national banks are members of Fed Reserve System; required all banks to have required reserves; all banks can borrow from fed
Board of Governors of the Fed Reserve System
1. seven members, including the chairman, appointed by the president of the US and confirmed by the Senate
2. head of the fed; monetary policy; FOMC; set reserve requirements; control discount rate; mergers; bank holding companies; supervises the activities of foreign banks in US
Federal Open Market Committee
1. influence money supply and interest rates
2. open market operations
The FOMC Meeting, Why the Chairman of the Board of Governors Really Runs the Show
How Independent is the Fed?
1. instrument iindependence: the ability of the central bank to set monetary policy instruments
2. Goal independence: the ability of central bank to set the goals of monetary policy
3. The fed has both types of independence
4. factor that contribue to independence: income from Fed
5. Congress can change fed structure; president can appoint governors
Structure and Independence of the European Central Bank
1. conducts monetary policy for countries that are members of the European Monetary Union
2. The central banks for each country has similar role to that of the Federal Reserve Banks
Differences Between the European System of Central Banks and the Federal Reserve System
1. budgets of fed controlled by board of governors, while national central banks control their own budgets and the budget of the ECB in Frankfurt; ECB has less power than does the BoG
2. monetary operations of teh ECB are conducted by the NCB in each country so monetary operations are not centralized as Fed.
3. ECB not involved in supervision and regulation of financial institutions
Governing Council
1. concensus but no votes; fed releases statement of fomc; ECB have news conference
How independent is the ECB?
1. most independent central bank in the world; long-term goal is price stability
2. ecb's charter cannot be changed by legislation
Structure and independence of other foreign central banks
1. Bank of Canada
-gave monetary policy to the government; on paper, BoC is not as instrument-independent as the fed.; in practice, does control monetary policy
-goal for monetary policy, a target for inflation, is set jointly by the bank of canada an the government so the bank of canada has less goal independence than the fed.
2. Bank of England
-least independent of the central banks because the decision to raise or lower interest rates is controlled by the chancellor
-makes it monetary policy independently from the ECB.
-inflation target is set by chancellor so less goal-independent than fed
3. Bank of Japan
-price stability, granted greater instrument and goal independence
-Ministry of Finance has control over budget --> limit independence
4. The trend toward greater independence
-greater independence produce better monetary policy
Explaining central bank behavior
1. factor affecting central bank behavior is its attempt to increase its power and prestige
2. fed maintain autonomy; avoid conflict with powerful groups
3. hide actions from public and politicians to avoid conflicts with them
Should the fed be independent?
1. favor
-inflationary bias to monetary policy; politicians are short-sighted; politically insulated fed is more likely to be concerned with long-run objectives
-political business cycle: just before election, expansionary policies are pursued to lower unemployment and interest rates.
2. against
-undemocratic to have monetary policy controlled by elite troup that is responsible to no one.; lack of accountability; only by placing monetary policy under the control of politicians who also control fiscal policy can these two policies be prevented from working at cross-purposes.
-fed has not always used its greedom sucessfully.
Saturday, December 8, 2007
Chapter 7: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis
-Theory of rational expectations; financial markets: efficient market hypothesis
Computing the price of common stock
1. the principal way to raise capital; right to vote and residual claimant of profits; dividends
2. Price equals the present value of all cash flows the investment will generate over its life.
3. one-period valuation model: to find price of stock; buy stock, hold it for one period to get dividend and sell it.
The one-period valuation model and The generalized dividend valuation model
1. Stocks that do not pay dividends: buyers of the stock expect that the firm will pay dividends someday.
The Gordon Growth Model
1. increase dividends at a constant rate each year.
2. assumptions:
-dividends are assumed to continue growing at a constant rate forever or at least for an extended period of time
-the growth rate is assumed to be less than the required return on equity, ke. If the growth rate were faster than the rate required, the firm would grow impossibly large.
How the market sets stock prices
1. the price is set by the buyer willing to pay the highest price.
2. the market price will be set by buyer who can take advantage of the asset
3. superior information can increase value by reducing risk
4. market price is set by buyers bidding against each other; new information causes change in expectations and change in stock prices.
Application: monetary policy and stock prices
1. Monetary policy affect stock prices in two ways
-Fed lowers interest rates, the return on bonds dclins and investors are likely to accept a lower required rate of retrun on an investment in equity (ke) --> raise stock prices
-Lower interest rate --> stimulate economy --> rise in g --> rise in stock prices
Application: the 911 terrorist attacks, the Enron Scandal, and the stock market
1. 911: raised possibility that terrorism would paralyze the country; expect lower growth --> decrease in g --> decline in stock prices
2. increased uncertainty would raise the ke --> decline in stock prices
3. the Enron scandal and overstated earnings cause doubt and uncertainty --> decrease in g and rise in ke --> decline in stock prices
The theory of rational expectations
1. Adaptive expectations: the changes in expectations will occur slowly over time as past data change.
2. people use more than just past information; people change expectations to new info
3. Rational expectations: expectations will be identical to optimal forecasts using all available information
-does not have to be perfectly accurate; only needs to be the best possible given the available information
-even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate
4. Two reasons why an expectation may fail to be rational
-people might be aware of all available information but find it takes too much effort to make their expectation the best guess possible
-people might be unaware of some available relevant information, so their best guess of the future will not be accurate
5. If an additional factor is important but not available, the expectation is still rational
Rationale behind the theory
1. people make their expectations match their best possible guess using all available information because it is costly for people not to do so.
Implications of the theory
1. if there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well
2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time; forecast errors of expectations cannot be predicted
The efficient market hypothesis: rational expectations in financial markets
1. application of rational expectations to the pricing of stocks
2. assumption that prices of securities in financial markets fully reflect all available information
3. R(of)=R* - current prices in a financial market will be set so that the optimal forecast of a security's return using all available information equals the security's equilibrium return.
4. a security's price fully reflects all available information
Rationale behind the hypothesis
1. Unexploited profit opportunity: people earning more than they should; R(of) > R* driving up P(of)t+1 lowering R(of) --> unexploited profit opportunity disappeared
2. In an efficient market, all unexploited profit opportunities will be eliminated
3. Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds; as long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities
Stronger version of the efficient market hypothesis:
1. not only does optimal forecasts using all available information but also in an efficient market is one in which prices reflect the true fundamental (intrinsic) value of the securities.
2. implies that one investment is as good as any other because the securities' prices are correct
3. implies that a security's price reflect all available information about the intrinsic value of the security
4. implies that security prices can be used by managers of both financial and nonfinancial firms to asses their cost of capital accurately and hence that security prices can be used to help make the correct decisions about whether the investment is worth making.
Evidence on the efficient market hypothesis
1. in favor
-having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future.
-stock prices reflect publicly available information
-random walk: future changes cannot be predicted; EMH states that stock prices should follow random walk - future changes in stock prices should, for all practical purposes, be unpredictable
-technical analysis: study past stock price data and search for patterns such as trends on regular cycles; waste of time
2. against
-small-firm effect: small firms have earned abnormally high returns over long periods of time even when the risk of these firms are taken into account; may be due to rebalancing of portfolios by institutional investors, tax issues, low liq of stocks, large info costs in eval small firms, inappropriate measurement of risk
-January effect: abnormal price rise from dec to jan that is predictable and inconsistent with random-walk behavior; decresed for large companies; due to tax issues --> incentive to sell sotcks before the end of year to reduce liabilities
-market overreaction: stock prices overreact to news announcements and pricing errors are correctly only slowly.
-excess volatility: related to market overreaction; fluct in prices greater than are warranted by fluct in fundamental value; prices driven by other factors
-mean reversion: stocks with low returns today have high returns in the future; predicatable positive change in the future price
-new information is not always immediately incorporated into stock prices: stock prices continue to rise after announcement of high profits
Application: practical guide to investing in the stock market
1. stock prices will respond to announcements only when the information is new and unexpected
Summary
1. Stocks are valued as sthe present value of future dividens. Unfortunately, we do not know very precisely what these dividens will be. This uncertainty introduced a great deal of error inot the valuation process. The gordon gorwth model is a simplified method of computing stock value that depends on the assumption that the dividends arer growing at a constant rate forevr. Given our uncertainty regarding future dividends, this assumption is often the best we can do.
2. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader who values the security the most (either because of less uncertainty about the cash flows or because of greater estimated cash flows) will be willing to pay the most. As new information is released, investors will revise their estimates of the true value of the security and will either buy or sell it depending on how the market price compares to their estimated valuation. Becasuse small changes in estimated growth rates or required return result in large changes in price, it is not surprising that the markets are often volatile.
3. The efficient market hypothesis states that current security prices will fully reflect all available information, because in an efficient market, all unexploited profit opport are eliminated. The elimination of unexp prof opport necess for a financial market to be efficient does not require that all market parti be well informed.
4. The evidence on the EMH is mixed. Early evidence are quite favorable.
Computing the price of common stock
1. the principal way to raise capital; right to vote and residual claimant of profits; dividends
2. Price equals the present value of all cash flows the investment will generate over its life.
3. one-period valuation model: to find price of stock; buy stock, hold it for one period to get dividend and sell it.
The one-period valuation model and The generalized dividend valuation model
1. Stocks that do not pay dividends: buyers of the stock expect that the firm will pay dividends someday.
The Gordon Growth Model
1. increase dividends at a constant rate each year.
2. assumptions:
-dividends are assumed to continue growing at a constant rate forever or at least for an extended period of time
-the growth rate is assumed to be less than the required return on equity, ke. If the growth rate were faster than the rate required, the firm would grow impossibly large.
How the market sets stock prices
1. the price is set by the buyer willing to pay the highest price.
2. the market price will be set by buyer who can take advantage of the asset
3. superior information can increase value by reducing risk
4. market price is set by buyers bidding against each other; new information causes change in expectations and change in stock prices.
Application: monetary policy and stock prices
1. Monetary policy affect stock prices in two ways
-Fed lowers interest rates, the return on bonds dclins and investors are likely to accept a lower required rate of retrun on an investment in equity (ke) --> raise stock prices
-Lower interest rate --> stimulate economy --> rise in g --> rise in stock prices
Application: the 911 terrorist attacks, the Enron Scandal, and the stock market
1. 911: raised possibility that terrorism would paralyze the country; expect lower growth --> decrease in g --> decline in stock prices
2. increased uncertainty would raise the ke --> decline in stock prices
3. the Enron scandal and overstated earnings cause doubt and uncertainty --> decrease in g and rise in ke --> decline in stock prices
The theory of rational expectations
1. Adaptive expectations: the changes in expectations will occur slowly over time as past data change.
2. people use more than just past information; people change expectations to new info
3. Rational expectations: expectations will be identical to optimal forecasts using all available information
-does not have to be perfectly accurate; only needs to be the best possible given the available information
-even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate
4. Two reasons why an expectation may fail to be rational
-people might be aware of all available information but find it takes too much effort to make their expectation the best guess possible
-people might be unaware of some available relevant information, so their best guess of the future will not be accurate
5. If an additional factor is important but not available, the expectation is still rational
Rationale behind the theory
1. people make their expectations match their best possible guess using all available information because it is costly for people not to do so.
Implications of the theory
1. if there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well
2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time; forecast errors of expectations cannot be predicted
The efficient market hypothesis: rational expectations in financial markets
1. application of rational expectations to the pricing of stocks
2. assumption that prices of securities in financial markets fully reflect all available information
3. R(of)=R* - current prices in a financial market will be set so that the optimal forecast of a security's return using all available information equals the security's equilibrium return.
4. a security's price fully reflects all available information
Rationale behind the hypothesis
1. Unexploited profit opportunity: people earning more than they should; R(of) > R* driving up P(of)t+1 lowering R(of) --> unexploited profit opportunity disappeared
2. In an efficient market, all unexploited profit opportunities will be eliminated
3. Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds; as long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities
Stronger version of the efficient market hypothesis:
1. not only does optimal forecasts using all available information but also in an efficient market is one in which prices reflect the true fundamental (intrinsic) value of the securities.
2. implies that one investment is as good as any other because the securities' prices are correct
3. implies that a security's price reflect all available information about the intrinsic value of the security
4. implies that security prices can be used by managers of both financial and nonfinancial firms to asses their cost of capital accurately and hence that security prices can be used to help make the correct decisions about whether the investment is worth making.
Evidence on the efficient market hypothesis
1. in favor
-having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future.
-stock prices reflect publicly available information
-random walk: future changes cannot be predicted; EMH states that stock prices should follow random walk - future changes in stock prices should, for all practical purposes, be unpredictable
-technical analysis: study past stock price data and search for patterns such as trends on regular cycles; waste of time
2. against
-small-firm effect: small firms have earned abnormally high returns over long periods of time even when the risk of these firms are taken into account; may be due to rebalancing of portfolios by institutional investors, tax issues, low liq of stocks, large info costs in eval small firms, inappropriate measurement of risk
-January effect: abnormal price rise from dec to jan that is predictable and inconsistent with random-walk behavior; decresed for large companies; due to tax issues --> incentive to sell sotcks before the end of year to reduce liabilities
-market overreaction: stock prices overreact to news announcements and pricing errors are correctly only slowly.
-excess volatility: related to market overreaction; fluct in prices greater than are warranted by fluct in fundamental value; prices driven by other factors
-mean reversion: stocks with low returns today have high returns in the future; predicatable positive change in the future price
-new information is not always immediately incorporated into stock prices: stock prices continue to rise after announcement of high profits
Application: practical guide to investing in the stock market
1. stock prices will respond to announcements only when the information is new and unexpected
Summary
1. Stocks are valued as sthe present value of future dividens. Unfortunately, we do not know very precisely what these dividens will be. This uncertainty introduced a great deal of error inot the valuation process. The gordon gorwth model is a simplified method of computing stock value that depends on the assumption that the dividends arer growing at a constant rate forevr. Given our uncertainty regarding future dividends, this assumption is often the best we can do.
2. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader who values the security the most (either because of less uncertainty about the cash flows or because of greater estimated cash flows) will be willing to pay the most. As new information is released, investors will revise their estimates of the true value of the security and will either buy or sell it depending on how the market price compares to their estimated valuation. Becasuse small changes in estimated growth rates or required return result in large changes in price, it is not surprising that the markets are often volatile.
3. The efficient market hypothesis states that current security prices will fully reflect all available information, because in an efficient market, all unexploited profit opport are eliminated. The elimination of unexp prof opport necess for a financial market to be efficient does not require that all market parti be well informed.
4. The evidence on the EMH is mixed. Early evidence are quite favorable.
Wednesday, December 5, 2007
Ecn 135
Problem set #7
Due Dec. 5th
1) Suppose the euro-dollar exchange rate moves from $0.90 per euro to $0.92 per euro. At the same time, the prices of European-made goods and services rise 1 percent, while prices of American-made goods and services rise 3 percent. What happens to the real exchange rate between the dollar and the euro? Assuming the same change in the nominal exchange rate, what if inflation were 3 percent in Europe and 1 percent in the United States?
2) The most common type of discount lending that the Fed extends to banks is called
a. Seasonal credit
b. Secondary credit
c. Primary Credit
d. Installment Credit
3) Monetary policy is considered time-inconsistent because
of the lag times associated with the implementation of monetary policy and its effect on the economy
policymakers are tempted to pursue discretionary policy that is more contractionary in the short run
policymakers are tempted to pursue discretionary policy that is more expansionary in the short run
of the lag times associated with the recognition of a potential economic problem and the implementation of monetary policy
4) Which of the following is a disadvantage to monetary targeting?
It relies on a stable money-inflation relationship
There is a delayed signal about the achievement of a target
It implies larger output fluctuations
It implies a lack of transparency
5) The monetary policy strategy that provides the least accountability is
Exchange rate targeting
Monetary targeting
Inflation targeting
The implicit nominal anchor
6) If the dollar depreciates relative to the Swiss franc
Swiss chocolate will become cheaper in the United States
American computers will become more expensive in Switzerland
Swiss chocolate will become more expensive in the United States
Swiss computers will become cheaper in the United States
7) According to the law of one price, if the price of Colombian coffee is 100 Colombian pesos per pound and the price of Brazilian coffee is 4 Brazilian reals per pound, then the exchange rate between the Colombian peso and the Brazilian real is:
40 pesos per real
100 pesos per real
25 pesos per real
0.4 pesos per real
8) If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the Canadian dollar in terms of Mexican pesos will
rise by 6 percent
rise by 2 percent
fall by 6 percent
fall by 2 percent
9) State whether the following statement is true or false AND explain why: "A decrease in the discount rate will always cause a decrease in the federal reserve funds rate."
10) The same television set costs $500 in the United States, 450 Euro in France, 300 Pounds in United Kingdom and 100,000 Yen in Japan. If the law of one price holds, what are the euro-dollar, pound-dollar, and yen-dollar exchange rates? Why might the law of one price fail?
11) One of the ways macroeconomic activity overseas can affect our economy is through exchange rates, especially in the short-run. Discuss how a decrease in European interest rates, keeping everything else constant, affects the euro-dollar parity. Make sure to demonstrate this effect on the exchange rate – dollar asset graph as well.
Chapter 15, question #10 and web exercise # 1
Problem set #7
Due Dec. 5th
1) Suppose the euro-dollar exchange rate moves from $0.90 per euro to $0.92 per euro. At the same time, the prices of European-made goods and services rise 1 percent, while prices of American-made goods and services rise 3 percent. What happens to the real exchange rate between the dollar and the euro? Assuming the same change in the nominal exchange rate, what if inflation were 3 percent in Europe and 1 percent in the United States?
2) The most common type of discount lending that the Fed extends to banks is called
a. Seasonal credit
b. Secondary credit
c. Primary Credit
d. Installment Credit
3) Monetary policy is considered time-inconsistent because
of the lag times associated with the implementation of monetary policy and its effect on the economy
policymakers are tempted to pursue discretionary policy that is more contractionary in the short run
policymakers are tempted to pursue discretionary policy that is more expansionary in the short run
of the lag times associated with the recognition of a potential economic problem and the implementation of monetary policy
4) Which of the following is a disadvantage to monetary targeting?
It relies on a stable money-inflation relationship
There is a delayed signal about the achievement of a target
It implies larger output fluctuations
It implies a lack of transparency
5) The monetary policy strategy that provides the least accountability is
Exchange rate targeting
Monetary targeting
Inflation targeting
The implicit nominal anchor
6) If the dollar depreciates relative to the Swiss franc
Swiss chocolate will become cheaper in the United States
American computers will become more expensive in Switzerland
Swiss chocolate will become more expensive in the United States
Swiss computers will become cheaper in the United States
7) According to the law of one price, if the price of Colombian coffee is 100 Colombian pesos per pound and the price of Brazilian coffee is 4 Brazilian reals per pound, then the exchange rate between the Colombian peso and the Brazilian real is:
40 pesos per real
100 pesos per real
25 pesos per real
0.4 pesos per real
8) If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the Canadian dollar in terms of Mexican pesos will
rise by 6 percent
rise by 2 percent
fall by 6 percent
fall by 2 percent
9) State whether the following statement is true or false AND explain why: "A decrease in the discount rate will always cause a decrease in the federal reserve funds rate."
10) The same television set costs $500 in the United States, 450 Euro in France, 300 Pounds in United Kingdom and 100,000 Yen in Japan. If the law of one price holds, what are the euro-dollar, pound-dollar, and yen-dollar exchange rates? Why might the law of one price fail?
11) One of the ways macroeconomic activity overseas can affect our economy is through exchange rates, especially in the short-run. Discuss how a decrease in European interest rates, keeping everything else constant, affects the euro-dollar parity. Make sure to demonstrate this effect on the exchange rate – dollar asset graph as well.
Chapter 15, question #10 and web exercise # 1
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