Vinay Panjabi

Money & Banking Final Exam

Lesson 10 Interest Rate DeterminationReal Interest Rates
! Determining "#antity Deman$e$ %or &sset 'relation (!)
! *ealt+, total reso#r-es o.ne$ by in$i/i$#al0 in-l#$ing assets '()
! Ex1e-te$ Ret#rn, ret#rne$ o/er next 1erio$ relati/e to ot+ers '()
! Risk, $egree o% #n-ertainty relati/e to ot+ers '!)
! Li2#i$ity, ease o% t#rning asset into -as+ /s ot+ers '()
! Basi- Bon$ 3#11ly an$ Deman$
! Lo.er 1ri-es '+ig+er interest rates)0 2#antity $eman$e$ is +ig+er '!)0 2#antity s#11lie$ is
lo.er '()
! Deman$ In%l#en-es
! Ex1e-te$ Interest Rate Fe$ Poli-y0 negati/e relations+i1
! Ex1e-te$ In%lation Rate0 negati/e relations+i1
! Ex1e-te$ Ret#rn on ot+er assets0 negati/e relations+i1
! Risk 'negati/e)
! Li2#i$ity0 1ositi/e relations+i1
! *ealt+0 1ositi/e
! 3#11ly In%l#en-es
! 4o/ernment $e%i-its in-rease$ $e%i-its0 in-rease s#11ly
! &lternati/e -ost o% %inan-ing
! Ex1e-te$ Pro%itability 1ositi/e relations+i1
! Ex1e-te$ In%lation 1ositi/e relations+i1
! Exam1le, In-rease in ex1e-te$ in%lation, $eman$ in.ar$0 s#11ly o#t.ar$0 1ri-es $o.n0
interest rates go #1
! *+y $o $e%i-its enlarge $#ring re-essions be-a#se o% 1#bli- .orks 1rograms
! I% all t+ings are e2#al0 an in-rease in treas#ry $ebt o#tstan$ing .o#l$ make bon$ 1ri-es %all an$
interest rates .o#l$ rise be-a#se s#11ly in-reases0 b#$get $e%i-its in-rease in re-essions0 1ri/ate -re$it
$eman$s ease0 in/estors %a/or risk %ree se-#rities 'treas#ries)
! I% $e%i-it .as 00 treas#ry .o#l$ still +a/e to iss#e ne. $ebt to re$eem mat#ring $ebt
! 5y1es o% bi$s, 6om1etiti/e0 7on-om1etiti/e0 Foreign International Monetary &#t+ority
'non-om1etiti/e)0 3ystem 81en Market &--o#nt 'roll o/er bi$)
Lesson 11 Risk an$ 5erm 3tr#-t#re o% Interest Rates
! *+y $on9t sto-k an$ bon$ 1ri-es mo/e in o11osite $ire-tions all t+e time:
! De%a#lt Risk .+en iss#er o% bon$ is #nable or #n.illing to make interest 1ayments
! Risk Premi#m s1rea$ bet.een interest rates on bon$s . $e%a#lt risk an$ interest rates on 5!bon$s
! 5reas#ry Bills
! 3+ort!term se-#rities mat#ring in one year or less
! Bills sol$ ; $is-o#nt %rom %a-e /al#e
! *+en it mat#res0 in/estors re-ei/e %a-e /al#e
! Pri-e < Fa-e Val#e ' 1 '$is-o#nt = time in $ays>?0))
! 5reas#ry 7otes & Bon$s interest 1ai$ semi!ann#ally
! 7otes interest bearing se-#rities0 %ixe$ mat#rity bet.een 1 an$ 10 years
! Bon$s mat#rity in ex-ess o% 10 years
! 5reas#ry In%lation Prote-te$ 3e-#rities '5IP3)
! interest rate is %ixe$ t+ro#g+o#t t+e term o% se-#rity
! 1rin-i1al amo#nt o% se-#rity is a$j#ste$ %or in%lation
! 35RIP3 3e1arate 5ra$ing o% Registere$ Interest an$ Prin-i1al 3e-#rities
! in/estors +ol$ an$ tra$e in$i/i$#al interest an$ 1rin-i1al -om1onents o% 5reas#ry notes an$
bon$s as se1arate se-#rities
! 1o1#lar i% yo# .ant to re-ei/e a kno.n 1ayment on a s1e-i%i- %#t#re $ate
! In/estor only re-ei/es 1ayment at mat#rity
! Fig+t to "#ality risk 1remi#m is t+e -+ange in 1ri-e o% bon$ i% t+ere .as an in-rease in $e%a#lt risk
on -or1orate bon$s be-a#se $eman$ %or -or1orate bon$ .o#l$ go $o.n0 an$ treas#ry bon$s .o#l$ go
#1
! I% tax rates are ex1e-te$ to go #10 $eman$ %or m#ni-i1al bon$s .o#l$ go #1 an$ treas#ry bon$
$eman$ .o#l$ go $o.n0 1ri-e o% m#ni-i1al bon$ goes #10 treas#ry goes $o.n
! 5+e @iel$ 6#r/e 1lot o% yiel$ on bon$s .it+ $i%%ering terms to mat#rity b#t t+e same risk0 li2#i$ity
an$ tax -onsi$erationsA
! B1.ar$!3lo1ing long term rates are abo/e s+ort term rates
! Flat long term < s+ort term rates
! In/erte$ long term rates are belo. s+ort term rates
! 5+eory o% 5erm 3tr#-t#re o% Interest Rates
! Interest rates on notes an$ bon$s o% $i%%erent mat#rities mo/e toget+er o/er time
! 3+ort term interest rates are lo.0 yiel$ -#r/e is likely to #1.ar$ slo1e0 in/erse is also tr#e
! @iel$ -#r/e almost al.ays slo1es #1.ar$
! @iel$ 6#r/e 5+eories
! Ex1e-tations 'mo/ing toget+er an$ lo. s+ort term C #1.ar$ slo1e)
! Interest rate on long term bon$ .ill e2#al a/erage o% ex1e-te$ s+ort term interest rates
o/er t+e li%e o% t+e bon$
! B#yers o% bon$s $on9t 1re%er one mat#rity o/er anot+er0 t+ey -are abo#t ex1e-te$ ret#rn
! Im1lie$ For.ar$ Rate,
! Eg, > yr yiel$ is >D0 E!yr yiel$ is >AFGD0 .+at is im1lie$ %.$ 1!year rate in
year E:
Et+ yr %.$ rate < 'E=>AFGD)!'>=>D) < ED
! Ex1lains .+y term str#-t#re o% interest rates -+anges at $i%%erent times
! 3egmente$ Markets '@iel$ -#r/e al.ays slo1es #1.ar$s)
! Bon$s o% $i%%erent mat#rities aren9t s#bstit#tes0 interest rate %or ea-+ bon$ .it+
$i%%erent mat#rity is $etermine$ by s#11ly an$ $eman$ o% t+at bon$
! In/estors 1re%er bon$s o% one mat#rity o/er t+e ot+er base$ o% t+eir nee$s0 exam1le0 i%
in/estors +a/e s+ort +ol$ing 1erio$s0 t+en t+ey 1re%er s+ort mat#rity bon$s .it+ less
interest!rate risk0 .+i-+ is .+y yiel$ -#r/e slo1es #1.ar$s
! Li2#i$ity Premi#m 5+eory '1ro/es all >)
! Interest rate on long term bon$ .ill e2#al a/erage o% s+ort term interest rates o/er t+e
bon$s li%e 1l#s a li2#i$ity 1remi#m t+at -orres1on$s to t+e s#11ly an$ $eman$ o% t+at
1arti-#lar bon$
! Bon$s o% $i%%erent mat#rities are s#bstit#tes b#t not 1er%e-t
Lesson 1F Fe$eral Reser/e 3ystem0 5rans1aren-y an$ In$e1en$en-e
! Fe$ $#ties in E main areas, -on$#-ting monetary 1oli-y0 s#1er/ising an$ reg#lating banking
instit#tions0 maintaining stability o% %inan-ial system an$ -ontaining systemi- risk t+at may arise0
1ro/i$ing %inan-ial ser/i-es to banks0 #s go/ernment an$ %oreign o%%i-ial instit#tions
! Boar$ o% go/ernors 'H) -ontrol t+e system0 an$ t+e boar$ o% go/ernors as .ell as %e$ reser/e bank
1resi$ents -om1rise t+e Fe$eral 81en Market 6ommittee .+i-+ $etermines monetary 1oli-y
! Reser/e Re2#irements set by boar$ o% go/ernors0 a$/ise$ by F8M6
! 81en Market 81erations $ire-te$ by F8M6
! Dis-o#nt rate re/ie.e$ an$ $etermine$ by boar$ o% go/ernors0 a$/ise$ by F8M60 %e$eral
reser/e banks establis+ it
! Boar$ o% 4o/ernors +as > bankers an$ > b#siness lea$ers ele-te$ by member banks0 an$ t+en >
1#bli- interest $ire-tors a11ointe$ by boar$ o% go/ernors
! Fe$eral Reser/e Banks F#n-tions,
1A 6lear 6+e-ks
FA Iss#e ne. -#rren-y.it+$ra. $amage$ -#rren-y
>A Make $is-o#nt loans to banks .it+in $istri-t
EA E/al#ate mergersex1ansions o% banking a-ti/ityLiaisons bet.een banks an$ Fe$ 3ystem
GA Examine bank +ol$ing -o9s an$ state!-+artere$ banks
?A 6olle-t $ata on lo-al b#siness -on$ition
HA Resear-+ to1i-s relate$ to -on$#-t o% monetary 1oli-y
! Fe$ Reser/e Bank o% 7@
! exe-#tes monetary 1oli-y
! agent o% B3 treas#ry an$ -on$#-ts B3 go/ %inan-ing o1erations
! exe-#tes inter/ention on %oreign market
! -#sto$yser/i-es to %oreign -entral banks
! 1resi$ent ser/es as /i-e -+air o% F8M6
! Boar$ o% 4o/ernors
! &11ointe$ by 1resi$ent0 -on%irme$ by senate
! 1E year non rene.able term0 staggere$ to limit one 1resi$ents in%l#en-e
! Presi$ent sele-ts -+airman %or %o#r!year rene.able term
! Vote on -on$#-t o% 81en Market 81eration
! 3et reser/e re2#irements
! 6ontrol $is-o#nt rateset margin re2#irements
! 3#1er/ises a-ti/ity o% %oreign banks in B3
! Fe$s goal is to be trans1arent b#t t+ey aren9t al.ays
! 5+ey +a/e in$e1en$ent re/en#e
! 6ongress -ontrols str#-t#re
! Presi$ent +as in%l#en-e on t+e %e$ be-a#se t+e 1resi$ent nominates -+airman an$ senate a11ro/es
! *+en ele-tions a11roa-+0 %e$ takes a-tion as #s#al b#t t+ey $o it in mo$eration0 t+en a%ter t+ey $o
.+at t+ey nee$ to $o .it+o#t mo$eration
! Bet.een late I0s early 00s0 %e$ starts to release statements an$ make t+ings more 1#bli-
! bene%its, le/els t+e 1laying %iel$
! makes %e$ more a--o#ntable
! re$#-es 1oli-y lags b -#tting re-ognition lags
! im1ro/es transmission o% 1oli-y /ia t+e ex1e-tations t+eory o% yiel$ -#r/e
! re$#-es li2#i$ity an$ term 1remi#ms in yiel$ -#r/e
! 5oo m#-+ trans1aren-y -omes at risks0 too m#-+ in%ormation -o#l$ in/ol/e riskier tra$es .+i-+
.o#l$ make e-onomy more /#lnerable to s#r1rises
! Jee1ing t+e Fe$ as a se1arate entity ens#res t+at 1oliti-al 1ress#re $oesn9t bias monetary 1oli-y0 an$
yo# -an9t %inan-e t+e treas#ry0 be-a#se t+en yo#9re j#st monetariKing %e$eral $ebt
Lesson 1> Money 3#11ly Pro-ess
! &gents, Fe$ Reser/e 3ystem0 Banks0 De1ositors & Borro.ers
! Fe$ a%%e-ts bank reser/es /ia se-#rities
! Monetary Base < Reser/es ( 6#rren-y '+ig+ 1o.er money)
! .e see a%ter %inan-ial -risis0 reser/es an$ -#rren-y goes #10 mainly reser/es
! Fe$ selling se-#rities re$#-es banking reser/es
! 81en Market 81erations, an o1en market 1#r-+ase in-reases /ol#me o% bank reser/es0 sales $e-rease
bank reser/es
! I% 1eo1le $eman$ more -#rren-y it re$#-es bank reser/es0 b#t not monetary base0 be-a#se money j#st
mo/es into -#rren-y %rom reser/es
! Borro.ing %rom $is-o#nt .in$o.0 in-reases bank reser/es0 1aying ba-k re$#-es reser/es
! 8t+er %a-tors a%%e-ting reser/es an$ monetary base, %loat0 treas#ry $e1osits at t+e %e$0 inter/entions in
%oreign ex-+ange market0 re$em1tion %rom %e$s 1ort%olio
! Ex-ess reser/es re1resent a -#s+ion against #n-ertainty banks $on9t make interest o%% o% it
! Money 3#11ly an$ De1osit gro.t+ is $etermine$ by %e$ a-tions an$ market $ynami-s
! M#lti1le De1osit -reation -+ange in $e1osits < -+ange in reser/esreser/e ratio
! De1osit M#lti1lier $oesn9t .ork in real .orl$ be-a#se o% lagge$ reser/e a--o#nting0 .+i-+ ren$ers
$is-onne-t bet.een $e1osit gro.t+ an$ re2#ire$ reser/es as .ell as %e$ %#n$s rate targeting0 i% $eman$
%or ex-ess reser/es in-reases be-a#se t+ere9s $eman$ in %e$ %#n$s market0 t+e %#n$s rate rises t+en t+e
%e$ nee$s to a$$ reser/es to get t+e %#n$s rate ba-k on target
! 81en Market 81erations F8M6 sets target FB7@ exe-#tes
! Reser/e Re2#irements Boar$ o% 4o/ernors
! Dis-o#nt Rate Dire-tors 1etition to Boar$ o% go/ernors
Lesson 1E 5ra$itional 5ools o% t+e Fe$
! 4oals o% Monetary Poli-y, Maxim#m 3#stainable 4ro.t+ & Em1loyment0 Pri-e 3tability0 Mo$erate
Long term Interest rates
! Maxim#m 3#stainable 4ro.t+ Rate, Real 4DP < Potential
! 3#stainable Em1loyment, 3omet+ing .it+ 1+illi1s -#r/e
! Pri-e 3tability, -ore 6PI an$ P6E
! 5ools o% t+e Fe$
1A 81en Market 81erations aime$ to a%%e-t bank reser/e balan-es
! 5o a$$ reser/es, b#y se-#rities or engage in tem1 re1#r-+ase agreements 'RP)
! 5o train reser/es, sell se-#rities or engage in re/erse RP 'RRP)
! B#y an$ sell se-#rities t+ro#g+ 1rimary $ealers
! B#ying se-#rities $e-reases %e$ %#n$s rate b- o% in-rease o% bank reser/es 's#11ly)
! Dynami-, %#n$amentally -+anging t+e %#n$s rate target, 1oli-y $e-ision
! De%ensi/e, o%%set -+anges in t+e a#tonomo#s %a-tors 'b#ying selling se-#rities or
engaging in RP or RRP)0 .it+ intent o% -+anging %#n$s rate
FA Reser/e Re2#irements
! In-rease in reser/e ratio, $eman$ -#r/e s+i%ts o#t C %#n$s rate goes #1
! Deman$ %or Reser/es < Ex-ess Deman$ ( Re2#ire$ Reser/es
! 3#11ly o% Reser/es < Balan-es at Fe$ ( Va#lt 6as+
! 5reas#ry $e1osits ; Fe$ $rain reser/es
! 7o longer regar$e$ as e%%e-ti/e 1oli-y tool
>A Dis-o#nt *in$o. Loans
! *+en banks borro.0 reser/es in-rease
! rate %ollo.s %e$ %#n$s rate0 slig+tly abo/e it0 -o#nte$ as a 1enalty rate
! %e$ t+o#g+t t+at t+is .o#l$ remo/e ba$ stigma o% borro.ing %rom t+e %e$
! Lo.ering t+e $is-o#nt rate +as no e%%e-t i% it9s still abo/e %e$ %#n$s rate
Lesson 1G 6re$it 6risis
! Lyman Minsky 3tability Bree$s Instability
! Fe$ 1oli-y .as too easy %or too long
! Lo. rate a$j#stable mortgages 1ro/i$e$ to boost +ome sales
! *+o .as to blame:
! Fe$ %or kee1ing rates %or too lo. %or too long
! Reg#lators in-l#$ing t+e %e$ s+o#l$ +a/e been 1roa-ti/e
! 3e-#ritiKation o% mortgages0 s+i%ting t+e risk %rom len$ers to broa$ s1e-tr#m o% in/estors
! Rating &gen-ies
! Risky Mortgage Instr#ments an$ little $is-i1line by Mortgage Brokers
! 7ai/e 1#bli-
! Inability to o% iss#ers to roll o/er -ommer-ial 1a1er %or-e$ borro.ers to s+o. #1 at $oorste1s o%
banks
! Banks attem1te$ to in-rease Manage$ Liabilities $#e to in-rease$ %#n$ing re2#irementsA 5+is is Large
5ime De1osits0 5erm Fe$ F#n$s an$ E#ro$ollarLibor Borro.ing
! Bi$$ing %or Manage$ Liabilities -a#se$ raise in Libor rate0 .+i-+ in-rease$ -ost o% borro.ing .+i-+
in-rease$ mortgage ratesA
Lesson 1? 6risis Relate$ Li2#i$ity Pro/isions
! Fe$ trie$ to re$#-e s1rea$ so banks .o#l$ borro. %rom t+em an$ take 1ress#re o%% bi$$ing & libor
rate .o#l$ go $o.n0 $i$n9t .ork
! 5+ey re$#-e$ s1rea$ again an$ exten$e$ terms o% loans0 still $i$n9t .ork
! 5erm &#-tion Fa-ility !