Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE

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Chapter 13
ANSWERS TO QUESTIONS

1. What are the two basic causes of financial crises in emerging market economies?
They are various factors that can cause financial crises in emerging market economies. But the
two basic courses of financial crises in these economies are (1) the mismanagement of
financial liberalization and globalization and (2) severe fiscal imbalances.

2. Why might financial liberalization and globalization lead to financial crises in emerging market
economies?
It is not financial liberalization and globalization that lead to financial crises in emerging
economies. Rather it is the mismanagement of these two processes that might lead to financial
crises. Because of the financial liberalization and globalization, restrictions of financial
institutions and capital flows across countries were eliminated. However, the emerging
economies lack the institutions that can supervise and manage these two processes effectively
especially in term of screening and monitoring of borrowers. Therefore, the two processes
have led to a lending boom in the emerging economies and most of the funds were channelled
towards high risk projects. This lending boom ultimately ends in lending crash resulting in
heavy losses and weakening of the bank balance sheet.
Another factor that explain why the two processes might lead to financial crises is the fact that
in emerging economies, the existence of powerful business interest prevents the supervisory
institution from performing their job properly and weakens the regulations that restrict their
banks from engaging in high-risk/high-payoff strategies.

3. Why might severe fiscal imbalances lead to financial crises in emerging market economies?
In emerging economies, governments usually cajole or force banks to purchase their debts.
Investors who lose confidence in the ability of the government to repay this debt unload the
bonds, which causes their prices to plummet. Banks that hold this debt then face a big hole on
the asset side of their balance sheets, with a huge decline in their net worth. With less capital,
these institutions will have fewer resources to lend and lending will decline. The situation can
even be worse if the decline in bank capital leads to a bank panic in which many banks fail at
the same time. The result of severe fiscal imbalances is therefore a weakening of the banking
system, which leads to a worsening of adverse selection and moral hazard problems.

4. What other factors can initiate financial crises in emerging market economies?

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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Other additional factors that initiate financial crises in emerging market economies are

A rise in interest rates from events abroad

e sheets
from asset write-downs

An increase in uncertainty due to unstable political systems

5. What events can ignite a currency crisis?

fiscal imbalances.

6. Why do currency crises make financial crises in emerging market economies even more
severe?
Currency crises make financial crises in emerging market economies even more severe
because in these countries both nonfinancial and financial firms had so much foreign currency
debt. Emerging market economies denominate many debt contracts in foreign currency
(usually dollars) leading to a problem of currency mismatch. With the falling of the local
currency, all dollar denominated-debt will increase in local currency term.
Also, the deterioration in bank balance sheets has an even greater negative impact on lending
and economic activity than in advanced countries, which tend to have sophisticated securities
markets and large nonbank financial sectors that can pick up the slack when banks falter. So
as banks stop lending, there are really no other players to solve adverse selection and moral
hazard problems

7. How did the financial crises in South Korea and Argentina affect aggregate demand, short-
run aggregate supply, and output and inflation in these countries?
The decline in lending by banks because of the increase in asymmetric information problems
lead to a contraction of AD and the AD curve would shift to the left. The collapse of the
currency led to a further contraction of AD and real GDP fell and unemployment rose sharply.
Due to the currency crisis, inflation, however, did not fall but rose: the collapse of the South
Korean and Argentine currency after the speculative attack raised import prices and weakened
the credibility of the central bank in both countries as an inflation fighter. These factors
would lead to an upward shift in the short-run AS resulting in a decline in the output declined
and an increase in inflation.

8. What can emerging market countries do to strengthen prudential regulation and supervision of
their banking systems? How might these steps help avoid future financial crises?
In order to strengthen prudential regulation and supervision of their banking systems, emerging

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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market economies need to ban commercial businesses from owning banking institutions so that
risky lending behaviour can be avoided. Prudential supervisors must also have adequate
resources (more qualified personnel and better facilities such as computers etc) so that they will
be able to perform their jobs properly and effectively. The regulatory and supervisory agency
also needs to be independent from any political pressure and influences. These steps are
important as it will promote a safer and sounder banking system by ensuring that banks have
proper risk management procedures in place, including 1) good risk measurement and
monitoring systems, 2) policies to limit activities that present significant risks, and 3) internal
controls to prevent fraud or unauthorized activities by employees.

9. How can emerging market economies avoid the problems of currency mismatch?
Governments can limit currency mismatch by implementing regulations or taxes that
discourage the issuance of debt denominated in foreign currency by nonfinancial firms.
Regulation of banks can also limit bank borrowing in foreign currencies. Moving to a flexible
exchange rate regime in which exchange rates fluctuate can also help discourage borrowing in
foreign currencies because there is now more risk in doing so. Monetary policy that promotes
price stability also helps by making the domestic currency less subject to decreases in its value
as a result of high inflation, thus making it more desirable for firms to borrow in domestic
currency and not foreign currency

10. Why might emerging market economies want to implement financial liberalization and
globalization gradually rather than all at once?
Financial liberalization should be implemented gradually because there is a need to ensure
that proper institutional infrastructures such as a strong prudential regulation and supervision,
policies limiting currency mismatch and disclosure requirements are in place first in order to
avoid financial crises. If these infrastructures are not in place when liberalization occurs, the
necessary constraints on risk-taking behavior will be far too weak. And since implementing
these policies/infrastructure takes time, financial liberalization may have to be phased in
gradually, with some restrictions on credit issuance imposed along the way.

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Chapter 14
ANSWERS TO QUESTIONS

1. Why was the Federal Reserve System set up with twelve regional Federal Reserve banks
rather than one central bank, as in other countries?
Because of traditional American hostility to a central bank and centralized authority, the
system of 12 regional banks was set up to diffuse power along regional lines.

2. What political realities might explain why the Federal Reserve Act of 1913 placed two Federal
Reserve Banks in Missouri?
The placement of two banks in the Midwest farm belt might have been engineered to placate
farmers, an important voting bloc in the early twentieth century.

3.

True. Like the U.S. Constitution, the Federal Reserve System, originally established by the
Federal Reserve Act, has many checks and balances and is a peculiarly American institution.
The ability of the twelve regional banks to affect discount policy was viewed as a check on the
ce
power of the federal government. The provision that there be three types of directors (A, B, and
C) representing different groups (professional bankers, business people, and the public) was

federal government and the setting up of the Federal Reserve banks as incorporated institutions
were further intended to restrict government power over the banking industry.

4. In what ways can the regional Federal Reserve Banks influence the conduct of monetary
policy?
The Federal Reserve Banks influence the conduct of monetary policy through their
administration of the discount facilit
on the FOMC, the main policymaking arm of the Fed.

5. Which entities in the Federal Reserve System control the discount rate? Reserve requirements?
Open market operations?
The Board of Governors sets reserve requirements and the discount rate; the FOMC directs
open market operations. In practice however, the FOMC helps make decisions about reserve
requirements and the discount rate.
The decision making process at the EMU takes place at three levels; the Governing Council,

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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the Executive Board and the General Council. The Governing Council is the decision maker
and formulates monetary policy for the Euro area. The Executive Board ensures the day to day
implementation of monetary policy through giving detailed instructions to all NCBs in
accordance with the decisions of the Governing Council.

6. Do you think that the fourteen-year nonrenewable terms for governors effectively insulate the
Board of Governors from political pressure?
The 14-year terms do not completely insulate the governors from political influence. The
governors know that their bureaucratic power can be reined in by congressional legislation
and so must still curry favor with both Congress and the president. Moreover, in order to gain
additional power to regulate the financial system, the governors need the support of Congress
and the president to pass favorable legislation.

7. Compare the structure and independence of the Federal Reserve System and the European
System of Central Banks.
The structure of the European System of Central Banks (ECSB) is similar to that of the
Federal Reserve: the National Central Banks (NCBs) have a similar role to the Federal
Reserve Banks and the Executive Board is similar to the board of Governors. The Governing
Council has a similar role to the FOMC, and its voting members include the presidents of the
NCBs and the Executive Board members, just as the FOMC has as its voting members
Federal Reserve Bank presidents and members of the Board of Governors. There are some
differences however. First, the budgets of the Federal Reserve Banks are controlled by the
Board of Governors, while the NCBs control their own budgets and the budget of the ECB in
Frankfurt. Second, the monetary operations of the Eurosystem are conducted by the NCBs in
each country, so monetary operations are not centralized as they are in the Federal Reserve
System. Third, in contrast to the Fed, the ECB is not involved in supervision and regulation of
financial institutions. The ECSB is more independent than the Fed because its charter can only
be changed by revision of the Maastricht Treaty, a very difficult process because all
signatories to the treaty must agree to accept any propos
be changed by legislation which is much easier to do. On the other hand, the goal for the
ECSB is more clearly specified than it is for the Fed because the Maastricht Treaty states that
the overriding long-run goal of

8. The Fed is the most independent of all U.S. government agencies. What is the main difference
reater independence?
The Fed is more independent because its substantial revenue from securities and discount
loans allows it to control its own budget.

9. What is the primary tool that Congress uses to exercise some control over the Fed?
The primary tool that the Congress uses to exercise some control is the threat that it will

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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10. In the 1960s and 1970s, the Federal Reserve System lost member banks at a rapid rate. How
can the theory o
all commercial banks to become members? Was the Fed successful in this campaign?
The theory of bureaucratic behavior indicates that the Fed will want to acquire as much power
as possible by requiring all banks to become members. Although the Fed did not succeed in
obtaining legislation requiring all banks to become members of the system, it was successful
in getting Congress to legislate extension of many of the regulations that were previously
imposed solely on member banks (for instance, reserve requirements) to all other depository
institutions. Thus the Fed was successful in extending its power.

11. Explain why eleven states of the EU have opted not to adopt the euro as their domestic
currency.
There are benefits to having one currency in a market as large as the European Union .i.e.
some costs (average cost of currency conversion for travelers and transaction costs),
exchange-rate uncertainty on trade and investment decrease. But there are also problems when
the business cycles are unsynchronized and labor is relatively immobile. The U.K., Denmark
and Norway chose not to be in the euro zone, whereas the countries becoming members in
2004 and 2007 have scheduled to adopt euro as their domestic currency.

12. What are the main difficulties encountered by the newly established central banks in
transition economies?
Prior the 1990, most of the transition nations possessed one state-owned bank that had the
dual roles of a commercial bank and a central bank, while a few others already possessed a
separate central bank that dominate the operations of other state-owned banks. Also the
banking sector had huge debt portfolio owned by the inefficient public sector firms besides
the problems of inflation, balance of payments and devaluation .After 1989 and 1991, central
bank are separated from commercial banks and gradually central bank independence has been
implemented.

13. What are the reasons that compel some developing nations to adopt currency unions?

because they do not possess a domestic currency. The national central bank cannot carry out
monetary policy due to large decline in the value of domestic currency. For example, Ecuador
discarded its national currency and adopted the US dollar in 2000.

14.
er.

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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clearly one objective of the Fed. The theory of bureaucratic behavior merely points out that
other objectives, such as maximizing power, also influence Fed decision making.

15.
business cycle?

impart an inflationary bias to monetary policy. Without independence, the central bank will
respond to short-run problems that will result an expansionary monetary policy and a political
business cycle.

16.
statement true, false, or uncertain? Explain your answer.
False. The Fed is still subject to political pressure, because Congress can pass legislation

accountable by passing legislation that the Fed does not like.

17.

It is uncertain. Although independence may help the Fed take the long view, because its
personnel are not directly affected by the outcome of the next election, the Fed can still be
influenced by political pressure. In addition, the lack of Fed accountability because of its
independence may make the Fed more irresponsible. Thus it is not absolutely clear that the
Fed is more farsighted as a result of its independence.

18. While the Fed promotes secrecy by not releasing the minutes of the FOMC meetings to
Congress or the public immediately, the ECB holds a press conference after each of its
meetings. Discuss the pros and cons of each of these policies.
The FED simply releases a statement about the setting of the monetary policy instruments.
The ECB goes further by having a press conference in which the president and vice president
of the ECB take questions from the news media. The theory of bureaucratic behavior suggests

prestige. Holding such a press conference as soon as the meeting over, can be tricky because it
requires the president and vice president to be quick on their feet in dealing with the press. If
they cannot manage, it might be understood as the loss of power and the weakness of the
decisions. On the other hand, the central bank should act in the public interest, having press
conference may refer as the transparency and accountability.

ANSWERS TO DATA ANALYSIS PROBLEMS

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Mishkin The Economics of Money, Banking, and Financial Markets, Eleventh Edition, GE
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1. Go to the St. Louis Federal Reserve FRED database, and find data on the unemployment rate
in each of the twelve Federal Reserve districts. These are coded as (D1URN), (D2URN),
(D3URN), . . . , (D12URN). For the most recent month of data available, determine which
district had the highest, and which had the lowest, unemployment rate.
For April 2014, of the twelve districts, the 12th district (San Francisco) had the highest
unemployment rate at 6.7%, while the 9th district (Minneapolis) had the lowest unemployment
rate at 4.6%.

2. Go to the St. Louis Federal Reserve FRED database, and find data on the federal funds rate
target (DFEDTAR, DFEDTARU, and DFEDTARL) and the discount, or primary credit rate
(DPCREDIT). When was the last time the federal funds rate target was changed? When was
the last time the primary credit rate was changed? Did the rates increase or decrease?
As of June 11, 2014, the last time the federal funds rate target was adjusted was Tuesday,
December 16, 2008. It decreased from a target of 1%, to a range of between 0% and 0.25%.
The last time the primary credit rate changed was Friday, February 19, 2010, increasing from
0.5% to 0.75%.

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