money and interest
TRANSCRIPT
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Understanding
Interest Rates
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Lottery Options
Option 1: you get a check today for $10,000 and one ayear from now for $10,000.
Option 2: pays you $2,000 today and each of the next 29
years.
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Lottery Options (cont)
What are the present values of these two options, assuming a12% interest rate. Which option do you prefer? Why?
What if the interest rate was 10%?
What if you thought you might die, what does that mean forthe interest rate youd use?
Other considerations?
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Present Value
A dollar paid to you one year from now
is less valuable than a dollar paid to
you today
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Discounting the Future
2
3
Let = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10)
In three years $121 X (1 + 0.10) = $133or 100 X (1 + 0.10)
In years
$100 X (1 + )n
i
n
i
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Simple Present Value
n
PV = today's (present) value
CF = future cash flow (payment)
= the interest rate
CFPV =
(1 + )
i
i
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Four Types of
Credit Market Instruments
Simple Loan
Fixed Payment Loan
Coupon Bond Discount Bond
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Yield to Maturity
The interest rate that equates the present
value of cash flow payments received froma debt instrument with its value today.
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Simple LoanYield to Maturity
1
PV = amount borrowed = $100
CF = cash flow in one year = $110
= number of years = 1
$110$100 =
(1 + )
(1 + ) $100 = $110
$110(1 + ) =
$100
= 0.10 = 10%
For simple loans, the simple interest rate equ
n
i
i
i
i
als the
yield to maturity
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Fixed Payment Loan
Yield to Maturity
2 3
The same cash flow payment every period throughout
the life of the loan
LV = loan value
FP = fixed yearly payment
= number of years until maturity
FP FP FP FPLV = . . . +
1 + (1 + ) (1 + ) (1 + )n
n
i i i i
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Coupon BondYield to Maturity
2 3
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
= years to maturity date
C C C C FP = . . . +
1+ (1+ ) (1+ ) (1+ ) (1n
n
i i i i
+ )ni
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When the coupon bond is priced at its face value, the yield to maturity
equals the coupon rate
The price of a coupon bond and the yield to maturity are negativelyrelated
The yield to maturity is greater than the coupon rate when the bond
price is below its face value
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Discount BondYield to Maturity
For any one year discount bond
i=
F - P
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
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Yield on a Discount Basis
Less accurate but less difficult to calculate
idb
=F - P
F
X360
days to maturityidb
= yield on a discount basis
F = face value of the Treasury bill (discount bond)
P = purchase price of the discount bond
Uses the percentage gain on the face valuePuts the yield on an annual basis using 360 instead of 365 days
Always understates the yield to maturity
The understatement becomes more severe the longer the maturity
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Distinction Between:
Interest Rates and Returns
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
RET = CP
t
+ Pt1 - PtP
t
RET = return from holding the bond from time tto time t + 1
Pt= price of bond at time t
Pt1
= price of the bond at time t + 1
C = coupon payment
C
Pt
= current yield = ic
P
t1- P
t
Pt
= rate of capital gain =g
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Rate of Return
and Interest Rates (contd)
The more distant a bonds maturity, the lower the rate of
return the occurs as a result of an increase in the interest rate
Even if a bond has a substantial initial
interest rate, its return can be negative if interest rates rise
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Rate of Return and Interest Rates
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Interest-Rate Risk
Prices and returns for long-term
bonds are more volatile than those for
shorter-term bonds
There is no interest-rate risk for any bond
whose time to maturity matches the holding
period
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Real and Nominal Interest Rates
Nominal interest rate makes no allowancefor inflation
Real interest rate is adjusted for changes in price level so itmore accurately reflects the cost of borrowing
Ex ante real interest rate is adjusted for expected changes inthe price level
Ex post real interest rate is adjusted for actual changes in theprice level
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Fisher Equation
= nominal interest rate
= real interest rate
= expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real inter
e
r
r
e
i i
i
i
est rate is a better indicator of the incentives to
borrow and lend.
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Real and Nominal Interest Rates
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Appendix
Slides after this point will most likely not be covered in class.
However they may contain useful definitions, or further
elaborate on important concepts, particularly materials
covered in the text book.
They may contain examples Ive used in the past, or slides I
just dont want to delete as I may use them in the future.
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Consol or Perpetuity
A bond with no maturity date that does not repay principal but pays
fixed coupon payments foreverPc
C/ ic
Pc price of the consol
C yearly interest payment
ic yield to maturity of the consol
Can rewrite above equation as ic C/Pc
For coupon bonds, this equation gives current yield
an easy-to-calculate approximation of yield to maturity
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Following the Financial News:
Bond Prices and Interest Rates
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The Behavior of Interest Rates
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Determining the
Quantity Demanded of an Asset Wealththe total resources owned by the individual, including all assets
Expected Returnthe return expected over the next period on one asset
relative to alternative assets
Riskthe degree of uncertainty associated with the return on one asset
relative to alternative assets
Liquiditythe ease and speed with which an asset can be turned into cash
relative to alternative assets
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Theory of Asset Demand
Holding all other factors constant:
1. The quantity demanded of an asset is positively related to wealth2. The quantity demanded of an asset is positively related to its
expected return relative toalternative assets
3. The quantity demanded of an asset is negatively related to the
risk of its returns relative to alternative assets4. The quantity demanded of an asset is positively related to its
liquidity relative to alternative assets
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Supply and Demand for Bonds
At lower prices (higher interest rates), ceteris
paribus, the quantity demanded of bonds is
higheran inverse relationship
At lower prices (higher interest rates), ceteris
paribus, the quantity supplied of bonds is
lowera positive relationship
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Market Equilibrium
Occurs when the amount that people are willing to buy(demand) equals the amount
that people are willing to sell (supply) at a given price When Bd= Bsthe equilibrium (or market clearing) price
and interest rate
When Bd> Bsexcess demandprice will rise and
interest rate will fall When Bd< Bsexcess supplyprice will
fall and interest rate will rise
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Shifts in the Demand for Bonds
Wealthin an expansion with growing wealth, the demand curve forbonds shifts to the right
Expected Returnshigher expected interest rates in the future lowerthe expected return for long-term bonds, shifting the demand curve tothe left
Expected Inflationan increase in the expected rate of inflationslowers the expected return for bonds, causing the demand curve toshift to the left
Riskan increase in the riskiness of bonds causes the demand curve toshift to the left
Liquidityincreased liquidity of bonds results in the demand curveshifting right
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Shift in Demand
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Factors that Shift the Bond Demand Curve
1. WealthA. Economy grows, wealth , Bd, Bdshifts out to right
2. Expected ReturnA. iin future, Refor long-term bonds , Bdshifts out to rightB. e, Relative Re, Bdshifts out to rightC. Expected return of other assets , Bd, Bdshifts out to right
3. RiskA. Risk of bonds , Bd, Bdshifts out to right
B. Risk of other assets , Bd
, Bd
shifts out to right4. Liquidity
A. Liquidity of Bonds , Bd, Bdshifts out to rightB. Liquidity of other assets , Bd, Bdshifts out to right
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Shifts in the Supply of Bonds
Expected profitability of investmentopportunitiesin an expansion, the supplycurve shifts to the right
Expected inflationan increase in expectedinflation shifts the supply curve for bonds tothe right
Government budgetincreased budgetdeficits shift the supply curve to the right
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Shift in Supply
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Loanable Funds Terminology
1. Demand for
bonds =
supply of
loanablefunds
2. Supply of
bonds =
demand for
loanable
funds
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Fisher Effect
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Fisher Effect
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Business Cycle and Interest Rates
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Business Cycle and Interest Rates
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Practice Problems
What happens to the equilibrium bond price,
and interest rate in the following scenarios
(ceteris paribus)?
Gold prices start to rise dramatically.
The stock market becomes relatively more liquid.
The stock market begins to fluctuate wildly.
Real Estate prices fall sharply.
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Interest Rate Ceilings
Regulation Q (max interest rate paid on
deposits)
Merchant of Venice (Shakespeare)
Bassanio, Antonio, Shylock, Portia
Deuteronomy 23:19 Thou shalt not lend upon interest to thy brother; interest of money, interest of
victuals, interest of any thing that is lent upon interest
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The Liquidity Preference Framework
Keynesian model that determines the equilibrium interest rate
in terms of the supply of and demand for money.
There are two main categories of assets that people use to storetheir wealth: money and bo
s s d d
s d s d
s d
s d
nds.
Total wealth in the economy = B M = B + M
Rearranging: B - B = M - M
If the market for money is in equilibrium (M = M ),
then the bond market is also in equilibrium (B = B ).
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Liquidity Preference Analysis
Derivation of Demand Curve1. Keynes assumed money has i= 02. As i, relative RETeon money (equivalently, opportunity cost of money
) Md3. Demand curve for money has usual downward slope
Derivation of Supply curve1. Assume that central bank controls Msand it is a fixed amount2. Mscurve is vertical line
Market Equilibrium1. Occurs when Md= Ms, at i* = 15%2. If i = 25%, Ms> Md(excess supply): Price of bonds , ito i* = 15%3. If i=5%, Md> Ms(excess demand): Price of bonds , i to
i* = 15%
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Shifts in the Demand for Money
Income Effecta higher level of income
causes the demand for money at each interest
rate to increase and the demand curve to shift
to the right
Price-Level Effecta rise in the price level
causes the demand for money at each interest
rate to increase and the demand curve to shiftto the right
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Shifts in the Supply of Money
Assume that the supply of money is controlled
by the central bank
An increase in the money supply engineeredby the Federal Reserve
will shift the supply curve for money to the
right
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Everything Else Remaining Equal?
Liquidity preference framework leads to the conclusion that anincrease in the money supply will lower interest ratesthe liquidityeffect.
Income effect finds interest rates rising because increasing the moneysupply is an expansionary influence on the economy.
Price-Level effect predicts an increase in the money supply leads to arise in interest rates in response to the rise in the price level.
Expected-Inflation effect shows an increase in interest rates because anincrease in the money supply may lead people to expect a higher pricelevel in the future.
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Money and Interest Rates
Effects of money on interest rates
1. Liquidity Effect
Ms, Msshifts right, i
2. Income Effect
Ms, Income , Md, Mdshifts right, i
3. Price Level Effect
Ms, Price level , Md, Mdshifts right, i
4. Expected Inflation Effect
Ms, e, Bd, Bs, Fisher effect, i
Effect of higher rate of money growth on interest rates is ambiguous1. Because income, price level and expected inflation effects work inopposite direction of liquidity effect
Price Level Effect
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Price-Level Effect
and Expected-Inflation Effect
A one time increase in the money supply will cause prices to rise to apermanently higher level by theend of the year. The interest rate will rise via the increased prices.
Price-level effect remains even after prices have stopped rising.
A rising price level will raise interest rates because people will expectinflation to be higher over the course of the year. When the price levelstops rising, expectations of inflation will return to zero.
Expected-inflation effect persists only as long as the price levelcontinues to rise.
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R l ti f Li idit P f
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Relation of Liquidity Preference
Framework to Loanable Funds
Keyness Major Assumption
Two Categories of Assets in Wealth
Money
Bonds
1. Thus: Ms+ Bs= Wealth
2. Budget Constraint: Bd+ Md= Wealth
3. Therefore: Ms+ Bs= Bd+ Md
4. Subtracting Mdand Bsfrom both sides:
MsMd= BdBs
Money Market Equilibrium5. Occurs when Md= Ms
6. Then MdMs= 0 which implies that BdBs= 0, so that Bd= Bsand bond market is
also in equilibrium
Relation of Liquidity Preference
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1. Equating supply and demand for bonds as in loanablefunds framework is equivalent to equating supply and
demand for money as in liquidity preference framework
2. Two frameworks are closely linked, but differ in practicebecause liquidity preference assumes only two assets,money and bonds, and ignores effects on interest rates
from changes in expected returns on real assets
Relation of Liquidity Preference
Framework to Loanable Funds
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The Risk and Term Structure of
Interest Rates
Ri k St t f L T B d i
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Risk Structure of Long-Term Bonds in
the United States
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Risk Structure of Interest Rates
Default riskoccurs when the issuer of the bond is unable orunwilling to make interest payments or pay off the face value
U.S. T-bonds are considered default free
Risk premiumthe spread between the interest rates on bonds with
default risk and the interest rates on T-bonds Liquiditythe ease with which an asset can be converted into
cash
Income tax considerations
Increase in Default Risk on Corporate
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Increase in Default Risk on Corporate
Bonds
Analysis of Figure 2: Increase in
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Analysis of Figure 2: Increase in
Default Risk on Corporate Bonds
Corporate Bond Market1. Reon corporate bonds , Dc, Dcshifts left2. Risk of corporate bonds , Dc, Dcshifts left3. Pc, ic
Treasury Bond Market
4. Relative Reon Treasury bonds , DT , DTshifts right5. Relative risk of Treasury bonds , DT, DTshifts right6. PT, iTOutcome:
Risk premium, iciT, rises
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Bond Ratings
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Corporate Bonds Become Less Liquid
Corporate Bond Market1. Less liquid corporate bonds Dc, Dcshifts left2. Pc, ic
Treasury Bond Market
1. Relatively more liquid Treasury bonds, DT, DTshiftsright
2. PT, iTOutcome:
Risk premium, iciT, rises
Risk premium reflects not only corporate bonds default risk, but also lowerliquidity
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Tax Advantages of Municipal Bonds
Analysis of Figure 3:
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Analysis of Figure 3:
Tax Advantages of Municipal Bonds
Municipal Bond Market
1. Tax exemption raises relative RETeon municipal bonds, Dm,Dmshifts right
2. Pm, im
Treasury Bond Market
1. Relative RETeon Treasury bonds , DT, DTshifts left
2. PT, iT
Outcome:im< iT
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Interest Rates on Different Maturity
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Interest Rates on Different Maturity
Bonds Move Together
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Yield Curves
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Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may havedifferent interest rates because the time remaining to maturity is different
Yield curvea plot of the yield on bonds with differing terms to maturity
but the same risk, liquidity and tax considerations
Upward-sloping
long-term rates are aboveshort-term rates
Flatshort- and long-term rates are the same
Invertedlong-term rates are below short-term rates
Facts Theory of the Term Structure of Interest
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Facts Theory of the Term Structure of Interest
Rates Must Explain
1. Interest rates on bonds of differentmaturities move together over time
2. When short-term interest rates are low,yield curves are more likely to have anupward slope; when short-term rates are
high, yield curves are more likely to slopedownward and be inverted
3. Yield curves almost always
slope upward
Three Theories
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Three Theories
to Explain the Three Facts
1. Expectations theory explains the first twofacts but not the third
2. Segmented markets theory explains fact
three but not the first two
3. Liquidity premium theory combines the two
theories to explain all three facts
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Expectations Theory
The interest rate on a long-term bond will equal an averageof the short-term interest rates that people expect to occur
over the life of the long-term bond Buyers of bonds do not prefer bonds of one maturity over
another; they will not holdany quantity of a bond if its expected returnis less than that of another bond with a different maturity
Bonds like these are said to be perfect substitutes
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Expectations TheoryExample
Let the current rate on one-year bond be 6%.
You expect the interest rate on a one-year bond to be 8% next
year.
Then the expected return for buying two one-year bondsaverages (6% + 8%)/2 = 7%.
The interest rate on a two-year bond must be 7% for you to be
willing to purchase it.
h l
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Expectations TheoryIn General
1
2
For an investment of $1
= today's interest rate on a one-period bond= interest rate on a one-period bond expected for next period
= today's interest rate on the two-period bond
t
e
t
t
i
i
i
Expectations TheoryIn General
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Expectations Theory In General
(contd)
2 2
2
2 2
2
2 2
2
2
Expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods
(1 + )(1 + ) 1
1 2 ( ) 1
2 ( )
Since ( ) is very small
the expected re
t t
t t
t t
t
i i
i i
i i
i
2
turn for holding the two-period bond for two periods is
2t
i
Expectations TheoryIn General
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Expectations Theory In General
(contd)
1
1 1
1 1
1
1
If two one-period bonds are bought with the $1 investment
(1 )(1 ) 11 ( ) 1
( )
( ) is extremely small
Simplifying we get
e
t t
e e
t t t t
e e
t t t t
e
t t
e
t t
i i
i i i i
i i i i
i i
i i
Expectations TheoryIn General
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Expectations Theory In General
(contd)
2 1
12
Both bonds will be held only if the expected returns are equal
2
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
e
t t t
e
t t
t
t t
nt
i i i
i ii
i ii
1 2 ( 1)...
The -period interest rate equals the average of the one-period
interest rates expected to occur over the -period life of the bond
e e e
t t ni i
n
n
n
M E l
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More Examples
Here are the following 1 year expectedinterest rates for the next 5 years.
3%, 5%, 8%, 5%, 3%
What would you expect for the 1,2,3,4 and 5
year interest rates?
E t ti Th
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Expectations Theory
Explains why the term structure of interest rates changes atdifferent times
Explains why interest rates on bonds with differentmaturities move together over time (fact 1)
Explains why yield curves tend to slope up when short-termrates are low and slope down when short-term rates arehigh (fact 2)
Cannot explain why yield curves usually slope upward (fact3)
S t d M k t Th
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Segmented Markets Theory
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by
the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors have short desired holding periods and generally prefer bonds
with shorter maturities that have less interest-rate risk, then this explains
why yield curves usually slope upward (fact 3)
Liquidity Premium &
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q y
Preferred Habitat Theories
The interest rate on a long-term bond willequal an average of short-term interest rates
expected to occur over the life of the long-
term bond plus a liquidity premium thatresponds to supply and demand conditions for
that bond
Bonds of different maturities are substitutesbut not perfect substitutes
Li idit P i Th
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Liquidity Premium Theory
int
it i
t1
e i
t2
e ... i
t(n1)
e
n l
nt
where lnt
is the liquidity premium for the n-period bond at time t
lnt
is always positive
Rises with the term to maturity
N i l E l
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Numerical Example
1. One-year interest rate over the next five years:5%, 6%, 7%, 8% and 9%
2. Investors preferences for holding short-term bonds, liquidity
premiums for one to five-year bonds:0%, 0.25%, 0.5%, 0.75% and 1.0%.
Interest rate on the two-year bond:
(5% + 6%)/2 + 0.25% = 5.75%
Interest rate on the five-year bond:
Interest rates on one to five-year bonds:
Comparing with those for the expectations theory, liquidity premium (preferredhabitat) theories produce yield curves more steeply upward sloped
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Liquidity Premium and Preferred Habitat Theories,
Explanation of the Facts
Interest rates on different maturity bonds move together over time;
explained by the first term in
the equation
Yield curves tend to slope upward when short-term rates are low and
to be inverted when short-term rates are high; explained by the
liquidity premium term in the first case and by a low expected average
in the second case
Yield curves typically slope upward; explainedby a larger liquidity premium as the term to
maturity lengthens
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Market Predictions of Future Short Rates
Spring 2001
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Spring 2001
Spring 2005
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Spring 2005
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Interpreting Yield Curves 19802006
Dynamic Yield Curve
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Dynamic Yield Curve
Yield curve changes plotted against DJIA http://stockcharts.com/charts/YieldCurve.html
Yield curves since the late 70s
http://fixedincome.fidelity.com/fi/FIHistoricalYield
Appendix
http://stockcharts.com/charts/YieldCurve.htmlhttp://fixedincome.fidelity.com/fi/FIHistoricalYieldhttp://fixedincome.fidelity.com/fi/FIHistoricalYieldhttp://stockcharts.com/charts/YieldCurve.html -
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Appendix
Slides after this point will most likely not be covered in class.However they may contain useful definitions, or further
elaborate on important concepts, particularly materials
covered in the text book.
They may contain examples Ive used in the past, or slides I
just dont want to delete as I may use them in the future.
Expectations Hypothesis
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Expectations Hypothesis
Key Assumption: Bonds of different maturities are perfect
substitutes
Implication: RETeon bonds of different maturities are equal
Investment strategies for two-period horizon
1. Buy $1 of one-year bond and when it matures buy another
one-year bond
2. Buy $1 of two-year bond and hold it
Expected return from strategy 2
(1 + i2t)(1 + i2t)1 1 + 2(i2t) + (i2t)21
=1 1
Since (i2t)2is extremely small, expected return is approximately 2(i2t)
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Expected Return from Strategy 1
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102
Expected Return from Strategy 1
More generally for n-period bond:
it+ ie
t+1+ ie
t+2+ ... + ie
t+(n1)
int= n
In words: Interest rate on long bond = average short rates expected to occurover life of long bond
Numerical example:
One-year expected interest rates over the next five years 5%, 6%, 7%, 8% and
9%:
Interest rate on two-year bond:
Interest rate for five-year bond:
Interest rate for one to five year bonds:
Expectations Hypothesis
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and Term Structure Facts
Explains why yield curve has different slopes:
1. When short rates expected to rise in future, average of future short rates = int
is above todays short rate: therefore yield curve is upward sloping
2. When short rates expected to stay same in future, average of future shortrates are same as todays, and yield curve is flat
3. Only when short rates expected to fall will yield curve be downward sloping
Expectations Hypothesis explains Fact 1 that short and long rates move together
1. Short rate rises are persistent
2. If ittoday, ie
t+1, ie
t+2etc. average of future rates int
3. Therefore: itint, i.e., short and long rates move together
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1. When short rates are low, they are expected to rise to normal level, and
long rate = average of future short rates will be well above todays short
rate: yield curve will have steep upward slope
2. When short rates are high, they will be expected to fall in future, and long
rate will be below current short rate: yield curve will have downward
slope
Doesnt explain Fact 3 that yield curve usually has upward slope
Short rates as likely to fall in future as rise, so average of future short
rates will not usually be higher than current short rate: therefore, yield
curve will not usually slope upward
Explains Fact 2 that yield curves tend to have steep slope when
short rates are low and downward slope when short rates are high
Segmented Markets Theory
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Segmented Markets Theory
Key Assumption: Bonds of different maturities are not substitutes at allImplication: Markets are completely segmented: interest rate at each
maturity determined separately
Explains Fact 3 that yield curve is usually upward sloping
People typically prefer short holding periods and thus have higher demand for
short-term bonds, which have higher price and lower interest rates than longbonds
Does not explain Fact 1 or Fact 2 because assumes long and short rates
determined independently
Liquidity Premium (Preferred Habitat)
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Theories
Key Assumption: Bonds of different maturities are substitutes, butare not perfect substitutes
Implication: Modifies Expectations Theory with features ofSegmented Markets Theory
Investors prefer short rather than long bonds must be paid positiveliquidity (term) premium, lnt, to hold long-term bonds
Results in following modification of Expectations Theory
it+ ie
t+1+ ie
t+2+ ... + ie
t+(n1)int= + lnt
n
Relationship Between the Liquidity Premium (Preferred
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Habitat) and Expectations Theories
Liquidity Premium (Preferred Habitat) Theories:
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Term Structure Facts
Explains all 3 Facts
Explains Fact 3 of usual upward sloped yield curve by
investors preferences for short-term bonds
Explains Fact 1 and Fact 2 using same explanations asexpectations hypothesis because it has average of future
short rates as determinant of long rate
Trading Experiment
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Trading Experiment
Instructions
Assign type
Assign trading location
Trading Experiment
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Trading Experiment
Questions for Discussion
What trades were you willing to make and why?
Did you have a particular trading strategy, and if so, what was
it?
Was your strategy effective at maximizing your total points?
Trading Experiment
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Trading Experiment
Did any item serve as a generally accepted medium of exchange in theexperiment?
If so, what item was it, why were people willing to accept it, and howwas the pattern of trades affected by the existence of a medium ofexchange? What were the advantages having a generally accepted
medium of exchange in this economy?
If not, why was there no generally accepted medium of exchange?
What would the effect on trading strategies have been if the storage
costs of all the goods had been equal?
Trading Experiment
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Trading Experiment
Can you think of any markets where some item other thancurrency serves as a generally accepted medium of exchange?
If so, what are the advantages and disadvantages of using this
item instead of currency?
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So What Is Money?
M i d F i f M
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Meaning and Function of Money
Economists Meaning of Money1. Anything that is generally accepted in payment for goods and
services
2. Not the same as wealth or income
Functions of Money1. Medium of exchange
2. Unit of account
3. Store of value
Evolution of Money
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Evolution of Money
Commodities Precious metals like gold and silver
Paper currency
Checks
Electronic means of payment: Fedwire, CHIPS, SWIFT, ACH
Electronic money: Debit cards, Stored-value cards, Electronic cashand checks
The First Money
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The First Money
700-637 BC Lydian Kingstamped electrumingots with lions head(Western Turkey)
Previous to this theymerely used items(grains, etc) to balance
out the barter.
The First Money
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The First Money
640 BC Lydian King stamped electrum ingots with lions head
Many countries used different commodities as a medium of exchange
Roman Empire (to 476 AD), used coins extensively.
Dark ages 476 AD - 1250, money disappeared or fell out of favor inEurope, maintained in the Byzantine Empire
The First Money
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The First Money
Aztecs used the cacao seeds. Largely to equalize a barter transaction.
Knights of Templar (1118 AD- 1314 AD) The first bankers. Managed
money for the French Kings, the Pope, and Crusaders
Freed from the requirement of physically transporting the gold, or
coin.
Goldsmiths story.
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Commodity Money
Criteria for commodity Money
1. Easily standardized
2. Widely accepted
3. Divisible
4. Easy to carry
5. Must not deteriorate
Examples: cigarettes, booze, gold, clams etc.
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History of Paper Currency
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History of Paper Currency
First identified in 1stcentury AD China
Full bodied currency
First bank note in Europe, 1661, backed by copper sheets weighing
500 lbs.
Fiat Currency
The Dollar
Fun Facts about the Dollar
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Fun Facts about the Dollar
Ave life of $1 bill is 18 months, 9 years for a $100
490 notes in a lb. So 10 Million in 100s weighs 204lbs.
of bills printed in a day are $1 denomination
http://www.wheresgeorge.com/
History of Money in US
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y y
Franklin The Father of Paper Money States issued currency
Continentals (1777-1781) Not worth a continental
Free Banking ( - 1866) States and banks issued their own currency
Greenbacks (Civil War) Nationalization of Gold (1933)
The Collapse of the Bretton Woods System (1971) Goodwin, Jason. 2003. Greenback : How the Dollar Changed the World. New York:
Henry Holt. http://news.mpr.org/play/audio.php?media=/midmorning/2003/01/31_midmorn2
Clips: Paper money 7:00; Metallists 14:45; Wizard of Oz 20:45; Dollar 49:00
Federal Reserves Monetary Aggregates
http://news.mpr.org/play/audio.php?media=/midmorning/2003/01/31_midmorn2http://news.mpr.org/play/audio.php?media=/midmorning/2003/01/31_midmorn2 -
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124
Federal Reserve s Monetary Aggregates
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Growth Rates of Feds
M t A t
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Monetary Aggregates
The Economic Organization of a POW Camp
R A Radford Economica 1945 189-201
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R.A. Radford Economica, 1945, 189 201
According to Radford, did cigarettes function well as money in the POW camp? Was it important to their use as currency that cigarettes had intrinsic value?
Why would individuals re-roll their machine-rolled cigarettes?
What is the significance of the fact that a halving of Red Cross parcels changedprices?
What accounts for the fall in the value of the "bully mark"?
What happened to prices during an air raid? Why?
The Economic Organization of a POW Camp
R A Radford Economica 1945 189-201
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R.A. Radford Economica, 1945, 189-201
Important monetary ideas: Increase in cigarettes caused prices to rise (that is to say, the number of
cigarettes it took to buy a particular item increased).
Decrease in the number of cigarettes caused prices to fall.
Demand for cigarettes other than as money affected their ability to function asmoney (non-monetary demand). It also affected the relationship between
prices and the quantity of cigarettes Prices responded to expectationsof changes in the number of cigarettes.
Prisoners were forward looking, rational, and prices reflected those beliefsabout the future.
The Money Quote
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y
"Lenin was certainly right. By a continuing process of inflation,governments can confiscate, secretly and unobserved, an importantpart of the wealth of their citizens. There is no subtler, no surermeans of overturning the existing basis of society than to debauch
the currency. The process engages all the hidden forces of economiclaw on the side of destruction, and does it in a manner which not oneman in a million is able to diagnose.." - John Maynard Keynes, `TheEconomic Consequences of The Peace'
Fiat money is the cause of inflation, and the amount which people
lose in purchasing poweris exactly the amount which was taken fromthem and transferred to their governments by this process. G.Edward Griffin, The Creature from Jekyll Island
More Money Quotes
http://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Purchasing_powerhttp://www.amazon.com/gp/product/0912986212http://www.amazon.com/gp/product/0912986212http://en.wikipedia.org/wiki/Purchasing_powerhttp://en.wikipedia.org/wiki/Inflation -
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y
A fiat monetary system allows power and influence to fall into the handsof those who control the creation of new money, and to those who get touse the money or credit early in its circulation. The insidious and eventualcost falls on unidentified victims who are usually oblivious to the cause oftheir plight. This system of legalized plunder (though not constitutional)allows one group to benefit at the expense of another. An actual transferof wealth goes from the poor and the middle class tothose in privileged
financial positions. Congressman Ron Paul (R-TX), "Paper Money andTyranny"
"It is well enough thatpeople of the nation do not understand our bankingand monetary system, for if they did, I believe there would be a revolutionbefore tomorrow morning." Henry Ford
http://en.wikipedia.org/wiki/Ron_Paulhttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://en.wikipedia.org/wiki/Ron_Paulhttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Henry_Fordhttp://en.wikipedia.org/wiki/Henry_Fordhttp://en.wikipedia.org/wiki/Henry_Fordhttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://en.wikipedia.org/wiki/Fractional-reserve_bankinghttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://www.house.gov/paul/congrec/congrec2003/cr090503.htmhttp://en.wikipedia.org/wiki/Ron_Paulhttp://en.wikipedia.org/wiki/Ron_Paulhttp://en.wikipedia.org/wiki/Ron_Paul -
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Multiple Deposit Creation and
the Money Supply Process
Four Players
in the Money Supply Process
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in the Money Supply Process
1. Central Bank: The Fed2. Banks
3. Depositors
4. Borrowers from banks
Federal Reserve System
1. Conducts monetary policy
2. Clears checks3. Regulates banks
The Feds Balance Sheet
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Federal Reserve System
Government securities
Discount loans
Currency in circulation
Reserves
Assets Liabilities
Monetary Base, MB = C + R
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If Person Cashes Check
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Public The Fed
Assets Liabilities Assets Liabilities
Securities $100 Securities + $100 Currency + $100
Currency + $100
Result: Runchanged, MB $100
Effect on MBcertain, on Runcertain
Shifts From Deposits into Currency
Public The Fed
Assets Liabilities Assets Liabilities
Deposits $100 Currency + $100
Currency + $100 Reserves $100
Banking System
Assets Liabilities
Reserves $100 Deposits $100
Result: R $100, MBunchanged
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Deposit Creation: Single Bank
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137
First National Bank
Assets Liabilities
Securities $100
Reserves + $100
First National Bank
Assets Liabilities
Securities $100 Deposits + $100
Reserves + $100
Loans + $100
First National BankAssets Liabilities
Securities $100 Deposits + $100
Loans + $100
Deposit Creation: Banking System
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Bank A
Assets LiabilitiesReserves + $100 Deposits + $100
Bank A
Assets Liabilities
Reserves + $10 Deposits + $100
Loans + $90Bank B
Assets Liabilities
Reserves + $90 Deposits + $90
Bank B
Assets LiabilitiesReserves + $ 9 Deposits + $90Loans + $81
Deposit Creation
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Deposit Creation
Deposit Creation
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If Bank A buys securities with $90 check
Bank A
Assets Liabilities
Reserves + $10 Deposits + $100
Securities + $90
Seller deposits $90 at Bank B and process is same
Whether bank makes loans or buys securities, get same deposit
expansion
Deposit Multiplier
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Simple Deposit Multiplier1
D= Rr
Deriving the formula
R= RR= rD1
D= Rr
1D= Rr
Deposit Creation:
Banking System as a Whole
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Banking System as a Whole
Banking SystemAssets Liabilities
Securities$100 Deposits + $1000
Reserves + $100Loans + $1000
Critique of Simple Model
Deposit creation stops if:
1. Proceeds from loan kept in cash
2. Bank holds excess reserves
The Monetary Base
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1. MB = C+ R= (Fed notes) + (bank deposits) + (Treasury currency)(coin)Asset = Liabilities of Fed balance sheet
2. (Fed notes) + (bank deposits) = (securities) + (discount loans) +
(gold and SDRs) + (coin) + (cash items in process of collection) + (other Fed
assets)(Treasury deposits)(foreign and other deposits)(deferred-
availability cash items)(other Fed liabs)
Float = (cash items in process of collection)(deferred-availability cash items)
Substituting 2 into 1 and using definition of float:
MB= (securities) + (discount loans) + (gold and SDRs) + (float) + (other Fed
assets) + (Treasury currency)(Treasury deposits)(foreign and other
deposits)(other Fed liabs)
Summary: Factors that Affect the Monetary Base
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Wizard of OZ
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The Wizard of OZ as a monetary allegory Rockoff, Hugh. 1990. "The "Wizard of Oz" as a Monetary
Allegory."Journal of Political Economy, 98:4, pp. 739-60.
http://www.uno.edu/~coba/econ/projects/oz/
http://www.micheloud.com/FXM/MH/Crime/WWIZOZ.htm
http://www.ryerson.ca/~lovewell/oz.html
William Jennings Bryan
http://www.uno.edu/~coba/econ/projects/oz/http://www.micheloud.com/FXM/MH/Crime/WWIZOZ.htmhttp://www.ryerson.ca/~lovewell/oz.htmlhttp://www.ryerson.ca/~lovewell/oz.htmlhttp://www.micheloud.com/FXM/MH/Crime/WWIZOZ.htmhttp://www.uno.edu/~coba/econ/projects/oz/ -
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Bryan gave a very passionate speech and "brought the delegates to their feet howling inecstasy with his cry toward the end: (Boller, p. 168)
We have petitioned, and our petitions have been scorned; we have entreated, and ourentreaties have been disregarded; we have begged, and they have mocked when ourclamity came. We beg no longer; we entreat no more. We defy them ...! Having behindus the producing masses of this nation and the world, supported by the commercialinterests, the laboring interests, and the toilers everywhere, we will answer theirdemand for a gold standard by saying to them: You shall not press down upon the browof labor this crown of thorns, you shall not crucify mankind upon a cross of gold!
http://www.americanpresidents.org/presidents/yearschedule.asp
http://www.americanpresidents.org/ram/amp082399g2.ram
At 24 minutes
http://www.americanpresidents.org/presidents/yearschedule.asphttp://www.americanpresidents.org/ram/amp082399g2.ramhttp://www.americanpresidents.org/ram/amp082399g2.ramhttp://www.americanpresidents.org/presidents/yearschedule.asp -
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Structure of Central Banks and
the Federal Reserve System
First Bank of United States 1791-1811
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Second Bank of United States 1816-1836
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Formal Structure of the Fed
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Federal Reserve Districts
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Informal Structure of the Fed
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Central Bank Independence
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Factors making Fed independent1. Members of Board have long terms
2. Fed is financially independent: This is most important
Factors making Fed dependent
1. Congress can amend Fed legislation
2. President appoints Chairmen and Board members and can influence legislation
Overall: Fed is quite independent
Other Central Banks
1. Bank of England least independent: Govt. makes policy decisions
2. European Central Bank: most independentprice stability primary goal
3. Bank of Canada and Japan: fair degree of independence, but not all on paper
4. Trend to greater independence: New Zealand, European nations
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Central Bank Independence and
Macro Performance in 17 Countries
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Tools of Monetary Policy
The Market for Reserves
and the Fed Funds Rate
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Demand Curve for Reserves1. R= RR+ ER
2. i opportunity cost of ER, ER
3. Demand curve slopes down
Supply Curve for Reserves1. If iff is below id, then discount borrowing, R
s= Rn (non-borrowed
reserves, controlled by OMO)
2. Supply curve flat (infinitely elastic) at idbecause as iffstarts to go
above id, banks borrow more at id
Market Equilibrium
Rd= Rs at i*ff
Supply and Demand for Reserves
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Response to Open Market Operations
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Open Market Purchase
Nonborrowed reserves, Rn,
and shifts supply curve
to right Rs2
: i to i2ff
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Reserve Requirements
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Advantages1. Powerful effect
Disadvantages
1. Small changes have very large effect on Ms
2. Raising causes liquidity problems for banks
3. Frequent changes cause uncertainty for banks
4. Tax on banks
Proposed Reforms
1. Abolish reserve requirements
2. 100% reserve requirements (Milton Friedman)A. Advantage: complete control of Ms
B. Disadvantage: Fed controls official Msbut not
economically relevant Ms
Response to a Change in the Discount Rate
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163
(a) No discount lending Lower Discount
Rate
Horizontal to section and supply curvejust shortens, iffstays same
(b) Some discount lending
Lower Discount Rate
Horizontal section , iff to i2ff
= i2d
Discount Loans
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3 Types
1. Primary Credit
2. Secondary Credit
3. Seasonal Credit
Lender of Last Resort Function
1. To prevent banking panics
FDIC fund not big enoughExample: Continental Illinois
2. To prevent nonbank financial panics
Examples: 1987 stock market crash and September 11 terrorist incident
Announcement Effect
1. Problem: False signals
Discount Policy
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Advantages1. Lender of Last Resort Role
Disadvantages1. Confusion interpreting discount rate changes2. Fluctuations in discount loans cause unintended fluctuations in money supply3. Not fully controlled by Fed
Proposed Reforms1. Abolish discounting (Milton Friedman)
A. Eliminates fluctuations in Ms
B. However, lose lender of last resort role2. Tie discount rate to market rate
A. i id= constant, so less fluctuations ofDL and Ms
B. Easier administrationC. No false announcement signals
Adopted ReformsPenalty discount rate where Discount Rate>ff
Market Interest Rates and the Discount Rate
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How Primary Credit Facility Puts Ceiling on iff
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167
Rightward shift of Rs
to Rs
2moves equilibrium to point
2 where i2ff= i
dand discount
lending rises from zero to
DL 2
Channel/Corridor System for Setting Interest Rates in
Other Countries
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In the channel/corridor system
standing facilities result in a
step function supply curve,Rs.
If demand curve shifts
betweenRd1andRd2, iffalways
remains between irand il
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Conduct of Monetary Policy:
Goals and Targets
Goals of Monetary Policy
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Goals:1. High Employment
2. Economic Growth
3. Price Stability4. Interest Rate Stability
5. Financial Market Stability
6. Foreign Exchange Market StabilityGoals often in conflict
Central Bank Strategy
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Money Supply Target
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1. Mdfluctuates between
Md'and Md''
2. With M-target at M*, i
fluctuates between i'and
i''
Interest Rate Target
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1. Mdfluctuates between
Md'and
Md''
2. To set i-target at i* Ms
fluctuates between M'
and M''
Criteria for Choosing Targets
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Criteria for Intermediate Targets
1. Measurability
2. Controllability
3. Ability to predictably affect goals
Interest rates arent clearly better than Mson criteria 1 and 2 because
hard to measure and control real interest rates
Criteria for Operating Targets
Same criteria as above
Reserve aggregates and interest rates about equal on criteria 1 and 2.
For 3, if intermediate target is Ms, then reserve aggregate is better
History of Fed Policy Procedures
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Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 192021
Discovery of Open Market Operations
1. Made discovery when purchased bonds to get income in 1920s
Great Depression
1. Failure to prevent bank failures
2. Result: sharp drop in Ms
Reserve Requirements as Tool1. Banking Act of 1935
2. Required reserves in 1936, 1937 to reduce idle reserves:
Result:Msand severe recession in 193738
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Pegging of Interest Rates: 1942-51
1. To help finance war, T-bill at 3/8%, T-bond at 2 1/2%
2. Fed-Treasury Accord in March 1951
Money Market Conditions: 1950s and 60s
1. Interest Rates
A. Procyclical M
Y iMBM
e iMBM
Targeting Monetary Aggregates: 1970s
1. Fed funds rate as operating target with narrow band
2. Procyclical M
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New Operating Procedures: 1979821. Deemphasis on fed funds rate
2. Nonborrowed reserves operating target
3. Fed still using interest rates to affect economy and inflation
Deemphasis of Monetary Aggregates: 1982Early 1990s
1. Borrowed reserves (DL) operating target
A. Procyclical M
YiDLMBM
Fed Funds Targeting Again: Early 1990s to the present
1. Fed funds target now announced
International Considerations
1. Min 1985 to lower exchange rate, Min 1987 to raise it2. International policy coordination
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Federal
Funds Rate
and Money
Growth
Before and
After
October1979
Taylor Rule, NAIRU and the Phillips Curve
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Taylor RuleFed funds rate target = inflation rate +
equilibrium real fed funds rate +
1/2 (inflation gap) +
1/2 (output gap)
Phillips Curve TheoryChange in inflation influenced by output relative to potential, andother factors
When unemployment rate < NAIRU, inflation rises
NAIRU thought to be 6%, but inflation falls with unemployment ratebelow 5%
Phillips curve theory highly controversial
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Taylors Rule in Early 2000s
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http://research.stlouisfed.org/publications/mt/page10.pdf
McCallums Monetary Base Rule
http://research.stlouisfed.org/publications/mt/page10.pdfhttp://research.stlouisfed.org/publications/mt/page10.pdf -
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MB*= *+(10yr MA growth of Real GDP) - (4yr MA of Basevelocity growth)
Where *=0,1,2,3,4 percent
McCallums Rule
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Appendix
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Slides after this point will most likely not be covered inclass. However they may contain useful definitions, or
further elaborate on important concepts, particularly
materials covered in the text book.
They may contain examples Ive used in the past, or slides I
just dont want to delete as I may use them in the future.
E- Money
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1. Closed stored value system2. Open stored value system
3. Debit card system
4. Online vs. offline
5. Identified e-money vs anonymous e-money