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– Answer the questions showing all of your work.- Use your own words. ( No citation, No References , No Quotes).- Do Not use Excel for solving calculations questions. ( Use Financial calculator Only ).- Do Not write long answers for the writing questions ( 2-4 sentences Maximum).- I have attached two power point files for each chapter’s questions ( You might find the answers there).
ch_10_hw.docx

ch_11_hw.docx

chapter_10_powerpoint.pptx

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Chapter 10 Homework Assignment
Finance 4063: Financial Institutions and Markets
Name _________________________________
1. Consider a bank policy to maintain 12% of deposits as reserves. The bank currently has $10
million in deposits and holds $400,000 in excess reserves. What is the required reserve on a new
deposit of $50,000?
2. Suppose a bank currently has $150,000 in deposits and $15,000 in reserves. The required reserve
ratio is 10% (so this bank holds no excess reserves). If there is a deposit outflow (i.e., someone
withdraws funds from her account) for $5,000, would this bank still comply with the Fed’s
requirement of keeping 10% of its deposits in the form of reserves? What would be the cost for
this bank to comply with this regulation if the bank decides to borrow from another bank to
eliminate its reserve shortage? Assume a federal funds rate of 0.25%.
3. Refer to the previous problem. What would be the cost for this bank to comply with its required
reserves if the bank decides to borrow from the Fed at a discount rate of 0.75%? Can you now
explain why excess reserves serve as insurance against deposit outflows?
4. The short-term nominal interest rate is 5%, with an expected inflation of 2%. Economists forecast
that next year’s nominal rate will increase by 100 basis points, but inflation will fall to 1.5%.
What is the expected change in real interest rates?
5. The Federal Open Market Committee (FOMC) meets about every six weeks to assess the state of
the economy and to decide what actions the central bank should take. The minutes of this meeting
are released three weeks after the meeting; however, a brief press release is made available
immediately. Find the schedule of minutes and press releases at www.federalreserve.gov/fomc/.
a. When was the last scheduled meeting of the FOMC? When is the next meeting?
b. Review the press release from the last meeting. What did the committee decide to do
about short- term interest rates?
c. Review the most recently published meeting minutes. What areas of the economy seemed
to be of most concern to the committee members?
Chapter 11 Homework Assignment
Finance 4063: Financial Institutions and Markets
Name _________________________________
1. What are the annualized discount rate and your annualized investment rate on a Treasury bill that
you purchase for $9,940 that will mature in 91 days for $10,000?
2. If you want to earn an annualized discount rate of 3.5%, what is the most you can pay for a 91day Treasury bill that pays $5,000 at maturity?
3. The price of 182-day commercial paper is $7,840. If the annualized investment rate is 4.093%,
what will the paper pay at maturity?
4. The annualized yield is 3% for 91-day commercial paper and 3.5% for 182-day commercial
paper. What is the expected 91-day commercial paper rate 91 days from now?
5. In a Treasury auction of $2.1 billion par value 91-day T-bills, the following bids were submitted:
Bidder
1
2
3
4
5
Bid
Amount ($
million)
600
750
1
1.5
500
Price
per
$100
99.4
99.01
99.25
99.36
99.39
If only these competitive bids are received, who will receive T-bills, in what quantity, and at what
price?
6. If the Treasury also received $750 million in non- competitive bids, who will receive T-bills, in
what quantity, and at what price? (Refer to the table in problem 5.)
7. Up-to-date interest rates are available from the Federal Reserve at http://www.federalreserve.gov/
releases. Locate the current rate on the following securities:
a. Prime rate
b. Federal funds
c. Commercial paper (financial)
d. Certificates of deposit
e. Discount rate
f.
One-month Eurodollar deposits
Chapter 10:
Conduct of
Monetary Policy:
Tools, Goals,
Strategy, and
Tactics
Chapter Preview (1 of 3)
“Monetary policy” refers to the management of the money supply.
The theories guiding the Federal Reserve are complex and often
controversial. We are affected by this policy, and a basic
understanding of how it works is, therefore, important.
Chapter Preview (2 of 3)
• How Fed Actions Affect Reserves in the Banking System
• The Market for Reserves and the Federal Funds Rate
• Conventional Monetary Policy Tools
• Nonconventional Monetary Policy Tools and Quantitative Easing
• Monetary Policy Tools of the ECB
• The Price Stability Goal and the Nominal Anchor
Chapter Preview (3 of 3)
• Other Goals of Monetary Policy
• Should Price Stability be the Primary Goal of Monetary Policy?
• Inflation Targeting
• Should Central Banks Respond to Asset-Price Bubbles?
Lessons from the Global Financial Crisis
How Fed Actions Affect Reserves
in the Banking System (1 of 2)
All banks have an account at the Fed in which they hold deposits.
Reserves consist of deposits at the Fed plus currency that is
physically held by banks.
Reserves are divided into two categories:
• Required reserves
• Excess reserves
How Fed Actions Affect Reserves
in the Banking System (2 of 2)
The Fed sets the required reserve ratio – the portion of deposits
banks must hold in cash. Any reserves deposited with the Fed
beyond this amount are excess reserves.
The Fed injects reserves into the banking system in two ways:
• Open market operations
• Loans to banks, referred to as discount loans.
Open Market Operations
• In the next two slides, we will examine the impact of open
market operations conducted through primary dealers. As
suggested in the last slide, we will show the following:
– Purchase of bonds increases the money supply
– Making discount loans increases the money supply
• Naturally, the Fed can decrease the money supply by reversing
these transactions.
The Federal Reserve Balance Sheet (1 of 2)
• Open Market Purchase from Primary Dealer
Banking System
Blank
The Fed
Blank
Assets
Liabilities
Assets
Liabilities
Securities
–$100 m
Reserves
+$100 m
Blank
Blank
Blank
Blank
• Result R ↑ $100, MB $100
Securities
+$100
m
Reserves
+$100
m
The Federal Reserve Balance Sheet (2 of 2)
• Discount Lending
Banking System
Blank
The Fed
Blank
Assets
Liabilities
Assets
Liabilities
Reserves
Loans
Discount loans
Reserves
+$100
+$100 m m
• Result R ↑ $100, MB $100
+$100
+$100 m m
The Market for Reserves and the Federal
Funds Rate
We will now examine how this change in reserves affects the
federal funds rate, the rate banks charge each other for
overnight loans.
Figure 10.1 Equilibrium in the Market for
Reserves
Figure 10.2 Response to Open Market
Operations
Figure 10.3 Response to Change in
Discount Rate
Figure 10.4 Response to Change in
Required Reserves
Figure 10.5 Response to Change in
Discount Rate
Case: How Operating Procedures Limit
Fluctuations in Fed Funds Rate
Changes in the demand for reserves will not affect the fed funds
rate – borrowed reserves will increase to match the demand!
This is true whether the demand increases, or decreased.
Figure 10.6 How Operating Procedures
Limit Fluctuations in Fed Funds Rate
Conventional Monetary Policy Tools
We further examine each of the tools in turn to see how the Fed
uses them in practice and how useful each tools is.
Tools of Monetary Policy: Open Market
Operations
• Open Market Operations
1. Dynamic: Change reserves and monetary base
2. Defensive: Offset factors affecting reserves, typically uses
repos
• Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
Inside the Fed: A Day at the Trading Desk (1 of 2)
• The staff reviews the activities of the prior day and issue
forecasts of factors affecting the supply and demand
for reserves.
• This information is used to determine reserve changes needed
to obtain a desired fed funds rate.
• Government securities dealers are contacted to better
determine the condition of the market.
• Projections are compared with the Monetary Affairs Division of
the BOG, and a course of action is determined.
• Once the plan is approved, the desk carries out the required
trades, via the TRAPS system.
Inside the Fed: A Day at the Trading Desk (2 of 2)
• The trading desk typically uses two types of transactions to
implement their strategy:
– Repurchase agreements: the Fed purchases securities,
but agrees to sell them back within about 15 days. So, the
desired effect is reversed when the Fed sells the securities
back—good for taking defense strategies that will reverse.
– Matched sale-purchase transaction: essentially a reverse
repro, where the Fed sells securities, but agrees to buy
them back.
Tools of Monetary Policy: Discount Policy (1 of 3)
• The Fed’s discount loans, through the discount window, are:
– Primary Credit: Healthy banks borrow as they wish from the
primary credit facility or standing lending facility.
– Secondary Credit: Given to troubled banks experiencing
liquidity problems.
– Seasonal Credit: Designed for small, regional banks that
have seasonal patterns of deposits.
Tools of Monetary Policy: Discount Policy (2 of 3)
• Lender of Last Resort Function
– To prevent banking panics
– Example: Continental Illinois
• Really needed? What about the FDIC?
– Problem 1: FDIC only has about 1% of deposits in the
insurance trust
– Problem 2: over $1.1 trillion are large deposits not insured
by the FDIC
Tools of Monetary Policy: Discount Policy (3 of 3)
• Lender of Last Resort Function
– Can also help avoid panics
▪ Ex: Market crash in 1987 and terrorist attacks in 2001 bad events, but no real panic in our financial system
• But there are costs!
– Banks and other financial institutions may take on more risk
(moral hazard) knowing the Fed will come to the rescue
Tools of Monetary Policy: Reserve
Requirements
Reserve Requirements are requirements put on financial
institutions to hold liquid (vault) cash again checkable deposits.
• Everyone subject to the same rule for checkable deposits:
– 3% of first $48.3M, 10% above $48.3M
– Fed can change the 10%
• Rarely used as a tool
– Raising causes liquidity problems for banks
– Makes liquidity management unnecessarily difficult
Nonconventional Monetary Policy Tools
and Quantitative Easing
The Global Financial Crisis challenged the Fed’s ability to stabilize
the economy:
• Financial system seized
• Zero-lower-bound problem – could take rates below zero
The problems called for the use of nonconventional tools.
Liquidity Provisions
• Discount windows expansion – discount rate lowered several
times.
• Term auction facility – another loan facility, offering another $400
billion to institutions.
• New lending programs – included lending to IBs, and lending to
promote purchase of asset-backed securities.
Inside the Fed
• The Global Financial Crisis tested the Fed’s ability to act as a
lender of last resort.
• The next two slides detail some of the Fed’s efforts during this
period to provide liquidity to the banking system.
Fed Lending Facilities During the Global
Financial Crisis (1 of 4)
Lending Facility
Term Auction Facility
(TAF)
Term Securities
Lending Facility
(TSLF)
Swap Lines
Date of Creation
Function
December 12, 2007 To make borrowing from the Fed more
widely used; extends loans of fixed amounts
to banks at interest rates that are
determined by competitive auction rather
than being set by the Fed, as with normal
discount lending
March 11, 2008
To provide sufficient Treasury securities to
act
as collateral in credit markets; lends
Treasury
securities to primary dealers for terms
longer than overnight against a broad range
of collateral
March 11, 2008
Lends dollars to foreign central banks in
exchange for foreign currencies so that
these central banks can in turn make dollar
loans to their domestic banks
Fed Lending Facilities During the Global
Financial Crisis (2 of 4)
Lending Facility
Loans to J.P. Morgan
to buy Bear Stearns
Date of Creation
March 14, 2008
Function
Bought $30 billion of Bear Stearns assets
through nonrecourse loans to J.P. Morgan to
facilitate its purchase of Bear Stearns
Primary Dealer Credit
Facility (PDCF)
March 16, 2008
Lends to primary dealers (including
investment banks) so that they can borrow
on similar terms to banks using the
traditional discount window facility
Loans to AIG
September 16, 2008 Loaned $85 billion to AIG
Fed Lending Facilities During the Global
Financial Crisis (3 of 4)
Lending Facility
Loans to J.P. Morgan
to buy Bear Stearns
Date of Creation
March 14, 2008
Function
Bought $30 billion of Bear Stearns assets
through nonrecourse loans to J.P. Morgan to
facilitate its purchase of Bear Stearns
Primary Dealer Credit
Facility (PDCF)
March 16, 2008
Lends to primary dealers (including
investment banks) so that they can borrow
on similar terms to banks using the
traditional discount window facility
Loans to AIG
September 16, 2008 Loaned $85 billion to AIG
Fed Lending Facilities During the Global
Financial Crisis (4 of 4)
Lending Facility
Commercial Paper
Funding Facility
(CPFF)
Date of Creation
October 7, 2008
Function
Finances purchase of commercial paper
from issuers
Money Market
Investor Funding
Facility (MMIFF)
October 21, 2008
Lends to special-purpose vehicles so that
they can buy a wider range of money
market mutual fund assets
Term Asset-Backed
Securities Loan
Facility (TALF)
November 25, 2008 Lends to issuers of asset-backed securities
against these securities as collateral to
improve functioning of this market
Large-Scale Asset Purchases
(Quantitative Easing)
• Nov 2008 – QE1 established, purchasing $1.25 trillion in MBSs.
• Nov 2010 – QE2, Fed purchases $600 billion in Treasuries,
lower long-term rates.
• Sept 2012 – QE3, Fed commits to buying $40 billion in MBSs
each month.
Quantitative Easing v. Credit Easing
• QE programs dramatically increases the Fed’s balance sheet.
• Power force to stimulate the economy, but perhaps also lead to
inflation?
Figure 10.7 Total Federal Reserve Assets,
2007 – 2016
Source: Federal Reserve Bank of St. Louis, FRED database:
https://fred.stlouisfed.org/series/WALCL#0.
Quantitative Easing vs. Credit Easing (1 of 3)
Quantitative Easing v. Credit Easing
• However, short-term rate is already near zero – not clear further
action helps.
• Banks are not lending
• Money supply did not expand
Quantitative Easing vs. Credit Easing (2 of 3)
• Fed Chairman Ben Bernanke argues that the Fed has been
engaged in credit easing, actions to impact credit markets.
• How does this work?
Quantitative Easing vs. Credit Easing (3 of 3)
• Liquidity can help unfreeze markets that have seized.
• Asset purchases can lower rates on those assets, focusing on
specific markets.
Forward Guidance (1 of 4)
• By committing to maintain short-term rates near zero, future
short-term rates should also be zero, meaning long-term rates
fall.
• This is known as forward guidance.
Forward Guidance (2 of 4)
• Fed started this policy in late 2008, committing to hold rates low
through mid-2015.
• Long rates fell, although cause not clear.
Forward Guidance (3 of 4)
• Commitment to low fed funds rate is conditional, predicated on
weak economy.
• Could make an unconditional commitment to keep rates low,
regardless of the economy.
Forward Guidance (4 of 4)
• However, unconditional commitments can be tough, especially
if circumstances change. Becomes a credibility problem.
• 2003 experience confirmed this – Fed’s unconditional
commitment of low rates needed to change.
• With the unemployment rate over 6%, at its March 2014
meeting the FOMC dropped forward guidance based on
unemployment and inflation thresholds.
Negative Interest Rates on Banks’
Deposits (1 of 2)
• Central banks in Europe and Japan have started experimenting
with charging banks negative interest rates on deposits held at
the central bank.
• Sweden – 2009, Denmark – 2012, etc.
• Supposed to encourage banks to lend, as opposed to holding
deposits.
Negative Interest Rates on Banks’
Deposits (2 of 2)
• Banks could just hold cash instead of depositing money with the
central bank. But the costs of that (vaults, guards, security
systems) is high.
• Lower profitability might lead to banks to lend less.
• Results not clear. The U.S. Fed announced that it would not use
negative interest rates as a tool.
Monetary Policy Tools of the European
Central Bank
ECB policy signals by
• setting a target financing rate,
• which establishes the overnight cash rate.
The EBC has tools to implement its intended policy: (1) open
market operations, (2) lending to banks, and (3) reserve
requirements.
ECB Open Market Operations
• Like the Fed, open market operations are the primary tool to
implement the policy.
• The ECB primarily uses main refinancing operations (like
repos) via a bid system from its credit institutions.
• Operations are decentralized—carried out by each nation’s
central bank.
• Also engage in long-term refinancing operations, but not
really to implement policy.
ECB Lending to Banks
• Like the Fed, the ECB lends to its member banks via its
marginal lending facility.
• Banks can borrow at the marginal lending rate, which is 100
basis points above the target lending rate.
• Also has the deposit facility. This provides a floor for the
overnight market interest rate.
ECB Interest on Reserves
• Like the Fed, ECB has a deposit facility, where banks can store
excess cash and earn interest.
• As previously discussed, the interest rate is not always positive
(negative starting in July 2014).
ECB Reserve Requirements
• Like the Fed, ECB requires banks to hold 2% of checkable
deposits, plus a minimum reserve requirement.
• The ECB does pay interest on reserves, unlike the Fed.
Price Stability Goal & the Nominal
Anchor (1 of 3)
Policymakers have come to recognize the social and economic
costs of inflation.
• Price stability, therefore, has become a primary focus.
• High inflation seems to create uncertainty, hampering economic
growth.
• Indeed, hyperinflation has proven damaging to countries
experiencing it.
Price Stability Goal & the Nominal
Anchor (2 of 3)
• Policymakers must establish a nominal anchor which defines
price stability. For example, “maintaining an inflation rate
between 2% and 4%” might be an anchor.
• An anchor also helps avoid the time-inconsistency problem.
Price Stability Goal & the Nominal
Anchor (3 of 3)
• The time-inconsistency problem is the idea that day-by-day
policy decisions lead to poor long-run outcomes.
– Policymakers are tempted in the short-run to pursue
expansionary policies to boost output. However, just the
opposite usually happens.
– Central banks will have better inflation control by avoiding
surprise expansionary policies.
– A nominal anchor helps avoid short-run decisions.
Other Goals of Monetary Policy
• Goals
– High employment
▪ Want demand = supply, or natural rate of
unemployment
– Economic growth (natural rate of output)
– Stability of financial markets
– Interest-rate stability
– Foreign exchange market stability
• Goals often in conflict
Should Price Stability be the Primary
Goal? (1 of 4)
• Price stability is not inconsistent with the other goals in the longrun.
• However, there are short-run trade-offs.
• An increase in interest rates will help prevent inflation, but
increases unemployment in the short-run.
Should Price Stability be the Primary
Goal? (2 of 4)
• The ECB uses a hierarchical mandate, placing the goal of
price stability above all other goals.
• The Fed uses a dual mandate, where “maximizing employment,
stable prices, and moderate long-term interest rates” are all
given equal importance.
Should Price Stability be the Primary
Goal? (3 of 4)
Which is better?
• Both hierarchical and dual mandates achieve the natural rate of
unemployment. However, usually more complicated in practice.
• Also, short-run inflatio …
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