# ECN 506 Chapter 13: Chapter 13-Money and Banking

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4 Aug 2016
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Chapter 13: Economic Fluctuations, Monetary Policy and the Financial System
The Fed offsets expenditure shocks by changing real interest rates.
The monetary transmission process (shown in slide 27)is the process through which
monetary policy affects output.
The time lags between central bank actions and the results of policies make stabilizing
the economy difficult.
Problems within the financial system cause expenditure shocks, shifting the AE curve.
13.1 Monetary Policy and the Term Structure
The Fed(Bank of Canada) controls the federal funds rate, an interest rate for 1-day loans,
while economic activity is affected by intermediate (e.g., 5-year car loans) and long-term
(e.g., 10-year corporate bond) interest rates.
Changes in the federal funds rate affect longer- term interest rates through the term
structure of interest rates.
The Term Structure Again
The expectations theory states that a long-term interest rate equals the average of current
and expected one-period rates plus a term premium, n :
in(t) = (1/n)[i1(t)+ Ei1(t+1) + ... + Ei1(t+n–1)] + n
If a period is 1 day, the 1-year rate is a 365-period rate equal to the average of expected
federal funds rates over the next year plus the term premium for 1 year bonds:
i365(t) = (1/365)[i1(t)+Ei1(t+1) + ... + Ei1(t+364)] + 365
A Policy Surprise
Assume the Fed unexpectedly increases its target rate from 3% to 3.5%.
The increase in the 1-day rate is 1/365 of the 1-year rate therefore the increase is very
small.
The rate increase likely increases expected interest rates for the entire year, so the 1-year
rate increases by the amount of the increase in the overnight rate.
If additional rate increases are expected, say to 4% in 6 months, the 1-year rate increases
to 4.75% (which is the average of 3.5% and 4% plus a 1% term premium).
Page 392
Longer-Term Rates
If a surprise policy change is expected to persist for several years, the change will have a
strong impact on 5-year rates.
Any Fed action has its smallest effect on the longest term assets (e.g., 30-year bonds)
since these rates depended on expected interest rates over a very long horizon and
expected rates in the distant future are unlikely to change.
A Historical Examples
On January 21, 2008 the FOMC held a videoconference and cut rates by 0.75%, to 3.5%.
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Rates were falling faster than market participants expected, lowering their expectations of
future interest rates.
The 3-month and 2-year rates fell, but the longest term bond rates were little affected.
Page 393
Expected Policy Changes
Expected rate changes are already reflected in expected future interest rates and thus
don’t change rates.
Fed officials may signal rate changes in speeches before the rate is changed.
Bond traders may infer changes based on a likely recession or increased inflation.
The Effects of Changing Expectations
If a policy change is expected, interest rates change before the policy action.
If a rate change is expected at a future date, the 1-year rate will jump as of the date that
expectations change, which is in advance of the rate change.
13.2 The Financial System and Aggregate Expenditure
Financial markets and the banking system influence aggregate expenditure(Consumption
expenditure + Investment Expenditure+ Government Expenditure +Net Exports):
1. Events in the financial system are one of the initial causes of output fluctuations;
asset-price crashes and banking crises have caused recessions.
2. The financial system is part of the monetary transmission mechanism and central bank
actions affect asset prices and bank lending, which magnify the response of output to policy
actions.
Changes in Asset Prices
-generally an increase in asset prices raises aggregate expenditure
-AE shifts to the right output is higher for any real interest rate
-assets prices affect expenditure in several ways related to consumption and investment
Page 397, graph
-curve to the left is the opposite
Wealth and Consumption
Increases in stock prices increase people’s wealth which increases consumption
expenditure.
Rises in asset prices raises consumption
Economists estimate that a \$1.00 change in wealth changes consumption by \$0.04 (4
cents).
The increase in stock value from 1994 to 1999 increased consumption by \$270 billion,
contributing to the economic boom at that time.
Stock Prices and Investment
-changes in asset prices also affect the investment component of aggregate expenditure
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When stock prices increase, firms raise more money per share, so financing investment
by selling stock becomes cheaper.
Rising stock prices thus increase investment expenditure.
Selling fewer shares results in less dilution of existing equity shares.
Effects on Net Worth and Collateral
-changing asset prices also affect spending by changing the availability of bank loans
Higher asset prices increase the values of collateral and net worth, reducing adverse
selection and moral hazard, so banks are more willing to lend and credit rationing is
reduced.
Interest rates are lower
Greater lending increases investment.
Increased house prices increase home equity loans which increase consumption spending
(home improvements).
Changes in Bank Lending Policies
Bank lending policies change when asset prices change
Banks may be more willing to lend increasing investment or less willing, decreasing
investment; a sharp fall in lending is a credit crunch.
The three main reasons why banks change lending policies:
1. Risk perceptions change as events change assessments of default risk.
2. Regulation changes over time, becoming more or less stringent.
3. Capital requirements may force banks to reduce their assets (loans) if losses
reduce capital. They set a minimum for a bank equity ratio of capital to assets.
Capital falls if banks suffer losses for any reason, such as rise in loan defaults.
Banks must reduce their assets therefore they decrease their lending.
A capital crunch is a fall in capital that forces banks to reduce lending.
Recent Recessions
Expenditure shocks from the financial system have contributed to the last three U.S.
recessions:
-The 1990-1991 recession was due in part to a credit crunch that followed the Savings & Loan
crisis as bank capital fell and regulators tightened lending restrictions.
-Falling stock prices that many felt was the end of a bubble contributed to the 2001 recession.
-The 2007-2009 financial crisis was the worst since the Great Depression, and the many
problems contributed to a deep recession:
There were large declines in stock and house prices.
Failure and near failure of major financial institutions.
Losses on subprime mortgages and the breakdown of loan securitization
caused a credit crunch.
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