Solutions Manual for Money, Banking and Financial Markets 2024 Release By Stephen Cecchetti and Kerm by ACADEMIAMILL

SOLUTIONS MANUAL SolutionBanking Manual For Money, and Financial Markets Money, Banking and Financial Markets 2024 Release By Stephen 2024 Release By Stephen Cecchetti and Cecchetti and Kermit Schoenholtz Kermit Schoenholtz Chapter 1-23

Chapter 1 An Introduction to Money and the Financial System Problems 1. List some financial transactions you have engaged in over the past week and note how you paid for them. How might each one have been carried out 50 years ago? (LO1) Answer: Commercial purchases that you made likely used credit or debit cards. You may have split a restaurant bill with friends by using a payment app such as Venmo. Fifty years ago they would have all used cash. Payment of utilities (if you do it) might have been done by electronic transfer, rather than a check (which would have been the method 50 years ago).

2. How were you, or your family or your friends, affected by the failure of the financial system to function normally during the COVID pandemic? (LO1) Answer: While the COVID-pandemic did not lead to the widespread failure of financial institutions like the financial crisis of 2007-2009 did, the forced closure of bank branches may have changed the way you interacted with your bank. For example, you may have carried out transactions online instead of going to the bank in person. You or someone you know may have been refused a business loan or a mortgage, as financial institutions dealt with higher rates of defaults on existing loans in light of business failures and high unemployment due to the pandemic.

3. List three items you used to buy with cash but you now purchase with a debit card. (LO1) Answer: Among the possibilities: purchases of cappuccino at the local coffee shop, gasoline for your car, and groceries for the week.

4. Various financial instruments usually serve one of two distinct purposes: to store value or to transfer risk. Name a financial instrument used for each purpose. (LO1) Answer: Financial instruments used to store value include bank accounts, stocks and bonds. Instruments used to transfer risk include car insurance and life insurance. 5. Financial innovation has reduced individuals’ need to carry cash. Explain how. (LO1)

Answer: Everyone has a number of alternative methods of payment. Electronic forms, like credit and debit cards, are the primary ones that have reduced the need to carry cash. Mobile payment services, such as Venmo and Apply Pay, have also become increasingly popular. 6. * Many people believe that, despite ongoing financial innovations, cash will always be with us to some degree as a form of money. What core principle could justify this view? (LO2) Answer: Core Principle 3 – information is the basis for decisions. When cash is used to settle a transaction, it is a final payment, not some form of a promise to pay. No information is needed about the payer once cash has been handed over to settle a transaction. This has obvious advantages for the recipient, as the information costs are negligible. In some circumstances, one or both parties to a transaction may wish to preserve their anonymity, and cash allows this.

7. When you apply for a loan, you are required to answer lots of questions. Why? Why is the set of questions you must answer standardized? (LO2) Answer: The reasons for the questions relate to Core Principle 3 – information is the basis for decisions, and Core Principle 2 – risk requires compensation. The questions are aimed at figuring out how likely you are to repay the loan. Standardizing the questions reduces the cost of gathering information and therefore of making the loan.

8. Name two distinct financial markets and describe the kind of asset traded in each. (LO1) Answer: Among the best-known financial markets are those for stocks and for bonds. In the stock markets, equities or ownership shares in companies are bought and sold. In the bond market, debt issues of government units or companies are traded.

9. * Why do you think the global financial system has become more globally integrated over time? Can you think of any downside to this increased integration? (LO1) Answer: Technological progress is one obvious reason. According to Core Principle 3, information is the basis for decisions. Improvements in technology have allowed for huge volumes of information to be collected and disseminated quickly and cheaply on a global basis, facilitating long distance financial transactions. A downside of this increased integration is that it allows for problems that arise in the financial system of one country to spread more quickly and easily to other countries, as we saw during the financial crisis of 2007-2009.

10. The government is heavily involved in the financial system. Explain why. (LO1) Answer: For markets to work there have to be rules. And the rules need to be enforced. The government both makes the rules and enforces them so that we all trust the markets to work as they should. Without the government to monitor the financial system, ensuring that people behave themselves, the system would collapse. 11. If offered the choice of receiving $1,000 today or $1,000 in one year’s time, which option would you choose, and why? (LO2)

Answer: Core Principle 1 states that time has value, so you should choose option 1. By receiving the $1,000 today, you can immediately put the money to use. Perhaps you buy a new computer or put the money in the bank to earn interest. Regardless of what you do with the money, waiting a year to receive the money involves an opportunity cost.

12. If time has value, why are financial institutions often willing to extend you a 30-year mortgage at a lower annual interest rate than they would charge for a one-year loan? (LO2) Answer: With a mortgage, the house you purchase acts as collateral for the loan. In the event you default, the bank can sell the house and recoup its funds. The existence of collateral reduces the risk associated with the loan and so reduces the compensation the bank requires.

13. Using Core Principle 2, under what circumstances would you expect a job applicant to accept an offer of a low base salary and an opportunity to earn commission over one with a higher base salary and no commission potential? (LO2) Answer: The applicant would have to expect to earn a higher total salary working for a low base and commission, as they require compensation for the risk they assume due to the uncertainty about the level of commission earnings.

14. Suppose medical research confirms earlier speculation that red wine is good for you. Why would banks be willing to lend to vineyards that produce red wine at a lower interest rate than before? (LO2) Answer: The future prospects for the vineyards have improved, reducing the risk involved in lending to them. The banks require less compensation than before.

15. * If the U.S. Securities and Exchange Commission eliminated its requirement for public companies to disclose information about their finances, what would you expect to happen to the stock prices for these companies? (LO2) Answer: You should expect the stock prices to fall. Gathering sufficient information upon which to make an informed investment decision would become much more costly for investors, reducing the demand for the stock at a given price. 16. If 2 percent growth is your break-even point for an investment project, under which outlook for the economy would you be more inclined to go ahead with the investment: (1) a forecast for economic growth that ranges from 0 to 4 percent, or (2) a forecast of 2 percent growth for sure, assuming the forecasts are equally reliable? What core principle does this illustrate? (LO2) Answer: You would be more inclined to invest in the project if you knew for sure that growth would be 2%. Uncertainty about the future makes investment less attractive, as you run the risk of losing out if the lower end of the forecast is realized. This illustrates Core Principle 5 – stability improves welfare.

17. * Why are large, publicly listed companies much more likely than small businesses to sell financial instruments such as bonds directly to the market, while small businesses get their financing from financial institutions such as banks? (LO2) Answer: Information costs associated with small businesses are higher than those for large, publicly listed companies—costs that bond market investors are unlikely to be willing to incur. Banks are skilled at gathering information about borrowers and evaluating the risks associated with loans. Therefore, they are more likely to be willing to lend to smaller businesses.

18. * During the financial crisis of 2007-2009, some financial instruments that received high ratings in terms of their safety turned out to be much riskier than those ratings indicated. Explain why markets for other financial instruments might have been adversely affected by that development. (LO2) Answer: Core Principle 3 states that information is the basis for decisions. Ratings are an important source of information for investors in assessing many financial instruments, and so when confidence in that information is undermined, they are more reluctant to lend. 19. Suppose financial institutions didn’t exist but you urgently needed a loan. Where would you most likely get this loan? Using core principles, identify an advantage and a disadvantage this arrangement might have over borrowing from a financial institution. (LO2) Answer: In the absence of financial institutions, you are most likely to borrow from a family member or a friend. An advantage of this arrangement, under Core Principle 3, would be that your family and friends naturally have more information about you than a bank and know, without having you fill in copious forms, that you can be relied upon to pay them back. A disadvantage would be the necessity of finding a family member or friend who happened to have funds available to lend to you at that particular point in time. Financial institutions help bring potential borrowers and lenders in the financial market together to allocate available resources (Core Principle 4). 20. In broad terms, explain how a central bank tries to maintain economic and financial stability and encourage economic growth. (LO1) Answer: Central banks can moderate business cycle fluctuations by adjusting interest rates. They also have powerful tools to steady fragile financial systems and to support dysfunctional markets. By helping to reduce the volatility associated with business cycles and financial instability, they reduce the risks that individuals can’t eliminate on their own, allowing them to invest in the future. That promotes economic growth.

21. The Dodd-Frank Act, enacted in the United States in the aftermath of the 2007-2009 financial crisis, includes provisions aimed at enhancing the coordination of various regulatory agencies. Which two core principles might best explain these reforms? (LO2) Answer: Core Principle 3 – Information is the basis for decisions. Coordination should improve the flow of information among regulatory agencies, enabling better decision making.

Core Principle 5 – Stability improves welfare. Improved regulation as a result of greater coordination should bring greater stability to the financial system and so improve welfare.

22. Having cut its policy interest rate target range to close to zero at the onset of the COVIDpandemic, the Federal Reserve subsequently increased the target range to 5.25–5.50% in a sequence of 11 steps between March 2022 and July 2023. What might you infer from the 2022– 23 rise in the policy interest rate about the Fed’s view of the economy over this time period? (LO2) Answer: Central banks use their policy tools to promote low inflation, high growth and the stability of the financial system. The Federal Reserve’s decision to increase the target range for the policy interest rate by more than five percentage points from its historic low level reflected its concern about high inflation. 23. What steps should you take to protect yourself from identity theft and why is it important to do so in the context of the financial system? (LO3) Answer: You should protect your personal information by limiting instances when you share key information such as your social security number to situations where it is absolutely necessary, and by carefully monitoring your financial records. If your identity is stolen, others could use it to access credit in your name. * indicates more difficult problems

Data Exploration 1. Go to the FRED website (http://fred.stlouisfed.org). Register to set up your own account. Doing so will allow you to save and update graphs, alter them for submitting assignments and making presentations, and receive a notice whenever the data is updated. Answer: Sign up as indicated. 2. To begin using FRED, plot the consumer price index (FRED code: CPIAUCSL) and find the date and level of the latest monthly observation. Then plot the inflation rate as measured by the percent change from a year ago of this index. Answer: As of July 2023, the value of the index was 304.348; note that this value is subject to revision. The plot for the CPI (adjusting for any data revisions) is:

The plot for the CPI inflation rate is:

Recessions are depicted by vertical shaded bars.

3. Plot the level of real GDP (FRED code: GDPC1). Then plot the rate of economic growth as the percent change from a year ago of this index. Describe how real GDP behaves in recessions, which are denoted in the FRED graph by vertical shaded bars. If you registered on FRED (as in Data Exploration Problem 1), save the graph so that you can recall and update the graph easily when new observations become available. Answer: The graph for the level of real GDP is:

The plot of the rate of economic growth, expressed as the percentage change from year ago, is:

Real GDP usually declines in recessions and rebounds afterwards. In the 2007-2009 episode, the percentage decline of nominal was the largest since 1950 (as in the plot for problem 4 below) and for real GDP the largest since the Great Depression. The declines in the pandemic year of 2020 in both nominal and real GDP were even larger than during the 2007-2009 experience. However, they were also briefer, while the subsequent recovery was far more rapid. Indeed, the recession that started in February 2020 was highly atypical: it reflected a pandemic-driven plunge in demand for in-person services combined with temporary government lockdowns. The recovery also was atypical, reflecting an unprecedented peacetime government support for the economy.

4. Examine nominal GDP (FRED code: GDP) based on a figure showing percent change from a year ago. What was special about the behavior of nominal GDP during the financial crisis of 2007-2009 and during the 2020 pandemic compared to previous decades? Answer: The plot appears below. Unlike other recessions prior to 1960, nominal GDP fell noticeably during both the 2007-2009 financial crisis and the pandemic year of 2020.

5. Plot on one figure the percent change from a year ago of both the GDP deflator (FRED code: GDPDEF) and real GDP (FRED code: GDPC1). How does the GDP deflator link nominal and real GDP? Since the mid-1980s, does it fluctuate more or less than real GDP? Answer: The data plots with real GDP and the GDP deflator is given below:

Nominal GDP is the product of real GDP and the GDP deflator. Alternatively, real GDP is nominal GDP divided by the deflator. In simple terms, if Y is nominal GDP, P is the deflator, and Q is real GDP, then Y = PQ or equivalently Q = Y/P. Compared with earlier periods, the GDP deflator became less variable from the mid-1980s until the pandemic hit in 2020. During this period from around 1985 to 2019, it also was less volatile than real GDP. Regulationofmetabolicpathwaysthroughenzymeactivityandgeneexpression.**EnergyEfficiencyandConservation**:DiscussionontheefficiencyofATPproductionthroughaerobicrespirationcomparedtoanaer obicpathways.Energyconservationstrategiesinbiologicalsystems.**EmergingTopicsinCellularEnergy**:Introductiontocurrentresearchtopicsandadvancementsincellularenergymetabolism,suchasmetaboli cdisorders,metabolicengineering,andbiofuels.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtoenergyforcells,reinforcingunderstandingoftheprinciplesgovernin genergyacquisition,utilization,andregulationinbiologicalsystems.Chapter7providesacomprehensiveexplorationofcellularenergyprocesses,highlightingtheinterconnectedpathwaysandregulatorymechanis msthatallowcellstomaintainlifeandrespondtotheirenvironment.Itbuildsuponfoundationalknowledgeofenergymetabolismandpreparesstudentsforfurtherexplorationintophysiologicalmechanisms,genetics,a ndecologicalinteractionscoveredinsubsequentchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter7,feelfreetoask! Chapter8:CellularReproductionChapter8of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"CellularReproduction,"typicallyfocusesontheprocessesofcelldivisionandreproduction. Here’sanoverviewofwhatyoumightfindinthischapter:**IntroductiontoCellularReproduction**:Definitionofcellularreproductionastheprocessbywhichcellsdivideandreproduce,essentialforgrowth,repair,an dmaintenanceofmulticellularorganisms.**TheCellCycle**:Detailedexplorationofthecellcycle,includingitsphases:**Interphase**:G1phase(cellgrowth),Sphase(DNAreplication),G2phase(preparationford ivision).**MitoticPhase**:Mitosis(nucleardivision)andcytokinesis(divisionofthecytoplasm).**RegulationoftheCellCycle**:Mechanismsandcheckpointsthatregulatethecellcycle,ensuringaccurateDNAre plication,mitosis,andpropercelldivision.**Mitosis**:Step-bystepexplanationofmitosis,includingprophase,metaphase,anaphase,andtelophase.Roleofmicrotubules,spindlefibers,andcentriolesinchromosomesegregationandnucleardivision.**Meiosis**:Overviewofme iosisasaspecializedformofcelldivisionthatproducesgametes(spermandeggs)withhalfthechromosomenumberoftheparentcell.ComparisonofmeiosisIandmeiosisII.**SexualandAsexualReproduction**:Comp arisonofsexualreproduction(involvinggametesandgeneticrecombination)andasexualreproduction(e.g.,binaryfission,budding).Advantagesanddisadvantagesofeachreproductivestrategy.**CellCycleRegul ationandCancer**:Explanationofhowdisruptionsincellcycleregulationcanleadtocancerousgrowth.Causesofcancer(mutations,environmentalfactors)andstrategiesforcancerpreventionandtreatment.**Regul ationofCellDivision**:Discussionontheroleofregulatoryproteins(cyclins,cyclindependentkinases)incontrollingthetimingandprogressionofthecellcycle.**StemCellsandDifferentiation**:Introductiontostemcells,theirproperties(pluripotent,multipotent)androlesindevelopment,tissuerep air,andregenerativemedicine.**CellularSenescenceandAging**:Overviewofcellularsenescence,telomeres,andtheirroleinagingandagerelateddiseases.Relationshipbetweencellularreproductionandlongevity.**EmergingTopicsinCellularReproduction**:Introductiontocurrentresearchtopicsandadvancementsincellularreproduction,suchasre productivecloning,inducedpluripotentstemcells,andregenerativemedicine.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtocellularreproduction,reinforcingund erstandingoftheprocessesandsignificanceofcelldivisioninbiologicalsystems.Chapter8providesacomprehensiveexplorationofcellularreproduction,highlightingthemechanismsandregulationofcelldivision,th eimportanceofgeneticdiversitythroughsexualreproduction,andtheimplicationsofcellcycleabnormalitiesinhealthanddisease.Itbuildsuponfoundationalknowledgeofcellstructureandmetabolismandpreparesst udentsforfurtherexplorationintogenetics,developmentalbiology,andphysiologicalmechanismscoveredinsubsequentchaptersofthetextbook.Ifyouhavespecificquestionsaboutanyofthesetopicsorwouldlikem oredetailedinformationonaparticularaspectofChapter8,feelfreetoask!Chapter9:MeiosisandtheGeneticBasisofSexualReproductionChapter9of"EssentialsofBiology"bySylviaMaderandMichaelWinde lspecht,titled"MeiosisandtheGeneticBasisofSexualReproduction,"typicallyfocusesontheprocessesofmeiosis,geneticvariation,andtherolestheseplayinsexualreproduction.Here’sanoverviewofwhatyoumig htfindinthischapter:**IntroductiontoMeiosis**:Definitionofmeiosisasaspecializedtypeofcelldivisionthatproduceshaploidgametes(spermandeggs)fromdiploidgermcells.**PurposeofMeiosis**:Explanatio nofthebiologicalsignificanceofmeiosisinsexualreproduction,includingthegenerationofgeneticdiversityandthereductionofchromosomenumber.**ComparisonofMeiosisandMitosis**:Contrastbetweenmitosi sandmeiosisintermsof:Numberofdivisions(oneinmitosis,twoinmeiosis).Productionofdaughtercells(geneticallyidenticalinmitosis,geneticallyvariableinmeiosis).Roleinmulticellularorganisms(growthandrep airinmitosis,gameteproductioninmeiosis).**PhasesofMeiosis**:Detailedexplanationofthestagesofmeiosis:**MeiosisI**:ProphaseI(crossingoverandsynapsis),metaphaseI,anaphaseI,telophaseI.**MeiosisII **:Similartomitosisbutwithhaploidcells.**GeneticVariationandCrossingOver**:Mechanismsthatcontributetogeneticdiversityduringmeiosis,includingcrossingover(exchangeofgeneticmaterialbetweenho mologouschromosomes)andindependentassortmentofchromosomes.**FertilizationandGeneticDiversity**:Howfertilizationcombinesgeneticmaterialfromtwoparentstogenerateuniquegeneticcombination sinoffspring.**MendelianGeneticsandMeiosis**:IntegrationofMendelianprinciples(lawsofsegregationandindependentassortment)withmeioticprocessestoexplaininheritancepatterns.**SexChromosomes andSexDetermination**:Explanationofsexdeterminationsystems,includingXX/XY(mammals),ZZ/ZW(birds,somereptiles),andenvironmentalfactors(temperaturedependentsexdetermination).**GeneticDisordersandChromosomalAbnormalities**:Overviewofgeneticdisorderscausedbyerrorsinmeiosis,suchasnondisjunction(failureofchromosomestoseparateproperly ),trisomies(e.g.,Downsyndrome),andmonosomies.**HumanReproductionandGametogenesis**:Overviewofhumanreproductiveanatomy,gameteproduction(spermatogenesisandoogenesis),andtherolesofh ormones(e.g.,testosterone,estrogen)inreproductivedevelopment.**EmergingTopicsinMeiosisandReproduction**:Introductiontocurrentresearchtopicsandadvancementsinmeiosis,reproductivetechnologies (e.g.,invitrofertilization,geneediting),andethicalconsiderations.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtomeiosisandthegeneticbasisofsexualreproductio n,reinforcingunderstandingoftheprocessesthatunderpingeneticdiversityandinheritance.Chapter9providesacomprehensiveexplorationofmeiosis,geneticvariation,andthegeneticbasisofsexualreproduction.It buildsuponfoundationalknowledgeofcelldivision(coveredinChapter8)andpreparesstudentsforfurtherexplorationintogenetics,developmentalbiology,andevolutionaryprocessescoveredinsubsequentchapter softhetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter9,feelfreetoask!Chapter10Chapter10typicallycovers"PatternsofInherit ance"inbiologyorgenetics.Here'sageneraloverviewofwhatthischapteroftenincludes:**MendelianGenetics**:ItstartswiththebasicprinciplesofinheritanceasdiscoveredbyGregorMendel,suchasdominantandr ecessivealleles,andthelawsofsegregationandindependentassortment.**ExtensionsofMendelianGenetics**:**IncompleteDominance**:Whereneitheralleleiscompletelydominant.**Codominance**:Wher ebothallelescontributetothephenotype.**MultipleAlleles**:Genesthathavemorethantwoalleles.**PolygenicInheritance**:Traitsinfluencedbymultiplegenes.**SexlinkedInheritance**:Inheritancepatternswheregenesarelocatedonthesexchromosomes(XandYchromosomes).**PedigreeAnalysis**:Howtointerpretfamilytreestodeducepatternsofinheritanceandpredictpr obabilitiesofgenetictraitsinoffspring.**NonMendelianInheritance**:IncludesexceptionstoMendel'slawssuchasepistasis(interactionbetweengenes)andenvironmentalinfluencesongeneexpression.**GeneticDisorders**:Examplesofgeneticdiseasesan ddisorders,andhowtheyareinherited.**GeneticCounseling**:theroleofgeneticcounselorsinhelpingindividualsandfamiliesunderstandandcopewithgeneticdisordersandriskfactors.Thischapteriscrucialinunde rstandinghowtraitsarepassedfromonegenerationtothenextandthecomplexitiesinvolvedingeneticinheritancebeyondthesimpledominantandrecessivetraitsinitiallydescribedbyMendel.Chapter11of"Essentials ofBiology"bySylviaMaderandMichaelWindelspecht,titled"TheInstructionsforLife:DNAandRNA,"typicallyexploresthemolecularbasisofgeneticinformationstorageandexpression.Here’sanoverviewofwh atyoumightfindinthischapter:**IntroductiontoDNAandRNA**:DefinitionofDNA(deoxyribonucleicacid)andRNA(ribonucleicacid)asnucleicacidsthatstoreandtransmitgeneticinformationinlivingorganism s.**StructureofDNA**:DetailedexaminationofthedoublehelixstructureofDNA,including:**Nucleotides**:CompositionofDNAnucleotides(adenine,thymine,cytosine,guanine)andtheircomplementarybase pairing.**SugarPhosphateBackbone**:Phosphodiesterbondslinkingnucleotides.**AntiparallelStrands**:OrientationofDNAstrandsinoppositedirections.**DNAReplication**:OverviewoftheprocessbywhichDNAmakesc

opiesofitselfbeforecelldivision:**Enzymes**:Roleofenzymes(e.g.,DNApolymerase,helicase)inunwindingandreplicatingDNAstrands.**SemiconservativeReplication**:PreservationofoneoriginalDNAstrandineachnewdoublehelix.**RNAStructureandFunction**:ComparisonofRNAwithDNAintermsofstructureandfunction:**TypesofRNA**:m RNA(messengerRNA),tRNA(transferRNA),rRNA(ribosomalRNA),andtheirrolesinproteinsynthesis.**Transcription**:ProcessofsynthesizingmRNAfromaDNAtemplate(geneexpression).**GeneticCod eandProteinSynthesis**:Explanationofthegeneticcodeasthecorrespondencebetweennucleotidetriplets(codons)andaminoacids.Stepsinproteinsynthesis:**Transcription**:SynthesisofmRNAfromDNA.**T ranslation**:ConversionofmRNAsequenceintoaspecificsequenceofaminoacidsinaprotein.**RegulationofGeneExpression**:Mechanismsbywhichcellscontrolwhenandhowgenesareturnedonoroff,includin g:**PromotersandEnhancers**:DNAsequencesthatregulatetranscription.**TranscriptionFactors**:Proteinsthatbindtoregulatorysequencestocontrolgeneexpression.**EpigeneticModifications**:Changes ingeneexpressionwithoutalteringDNAsequence(e.g.,DNAmethylation,histonemodification).**MutationsandGeneticVariation**:Typesofmutations(e.g.,pointmutations,insertions,deletions)andtheireffect sonDNAsequenceandproteinfunction.Roleofmutationsinevolutionandgeneticdiversity.**DNATechnologyandGeneticEngineering**:ApplicationsofDNAtechnology,includingpolymerasechainreaction(P CR),genecloning,geneticmodificationoforganisms(GMOs),andgenetherapy.**GenomicsandPersonalizedMedicine**:Introductiontogenomicsasthestudyofwholegenomesanditsapplicationsinunderstandin gdiseases,predictingrisks,anddevelopingpersonalizedtreatments.**EmergingTopicsinDNAandRNA**:IntroductiontocurrentresearchtopicsandadvancementsinDNAandRNAresearch,suchasCRISPRCas9genomeediting,RNAinterference(RNAi),andsyntheticbiology.**SummaryandKeyConcepts**:ThechapterconcludeswithasummaryofkeyconceptsrelatedtoDNAandRNA,reinforcingunderstandingof themolecularbasisofgeneticinformationanditsexpression.Chapter11providesacomprehensiveexplorationofthemolecularmechanismsunderlyinggeneticinformationstorage,transmission,andexpression.Itbu ildsuponfoundationalknowledgeofcellularprocessesandpreparesstudentsforfurtherexplorationintomoleculargenetics,genomics,andbiotechnologycoveredinsubsequentchaptersofthetextbook.Ifyouhavespe cificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter11,feelfreetoask!Chapter12Chapter12:BiotechnologyandGenomicsChapter12of"EssentialsofBi ology"bySylviaMaderandMichaelWindelspecht,titled"BiotechnologyandGenomics,"typicallydelvesintotheapplicationsandimplicationsofbiotechnologyinmodernbiology,withafocusongenomics.Here’sa noverviewofwhatyoumightfindinthischapter:**IntroductiontoBiotechnology**:Definitionofbiotechnologyastheuseofbiologicalsystems,organisms,orprocessestodevelopproductsorapplicationsforvariousp urposes.**ToolsofBiotechnology**:Overviewofkeytoolsandtechniquesusedinbiotechnology,including:**RecombinantDNATechnology**:TechniquesformanipulatingDNA,suchasgenecloning,PCR(Pol ymeraseChainReaction),andgeneediting(e.g.,CRISPRCas9).**DNASequencing**:MethodsfordeterminingthepreciseorderofnucleotidesinaDNAmolecule.**GenomicLibraries**:CollectionsofclonedDNAfragmentsrepresentinganorganism'sentiregenome.** ApplicationsofBiotechnology**:Explorationofpracticalapplicationsofbiotechnologyinvariousfields:**Medicine**:Genetherapy,personalizedmedicine,productionoftherapeuticproteins(e.g.,insulin).**Agr iculture**:Geneticallymodifiedorganisms(GMOs),cropimprovement,pestresistance.**Industry**:Bioremediation,biofuels,enzymeproduction.**Forensics**:DNAfingerprinting,forensicanalysis.**Geno micsandHumanHealth**:Introductiontogenomicsasthestudyofwholegenomes,including:

**HumanGenomeProject**:Overview,goals,andimpactonunderstandinghumangeneticsanddisease.**GenomicMedicine**:Applicationsofgenomicsindiagnosis,treatment,andpreventionofdiseases(e.g.,ca ncergenomics,pharmacogenomics).**EthicalandSocialIssuesinBiotechnology**:Discussiononethicalconsiderationsrelatedtobiotechnologicaladvancements,including:**GeneticPrivacy**:Issuessurround ingtheuseandprotectionofgeneticinformation.**Bioethics**:Considerationsoffairness,access,andthepotentialconsequencesofbiotechnologicalapplications.**RegulationofBiotechnology**:Overviewofreg ulatoryframeworksandagenciesresponsibleforoverseeingbiotechnologicalresearch,development,andapplications(e.g.,FDA,USDA).**EmergingTechnologiesinBiotechnology**:Introductiontocurrentande mergingtechnologiesinbiotechnologyandgenomics,suchassyntheticbiology,CRISPRbasedgenomeediting,andbioinformatics.**ImpactofBiotechnologyonSociety**:Examinationofthebroaderimpactsofbiotechnologyonsociety,includingeconomicimplications,jobcreation,andpublicperceptio ns.**FutureDirectionsinBiotechnology**:Speculationonfuturetrendsandpotentialbreakthroughsinbiotechnology,includingapplicationsinspaceexploration,environmentalsustainability,andbeyond.**Sum maryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtobiotechnologyandgenomics,reinforcingunderstandingoftheapplications,implications,andethicalconsiderationsassociat edwithbiotechnologicaladvancements.Chapter12providesacomprehensiveexplorationofthediverseapplicationsandethicalconsiderationsofbiotechnology,withafocusongenomicsanditsimpactonvariousasp ectsofhumanhealth,agriculture,industry,andsociety.Itbuildsuponfoundationalknowledgeofmoleculargeneticsandpreparesstudentsforfurtherexplorationintoadvancedtopicsingenetics,biotechnology,andbio ethicscoveredinsubsequentchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter12,feelfreetoask!Chapter13:Muta tionsandGeneticTestingChapter13of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"MutationsandGeneticTesting,"typicallyfocusesonthenatureofmutations,theircauses,conseque nces,andtheroleofgenetictestinginidentifyinggeneticdisorders.Here’sanoverviewofwhatyoumightfindinthischapter:**IntroductiontoMutations**:DefinitionofmutationsaschangesintheDNAsequencethatca nalterthestructureandfunctionofproteinsencodedbygenes.**TypesofMutations**:Explanationofdifferenttypesofmutations:**PointMutations**:Changesinasinglenucleotide(substitutions,insertions,deletio ns).**ChromosomalMutations**:Structuralchangesinchromosomes(e.g.,deletions,duplications,inversions,translocations).**Mutagens**:Environmentalfactors(chemicals,radiation)thatcanincreasetherat eofmutations.**CausesofMutations**:Overviewofspontaneousmutations(arisingfromerrorsinDNAreplicationorrepair)andinducedmutations(causedbymutagens).**ConsequencesofMutations**:Impactof mutationsonproteinstructureandfunction:**SilentMutations**:Nochangeinaminoacidsequence.**MissenseMutations**:Changeinoneaminoacid.**NonsenseMutations**:Prematureterminationofproteins ynthesis.**FrameshiftMutations**:Insertionordeletionofnucleotides,leadingtoashiftinthereadingframe.**GeneticTesting**:DefinitionofgenetictestingastheanalysisofDNA,RNA,orchromosomestodetectg eneticvariationsassociatedwithinheriteddisordersorpredispositionstodiseases.**TypesofGeneticTesting**:Overviewofdifferentmethodsusedingenetictesting:**DiagnosticTesting**:Identificationofaspeci ficgeneticconditioninanindividual.**CarrierTesting**:Identificationofindividualscarryingrecessiveallelesforgeneticdisorders.**PredictiveandPresymptomaticTesting**:Assessmentofriskfordevelopingge neticconditionslaterinlife.**PrenatalTesting**:Screeningforgeneticdisordersinfetusesduringpregnancy.**NewbornScreening**:Testingforgeneticdisordersshortlyafterbirth.**EthicalandSocialIssuesinGe neticTesting**:Discussiononethicalconsiderationsrelatedtogenetictesting,includingprivacy,confidentiality,informedconsent,andimplicationsforindividualsandfamilies.**GeneticCounseling**:Roleofgene ticcounselorsininterpretinggenetictestresults,providinginformation,andsupportingdecisionmakingregardinggenetictestingandfamilyplanning.**GeneticDisordersandPublicHealth**:Impactofgenetictestingonpublichealthinitiatives,diseaseprevention,andmanagementofgeneticdisorders.**Emerg ingTechnologiesinGeneticTesting**:Introductiontoadvancesingenetictestingtechnologies,suchasnext-generationsequencing(NGS),wholeexomesequencing(WES),anddirect-toconsumergenetictesting.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtomutationsandgenetictesting,reinforcingunderstandingofthecauses,consequences,appli cations,andethicalconsiderationsassociatedwithgeneticvariationandtesting.Chapter13providesacomprehensiveexplorationofmutations,genetictestingtechnologies,andtheirimplicationsindiagnosing,preve nting,andmanaginggeneticdisorders.Itbuildsuponfoundationalknowledgeofmoleculargeneticsandpreparesstudentsforfurtherexplorationintopersonalizedmedicine,geneticcounseling,andethicalissuesinge neticscoveredinsubsequentchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter13,feelfreetoask!Chapter14Chapter 14of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"DarwinandEvolution,"typicallyexplorestheprinciplesofevolution,itsmechanisms,andthecontributionsofCharlesDarwintoevoluti onarytheory.Here’sanoverviewofwhatyoumightfindinthischapter:**IntroductiontoEvolution**:Definitionofevolutionastheprocessofchangeovertimeinpopulationsoforganisms,leadingtothediversityoflifeo nEarth.**Darwin'sContributions**:OverviewofCharlesDarwin'sobservationsandinsightsthatledtothedevelopmentofthetheoryofevolutionbynaturalselection:**VoyageoftheBeagle**:Darwin'stravelsandob servationsofbiodiversityandgeologicalformations.**NaturalSelection**:MechanismproposedbyDarwintoexplainhowevolutionoccursthroughdifferentialsurvivalandreproductionoforganismswithadvanta geoustraits.**EvidenceforEvolution**:Examinationofvariouslinesofevidencesupportingthetheoryofevolution:**FossilRecord**:Transitionalformsandpatternsofspecieschangeovertime.**Biogeography* *:Distributionofspeciesandsimilaritiesamongorganismsondifferentcontinents.**ComparativeAnatomy**:Homologousstructuresandvestigialorgansamongdifferentspecies.**MolecularBiology**:Similari tiesinDNA,RNA,andproteinsequencesamongorganismsindicatingcommonancestry.**MechanismsofEvolution**:Explorationofprocessesthatdriveevolutionarychange:**NaturalSelection**:Differentials urvivalandreproductionofindividualswithadvantageoustraits.**GeneticDrift**:Randomchangesinallelefrequenciesinsmallpopulations.**GeneFlow**:Movementofgenesbetweenpopulationsthroughmigr ation.**Mutation**:Sourceofnewgeneticvariation.**ModernSynthesisofEvolutionaryTheory**:IntegrationofDarwinianevolutionwithgenetics(populationgenetics),explaininghowgeneticvariationandnatu ralselectionshapeevolutionarypatterns.**PatternsandRatesofEvolution**:Examinationofevolutionarypatterns,including:**AdaptiveRadiation**:Diversificationofasingleancestralspeciesintoavarietyoffor msinresponsetodifferentenvironmentalniches.**ConvergentEvolution**:Independentevolutionofsimilartraitsindifferentlineages.**PunctuatedEquilibrium**:Periodsofrapidevolutionarychangefollowed bylongperiodsofstability.**HumanEvolution**:Overviewofhumanevolution,includingfossilevidence(e.g.,Australopithecus,Homospecies)andgeneticstudiesrevealingrelationshipsamongmodernhumanpo pulations.**EvolutionaryMechanismsandAdaptation**:Discussiononhowevolutionarymechanisms(naturalselection,geneticdrift)contributetoadaptationoforganismstotheirenvironments.**EvolutionandS peciation**:Explanationofspeciationastheprocessbywhichnewspeciesarise,includingallopatric,sympatric,andparapatricspeciation.**EmergingTopicsinEvolutionaryBiology**:Introductiontocurrentresear chtopicsandadvancementsinevolutionarybiology,suchasevolutionarydevelopmentalbiology(evodevo),molecularevolution,andthestudyofevolutionaryprocessesinresponsetoenvironmentalchanges.**SummaryandKeyConcepts**:ThechapterconcludeswithasummaryofkeyconceptsrelatedtoDarwinan devolution,reinforcingunderstandingoftheprinciples,mechanisms,andevidencesupportingevolutionarytheory.Chapter14providesacomprehensiveexplorationofevolutionarytheory,Darwin'scontributions,an dthemechanismsthatdriveevolutionarychange.Itbuildsuponfoundationalknowledgeofgeneticsandpreparesstudentsforfurtherexplorationintoecology,biodiversity,andevolutionarybiologycoveredinsubsequ entchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter14,feelfreetoask!Chapter15:EvolutiononaSmallScaleCh apter15of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"EvolutiononaSmallScale,"typicallyfocusesonevolutionaryprocessesthatoccurwithinpopulationsandspecies.Here’sanovervi ewofwhatyoumightfindinthischapter:**IntroductiontoMicroevolution**:Definitionofmicroevolutionasevolutionarychangeoccurringwithinpopulationsoverrelativelyshortperiodsoftime.**PopulationGene tics**:Overviewofpopulationgenetics,whichstudiesthedistributionandchangeofallelefrequenciesinpopulations:**GenePool**:Totalcollectionofallelesinapopulation.**HardyWeinbergPrinciple**:Mathematicalmodeldescribingallelefrequenciesinanonevolvingpopulation.**FactorsInfluencingMicroevolution**:Discussiononthemechanismsthatdrivemicroevolutionarychanges:**NaturalSelection**:Differentialsurvivalandreproductionofindividualswith advantageoustraits.**GeneticDrift**:Randomchangesinallelefrequenciesduetochanceevents,morepronouncedinsmallpopulations.**GeneFlow**:Movementofgenesbetweenpopulationsthroughmigration .**Mutation**:Sourceofnewgeneticvariation.**TypesofNaturalSelection**:Explorationofdifferenttypesofnaturalselection:**StabilizingSelection**:Selectionagainstextremes,favoringintermediatephenot ypes.**DirectionalSelection**:Shifttowardoneextremephenotypeinresponsetoenvironmentalchange.**DisruptiveSelection**:Selectionfavoringbothextremes,leadingtopolymorphism.**AdaptationandFit ness**:Definitionofadaptationastheprocessbywhichpopulationsbecomebettersuitedtotheirenvironmentsthroughnaturalselection.Measurementoffitnessastherelativereproductivesuccessofindividualswitha particulargenotype.**GeneticVariationandPolymorphism**:Explanationofgeneticvariationwithinpopulations,including:**PolygenicTraits**:Traitsinfluencedbymultiplegenes.**QuantitativeGenetics**: Studyofcomplextraitsinfluencedbymultiplegenesandenvironmentalfactors.**SpeciationandReproductiveIsolation**:Introductiontospeciationastheprocessbywhichnewspeciesarise,includingmechanismso freproductiveisolation:**PrezygoticBarriers**:Preventmatingorfertilizationbetweenspecies.**PostzygoticBarriers**:Reduceviabilityorfertilityofhybridoffspring.**PatternsofMicroevolution**:Examinat ionofevolutionarypatternsobservedinnaturalpopulations,including:**SelectivePressures**:Environmentalfactorsinfluencingadaptation.**PopulationBottlenecks**:Reductioninpopulationsizeleadingtoge neticdrift.**FounderEffect**:Geneticdriftinsmallfoundingpopulations.**HumanImpactonMicroevolution**:Discussiononhowhumanactivities(e.g.,habitatdestruction,pollution,climatechange)caninfluenc emicroevolutionaryprocessesinnaturalpopulations.**EmergingTopicsinMicroevolution**:Introductiontocurrentresearchtopicsandadvancementsinmicroevolutionarystudies,suchasevolutionaryresponsest orapidenvironmentalchangesandtheroleofepigeneticsinevolution.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtomicroevolution,reinforcingunderstandingofth emechanismsandpatternsofevolutionarychangewithinpopulations.Chapter15providesacomprehensiveexplorationofmicroevolutionaryprocesses,includingnaturalselection,geneticdrift,geneflow,andtheirro lesinshapinggeneticdiversityandadaptationwithinpopulations.Itbuildsuponfoundationalknowledgeofgeneticsandevolutionarytheory,preparingstudentsforfurtherexplorationintomacroevolution,ecological genetics,andconservationbiologycoveredinsubsequentchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter15,feelf reetoask!Chapter16:EvolutiononaLargeScaleChapter16of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"EvolutiononaLargeScale,"typicallyexploresevolutionaryprocessesthat occuroverlongertimescalesandacrosslargertaxonomicgroups.Here’sanoverviewofwhatyoumightfindinthischapter:**IntroductiontoMacroevolution**:Definitionofmacroevolutionasevolutionarypatternsan dprocessesthatoccurabovethespecieslevel,leadingtothediversificationoflifeformsovergeologictimescales.**Speciation**:Detailedexplorationofspeciation,theprocessbywhichnewspeciesarise:**Allopatric Speciation**:Geographicisolationleadingtoreproductiveisolation.**SympatricSpeciation**:Speciationoccurringwithinthesamegeographicareaduetofactorslikepolyploidyorhabitatdifferentiation.**Parapa tricSpeciation**:Speciationoccurringinadjacentbutdifferenthabitats.**PatternsofMacroevolution**:Examinationofmajorpatternsandtrendsobservedinthefossilrecordandbiologicaldiversity:**AdaptiveRadi ation**:Diversificationofasingleancestralspeciesintoavarietyofecologicalniches.**ExtinctionEvents**:Massextinctionsandtheirimpactonbiodiversity.**ConvergentEvolution**:Independentevolutionofsi milartraitsinunrelatedlineages.**EvolutionaryTrends**:Analysisofevolutionarytrendsobservedinvarioustaxonomicgroups:**Coevolution**:Reciprocalevolutionarychangesbetweeninteractingspecies(e.g .,predator-prey,host-parasite).**EvolutionaryDevelopmentalBiology(Evodevo)**:Studyofhowchangesindevelopmentalprocessescontributetoevolutionarychange.**EvolutionofComplexity**:Emergenceofcomplextraitsandbiologicalstructuresoverevolutionarytime.**Biogeogr aphy**:Explorationofthedistributionofspeciesandhowhistoricalandecologicalfactorsinfluencepatternsofbiodiversity:**ContinentalDrift**:Movementofcontinentsanditsimpactonbiogeographicpatterns.** IslandBiogeography**:Patternsofspeciesdiversityonislandsinfluencedbycolonizationandextinction.**EvolutionaryEcology**:Integrationofevolutionarybiologywithecologicalprinciples,including:**Adap tiveRadiation**:Ecologicalopportunitiesdrivingspeciation.**SpeciesInteractions**:Coevolutionaryrelationshipsandtheirecologicalandevolutionaryconsequences.**EvolutionaryDevelopment**:Discussi onontheroleofdevelopmental processesinshaping evolutionary trajectories and patternsofphenotypic variation.**Human Evolution**:Overviewofhuman evolutionary history, including fossil evidence (e.g., Australopithecus, Homo species) and genetic studies revealing relationships among modern human populations.**Emerging TopicsinMacroevolution**:Introduction tocurrent research topics and advancementsinmacroevolutionary studies, such as evolutionary responses toclimate change, genomic approaches tounderstanding macroevolution, and theroleofevolutionary theoryinconservation biology.**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related tomacroevolution, reinforcing understandingofthepatterns, processes, and implicationsofevolution at broader scales.Chapter 16 providesacomprehensive explorationofmacroevolutionary processes, including speciation, evolutionary trends, biogeography, and theintegrationofevolutionary biology with ecology and developmental biology. It builds upon foundational knowledgeofgenetics and microevolution, preparing students forfurther exploration into paleontology, evolutionary ecology, and interdisciplinary studiesinevolutionary biology coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 16, feel free toask!Chapter 16of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Evolutionona Large Scale," typically explores evolutionary processes that occur over longer time scales and across larger taxonomic groups. Here’s an overviewofwhat you might findinthis chapter:**Introduction toMacroevolution**:Definitionofmacroevolution as evolutionary patterns and processes that occur above thespecies level, leading tothediversificationoflife forms over geologic time scales.**Speciation**:Detailed explorationofspeciation, theprocess by which new species arise:**Allopatric Speciation**: Geographic isolation leading toreproductive isolation.**Sympatric Speciation**: Speciation occurring within thesame geographic area due tofactors like polyploidy or habitat differentiation.**Parapatric Speciation**: Speciation occurringinadjacent but different habitats.**PatternsofMacroevolution**:Examinationofmajor patterns and trends observedinthefossil record and biological diversity:**Adaptive Radiation**: Diversification ofasingle ancestral species intoavarietyofecological niches.**Extinction Events**: Mass extinctions and their impactonbiodiversity.**Convergent Evolution**: Independent evolutionofsimilar traitsinunrelated lineages.**Evolutionary Trends**:Analysisofevolutionary trends observedinvarious taxonomic groups:**Coevolution**: Reciprocal evolutionary changes between interacting species (e.g., predator-prey, host-parasite).**Evolutionary Developmental Biology (Evo-devo)**: Studyofhow changesindevelopmental processes contribute toevolutionary change.**EvolutionofComplexity**: Emergenceofcomplex traits and biological structures over evolutionary time.**Biogeography**:Explorationofthedistributionofspecies and how historical and ecological factors influence patternsofbiodiversity:**Continental Drift**: Movementofcontinents and its impactonbiogeographic patterns.**Island Biogeography**: Patternsofspecies diversityonislands influenced by colonization and extinction.**Evolutionary Ecology**:Integrationofevolutionary biology with ecological principles, including:**Adaptive Radiation**: Ecological opportunities driving speciation.**Species Interactions**: Coevolutionary relationships and their ecological and evolutionary consequences.**Evolutionary Development**:Discussionontheroleofdevelopmental processesinshaping evolutionary trajectories and patternsofphenotypic variation.**Human Evolution**:Overviewofhuman evolutionary history, including fossil evidence (e.g., Australopithecus, Homo species) and genetic studies revealing relationships among modern human populations.**Emerging TopicsinMacroevolution**:Introduction tocurrent research topics and advancementsinmacroevolutionary studies, such as evolutionary responses toclimate change, genomic approaches tounderstanding macroevolution, and theroleofevolutionary theoryinconservation biology.**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related

I. II.

Chapter 2

Money and the Payments System

Conceptual and Analytical Problems 1. Describe four ways you could pay for your morning cup of coffee. What are the advantages and disadvantages of each? (LO2) Answer: You could use money, a check, a debit card, or a mobile payment app. Money: This is the most likely to be accepted, but it means you have to replenish your supply periodically. Check: The least likely to be accepted, and it means you have to walk around with your checkbook. But the funds remain in your bank account for the time it takes the check to make its way through the clearing system. Debit Card: This is very convenient, and likely to be accepted. But when the electronic signal arrives at your bank later in the day, the funds are withdrawn immediately from your account.

Mobile Payment App: This is very convenient and fast, as you can complete payment with a simple tap of your mobile device. But you are vulnerable to your device running out of power and to hackers possibly accessing your information.

2. What were the major factors behind the surge in money growth, as measured by the annual percentage change in M2, during the first years of the COVID pandemic? (LO3) Answer: Two major factors were i) the fall in interest rates on other assets, reducing the opportunity cost of holding components of M2, and ii) Government payments made to households and businesses in response to the pandemic that increased bank deposits. 3. Explain how money encourages specialization, and how specialization improves everyone’s standard of living. (LO3) Answer: Without money, people have to barter to exchange goods and services. This requires a ―double coincidence of wants,‖ which makes it difficult to specialize. In the example in the text, a plumber is buying groceries; if the grocer doesn’t need a plumbing repair, but does need the outside of his store painted, the plumber may decide to paint the store in order to pay for his groceries even though it is not what he does best. When money is used, people are free to specialize in areas in which they have a comparative advantage, increasing the production of society as a whole, and improving everyone’s standard of living.

4. *Could the dollar still function as the unit of account in a totally cashless society? (LO2) Answer: Yes. Using dollars and cents to quote prices and record debts does not depend on cash being used as a means of payment. Dollars and cents may still serve as the standard measurement of value even if they are not themselves exchanged.

5. Give four examples of ACH transactions you might make. (LO2) Answer: a. You receive your paycheck as an electronic transfer from your employer’s account into your account, which may be at a bank different from your employer’s. b. You schedule your monthly electric bill payment to be made automatically. c. You make your payments on your credit card to your bank by scheduling the payment each month for the outstanding balance. d. You make your monthly car payment by arranging for the amount to be deducted from your checking account on the fourth day of each month.

6. A subset of European Union countries has adopted the euro, while the remaining member countries have retained their own currencies. What are the advantages of a common currency for someone who is traveling through Europe? (LO1) Answer: Each country has the same unit of account, making it easier for a traveler to compare prices in different countries. The traveler also saves the costs of exchanging currencies.

7. Why might each of the following commodities not serve well as money? (LO2) a. Tomatoes b. Bricks c. Cattle Answer: a. Tomatoes are perishable and thus would not serve as a store of value. b. Bricks are heavy and bulky and will break easily. In addition, even though bricks break easily, they are not easily divisible into usable units. c. Cattle are not standardized in terms of weight and other potentially important characteristics.

8. Despite the efforts of the United States Treasury and the Secret Service, someone discovers a cheap way to counterfeit $100 bills. What will be the impact of this discovery on the economy? (LO3) Answer: People will be unwilling to accept $100 bills as payment and will require payment via check, credit card, debit card, or electronic transfer instead, all of which are more costly. Theoretically, inflation could result if the supply of money was increased by a large enough amount.

9. What do you think accounts for the wide-spread adoption of mobile-based payment services in emerging economies? (LO2) Answer: In these countries, large segments of the population may have lacked access to more traditional bank-based payment mechanisms. Technological innovations enable mobile phonebased payment services to reach many people at a relatively low cost, especially those living in remote, rural areas. 10. Over a nine-year period in the 16th century, King Henry VIII reduced the silver content of the British pound to one-sixth its initial value. Why do you think he did so? What do you think happened to the use of pounds as a means of payment? If you held both the old and new pounds, which would you use first, and why? (LO1) Answer: King Henry needed silver to pay for wars. The use of pounds as a means of payment declined because people could not be sure how much silver each coin contained. People spent the new coins first since the old coins had a higher intrinsic value.

11. Under what circumstances might you expect barter to reemerge in an economy that has fiat money as a means of payment? (LO3) Answer: You might expect an economy to revert to barter when the public loses confidence in the fiat money issued by the government, perhaps because of over-use of the printing presses.

12. You visit a tropical island that has only four goods in its economy—oranges, pineapples, coconuts, and bananas. There is no money in this economy. (LO1) a. Draw a grid showing all the prices for this economy. (You should check your answer using the n(n – 1)/2 formula where n is the number of goods.) b. An islander suggests designating oranges as the means of payment and unit of account for the economy. How many prices would there be if her suggestion were followed? c. Do you think the change suggested in part b is worth implementing? Why or why not? Answer: a. There would be six prices in total. Oranges Pineapples Oranges Pineapples Pineapples/Oranges Coconuts Coconuts/Oranges Coconuts/Pineapples Bananas Bananas/Oranges Bananas/Pineapples

Coconuts

Bananas

Bananas/Coconuts

b. There would be three prices—pineapples/oranges, coconuts/oranges and banana/oranges. c. In the case of this four-good economy, there is only a small gain by using oranges as a unit of account. The gains would be significantly bigger in an economy with more goods. If the islanders think the range of goods in their economy is likely to expand, then it is probably worth implementing the change. One of the drawbacks to consider would be the danger that more people would grow oranges, due to their special status, thus pushing up the prices of the other fruits in terms of oranges.

13. Consider a fruit-growing, tropical island economy without money. Under what circumstances would you recommend the issue of a paper currency by the government of the island? What advantages might this strategy have over the use of oranges as money? (LO1) Answer: The islanders must have enough confidence in their government to accept notes backed only by a government decree that have no intrinsic value themselves. The have to believe that these notes will be widely accepted by other islanders as final payment for goods and services and in settlement of debts. They must trust that the government will not print too much of the money and undermine its value. Some advantages of paper money over commodity money in the form of oranges include: being easier to carry, longer lasting and more divisible. Most importantly, it would be the government that would control the supply of money on the island as only the government could print new notes, while any of the islanders might decide to grow more oranges.

14. What factors should you take into account when considering using the following assets as stores of value? (LO1) a. Gold b. Real estate c. Stocks d. Government bonds e. Cryptocurrencies

Answer:

a. The potential for the price of gold to rise, the ability to buy and sell gold easily and any costs associated with storage and security. b. The rate at which real estate is appreciating and is likely to appreciate in the future; how easy or difficult it is to sell real estate; the housing services you could receive from holding the real estate. c. The potential appreciation in nominal value of the stock; the historical volatility of the stock price; the volume of the stock being traded on the secondary market to gauge its liquidity. d. The rate of return on the bonds—including any potential capital gain as well as interest payments. e. The extreme volatility of the value of cryptocurrencies such as Bitcoin, and the classification of any gains for tax purposes. When assessing an asset as a store of value, the primary things to consider are the risk and return of the asset and its liquidity.

15. *Under what circumstances might money in the form of currency be the best option as a store of value? (LO3) Answer: If there were deflation in the economy, then paper currency would increase in value. When deflation occurs, overall prices in the economy are falling and so the currency you hold has more purchasing power. During periods of falling prices of goods and services, prices of assets often fall too and so currency might be an attractive option as a store of value.

16. Suppose a significant fall the price of certain stocks caused the market makers in those stocks to experience difficulties with their funding liquidity. Under what circumstances might that development lead to liquidity problems in markets for other assets? (LO3) Answer: Faced with difficulties in borrowing money, the market makers in the stocks may decide to hold more cash to ensure their ability to meet clients’ demands. This, in turn, reduces loans available for other market participants potentially causing them to alter their behavior and could lead to funding liquidity problems throughout the financial system. Moreover, to fund itself, the market maker might try to sell other assets, depressing their prices and spreading the disruption.

17. At the onset of the COVID pandemic, the Federal Reserve took actions to support the U.S. Treasury market. Why might such actions be justified? What downside might be associated with such actions? (LO3) Answer: Given the importance of the U.S. Treasury market in the global financial system, interventions to ensure its smooth functioning are consistent with the Federal Reserve’s responsibility to promote financial stability. They are also justified by the Fed’s responsibility to

indirectly support the financing of the Federal Government during times of emergency. A possible downside of such interventions, especially if such interventions become frequent, is that market participants will come to expect that the Fed will come to the rescue whenever things go wrong, encouraging more risky behavior and undermining the stability of the financial system. (This risk-taking consequence is an example of ―moral hazard‖—a concept that will be explored in more depth in Chapter 11.)

18. Provide arguments for and against the proposition that a market that settles trades via a central counterparty is preferable to one where trades are settled bilaterally. (LO3) Answer: Having a central counterparty (CCP) can expand the trading capacity of market makers by reducing their liquidity needs and can make a market safer by providing better information about risk taking of traders. On the other hand, the existence of a CCP could make a market riskier, because the failure of the CCP itself could shut down the market.

19. If money growth is related to inflation, what would you expect to happen to the inflation rates of countries that join a monetary union and adopt a common currency such as the euro? (LO3) Answer: Once countries join a monetary union, they effectively share a common money supply. Given the link between money growth and inflation, you would expect the inflation rates of these countries to converge.

20. Why might one doubt that current new forms of digital money, such as digital tokens or stablecoins, will replace more traditional fiat currencies? (LO2) Answer: Compared with more traditional fiat currencies, these private digital currencies currently do not successfully fulfill the three key functions of money—means of payment, unit of account, and store of value. The value of digital tokens such as Bitcoin have been extremely volatile, while some stablecoins have lost value relative to their target currency. 21. Is the challenge of making ―time consistent‖ policy unique to fiat-based paper money? (LO2) Answer: No. Even if the value of money is linked to a commodity such as gold, the government could abolish this current commitment at a point in the future such as in a time of crisis. For example, the United States exited the Gold Standard in 1933, allowing the price of gold to vary in dollar terms for the first time in a century.

22. How might increasing the efficiency of the payments system have a positive impact on economic activity? (LO2) Answer: Increased efficiency of the payments system means that payments can be settled more quickly and cheaply, leading to increased consumption and investment. For example, being able to receive wages more quickly can boost workers’ ability to purchase goods and services. Businesses may be more likely to expand when faced with lower fees associated with their sales. The 2023 introduction of the Federal Reserve’s FedNow service may lead to such benefits for the U.S. economy.

23. What are some of the advantages and disadvantages of a government continuing to issue paper currency in the face of widespread financial innovation? (LO3) Answer: A major advantage is that paper currency facilitates anonymity in payments, thus protecting freedom and privacy. Moreover, issuing paper currency can generate significant revenue for governments in the form of seignorage. A disadvantage is that criminals are major beneficiaries of the anonymity of cash. This is particularly true in the case of large-denomination notes.

24. Suppose people spend 30 percent of their income on food, 60 percent on housing, and 10 percent on transportation each year. Using the numbers in the table below: (LO3) a. Calculate the cost of the consumer basket for each of the three years b. Using Year 1 as the base year for the consumer price index (CPI), compute the CPI for the other years and calculate the inflation rate for Year 2 and Year 3. Year Year 1 Year 2 Year 3

Price of Food $30 $32 $38

Price of Housing $50 $52 $55

Price of Transportation $10 $12 $16

Answer a. The cost of the basket each year is calculated as: Cost of the basket = 0.3 × Price of food + 0.6 × Price of housing + 0.1 × Price of transportation Year 1: Cost of the basket = 0.3 × $30 + 0.6 × $50 + 0.1 × $10 = $40 Year 2: Cost of the basket = 0.3 × $32 + 0.6 × $52 + 0.1 × $12 = $42 Year 3: Cost of the basket = 0.3 × $38 + 0.6 × $55+ 0.1 × $16 = $46 Year

Price of Food

Price of Housing

Price of Transportation

Cost of the Basket

Consumer Price Index

Year 1 Year 2 Year 3

30 32 38

50 52 55

10 12 16

40 42 46

100 105 115

b. To calculate the inflation rate, we first need the CPI for each year. Year 1 is the base year = 100 Using the formula CPI = Cost of the basket in current year ÷ Cost of the basket in base year × 100: CPI Year 2 = 42 ÷ 40 × 100 = 105 CPI Year 3 = 46 ÷ 40 × 100 = 115 Inflation rate Year 2 = (105 – 100) ÷ 100 × 100 = 5.0% Inflation rate Year 3 = (115 – 105) ÷ 105 × 100 = 9.5% * indicates more difficult problems

Data Exploration 1. Find the most recent level of M2 (FRED code: M2SL) and of the U.S. population (FRED code: POP). Compute the quantity of money divided by the population. (Note that M2 is measured in

billions of dollars and population is in thousands of individuals.) Do you think your answer is large? Why? (LO1) Answer: In June 2023, the value of M2 was $20,890 billion. The total population was 335.05 million, resulting in M2 per capita of $62,348. This seems like a lot, but M2 includes money market mutual fund shares, money market deposit accounts, small-denomination time deposits, and demand deposits, in addition to currency in the hands of the public. It also includes holdings by businesses, in addition to households.

2. Reproduce Figure 2.3 from 1960 to the present, showing the percent change from a year ago of M2 (FRED code: M2SL). Comment on the pattern since March 2020. (LO3) Answer: The data plot of Figure 2.3 is:

Following the onset of the pandemic, the growth rate of M2 reached a record level. As the economy recovered, the growth rate fell and turned negative for the first time. Clearly, M2 growth became far more volatile following the pandemic.

3. Plot the percent change from a year ago of retail money market funds (RMFSL) from 2000 the present. On the graph, add the level of the 3-month Treasury Bill rate (TB3MS)—be sure to choose the units as ―percent‖. Using the format tool, set the y-axis position for the 3-month Treasury Rate to ―Right‖. (Check that the dates are still 2000 to present.) Interpret the pattern in these two series. What happens when interest rates are high? What happens when recessions occur? (LO3) Answer: As interest rates rise, balances in retail money market funds grow. During a recession, interest rates fall, and the growth of retail money market funds slows or even turns negative.

4. To complete payments, do you think people need more or less currency per dollar of transactions than they did 30 years ago? After stating your hypothesis, plot currency in circulation as a percent of GDP from 1990 (FRED codes: CURRSL and GDP). Was your intuition consistent with the data? What might account for the trend you observe? (LO1) Answer: With increasing use of credit and debit cards even for small purchases, it is easy to speculate that currency per dollar of transactions is falling. As the data plotted below shows, that guess is incorrect. Currency per dollar of GDP has risen over the past three decades. The increase in currency as a percentage of GDP is due to several factors. First, rising GDP both in the United States and around the world increases the demand for the U.S. currency. Indeed, a substantial amount of U.S. currency is held abroad. Second, increases in risk associated with the financial crisis of 2007-2009 may have increased the demand for safe assets, including currency. Similarly, during the pandemic in 2020, a rise in perceived risk associated with widespread layoffs and business disruptions may have also increased the attractiveness of safe assets like currency. Third, falling interest rates lower the opportunity cost of holding currency. Notably, the currency ratio fell in 2021-22 as interest rates rose amid the rapid U.S. recovery from the pandemic.

5. Plot the annual inflation rate based on the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL). Comment on the average and variability of inflation in the 1960s, the 1970s, and the most recent decade. (LO3) Answer: The indicated data plot is:

The variability of inflation in the 1960s was reasonably low in the first part of the decade, then rising with the trend of inflation toward the end. In the 1970s, inflation was highly variable and averaged well above the 1960s norm. Over the past twenty years, inflation was variable mostly during the financial crisis of 2007-2009 and following the onset of the pandemic in 2020. In general, periods with low average inflation—such as the first half of the 1960s, the long interval from the mid-1980s to the financial crisis, and the decade prior to the pandemic—also were periods of relatively low inflation variability.

III. IV.

Chapter 3

Financial Instruments, Financial Markets, and Financial Institutions Conceptual and Analytical Problems

1. As the end of the month approaches, you realize that you probably will not be able to pay the next month’s rent. Describe both an informal and a formal financial instrument that you might use to solve your dilemma. (LO1) Answer: Informal—borrow from family or friends. Formal—obtain a loan from a bank.

2. *While we often associate informal financial arrangements with poorer countries where financial systems are less developed, informal arrangements often coexist within the most developed financial systems. What advantages might there be to engaging in informal arrangements rather than utilizing the formal financial sector? (LO1) Answer: Informal financial arrangements are prevalent among certain ethnic groups in the United States, where community ties are strong. (See for example P. Bond and R Townsend (1996) ―Formal and Informal Financing in a Chicago Ethnic Neighborhood‖ Economic Perspectives, Federal Reserve Bank of Chicago, July.) Information and monitoring costs can be lower than for formal loans, as the parties to the arrangement are generally known to each other and social and cultural factors will ensure the arrangements are honored. In addition, informal arrangements are often more flexible than standardized formal loans.

3. If higher leverage is associated with greater risk, explain why the process of deleveraging (reducing leverage) can be destabilizing. (LO2) Answer: The problem arises if too many institutions try to reduce their leverage at the same time. A large number of institutions selling assets will push down asset prices. With asset values falling relative to liabilities, net worth falls, increasing leverage and prompting further asset sales, potentially destabilizing those markets.

4. The Chicago Mercantile Exchange offers many financial instruments that help manage weatherrelated risks. Consider an example based on rainfall, where parties agree that for each inch of rain over and above the average rainfall for a particular month, the seller will pay the buyer $1,000. Who could benefit from buying such a contract? Who could benefit from selling it? (LO1) Answer: Someone who benefits from above average rainfall could sell the contract, and someone who is harmed by above average rainfall should buy the contract. Crops can benefit from additional rainfall during certain times of the year, but may be harmed by too much rain at other times; so, depending on the season, farmers could be buying or selling derivatives.

Hydroelectric companies could also sell the contracts, while people who benefit from dry weather – like golf course operators – would buy them.

5. You wish to buy an annuity that makes monthly payments for as long as you live. Describe what happens to the purchase price of the annuity if (1) your age at the time of purchase goes up, (2) the size of the monthly payment rises, and (3) your health improves. (LO1) Answer: a. The number of expected monthly payments declines so the price of the annuity falls. b. The price of the annuity rises as each payment is larger. c. The purchaser is expected to live longer; the number of expected monthly payments rises so the price of the annuity rises.

6. Which of the following would be more valuable to you: a portfolio of stocks that rises in value when your income rises or a portfolio of stocks that rises in value when your income falls? Why? (LO1) Answer: A portfolio of stocks that rises in value when your income falls is more valuable because it pays off when you need it the most (when your marginal utility is high).

7. Has the distinction between direct and indirect forms of finance become more or less important in recent times? Why? (LO3) Answer: The distinction has become less important. The increasing sophistication of the financial system has led to greater institutionalization, so that even direct finance transactions usually involve a financial institution to some extent.

8. Designated market makers, who historically have provided liquidity (that is, have stood by ready to buy and sell) in markets for specific stocks, have declined in importance. Explain this decline in terms of technology and global economic integration. (LO2) Answer: Advances in technology have made it possible for investors from around the world to trade via electronic exchanges and communications networks. Large numbers of electronic buyers and sellers create sufficient liquidity to replace the activities previously provided by the designated market makers. However, complete elimination of these market makers would require near-foolproof software to match the buy and sell orders. Instead, there have been numerous examples of headline-making market disturbances associated with electronic trading mishaps. 9. The design and function of financial instruments, markets, and institutions are tied to the importance of information. Describe the role played by information in each of these three pieces of the financial system. (LO2) Answer: The design and function of financial instruments, markets, and institutions are tied to the importance of information. Financial instruments summarize essential information about the borrower. Financial markets aggregate information from many sources and communicate it widely. Financial institutions produce information to screen and monitor borrowers.

10. Suppose you need to take out a personal loan with a bank. Explain how you could be affected by problems in the interbank lending market such as those seen during the 2007-2009 financial crisis. (LO2) Answer: The strains in the interbank market pushed up interbank lending rates, which increases the cost of funds to banks and would likely lead to an increase in the rate on your personal loan. If your bank is having trouble obtaining short-term funding in the interbank market, it may decide to hold more cash and reduce lending, impacting your ability to secure a loan at all.

11. *Advances in technology have facilitated the widespread use of credit scoring by financial institutions in making their lending decisions. Credit scoring can be defined broadly as the use of historical data and statistical techniques to rank the attractiveness of potential borrowers and guide lending decisions. In what ways might this practice enhance the efficiency of the financial system? (LO3) Answer: The use of credit scoring techniques standardizes the assessment of loan applicants and reduces information costs. This allows financial institutions to lend to a broader range of borrowers and facilitates the creation of asset-backed securities based on these loans. Lending practices based on more objective criteria reduce subjectivity and discrimination in lending decisions, leading to a more efficient allocation of resources.

12. Commercial banks, insurance companies, investment banks, and pension funds are all examples of financial intermediaries. For each of these, give an example of a source of their funds and an example of their use of funds. (LO3) Answer: Commercial banks receive deposits in checking and savings accounts and borrow from other entities. The funds they receive are used to make loans and purchase government securities. Insurance companies receive premium payments, which they invest in securities or other assets to earn income until claims are paid. Investment banks charge fees for advising clients on mergers and acquisitions and for preparing new stock and bond issues for the market. They may use funds to participate in some of the initial public offerings they distribute. Pension funds receive regular contributions from companies providing for retirement promises. These funds are invested in assets that will later be used to pay retirement benefits to company employees.

13. Life insurance companies tend to invest in long-term assets such as loans to manufacturing firms to build factories or to real estate developers to build shopping malls and skyscrapers. Automobile insurers tend to invest in short-term assets such as Treasury bills. What accounts for these differences? (LO3) Answer: Automobile insurers generally need to have funds readily available when a policyholder makes a claim, and Treasury bills are highly liquid. Life insurance companies have

liabilities with a much longer horizon. A life insurance policy is expected to pay off in 30 years, say, so that assets with longer horizons correspond to their longer-term liabilities. In general, insurers can limit their risks by matching the terms of their liabilities with the terms of their assets.

14. For each pair of instruments below, use the criteria for valuing a financial instrument to choose the one with the highest value. (LO1) a. A U.S. Treasury bill that pays $1,000 in six months or a U.S. Treasury bill that pays $1,000 in three months. b. A U.S. government Treasury bill that pays $1,000 in three months or commercial paper issued by a private corporation that pays $1,000 in three months. c. An insurance policy that pays out in the event of serious illness or one that pays out when you are healthy, assuming you are equally likely to be ill or healthy. Explain each of your choices briefly. Answer: a. The T-bill that pays out in three months, as the sooner the payment the more valuable. b. The T-bill is more valuable as the likelihood of the U.S government honoring its debts is higher than a private corporation. c. The insurance policy that pays out when you are ill, as this is when the payment is most needed.

15. Arya and Mike purchase identical houses for $400,000. Arya makes a down payment of $80,000 while Mike only puts down $20,000; for each individual, the down payment is the total of their net worth and each finances the remainder of the house price with a mortgage. Assuming everything else equal, who is more highly leveraged? If house prices in the neighborhood immediately fall by 10 percent (before any mortgage payments are made), what would happen to Arya’s and Mike’s respective net worth? (LO2) Answer: Leverage is defined as borrowing to finance part of an investment. Mike is more highly leveraged as he has financed a larger part of his asset with borrowing (95 percent compared with Arya’s 80 percent). Assuming they have no other assets or liabilities, if house prices fall by 10 percent, Arya’s net worth would still be positive at $40,000 ($360,000 in assets and $320,000 liabilities) but Mike’s would be negative. He would owe $380,000 on his mortgage for a house worth $360,000.

16. *Everything else being equal, which would be more valuable to you—a derivative instrument whose value is derived from an underlying instrument with a very volatile price history or one derived from an underlying instrument with a very stable price history? Explain your choice. (LO2) Answer: The primary use of derivatives is to transfer risk from one party to another. The more volatile the price of the instrument upon which the derivative is based, the higher the risk, everything else being equal. Therefore, the derivative based on the more volatile underlying asset should have more value to you. For example, an option to buy a particular asset as some date in the future at a pre-determined price would have little value if the price of that asset never changed over time.

17. You decide to start a business selling covers for smartphones in a mall kiosk. To buy inventory, you need to borrow some funds. Why are you more likely to take out a bank loan than to issue bonds? (LO3) Answer: Issuing bonds is a form of direct finance and would require finding a buyer who would be willing to bear the information and monitoring costs associated with the loan. For a small, unknown business, these costs would usually be prohibitive. In the case of a bank loan, the lending institution becomes the counterparty to the transaction. These financial institutions overcome problems associated with asymmetric information by using their expertise to screen loan applicants and use standardized loan contracts to reduce transaction costs.

18. Splitland is a developing economy with two distinct regions. The northern region has great investment opportunities, but the people who live there need to consume all of their income to survive. Those living in the south are better off than their northern counterparts and save a significant portion of their income. The southern region, however, has few profitable investment opportunities and so most of the savings remain in shoeboxes and under mattresses. Explain how the development of the financial sector could benefit both regions and promote economic growth in Splitland. (LO2) Answer: In the absence of financial markets, resources are not being allocated to the best investment opportunities available—in this case, to the northern region. The introduction of a financial intermediary, for example, could channel the available savings from the southerners to the most productive investment opportunities that are available in the northern region. The presence of the intermediary would reduce the information costs that may have prevented the southerners lending directly to the northerners in the past. The southerners would benefit by earning a return on their savings while the northern region would benefit from the increased investment. Splitland would benefit from higher economic growth as the available resources are allocated more efficiently.

19. What would you expect to happen to investment and growth in the economy if the U.S. government decided to abolish the Securities and Exchange Commission? (LO2) Answer: The role of the Securities and Exchange Commission (SEC) is to protect investors by working to insure that all investors have access to certain information about companies. (See www.sec.gov for further details.) According to Core Principle 3 from Chapter 1, information is the basis for decisions. If the SEC were abolished, it would be more difficult for investors to make good, well-informed decisions. Capital markets would likely function less efficiently to the detriment of investment and growth.

20. Use Core Principle 3 (information is the basis for decisions) to suggest some ways in which the problems associated with the shadow banking sector during the 2007-2009 financial crisis might be mitigated in the future. (LO3) Answer: Core Principle 3 states that information is the basis for decisions. Many of the problems in the shadow banking sector during the financial crisis arose because investors and trading partners lacked information about activities of the shadow banks. Measures to improve

the transparency of shadow banking activities, through increased regulation of these institutions, for example, could help mitigate the problems that arose.

21. What risks might financial institutions face by funding long-run loans such as mortgages to borrowers (often at fixed interest rates) with short-term deposits from savers? As the manager of a financial institution, what steps could you take to reduce these risks? (LO3) Answer: If savers decide to withdraw in large numbers from the financial institution, the institution may not have sufficient funds readily available for them if the funds had been lent out as a 30year mortgage, for example. (Assume the mortgage is held on the balance sheet of the institution in question.) Moreover, long-term mortgage loans are often made at fixed interest rates while rates on short-term deposits fluctuate with the market. The financial institution faces the risk that interest rates will rise, requiring higher interest rates to be paid to continue to attract deposits while the payments received from the mortgage loans stay the same. Some strategies to reduce these risks include pooling mortgages into mortgage-backed securities and selling them or using derivative instruments to transfer the risk associated with interest rate increases. This could be done, for example, by purchasing a derivatives instrument that pays off when interest rates rise.

22. Give two examples of how greater financial inclusion might benefit a small farmer who previously did not have access to modern finance. (LO3) Answer: 1) Access to savings instruments offered by the financial system facilitates the management of risk. 2) Participation in the financial system creates information that can help judge the creditworthiness of a potential borrower and so can help the farmer borrow from a financial institution.

23. How might broader access to finance benefit a country where access was previously very limited? (LO3) Answer: Greater access to finance can boost economic growth by lowering transaction costs, facilitating the channeling of savings to the most productive uses and enabling greater specialization.

24. Secondary-market trading in stocks has become increasingly decentralized. Identify some reasons why you might expect this trend to continue. (LO2) Answer: Technological advances have mitigated the necessity to physically gather in a common location to trade. Although electronically decentralized exchange brings its own set of problems, further system and technological improvements may mitigate these disadvantages in the future. Moreover, decentralized trading avoids the operational risk associated with trading on a centralized trading floor.

* indicates more difficult problems

Data Exploration 1. The broadest stock index in the United States is the Wilshire 5000. Plot this index (FRED code: WILL5000PR) over the period from 1971 to the present. (LO2) Answer: The requested data plot is:

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR.

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. One of the broad stock indexes in the United States is the S&P 500. Plot this index (FRED code: SP500) over the past 10 years on a monthly basis (selecting ―end of period‖ data for each month under the ―aggregation method‖ in FRED). (LO2) Answer: The requested data plot is:

2. Plot the percent change from a year ago of the Wilshire 5000 (FRED code: WILL5000PR). Discuss the behavior of changes in the index before, during, and after recession periods, which are indicated by the vertical, shaded bars on the graph. (LO2) Answer: It is common for the index to fall prior to or coincident with the onset of recession and then to rise in advance of or coincident with the onset of economic expansion. However, large swings in the index occur more frequently than recessions, so they are a useful, but imperfect, device for anticipating business cycle changes. For example, the index plunge in 1987 was not followed by a recession. Similarly, the recovery after the 2001 recession includes a sustained decline of the index. During this period, accounting irregularities at failed companies like Enron and WorldCom raised concerns about the well-being of the U.S. corporate sector more generally even as the economy grew. Note that one of the largest index swings was associated with the financial crisis of 2007-2009. Importantly, despite the depth of the 2020 pandemic recession, the stock market index did not fall as much in this period as it had during the 2007-09 crisis. Moreover, during the recovery from the pandemic, the surge of the index was the largest on record. As we will see in later chapters, one reason is that unprecedented government support for the economy in 2020-21 fueled financial market expectations of a rapid economic recovery. The requested data plot is:

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR.

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. Using the data from question 1, plot the percent change from a year ago of the S&P 500 (FRED code: SP500). Discuss the behavior of changes in the index before, during, and after recession periods, which are indicated by the vertical, shaded bars on the graph. (LO2) Answer: It is common for the index to fall prior to or coincident with the onset of recession and then to rise in advance of or coincident with the onset of economic expansion. However, large swings in the index occur more frequently than recessions, so they are a useful, but imperfect, device for anticipating business cycle changes. For example, the index plunge in 2022 was not followed by a recession. Importantly, despite the depth of the 2020 pandemic recession, the stock market index did not fall as much in this period as it had during the 2007-09 crisis (not shown in the chart). Moreover, during the recovery from the pandemic, the surge of the index was the largest on record. As we will see in later chapters, one reason is that unprecedented government support for the economy in 2020-21 fueled financial market expectations of a rapid economic recovery. The requested data plot is:

3. Do changes in stock values affect the wealth of households? Beginning in 1971, plot on a quarterly basis the percent change from a year ago of the Wilshire 5000 (FRED code: WILL5000PR) and the percent change from a year ago of household net worth (FRED code: TNWBSHNO). Format the graph so that the first line is on the left scale and the second is on the right scale. Compare the two lines. (LO2) Answer: The percentage swings in household net worth are smaller in amplitude than those in the stock index. They usually move together (we say they are ―positively correlated‖), but not always (consider the late 1970s). Stocks make up only part of household wealth, the biggest component of which is housing. Note the record plunge in household wealth in the 2007-2009 financial crisis, which witnessed the largest decline in the value of housing since the 1930s in addition to the plunge of the stock index. In contrast, wealth did not fall in 2020 despite the temporary plunge of GDP. This is another atypical feature of the pandemic recession. The requested data plot is:

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR.

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. Do changes in stock values affect the wealth of households? For the past 10 years, plot on a quarterly basis the percent change from a year ago of the S&P 500 (FRED code: SP500) and the percent change from a year ago of household net worth (FRED code: TNWBSHNO). Compare the two lines. (LO2) Answer: The percentage swings in household net worth are considerably smaller in amplitude than those in the stock index. They usually move together (we say they are ―positively correlated‖), but not always. Stocks make up only part of household wealth, the biggest component of which is housing. Notably, wealth did not fall in 2020 (compared to year-ago levels) despite the temporary drop in the stock market and the first-quarter plunge of GDP. This is another atypical feature of the COVID pandemic recession. The requested data plot is:

4. The Dow Jones Industrial Average is a well-known index of equity prices but includes only 30 stocks. Consider a much broader measure of the stock market—the market value of corporate equities in nonfinancial corporations (FRED code: NCBEILQ027S)—which sums the price of each stock times the number of outstanding shares. After plotting it, comment on its pattern since the mid-1990s. (LO2) (NOTE: The series MVEONWMVBSNNCB was discontinued; It has been replaced it with the identical series NCBEILQ027S which is being maintained.) Answer: The indicated data plot is:

The equity market is very volatile and very cyclical, frequently declining in recession. There are several notable periods of volatility over the past 30 years. First, the ―Dot.Com‖ bubble that emerged in the 1990s burst spectacularly at the start of the new millennium. Second, the run-up of the market to 2007 gave way when the 2007-2009 financial crisis began. The third episode began when the pandemic hit was in the first quarter of 2020. Following each episode, stock prices rebounded. However, the pace of these rebounds varied substantially. For example, following the Dot.Com bubble, it took until 2014 for the inflationadjusted value of outstanding equities to reach the Dot.Com peak. In contrast, the rebound following the 2020 pandemic was rapid despite high inflation.

5. In Data Exploration Problem 3, you looked at changes in household net worth. In Data Exploration Problem 4 you examined stock market wealth. Aside from stock market wealth, what other assets contribute to household net worth? (LO1) Answer: While the value of housing and financial assets like equities and bonds are very important for household wealth, other components include bank deposits and the value of personal items such as automobiles.

6. The role and scale of the stock market differs across countries and over time. Plot stock market capitalization as a percent of GDP for the United States (FRED code: DDDM01USA156NWDB) and for China (FRED code: DDDM01CNA156NWDB). Comment on the relative trend since 2003. (LO2) Answer: The indicated data plot is:

World Bank, Stock Market Capitalization to GDP for United States [DDDM01USA156NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDDM01USA156NWDB. World Bank, Stock Market Capitalization to GDP for China [DDDM01CNA156NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDDM01CNA156NWDB.

The value of equity relative to GDP can vary across countries for several reasons. First, countries with less mature financial markets generally are less efficient in allocating financial capital to productive uses. Second, widespread governments restraints on private economic activity typically dampen the value of equities. Third, risk factors such as the likelihood of financial fraud, poor protection of property rights, and lax accounting standards all make investment in capital less attractive. Finally, financial illiteracy may inhibit individuals from undertaking investment activity.

Chapter 4 Future Value, Present Value, and Interest Rates

Conceptual and Analytical Problems 1. Compute the future value of $100 at a 7 percent interest rate 5, 10, and 15 years into the future. What would the future value be over these time horizons if the interest rate were 4 percent? Explain the patterns you see in your answers over different time horizons and at different interest rates. (LO1) Answer:

Future value in 5 years = $100 × (1.07)5 = $140.26 Future value in 10 years = $100 × (1.07)10 = $196.72 Future value in 15 years = $100 × (1.07)15 = $275.90 Future value in 5 years = $100 × (1.04)5 = $121.67 Future value in 10 years = $100 × (1.04)10 = $148.02 Future value in 15 years = $100 × (1.04)15 = $180.09 The future value of $100 is higher for any given time horizon when the interest rate is higher, as more is being earned each year. The future value of $100 at a given interest rate increases as we go further into the future, because longer time horizons provide additional years in which to earn interest. The additional benefit of a longer time horizon is greater when the interest rate is higher. For example, going from a 5 to a 10-year horizon, the future value increases by 40 percent when the interest rate is 7 percent, but only 22 percent when the interest rate is 4 percent. This reflects compounding.

2. Compute the present value of a $100 investment to be made 6 months, 5 years, and 10 years from now at 5 percent interest. Explain why the present value is lower the further into the future the investment is to be made. (LO1) Answer: 6 months: Present Value = 100/(1.05)0.5 = $97.59 5 years: Present Value = 100/(1.05)5 = $78.35 10 years: Present Value = 100/(1.05)10 = $61.39 Remember, you are calculating the present value of an investment to be made in the future. Notice that the exponent for the 6-months calculation is 0.5, representing one-half of one year into the future. The further into the future the investment is to be made, the more time that is available to earn interest on a current investment to reach the $100 target, and therefore the lower the present value of the $100.

3. Assuming that the current interest rate is 3 percent, compute the present value of a five-year, 5 percent coupon bond with a face value of $1,000. What happens when the interest rate goes to 4 percent? What happens when the interest rate goes to 2 percent? (LO2) Answer: Present Value for 5-year 5 percent coupon bond with face value of $1,000 (i = 3%) = $50/(1.03) + $50/(1.03)2 + $50/(1.03)3 + $50/(1.03)4 + $1,050/(1.03)5 = $1,091.59 Present Value for 5-year 5 percent coupon bond with face value of $1,000 (i = 4%) =

$50/(1.04) + $50/(1.04)2 + $50/(1.04)3 + $50/(1.04)4 + $1,050/(1.04)5 = $1,044.52 The present value falls when the interest rate rises to 4 percent. Present Value for 5-year 5 percent coupon bond with face value of $1,000 (i = 2%) = $50/(1.02) + $50/(1.02)2 + $50/(1.02)3 + $50/(1.02)4 + $1,050/(1.02)5 = $1,141.40 The present value rises when the interest rate falls to 2 percent.

4. *Given a choice of two investments, would you choose one that pays a total return of 30 percent over five years or one that pays 0.5 percent per month for five years? (LO1) Answer: To compare the investments, you need to measure their returns in the same units. One option would be to convert both these returns to annual rates. The first investment gives us an annual increase of (1.30)1/5 – 1 = 0.053873952 or 5.39 percent per year. The second one gives (1.005)12 –1 = 0.061677812 or 6.17 percent. Therefore, choose this investment that pays 0.5 percent per month for five years. Alternatively, you could convert the first investment to a monthly return: (1.30) 1/60 – 1 = 0.004382312 or 0.44 percent per month– which is lower than the 0.5 percent on the second investment. A third option would be to convert the monthly rate on the second investment into a 5-year rate: (1.005)60 – 1 = 0.348850152 or 34.88 percent, which is higher than the 30 percent on the first investment.

When converted to a common unit of measurement, we see that the second investment gives a higher return.

5. A financial institution offers you a one-year certificate of deposit with an interest rate of 3 percent. You expect the inflation rate to be 2 percent. What is the real return on your deposit? (LO3) Answer: The real interest rate equals the nominal rate less the expected rate of inflation; therefore 3% – 2% = 1%

6. Consider two scenarios. In the first, the nominal interest rate is 6 percent, and the expected rate of inflation is 4 percent. In the second, the nominal interest rate is 5 percent, and the expected rate of inflation is 2 percent. In which situation would you rather be a lender? In which would you rather be a borrower? (LO3) Answer: In the first scenario the real interest rate is 2 percent (the difference between the nominal interest rate and the expected inflation rate) and in the second the real interest rate is 3 percent. As a lender you want a high real return and so would rather lend with the real interest rate at 3 percent (when the nominal rate is 5 percent). As a borrower, you want a low real interest rate and so would rather borrow when the real rate is 2 percent (even though the nominal interest rate is 6 percent).

7. A friend has received an unexpected windfall of $10,000 and is considering whether to use the money to pay down their existing debt, on which they pay 6 percent interest, or invest it in a mutual fund. What advice would you give to your friend? (LO3) Answer: Advise your friend that, unless they can find a risk-free investment that earns more than 6 percent, they should use the funds to pay down their debt. The opportunity cost of investing the funds is the interest they are paying on the debt. It is as if they are borrowing the funds to invest at an interest rate of 6 percent and so, if the investment doesn’t yield a risk-free interest rate higher than that, it is not worth it.

8. Most businesses replace their computers every two to three years. Assume that a computer costs $2,000 and that it fully depreciates in 3 years, at which point it has no resale value and is thrown away. (LO1) a.

If the interest rate for financing the equipment is equal to i, show how to compute the minimum annual cash flow that a computer must generate to be worth the purchase. Your answer will depend on i.

b. Suppose the computer did not fully depreciate but still had a $250 value at the time it was replaced. Show how you would adjust the calculation given in your answer to part (a). c.

What if financing can only be had at a 10 percent interest rate? Calculate the minimum cash flow the computer must generate to be worth the purchase using your answer to part (a).

Answer: a. If x = minimum annual cash flow: $2,000 = x/(1 + i) + x/(1 + i)2 + x/(1 + i)3 x = $2,000 / [1/(1 + i) + 1/(1 + i)2 + 1/(1 + i)3] b. $2,000 = x/(1 + i) + x/(1 + i)2 + x/(1 + i)3 + $250/(1 + i)3 x = [$2,000 – $250/(1 + i)3] / [1/(1+ i) + 1/(1+ i)2 + 1/(1 + i)3] c. x = $2,000/[1/(1 + 0.1) + 1/(1 + 0.1)2 + 1/(1 + 0.1)3] = $804.23

9. Some friends of yours have just had a child. Thinking ahead, and realizing the power of compound interest, they are considering investing for their child’s college education, which will begin in 18 years. Assume that the cost of a college education today is $125,000. Also assume there is no inflation and no tax on interest income used to pay college tuition and expenses. (LO1) a. If the interest rate is 5 percent, how much money will your friends need to put into their savings account today to have $125,000 in 18 years? b. What if the interest rate were 10 percent?

c. The chance that the price of a college education will be the same 18 years from now as it is today seems remote. Assuming that the price will rise 3 percent per year, and that today’s interest rate is 8 percent, what will your friend’s investment need to be? d. Return to part (a), the case with a 5 percent interest rate and no inflation. Assume that your friends don’t have enough financial resources to make the entire investment at the beginning. Instead, they think they will be able to split their investment into two equal parts, one invested immediately and the second invested in 5 years. Describe how you would compute the required size of the two equal investments, made five years apart. Answer: a. PV = $125,000/(1.05)18 = $51,940.08 b. PV = $125,000/(1.10)18 = $22,482.35 c. If the price rises 3 percent per year, the cost of a college education in 18 years will be: $125,000 × (1.03)18 = $212,804.13 PV = $212,804.13/(1.08)18 = $53,254.03 d. If x is the size of each investment: $125,000 = x(1.05)18 + x(1.05)13 x = $125,000/[(1.05)18 + (1.05)13] = $29,122.13

10. You are considering buying a new house, and have found that a $100,000, 30-year fixed-rate mortgage is available with an interest rate of 7 percent. This mortgage requires 360 monthly payments of approximately $651 each. If the interest rate rises to 8 percent, what will happen to your monthly payment? Compare the percentage change in the monthly payment with the percentage change in the interest rate. (LO1) Answer: If the annual interest rate is 8 percent, then the monthly rate is (1.08)1/12 – 1 = 0.006434 Rearranging Equation A5 from the Appendix to Chapter 4 to solve for C (the monthly payment), we get: C = ($100,000 × 0.006434)/[1 – (1/(1.006434)360)] = $714. Monthly payments have risen by ($714 – $651)/$651 = 9.7% and the interest rate has risen by (8% – 7%) / 7% = 14.3%.

11. *Use the Fisher equation to explain in detail what a borrower is compensating a lender for when he pays her a nominal rate of interest. (LO3) Answer: The Fisher equation illustrates that the nominal interest rate (i) can be broken down into two components: i = r + πe, where r is the real interest rate and πe is expected inflation. Taking i to be an annual interest rate, the borrower is compensating the lender for the inflation that is expected over the coming year, as this will reduce the purchasing power of a given number of dollars. The borrower is also paying the lender a real interest rate to compensate the lender for the use of her money. The lender is foregoing the use of her money for the duration of the loan and so needs to be compensated for this opportunity cost.

12. If the current interest rate increases, what would you expect to happen to bond prices? Explain. (LO2) Answer: Interest rates and bond prices are inversely related so bond prices will fall when interest rates increase. Bond prices are the sum of the present values of the future payments associated with the bond. The higher the interest rate, the lower the present value of these payments and so their sum will also be lower. You can see this clearly from the present value formula, where the interest rate is in the denominator.

13. Which would be most affected in the event of an interest rate increase– the price of a five-year coupon bond that paid coupons only in years 3, 4, and 5 or the price of a five-year coupon bond that paid coupons only in years 1, 2, and 3, everything else being equal? Explain. (LO2) Answer: The price of the bond with the later payments will fall by relatively more. The payments are made further into the future, so the change in the interest rate has a greater impact on their present value. From the present value formula we can see, for example, that a payment made in one year is divided by (1 + i) while a payment made in five years is divided by (1 + i)5, so the impact will be bigger in the latter case.

14. Under what circumstances might you be willing to pay more than $1,000 for a coupon bond that matures in three years, has a coupon rate of 10 percent, and a face value of $1,000? (LO2) Answer: If the interest rate in the market were less than 10 percent, the present value of the payment flows associated with the bond would be higher than $1,000. You can use the present value formula to verify this. For example, suppose the interest rate were 8 percent. The present value of the payment flows associated with the bond would be 100/1.08 +100/(1.08)2 +100/(1.08)3 +1,000/(1.08)3 = $1,051.54.

15. *Approximately how long would it take for an investment of $100 to reach $800 if you earned 5 percent? What if the interest rate were 10 percent? How long would it take an investment of $200 to reach $800 at an interest rate of 5 percent? Why is there a difference between doubling the interest rate and doubling the initial investment? (LO1) Answer: Using the rule of 72, we know that if the interest rate is 5 percent, it will take 72/5 = 14.4 years for the investment to double to $200. Repeating the exercise twice more (doubling from $200 to $400 and then from $400 to $800), we see that the investment will take 43.2 years to reach $800. If the interest rate is 10 percent, it will take 72/10 = 7.2 × 3 = 21.6 years to double – exactly half the time. (You can check that your calculations are approximately correct using the future value formula. Alternatively, you could have directly solved for n in the future value formula to find the number of years needed to get to $800.) If $200 is invested at 5 percent, it will take 72/5 = 14.4 × 2 = 28.8 years reach $800 – which is more than half the time it took for $100 to reach $800 at the same interest rate. The reason lies

in the compounding – the greater interest earnings having interest paid on them in subsequent years has a bigger impact than the interest being calculated from a larger initial investment.

16. Rather than spending $100 today on paint today, you decide to save the money until next year, at which point you will use it to paint your room. If a can of paint costs $10 today, how many cans will you be able to buy next year if the nominal interest rate is 21 percent and the expected inflation rate is 10 percent? (LO3) Answer: Saving $100 today means forgoing 10 cans of paint. Since the funds grow in nominal terms by 21 percent, $121 will be available in one year. Expected inflation is 10 percent, so the anticipation is that can of paint in one year will cost $11. Thus, the number of cans that can be bought in one year will be 11 = $121 / $11. So, even though the nominal interest rate is 21 percent, forgoing the purchase of 10 cans of paint today allows purchase of only 10 percent more next year; because the real interest rate is 10 percent. Note that, in this example, the Fisher equation approximation of the real interest rate (the nominal rate less expected inflation, or 11 percent in this example) is overstated. Because the nominal interest rate and the inflation rate are both high, the additional interaction term (described in text footnote 4) subtracts 1 percent (r × π = 0.10 × 0.10 = 0.01) from the approximation.

17. Recently, some lucky person won the lottery. The lottery winnings were reported to be $85.5 million. In reality, the winner got a choice of $2.85 million per year for 30 years or $46 million today. (LO1) a. Explain briefly why winning $2.85 million per year for 30 years is not equivalent to winning $85.5 million. b. The evening news interviewed a group of people the day after the winner was announced. When asked, most of them responded that, if they were the lucky winner, they would take the $46 million up-front payment. Suppose (just for a moment) that you were that lucky winner. How would you decide between the annual installments or the up-front payment? Answer: a. $2.85 million per year is not equivalent to winning $85.5 million because of the time value of money. If you received all the money today, you could invest it and earn interest on it. Given that you don’t receive most of the money until sometime in the future, the value is less because of the foregone interest. The equivalent amount today is the sum of the present values of the sequence of payments. b. I would calculate which payment option gave me the highest present value. I would look at the market to determine the appropriate interest rate to use and calculate the PV of the installments over 30 years. I would compare this with $46 million to see what is highest. Another factor to consider would be whether the tax treatment was the same for both options. 18. You are considering going to graduate school for a one-year master’s program. You have done some research and believe that the master’s degree will add $5,000 per year to your salary for the next 10 years of your working life, starting at the end of this year. From then on, after the next 10 years, it makes no difference. Completing the master’s program will cost you $35,000,

which you would have to borrow at an interest rate of 6 percent. How would you decide if this investment in your education were profitable? (LO1) Answer: You should calculate the internal rate of return from completing the master’s program. If the IRR is greater than 6 percent, then it will be profitable. The calculation is 35,000 = 5,000/(1 + i) +5,000/(1 + i)2 +5,000/(1 + i)3 5,000/(1 + i)4 5,000/(1 + i)5 5,000/(1 + i)6 + 5,000/(1 + i)7 + 5,000/(1 + i)8 +5,000/(1 + i)9 +5,000/(1 + i)10. Using a spreadsheet or financial calculator, we find the IRR is around 7 percent. As the IRR is greater than the interest rate, it is profitable to invest in the master’s program.

19. Assuming the chances of being paid back are the same, would a nominal interest rate of 10 percent always be more attractive to a lender than a nominal rate of 5 percent? Explain. (LO3) Answer: Lenders are concerned with the real return they receive. If the higher nominal interest rate represents a higher real interest rate, then the lender will find it more attractive. If, on the other hand, the higher nominal interest rate merely reflects higher expected inflation, this may not be to the benefit of the lender. For example, a nominal interest rate of 10 percent reflecting expected inflation of 8 percent and a real interest rate of 2 percent would not be preferred by lenders over a nominal interest rate of 5 percent reflecting expected inflation of 1 percent and a real interest rate of 4 percent. It is the real, not the nominal, interest rate that matters.

20. *Your firm has the opportunity to buy a perpetual motion machine to use in your business. The machine costs $1,000,000 and will increase your profits by $75,000 per year. What is the internal rate of return? (LO2) Answer: Using the result in the appendix equation (A5) as n becomes arbitrarily large, we have PV = C / i. The price of the machine is $1,000,000 and the constant stream of profits is $75,000 per year, so the internal rate of return is i = C / P = 0.075, or 7.5 percent

21. *Suppose two parties agree that the expected inflation rate for the next year is 3 percent. Based on this, they enter into a loan agreement where the nominal interest rate to be charged is 7 percent. If inflation for the year turns out to be 2 percent, who gains and who loses? (LO3) Answer: The ex ante real interest rate is 4 percent. This is what the borrower thinks they are paying and the lender thinks they are earning. If inflation turns out to be lower than expected, say 1 percent, the ex post real interest rate will be 5 percent. This benefits the lender, as they are earning more in real terms than they anticipated. The borrower loses when inflation is lower than expected, as they are paying a higher real interest rate than they anticipated.

* indicates more difficult problems

22. You have received data relating to two countries (Country A and Country B), but the information was not clearly marked with the country name. You know that the nominal interest rate in Country A is 8 percent and in Country B it is 2 percent. You have two observations for expected inflation, 1 percent and 10 percent. Which country is more likely to have the 10%

expected inflation rate? Why? What can you say about the real cost of borrowing in that country? (LO3) Answer: Differences in nominal interest rates across countries often largely reflect differences in expected inflation. As nominal interest rates are positively related to expected inflation via the Fisher equation, it is more likely that Country A has the 10 percent expected inflation rate. This implies that the ex ante real interest rate in Country A is in negative territory at -2 percent.

23. Suppose analysts agree that the losses resulting from climate change will reach x dollars 100 years from now. Use the concept of present value to explain why estimates of what needs to be spent today to combat those losses may vary widely. Would you expect the variation to narrow or get wider if the relevant losses were 200, rather than 100, years into the future? (LO1) Answer: From the present value formula, PV = FV/(1 + i)n, we can see that the PV of a given future value will vary with the discount rate (i) used. The higher the number of years (n) into the future the cost that is being valued is, the larger the impact on the PV of using different interest rates (discount rates). Therefore, the variation in PV estimates from this source will get wider as n increases at specified interest rates. 24. If a climate change analyst applies a discount rate of 2 percent to losses expected in 300 years’ time, how much, per $1 of expected loss, might she be willing to spend today to avoid those losses? Would your answer be higher or lower if the losses were expected sooner? Explain your answer. (LO1) Answer: The present value of $1 in 300 years’ time using a discount rate of 2 percent is PV = 1/(1.02)300 = 0.3%. If the losses were expected sooner, you would expect her to be willing to spend more today to avoid those losses, as she would weight them higher. In other words, the further into the future a loss is expected, the more it is discounted, for the same reason as the sooner payments are expected to be received, the more valuable they are, everything else equal.

Data Exploration 1. How does inflation affect nominal interest rates? (LO3) a. Plot the three-month U.S. Treasury bill rate (FRED code: TB3MS) from 1960 to the present. What long-run pattern do you observe? What may have caused this pattern? b. Plot the inflation rate based on the percent change from a year ago of the U.S. consumer price index (FRED code: CPIAUCSL) from 1960 to the present. How does U.S. inflation history reflect your explanation in part (a)? Answer: a. The data plot for the U.S. three- month Treasury bill is:

Notice that this rate trended higher until peaking above 15 percent in the early 1980s and then trended lower. The rate dropped close to zero after the financial crisis of 2007-2009 and then again at the outset of the pandemic. If the Fisher equation is correct, we would expect that inflation should follow roughly the same pattern. This hypothesis is examined in part (b). b. The CPI plot is:

Notice that the pattern of CPI inflation is roughly the same, but not identical, suggesting that the real interest rate varied over time.

2. In Data Exploration Problem 1, you saw the impact of inflation in the U.S. on short-term U.S. Treasury bill rates. Now examine similar data for Brazil. (LO3) a. Plot the Brazilian Treasury bill rate (FRED code: INTGSTBRM193N). Notice the range of values and compare them with the range in the U.S. Treasury bill plot from Data Exploration Problem 1. b. Plot the inflation rate based on the percent change from a year ago of the Brazilian consumer price index (FRED code: BRACPIALLMINMEI). Comment on the inflation rate in Brazil. Download the data at a quarterly frequency to a spreadsheet (You may need to widen the spreadsheet column to see the data.) What happens to the index in the 1990–1994 period?

Answer: a. The plot for the Brazilian interest rate is:

International Monetary Fund, Interest Rates, Government Securities, Treasury Bills for Brazil [INTGSTBRM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTGSTBRM193N.

Note the high nominal interest rate in the mid-1990s compared with rates in the United States. b. The plot for Brazilian inflation is:

Organization for Economic Co-operation and Development, Consumer Price Index: All Items for Brazil [BRACPIALLMINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BRACPIALLMINMEI.

Note that inflation in the mid-1990s exceeded 4,000 percent per year (following even higher inflation several years earlier). In comparison, the nominal interest rate in the previous graph was much lower, so the expected real interest rate was highly negative. The quarterly inflation rate data in the spreadsheet are: Date 1990-01-01 1990-04-01 1990-07-01 1990-10-01 1991-01-01 1991-04-01 1991-07-01 1991-10-01 1992-01-01 1992-04-01 1992-07-01 1992-10-01 1993-01-01 1993-04-01 1993-07-01 1993-10-01 1994-01-01 1994-04-01 1994-07-01 1994-10-01

Inflation Rate 4310.2 6038.6 3871.1 1997.2 640.2 373.8 380.0 447.5 529.9 774.2 1012.3 1117.3 1191.3 1387.5 1756.9 2287.3 3104.8 4453.0 2931.6 1216.3

Price Index 0.000249505 0.000507923 0.000719464 0.001103389 0.001846794 0.002406631 0.003453450 0.006040518 0.011632951 0.021039837 0.038412821 0.073531741 0.150219326 0.312970994 0.713301410 1.755452712 4.814174705 14.249490008 21.624614787 23.107559091

3. The expected real interest rate is the rate which people use in making decisions about the future. It is the difference between the nominal interest rate and the expected inflation rate, not the actual inflation rate. How does expected inflation over the coming year compare with actual inflation over the past year? Plot the inflation rate since 1978 based on the percent change from a year ago of the U.S consumer price index (FRED code: CPIAUCSL). Add to this figure as a second line the expected inflation rate from the University of Michigan survey (FRED code: MICH). Is expected inflation always in line with actual inflation? Which is more stable? (LO3) Answer: Expected inflation tends to move with actual inflation but varies somewhat less. One reason is that actual inflation often includes temporary price disturbances (such as energy price changes) that are not expected to persist. Here is the figure:

University of Michigan, University of Michigan: Inflation Expectation [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MICH.

4. Plot the ex-ante or expected real interest rate since 1978 by subtracting the Michigan survey inflation measure (FRED code: MICH) from the three-month Treasury bill rate (FRED code: TB3MS). Plot as a second line the ex post or realized real interest rate by subtracting from the three-month Treasury bill rate (FRED code: TB3MS) the actual inflation rate based on the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL). What does it mean when these two measures are different? (LO3) Answer: The data plots are:

University of Michigan, University of Michigan: Inflation Expectation [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MICH.

The expected real interest rate is computed by subtracting from the nominal three-month Treasury bill interest rate the Michigan survey expectations. The actual or ex post real interest rate subtracts from the same nominal Treasury bill rate the actual CPI inflation rate. As the plots show, these are similar in much of the time period. However, notable and sustained differences are evident after 2008 and in the period up to 1982. These deviations represent inflation surprises (either high or low compared to expectations). When the actual real interest rate is above the expected real rate (as in the period after 2008), inflation has surprised on the low side. As a result, borrowers pay a higher real rate than they had planned, while savers receive a larger real return than they had anticipated. The opposite surprise occurred in the late 1970s. Following the 2020 pandemic, the expected real interest rate varied less than the ex post real interest rate, indicating that expectations of inflation were more stable than actual inflation. On average, actual inflation was significantly higher than expected, so the ex post real interest rate was lower than the ex ante real interest rate.

V. VI.

Chapter 5 Understanding Risk

VII. VIII.

Conceptual and Analytical Problems

1. Consider a game in which a coin will be flipped three times. For each heads you will be paid $100. Assume that the coin comes up heads with probability ⅔. (LO2) a. Construct a table of the possibilities and probabilities in this game.

b. Compute the expected value of the game. c. How much would you be willing to pay to play this game? d. Consider the effect of a change in the game so that if tails comes up two times in a row, you get nothing. How would your answers to parts a-c change? Answer: a. The first step is to list all possible outcomes for the three coin tosses (heads (H), Toss 1 Toss 2 Toss 3 H

We can see that there are four distinct options—3H and 0T, 2H and 1T, 1H and 3T and 0H.

tails (T)).

2T, and

Next, we will need to assign a probability to each of these four options, taking into account that the probability of the coin coming up heads is 2/3 (and so the probability of it coming up tails is 1/3). We do this by multiplying the probabilities of a certain outcome for each coin toss. For example, the probability of getting 3H outcomes is 2/3 × 2/3 × 2/3 = 8/27. Possibilities 1

Probability 1/27

2/9

4/9

8/27

Outcome 0 heads, 3 tails 1 head, 2 tails 2 heads, 1 tail 3 heads, 0 tails

b. Expected Value = 1/27($0) + 2/9($100) + 4/9($200) + 8/27($300) = $200 c. A person who is risk-averse will want to pay less than $200; a person who is risk-neutral will be willing to pay $200. d.

Possi biliti es

Pro babi lity

1/27

Out

P a y o f f

c o m e 3

$0 t a i l s

2/27

Tai

$10 l s ,

h e a d s , t a i l s 3

2/27

Tai

$0 l s , t a i l s , h e a d s

2/27

$0 a d s ,

t a i l s , t a i l s 5

4/9

$20 h e a d s ,

1 t a i l s 6

8/27

$30 h e a d s , 0 t a i l s

Expected Value = 1/27($0) + 2/27($100) + 2/27($0) + 2/27($0) + 4/9($200) + 8/27($300) = $185 A person who is risk-averse will want to pay less than $185; a person who is riskneutral will be willing to pay $185.

2. *Why is it important to be able to quantify risk? (LO2) Answer: Core Principle 2 tells us that risk requires compensation. In order to determine what that compensation should be—to put a price on risk—we must have some measure of it. This facilitates the transfer of risk to those who are willing to bear it. 3. You are the owner of a high-end restaurant that provides an up-scale, in-person dining experience for your customers. (LO45) Give an example of a systematic risk and an idiosyncratic risk your business might have faced during the Covid pandemic. Answer: a. The economy-wide shutdown early in the pandemic is an example of a systematic risk facing the restaurant owner—as this affected all businesses that depended on direct contact with customers. An example of an idiosyncratic risk might be, when restaurants were allowed to operate, a key member of this restaurant’s staff suffered health problems and was unable to work for an extended period. Because this risk only affected this particular restaurant, it is idiosyncratic.

4. Assume that the economy can experience high growth, normal growth, or recession. Under these conditions, you expect the following stock market returns for the coming year: (LO2, LO3) State of the Economy High Growth Normal Growth Recession

Probability

Return

0.2 0.7

+30% +12%

0.1

-15%

a. If you invest $1,000 today, how much money do you expect to have next year? (In other words, what is the expected value of a $1,000 over the coming year?) What is the percentage expected rate of return? b. Compute the standard deviation of the percentage return over the coming year. c. If the risk-free return is 7 percent, what is the risk premium for a stock market investment? d. Suppose, instead, the probabilities were 0.2, 0.6, and 0.2 for high growth, normal growth and recession, respectively. Recalculate your answers for parts a-c and comment on how they have changed. Answer: a. Expected Value = 0.2($1,000)(1 + 0.30) + 0.7($1,000)(1 + 0.12) + 0.15) = $1,129

0.1($1,000)(1 –

Expected Percentage Return = 0.2(0.30) + 0.7(0.12) + 0.1(-0.15) = 0.129, or Alternatively, [(1,129 –1,000)/1,000] × 100 = 0.129, or 12.9%

12.9%

b. Standard Deviation = 0.2(30  12.9%) 2  0.7(12  12.9%) 2  0.1(15  12.9%) 2  11.7% c. Risk Premium = 12.9% – 7% = 5.9% d. Using the same formulas as above: EV = $1,102 Expected Percentage Return = 10.2%, Standard Deviation = 14.4% Risk Premium = 3.2% The lower probability of Normal Growth and the higher probability of Recession is associated with a lower expected return and higher standard deviation of a stock market investment and a lower risk premium, when the returns associated with each state of the economy and the riskfree rate of return are unchanged.

5. Assume that the economy can experience four possible states: high growth, normal growth, recession or depression. For each of those states, you expect the following stock market returns for the coming year: State of the Economy High Growth Normal Growth Recession Depression

Probability

Return

0.20

+20%

0.60

+8%

0.15 0.05

-10% -25%

In dollar terms, what is the value at risk (over a one-year horizon at a 5 percent probability) associated with a $1,000 investment? (LO2) Answer: Value at risk (VaR) measures how much is lost in the worst possible scenario. Since the worst outcome is a loss of 25 percent, the value at risk is $250 (= $1,000 × 0.25).

6. Car insurance companies sell a large number of policies. Explain how this practice minimizes their risk. (LO5) Answer: Individual automobile accidents are uncorrelated in the sense that one person having an accident doesn’t have any effect on whether someone else will have one. By selling lots of insurance policies, the company is reducing risk by spreading it. Put another way, if each individual has a 1% chance of having an automobile accident each year, then on average one out of each 100 policyholders will make a claim in a given year. If the company sells 1,000,000 policies, then it can be reasonably sure they will face 10,000 claims.

7. Mortgages increase the risk faced by homeowners. (LO2)

a. Explain how. b. What happens to the homeowner’s risk as the down payment on the house rises from 10 percent to 50 percent. Answer: a. The mortgage is the portion of the investment financed by borrowing, it is leverage for the homeowner, and leverage increases risk. b. We know that with 10 percent down, the leverage ratio is 10 [1/ (1 – 90/100)], and with 50 percent down, it is 2 (1/ 1 – 50/100). Leverage magnifies the effect of price changes. As the down payment rises, the portion borrowed to finance the investment—the leverage—falls. A down payment of 50 percent reduces risk by a factor of 5 relative to a down payment of 10 percent.

8. Banks pay substantial amounts to monitor the risks that they take. One of the primary concerns of a bank’s ―risk managers‖ is to compute the value at risk. Why is value at risk so important for a bank (or any financial institution)? (LO2) Answer: The first concern of a bank’s management is to stay open. This means making sure that the risk of bankruptcy remains very small. That means focusing on the worst case, which is what value at risk does.

9. Explain how liquidity problems can be an important source of systemic risk in the financial system. (LO4) Answer: Lack of liquidity can make it difficult or impossible for certain firms to meet their obligations to other firms in the system. For example, if one firm cannot convert some assets to cash due to market liquidity problems, or if it cannot borrow due to funding liquidity problems, it may not be able to deliver on an obligation to another firm. This, in turn, may compromise the second firm’s ability to meet its obligations and so on, leading to system-wide problems.

10. *Give an example of systematic risk for the U.S. economy and how you might reduce your exposure to such a risk. (LO4, LO5) Answer: A recession is one kind of systematic risk facing the U.S. economy. You could diversify your investments internationally. You could hedge against a U.S.-specific risk by investing in a country whose fortunes move in the opposite direction to those of the United States. Alternatively, you could reduce your risk by spreading your portfolio across a broad range of countries whose fortunes are independent of each other.

11. For each of the following events, explain whether it represents systematic risk or idiosyncratic risk and explain why. (LO4) a. Your favorite restaurant is closed by the county health department.

b. The government of Spain defaults on its bonds, causing the breakup of the euro area. c. Freezing weather in Florida destroys the orange crop. d. Solar flares destroy earth-orbiting communications satellites, knocking out cellphone service worldwide. Answer: a. This is idiosyncratic risk since it is unique to this particular establishment. b. This is a systematic risk that affects entire economies within the euro area and beyond. c. This is idiosyncratic risk as only one of several orange-growing areas in the country is affected. For example, orange groves in California are not damaged by the Florida freeze. d. This is systematic risk as communications around the globe are disrupted, perhaps until new satellites can be constructed and put into orbit. 12. You are planning for retirement and must decide whether to purchase only your employer’s stock for your 401(k) or, instead, to buy a mutual fund that holds shares in the 500 largest companies in the world. From the perspective of both idiosyncratic and systematic risk, explain how you would make your decision. (LO4, LO5) Answer: From both perspectives, you should purchase the more highly diversified portfolio containing the 500 large companies. If you own only your company’s stock, your retirement savings could be permanently lowered by an idiosyncratic risk to the firm. If you hold the diversified portfolio, even if your employer is one of the 500 companies in the mutual fund, only a small portion of your savings is affected. In the event of systematic risk, the percentage decline in the price of your employer’s stock may be similar to that of the broad portfolio since all companies face the same challenge. In neither case would you expect to be worse off holding the mutual fund, but you would be better protected against idiosyncratic risk.

13. For each of the following actions, identify whether the method of risk assessment motivating your action is due to the value at risk or the standard deviation of an underlying probability distribution. (LO2) a. You buy life insurance. b. You hire an investment advisor who specializes in international diversification in stock portfolios. c. In your role as a central banker you provide emergency loans to illiquid intermediaries. d. You open a kiosk at the mall selling ice cream and hot chocolate. Answer: a. Life insurance only pays off when you die and your heirs are left without your regular paycheck, presumably the worst outcome. So this is an example of a value at risk assessment.

b. You are taking steps to reduce idiosyncratic risk in a portfolio, attempting to minimize the variability of the portfolio’s value for a given expected return. It is an example of using the underlying probability distribution as the basis for the decision. c. Emergency loans to support the financial system are an attempt to avoid the worst outcome, and can be motivated by a value at risk assessment. d. You are trying to smooth out the earnings of the business across seasons. This is an example of using the seasonal probability distributions for both ice cream and hot chocolate sales to lower idiosyncratic risk.

14. Which of the following investments in the following table would be most attractive to a risk-averse investor? How would your answer differ if the investor were described as risk neutral? (LO3) Investment A B C

Expected Value 75 100 100

Standard Deviation 10 20 10

Answer: A risk-averse investor requires a higher return for taking on more risk. This investor will also prefer an investment with a higher expected value given a certain level of risk. Therefore, a risk-averse investor will prefer Investment C, as it yields a higher expected value than Investment A and the same expected value as Investment B for a lower level of risk, as measured by the standard deviation. A risk neutral investor is concerned only with the expected return of the investment and so would be indifferent between Investments B and C.

15. Consider an investment that pays off $800 or $1,400 per $1,000 invested with equal probability. Suppose you have $1,000 but are willing to borrow to increase your expected return. What would happen to the expected value and standard deviation of the investment if you borrowed an additional $1,000 and invested a total of $2,000? What if you borrowed $2,000 to invest a total of $3,000? (LO2) Answer: If you just invest your own $1,000, the expected value = 0.5($800) + 0.5($1,400) = $1,100, or 10% and the standard deviation = 300. If you borrow an additional $1,000, the expected value = 0.5($1,600-$1,000) + 0.5($2,800$1,000) = $1,200, or 20%. You have doubled the expected return. The standard deviation = √ deviation has also doubled.

= 600. The standard

If you borrowed $2,000 to invest a total of $3,000, the expected value = 0.5($2,400-$2,000) + 0.5($4,200-$2,000) = $1,300, or 30%. You have tripled the expected return versus the unleveraged investment.

The standard deviation = √ deviation has tripled versus the unleveraged investment.

= 900. The standard

You can confirm your answer using the leverage ratio: In the first case, the owner’s contribution to the purchase is $1 for each $1 invested, so the leverage ratio is 1. In the second case, you contribute half of the cost of the total investment, so the leverage ratio is 1/0.5 = 2, or $2,000/1,000 = 2. The expected value and standard deviation are increased by a factor of 2 —or doubled. In the third case, you contribute one third of the cost of the total investment, so the leverage ratio is 1/0.3333 = 3. The expected value and standard deviation are tripled.

16. Suppose an investment pays off $800 or $1,600 with equal probability per $1,000 invested. What is the maximum leverage ratio you could have and still have enough to repay the loan in the event the bad outcome occurred? (LO1) Answer: The bad outcome pays off $800 per $1,000 invested, so you lose $200 per $1,000 invested. Therefore, the maximum leverage ratio you could have is 5. Borrowing $4,000 would give a total investment of $5,000. In the event of the bad outcome, the payoff would be ($800 × 5) = $4,000—just enough to repay the loan. You would lose all of your own $1,000.

17. Consider two possible investments whose payoffs are completely independent of one another. Both investments have the same expected value and standard deviation. If you have $1,000 to invest, explain why you would benefit from dividing your funds between these investments? (LO5) Answer: Even though the investments have the same standard deviation, by spreading your $1,000 across both of them, you reduce your risk. Intuitively, you are adding combinations of possible payoffs that lie between the worst- and best-case scenarios and so the probabilityweighted spread of the possible payoffs is smaller. Mathematically, the variance of the payoffs is halved.

18. *Suppose you identify 10 possible investments whose payoffs are completely independent of one another. All the investments have the same expected value and standard deviation. You have $1,000 to invest. In terms of risk, would the benefit of spreading your $1,000 across all 10 investments be the same, greater or smaller compared with dividing your funds between just two investments? (LO5) Answer: The gains from spreading would be larger if you spread the $1,000 across ten investments. The risk, as measured by the variance of the payoffs, is inversely related to the number of independent investments, n. The more you spread the investment, the greater the number of possible payoffs combinations you add and, therefore, the lower the variance of the payoffs. This is the benefit of diversification.

19. You are considering three investments, each with the same expected value and each with two possible payoffs. The investments are sold only in increments of $500. You have $1,000 to invest and so you have the option of either splitting your money equally between two of the investments or placing all $1,000 in one of the investments. If the payoffs from Investment A are independent of the payoffs from Investments B and C and the payoffs from B and C are perfectly negatively correlated with each other (meaning when B pays off, C doesn’t and vice versa), which investment strategy will minimize your risk? (LO5) Answer: You should put $500 into each of B and C. Because one pays off when the other doesn’t, you eliminate your risk by hedging. Spreading your investment across A and either B or C would reduce your risk compared with investing all $1,000 in one investment but would not eliminate it.

20. In which of the following cases would you be more likely to decide whether to take on the risk involved by looking at a measure of the value at risk? (LO2) a. You are unemployed and are considering investing your life savings of $10,000 to start up a new business. b. You have a full-time job paying $100,000 a year and are considering making a $1,000 investment in stock of a well-established, stable company. Explain your reasoning. Answer: You should be more concerned about the value at risk - a measure of the worse possible loss with a given probability—in case a. Experiencing that loss would likely have dire consequences. In the second case, even in the unlikely event that the investment lost all its value, the outcome would not be catastrophic.

21. You have the option to invest in either Country A or Country B but not both. You carry out some research and conclude that the two countries are similar in every way except that the returns on assets of different classes tend to move together much more in Country A—that is, they are more highly correlated in country A than in Country B. Which country would choose to invest in and why? (LO5) Answer: You should invest in Country B as the benefits from diversification are greater than in Country A. If everything else is equal, spreading your risk across different asset classes brings greater benefit when the correlation among the returns is lower.

22. The imposition of new trade tariffs has resulted in tensions between the United States and some of its major trading partners. Suppose you are a small business owner in the United States. (LO3, LO4) a. How would you classify the risk of a U.S. economic downturn that results from such trade conflict? b. Do you think a strategy to reduce this risk through hedging or spreading risk within the U.S. economy would be successful? Explain your answer. Answer:

a. The prospect that the U.S. economy would suffer a downturn as a result of protectionist trade policies is an example of systematic risk. Systematic risk is economywide, rather than being specific to one firm or a small group of firms. The potential harm to economic growth would affect firms across the entire economy. b. Hedging and spreading risk are strategies that can be employed to manage idiosyncratic risks, but not systematic risk. Given the economywide nature of a macroeconomic downturn, it is unlikely that you would find a way to hedge by assuming an opposing risk. Consequently, the benefits of spreading risk within the U.S. economy would likely be limited. However, for certain firms, in addition to the macroeconomic risk of a downturn, there may be idiosyncratic risks for which risk management strategies would be effective.

23*The rise in wealth inequality in the United States has reduced the capacity of much of the population to cope with transitory income shocks. How might you expect that to impact workers’ preferences between fixed-salary jobs versus jobs with a low base salary and the potential for high commission-based earnings? (LO2, LO3) Answer: Without the ability to smooth negative income shocks by spending out of wealth, you might expect workers to become increasingly risk-averse, making fixed-salary jobs relatively more attractive. In the absence of a cushion from wealth, the consequences of a temporary income shortfall could be materially worse. For example, if commissions are very low, a worker without sufficient wealth to compensate for the dip in income might have their car repossessed, or be unable to pay their mortgage. Put differently, their perceived value-at-risk may be higher in the face of greater wealth inequality. * indicates more difficult problems

Data Exploration 1. Plot the percentage change from a year ago of the Wilshire 5000 stock index at a monthly frequency (FRED code: WILL5000PR). Visually, has the risk of the Wilshire 5000 index changed over time? (LO2) Answer: Visual examination of the plot below does not show any obvious change in the percentage volatility of stock prices. If this is approximately correct, then the variance or standard deviation of the index in percentage terms is a useful indicator of the risk.

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR. The following link produces an automatically updated graph: https://fred.stlouisfed.org/graph/?g=1970k

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. For the past 10 years, plot the percentage change from a year ago of the S&P 500 stock index at a monthly frequency (FRED code: SP500). Visually, has the risk of the S&P 500 index changed over this time period? (LO2) Answer: Visual examination of the plot below suggests that volatility increased following the 2020 COVID pandemic. Indeed, the standard deviation of the annual percent change of the S&P 500 doubled from 8.4% in 2015-2019 to 17.2% in 2020-2024. In practice, the standard deviation (or variance) can be a useful measure of risk. Indeed, the combination of the 2020 COVID pandemic and the 2022 Russian invasion of Ukraine probably added to the risk in the stock market (and other long-term assets).

2. Another way to understand stock market risk is to examine how investors expect risk to evolve in the near future. The DJIA volatility index (FRED code: VXDCLS) is one such measure. Plot the level of this volatility index at a monthly frequency since October 1997 and as a second line, the percent change from a year ago of the Wilshire 5000 index, also at a monthly frequency (FRED code: WILL5000PR). Compare their patterns. (LO2) Answer: The plot shows several spikes in the DJIA volatility index, usually in periods when the Wilshire 5000 index is falling. For example, the volatility index peaked at nearly 60% in the crisis of 2007-2009, a pattern repeated at the onset of the pandemic of 2020. In contrast, the volatility index is usually low when the stock market index is rising (see the periods between 2003 and 2007 and between 2010 and 2019). The causal relationship between expectations and market price swings can vary over time: falling stock prices encourage investors to revise upward their expectations of near-term market risks, but rising expectations of market risk also depress stock market prices. More information would be needed to distinguish these alternatives.

Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR. Chicago Board Options Exchange, CBOE DJIA Volatility Index© [VXDCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VXDCLS.

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. Another way to understand stock market risk is to examine how investors expect risk to evolve in the near future. The CBOE Nasdaq 100 volatility index (FRED code: VXNCLS) is one such measure. Plot the level of this volatility index at a monthly frequency since 2000 on the right axis and, as a second line on the left axis, plot the percent change from a year ago of the Nasdaq 100 index, also at a monthly frequency (FRED code: NASDAQ100). Compare their patterns. (LO2) Answer: The plot shows several spikes in the Nasdaq 100 volatility index, usually in periods when the Nasdaq 100 index is falling. For example, the volatility index peaked above 50% in the 2001 recession, in the crisis of 2007-2009, and at the onset of the pandemic of 2020. In contrast, the volatility index is usually low when the stock market index is rising (see the periods between 2004 and 2007 and between 2012 and 2019). The causal relationship between expectations and market price swings can vary over time: falling stock prices encourage investors to revise upward their expectations of near-term market risks but rising expectations of market risk also depress stock market prices. More information would be needed to distinguish these alternatives.

Chicago Board Options Exchange, CBOE DJIA Volatility Index© [VXDCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VXDCLS.

3. Uncertainty matters greatly for the economy, and there are many ways to measure it, including surveys, news reports, and stock market volatility. To see one such measure, plot on a monthly basis since 1985 the Infectious Disease Equity Market Volatility Tracker (FRED code: INFECTDISEMVTRACKD). What does it tell you about the impact on uncertainty of the COVID pandemic, which has infected more than 100 million people in the United States? How does that compare to the 2009 H1N1 flu, which infected more than 60 million people? What might account for the difference? Answer: The Disease Equity Market Volatility Tracker peaked at 65.2 in May 2020. This is more than five times the prior peak of 12.55 in December 2014, when there was an outbreak of bird flu. So, the tracker is telling us that disease-related uncertainty, measured on the basis of equity market volatility, was at a new record high in 2020. No less important, the 2020 COVIDpandemic driven jump in uncertainty persisted for years, so that even at the start of 2024 the residual impact of the 2020 COVID pandemic on the Volatility Tracker exceeded the 2014 peak. The H1N1 flu (also known as the swine flu) first emerged in the spring of 2009. During that initial episode, the tracker rose only as high as 5.01, slightly below the highest reading on record at the time—5.36 in November 1997—and far lower than what was then still to come in 2020. The differences between these two episodes—2009 and 2020—reflect the much deeper and more prolonged impact of the COVID pandemic on prospects for economic growth. A combination of unprecedented supply- and demand-driven economic disruptions—associated in part with shutdowns of large parts of the economy, with uncertainty about the timing of reopening, and with ongoing worries about viral mutations that could render treatment

ineffective—naturally also effected the stock market prices that form the basis for the Infectious Disease Equity Market Volatility Tracker. The COVID experience also highlighted the ongoing vulnerability of the global economy to future novel viruses. 4. Plot the difference since 1979 between the Moody’s Baa bond index (FRED code: WBAA) and the U.S. Treasury 10-year bond yield (FRED code: GS10). (Note that you first will need to convert the weekly Baa index to a monthly average using the ―Edit Graph‖ tool.) Comment on the trend and variability of this ―credit risk premium‖ (see Chapter 7) amid the 2007-2009 financial crisis and when the COVID pandemic hit in 2020. (LO1) Answer: The data plot is:

Moody's Seasoned Baa Corporate Bond Yield©, copyright, 2017, Moody's Investor Services, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WBAA.

Baa bonds are corporate issues with a higher probability of default than for government bonds, so the yield difference is an indicator of default risk. This ―credit risk premium‖ rose sharply during the 2007-2009 financial crisis. It slid again after the crisis but for several years remained somewhat elevated compared to past periods of economic expansion. When the pandemic hit in 2020, the credit risk premium jumped again, but the increase was far smaller than in 2007-09, and the premium quickly returned to a low level. This more benign pattern partly reflects the government’s unprecedented policy response to the pandemic that helped to limit investor expectations of corporate defaults despite the deep recession. (NOTE: The series BAA now brings up daily frequency and only extends back to 1986. As the question asked for data from 1979, in the Data Exploration Hints, we suggest starting with WBAA (the weekly analog) and then adjust to monthly.)

Chapter 6 Bonds, Bond Prices, and the Determination of Interest Rates IX.

Conceptual and Analytical Problems 1. Consider a U.S. Treasury Bill with a face value of $100 and 270 days to maturity. If the annual yield is 3.8 percent, what is the price? (LO1) Answer: P 

$100  $97.24 (1  0.038) 9 / 12

2. *You are an officer of a commercial bank and wish to sell one of the bank’s assets—a car loan—to another bank. Using equation A5 in the appendix to Chapter 4, compute the price you expect to receive for the loan if the annual interest rate is 6 percent, the car payment is $430 per month, and the loan term is five years. (LO1) Answer: The present value of the payments can be found by using equation A5 in the appendix to Chapter 4: PV = [

]

The monthly payment, C, is given as $430 per month and there are 60 months in the five-year horizon. The annual interest rate is 6 percent, so the monthly rate in decimal form is im = (1.06)1/12 – 1 = .00487 Thus, the value of the car loan is PV =

[

] = $22,326

3. *Your financial adviser recommends buying a 10-year bond with a face value of $1,000 and an annual coupon of $80. The current interest rate is 7 percent. What might you expect to pay for the bond (aside from brokerage fees)? (LO1) Answer: The value of the bond has two components: the present value of the coupon payments and the present value of the return of principal at maturity. The present value of the coupon payments can be found by using equation A5 in the appendix to Chapter 4 and gives the first component of the expression. The second component represents the present value of the principal in 10 years’ time. The price of the bond is: P= [

In this expression, C is the coupon payment, i is the interest rate, n is the number of periods the coupon payments are made, and F is the face value. Using the information in the question, we have P=

[

= 561.89 + 508.35 = 1,070.24

4. *Consider a coupon bond with a $1,000 face value and a coupon payment equal to 5 percent of the face value per year. (LO2) a.

If there is one year to maturity, find the yield to maturity if the price of the bond is $990.

Explain why finding the yield to maturity is difficult if there are two years to maturity and you do not have a financial calculator. Write down the formula you would use to make the calculation.

Answer: a. The yield to maturity can be found by equating the current price of the bond to the present value of the coupon payment plus the present value of the face value when both payments are due in one year. Specifically, 990 = Then (1 + i) =

= 1.061

so that i = 0.061 or 6.1 percent. b. If there are two years to maturity, then we would need to solve 990 = The presence of the quadratic term makes this equation much more time-consuming to solve without a financial calculator. Using a calculator, we see that the yield to maturity in this case is 5.5%.

5. Calculate the yield to maturity for each of the following one-year coupon bonds. All three bonds have a face value of $100. Explain why the first bond has the highest yield to maturity despite having the lowest coupon rate. (LO2) a. A 6 percent coupon bond selling for $85. b. A 7 percent coupon bond selling for $100. c. An 8 percent coupon bond selling for $115. Answer:

a. $85 

$6 $100   i  24.71% 1 i 1 i

b. $100 

$7 $100   i  7% 1 i 1 i

c. $115 

$8 $100   i  6.1% 1 i 1 i

Option (a) has the highest yield to maturity. The yield to maturity depends both on the coupon payment and any capital gain or loss arising from the difference between the selling price and the face value of the bond. While (a) has the lowest coupon rate, it is selling below face value, and so there is a capital gain. Option (b) is selling at face value, so there is no capital gain and option (c) is selling above face value and so there is a capital loss. As the calculations above show, the combination of the coupon payment and the capital gain on option (a) produces the highest yield to maturity.

6. You are considering purchasing a consol that promises annual payments of $4. (LO2) a. If the current interest rate is 5 percent, what is the price of the consol? b. You are concerned that the interest rate may rise to 6 percent. Compute the percentage change in the price of the consol and the percentage change in the interest rate. Compare them. c. Your investment horizon is one year. You purchase the consol when the interest rate is 5 percent and sell it a year later, following a rise in the interest rate to 6 percent. What is your holding period return? Answer: a. P 

$4  $80 0.05

newP 

$4  $66.67 0.06

Price falls by 16.7%; and interest rises by 20%. c.

$4 $66.67  $80   11.7% $80 $80

7. *Suppose you purchase a three-year, 5-percent coupon bond at par and hold it for two years. During that time, the interest rate falls to 4 percent. Calculate your annual holding period return. (LO2) Answer: The total holding period return over the two years consists of two coupon payments of $5 each plus the capital gain from the rise in the price of the bond due to the interest rate fall.

The price at which you sell the bond after two years will be (5/1.04) + (100/1.04) = $100.96. Holding period return over two years = (10/100) + [(100.96 –100)/100] = 0.1096 or 10.96%. The total payoff on the bond for which you paid $100 is $110.96. To calculate the annual rate of return, we refer to the footnote on p. 140. It is assumed, for simplicity, that the first-year coupon is not reinvested for the second year. The annual rate of return is [(110.96/100)1/2 – 1] = 0.0534 or 5.34 percent. Because the interest rate fell during the holding period and you made a capital gain, the annual holding period return is higher than the coupon rate.

8. In a recent issue of the Wall Street Journal (or on www.wsj.com or an equivalent financial website), locate the prices and yields on U.S. Treasury issues. For one bond selling above par and one selling below par (assuming they both exist), compute the current yield and compare it to the coupon rate and the ask yield listed. (LO2) Answer: Looking at www.wsj.com/market-data/bonds/treasuries, for the Treasury bond due May 15, 2030 with a coupon rate of 6.25% on July 19, 2023, the bond price was 114.0420 and the asked yield was 3.867%. That means the current yield was (6.25/114.0420) × 100 = 5.48%, so the coupon rate > current yield > asked yield, in line with Table 6.1 when the bond price is above the face value of 100. For the Treasury bond due July 31, 2029 with a coupon rate of 2.25% on July 19, 2023, the bond price was 93.0260 and the asked yield was 3.917%. That means the current yield was 2.625/93.0260 × 100 = 2.82%, so the coupon rate < current yield < asked yield, in line with Table 6.1 when the bond price is below the face value of 100.

9. In a recent issue of the Wall Street Journal (or on www.wsj.com), locate the yields on government bonds for various countries. Find a country whose 10-year government bond yield was above that on the U.S. 10-year Treasury bond and one whose 10-year yield was below the Treasury yield. What might account for these differences in yields? (LO4) Answer: According to www.wsj.com/marketdata/bonds/governmentbonds?mod=md_bond_view_govt_bonds_full, as of Wednesday, July 19, 2023, the 10-year U.S. Treasury yield was 3.741%, while the 10-year government bond yields in the United Kingdom and Japan were 4.212% and 0.467%, respectively. As the bonds all have the same maturity, yield differentials reflect differences in default risk and inflation risk. In these cases, they most likely reflect differences in long-run inflation expectations.

10. A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate circumstances, expected inflation rises from 2 percent to 3 percent. The face value of the bond is $100. (LO2, LO4) a. Assuming the nominal yield rises in an amount equal to the rise in expected inflation, compute the change in the price of the bond.

b. Suppose that expected inflation is still 2 percent, but the probability that it will move to 3 percent has risen. Describe the consequences for the price of the bond. Answer: a. Price (with 2% expected inflation) = 100/(1.06)10 = $55.84 Price (with 3% expected inflation) = 100/(1.07)10 = $50.83 The price has fallen by $5.01 b. There is increased inflation risk. Investors will require compensation for taking on additional risk, so the price will fall and the yield will rise.

11. You are sitting at the dinner table and your father is extolling the benefits of investing in bonds. He insists that as a conservative investor he will only make investments that are safe, and what could be safer than a bond, especially a U.S. Treasury bond? What accounts for his view of bonds? Explain why you think it is right or wrong. (LO4) Answer: Like most people, your father believes that the government guarantee means that he will get his investment back. He’s right that the U.S. Treasury is extremely unlikely to default. But he’s wrong about interest-rate and inflation risk. The value of the bond will fluctuate when the interest rate changes (moving inversely) and the purchasing power of the coupon and principal repayment will fluctuate with inflation. So, the bond is not risk free.

12. *Consider a one-year, 10-percent coupon bond with a face value of $1,000 issued by a private corporation. The one-year risk-free rate is 10 percent. The corporation has hit on hard times, and the consensus is that there is a 20 percent probability that it will default on its bonds. If an investor were willing to pay at most $775 for the bond, is that investor riskneutral or risk-averse? (LO4) Answer: If the bond were risk free, it would pay off $1,100 in one year’s time—$100 coupon payment and $1,000 face value of the bond. If there is a 20% risk of default, then the expected value of these payment flows associated with the bond are ($1,100 × 0.8) + ($0 × 0.2) = $880 The present value of $880 in one year’s time is $880/1.1 = $800. This would be the price a riskneutral investor would be willing to pay. If the investor is willing to pay at most $775 for the bond, the investor requires compensation for bearing the risk associated with the bond and so is risk-averse.

13. If, after one year, the yield to maturity on a multiyear coupon bond that was issued at par is higher than the coupon rate, what happened to the price of the bond during that first year? (LO2) Answer: The price of the bond fell below par. When a bond is at par, the yield to maturity equals the coupon rate. If the yield to maturity rises, the price of the bond falls. If you buy the bond below par, the capital gain you receive by holding it to maturity is included along with the coupon payments, so the yield to maturity is higher than the coupon rate alone.

14. Use your knowledge of bond pricing to explain under what circumstances you would be willing to pay the same price for a consol that pays $5 a year forever and a 5-percent, 10-year coupon bond with a face value of $100 that only makes annual coupon payments for 10 years, at which point principal is returned. (LO1, LO2) Answer: The price you are willing to pay for a bond reflects the present value of the payment flows from the bond. In this case, if i = 5%, the present value of the payment flows for both these bonds would be $100. Intuitively, while the consol makes coupon payments forever, the 10-year coupon bond pays back the principal at maturity, which then can be reinvested. Assuming you have no reason to believe that rates will rise or fall over the 10year period, you would be indifferent between these bonds. If you are certain that rates will be higher in ten years, you would prefer the 10-year coupon bond, whose proceeds can then be reinvested at the higher rate while the value of the consol would have fallen. Similarly, if you are certain that rates will be lower in ten years, you would prefer the consol. 15. *You are about to purchase your first home and receive an advertisement regarding adjustable-rate mortgages (ARMs). The interest rate on the ARM is lower than that on a fixed rate mortgage. The advertisement mentions that there would be a payment cap on your monthly payments and you would have the option to convert to a fixed-rate mortgage. You are tempted. Interest rates are currently low by historical standards and you are eager to buy a house and stay in it for the long term. Why might an ARM not be the right mortgage for you? (LO4) Answer: There are several factors to consider. First, with a fixed rate mortgage, your payments are fixed over the life of the loan. The interest rate on this mortgage is higher because the lender is assuming the interest rate risk. The ARM has a lower interest rate in part because you will assume risk associated with interest rate movements over the life of the loan (your payments will rise if rates rise). Given that interest rates are currently relatively low, it is more likely that they will rise, pushing up your payments. This problem is more likely to be an issue the longer you plan to stay in the house. Second, converting later to a fixed-rate mortgage from an adjustable rate loan often involves restrictions and fees. Third, payment caps may limit how much your monthly payments can rise, but may be associated with negative amortization if your payments don’t cover the interest costs of your loan. Shortages are added to the principal of your loan, pushing up your costs.

16. Use the model of supply and demand for bonds to illustrate and explain the impact of each of the following on the equilibrium quantity of bonds outstanding and on equilibrium bond prices and yields: (LO3) a. A new website is launched facilitating the trading of corporate bonds with much more ease than before. b. Inflationary expectations in the economy fall evoking a much stronger response from issuers of bonds than investors in bonds. c. The government removes tax incentives for investment and spends additional funds on a new education program. Overall, the changes have no effect on the government’s financing requirements. d. All leading indicators point to stronger economic growth in the near future. The response of bond issuers dominates that of bond purchasers.

Answer: a. The new website would increase the relative liquidity of bonds, shifting the bond demand curve to the right, increasing the equilibrium price of bonds and reducing yields. The equilibrium quantity of bonds outstanding rises.

Price of Bonds

P1 P0 D1

D0 Q0

Quantity of Bonds

b. For a given nominal interest rate, a fall in inflationary expectations increases the real interest rate, shifting the bond supply curve to the left and the bond demand curve to the right. If the response of the bond issuers is relatively stronger, the supply curve shift will dominate and the quantity of bonds outstanding will fall. Regardless of the relative size of the shifts, the equilibrium price of bonds will rise and yields will fall. S1 S0

Price of Bonds

Q1 Q0 Quantity of Bonds

c. The removal of tax incentives on investment would make investment more costly, reducing the supply of bonds by corporations, shifting the supply curve to the left. As there is no change in the financing requirements of the government, the supply of government bonds doesn’t change. Equilibrium quantity falls. Equilibrium bond prices rise and yields fall.

S1 S0

d. A business cycle upturn increases business investment opportunities, shifting the bond supply curve to the right. Wealth also increases, shifting the bond demand curve to the right. If the supply shift dominates, equilibrium bond prices fall and yields rise. The equilibrium quantity of bonds outstanding increases.

Price of Bonds

P0 P1 D0 Q0

Quantity of Bonds

17. Suppose that a sustainable peace is reached around the world, reducing military spending by the U.S. government. How would you expect this development to affect the U.S. bond market? (LO3) Answer: As the government’s need to issue bonds to finance military spending is reduced, the supply of government bonds will fall, shifting the supply curve to the left. Bond prices will increase and yields will fall.

18. Use the model of supply and demand for bonds to determine the impact on bond prices and yields of expectations that the real estate market is going to weaken. (LO3) Answer: If we think of real estate as an alternative investment to bonds, expected weakness in the real estate market implies an increase in the relative return on bonds. Bond demand shifts to the right, increasing the equilibrium bond prices and lowering yields.

19. *Suppose there is an increase in investors’ willingness to hold bonds at a given price. Use the model of the demand for and supply of bonds to show that the impact on the equilibrium bond price depends on how sensitive the quantity supplied of bonds is to the bond price. (LO3) Answer: The sensitivity of bond supply to changes in the price of bonds is reflected in the slope of the supply curve. The more sensitive quantity supplied is to a movement in the price, the flatter the supply curve and the smaller the impact on the equilibrium price for any given shift in the demand curve.

20. Under what circumstances would purchase of a Treasury Inflation Protected Security (TIPS) from the U.S. government be virtually risk free? (LO4) Answer: Purchasing a Treasury Inflation Protected Security (TIPS) would be virtually risk free if you purchased a bond whose maturity exactly matched your investment horizon. The default risk of holding a U.S. government-issued bond is very low while inflation risk is eliminated by the inflation-indexed nature of the TIPS. If you know your investment horizon with certainty and purchase a bond whose maturity matches that horizon, you eliminate interest rate risk, as you are confident that the bond will be redeemed at par when it matures. Interest rate movements that cause the price of the bond to change before it matures will not affect you.

21. In the wake of the financial crisis of 2007-2009, negative connotations often surrounded the term mortgage-backed security. What arguments could you make to convince someone that they may have benefitted from the growth in securitization over the past 50 years? (LO4) Answer: If the person you are trying to convince is a borrower, they may have received a lower mortgage interest rate due to the increased liquidity provided by securitization. If they are from a small town, they may have found it easier to get a mortgage as securitization broadened the potential sources of funds for their loan. If they are an investor, you might point to the opportunities for diversification provided by securitization.

22. During the euro-area sovereign debt crisis that began in 2009, the spread between the yields on bonds issued by the governments of geographically peripheral European countries (such as Greece, Ireland, Italy, Portugal, and Spain) and those on bonds issued by Germany widened considerably. Use the model of supply and demand for bonds to illustrate how this could be explained by a change in investors’ perceptions of the relative riskiness of peripheral sovereign versus German bonds. (LO3, LO4). Answer: Investor worries about the possibility of default on bonds issued by relatively indebted peripheral euro-area governments increased during the crisis. This can be illustrated with a leftward shift of the bond demand curve, lowering the price and raising the yield. For a given German bond yield, this would increase the spread of peripheral government bond yields above

those on German bonds, reflecting the need for a larger risk premium to compensate investors.

Price of Bonds

P0 P1

D1 Q1

Quantity of Bonds

23. Not long after the United Kingdom’s vote to leave the European Union in 2016, the yields on some British Government bonds (called gilts) turned negative. Assuming that these bonds were issued with a positive coupon rate, would you expect their market prices to be above, below or equal to their face value when the yields were negative? Explain your choice. (LO2) Answer: If the yield on a bond with a positive coupon rate is negative, the price must be above the face value. Thinking about maturity, if the yield is negative, the investor must suffer a capital loss to offset the positive coupon payments. Therefore, the market price of the bond must be above the face value. 24.*At the onset of the COVID pandemic, corporate bond prices fell and yields rose, as holders of these bonds sold them in favor of holding liquid cash. The quantity of corporate bonds traded rose. (LO3) a. Using the supply and demand model for bonds, which curve would you shift and in what direction would you shift it to illustrate this impact? b. As problems in the corporate bond market grew, the Federal Reserve developed new facilities that allowed it to purchase corporate bonds for the first time. How would you illustrate this impact in the model? Answer: a. This is best illustrated by shifting the supply curve to the right. The equilibrium price falls (and the yield rise) and equilibrium quantity rises. b. The Federal Reserve’s purchases of corporate bonds represent an increase in demand at any given price, shifting the demand curve to the right. This shift will bring the equilibrium prices in the market back up, with an associated fall in the yield. * indicates more difficult problems

Data Exploration

1. Graph investors’ long-term expected inflation rate since 2003 by subtracting from the 10-year U.S. Treasury bond yield (FRED code: GS10) the yield on 10-year Treasury Inflation Protected Securities (FRED code: FII10). Do these market-based inflation expectations appear stable? How did the financial crisis of 2007-2009 affect these expectations? What about the COVID pandemic? (LO4) Answer: The indicated data plot is:

This link produces a graph that updates automatically: https://fred.stlouisfed.org/graph/?g=1970M

Both the 2007-09 financial crisis and the pandemic led to temporary downward spikes in market-based long-term inflation expectations using this measure, but the crisis spike was much larger in amplitude. Following the financial crisis, inflation expectations by this measure fluctuated mostly in the range of 2.0 percent to 2.5 percent until 2014. For the five years until the pandemic, this measure of expected inflation drifted lower, presumably reflecting the persistent undershoot of the Fed’s 2 percent inflation target. Following the downward spike during the pandemic, inflation expectations by this measure again rose above 2 percent, but remained far below actual consumer price inflation, which peaked at 9 percent in 2022.

2. Compare long-run market expectations of inflation with a consumer survey measure of oneyear-ahead inflation expectations. Starting with the graph from Data Exploration Problem 1, add as a second line the University of Michigan survey measure of inflation expectations (FRED code: MICH). Why might these measures differ systematically? (LO4) Answer: The indicated data plot is:

University of Michigan, University of Michigan: Inflation Expectation [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MICH. Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1970Z

We should not expect that one-year ahead consumer inflation expectations match 10-year-ahead investor inflation expectations, but they are broadly correlated. Interestingly, consumer shortterm inflation expectations exceed investor long-term expectations virtually throughout this period. One reason may be that consumers focus more on the prices of goods that they buy frequently, such as food and gasoline where price changes are visible and frequent, and less on infrequent purchases (like electronics) for which inflation may be lower. In contrast, TIPS compensate investors for changes in the CPI that includes all these prices.

3. How does the variability of annual inflation—an indicator of inflation risk—change over time? Graph the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL) since 1990 and visually compare the decades of the 1990s, the 2000s, 2010s, and 2020s thus far. (LO4) Answer: The data plot is:

Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1971a.

By visual inspection, if variability of inflation represents inflation risk, then this risk changes notably over time. After inflation declines to around 3 percent in the early 1990s, inflation appears less variable. It also exhibited little variability in the 2010s. However, inflation variability was somewhat higher in the 2000s—especially during the financial crisis of 2007-09. After 2020, inflation variability surged, primarily reflecting the jump of inflation to 40-year highs in 2021-22.

4. Download the data from the graph you produced in Data Exploration Problem 3. Calculate the standard deviation of the annual inflation rate for the four time periods and compare these results against your visual assessment from Data Exploration Problem 3. (LO4) Answer: The standard deviation from 1990 through 1999 is 1.13. From 2000 through 2009, it is 1.42, but this masks a lower standard deviation of 0.84 from 2000 through 2007 (the onset of the Great Recession). From 2010 through December 2019, the standard deviation is 0.86. From 2021 to August 2023, the standard deviation jumped to 2.78. (Computations after this date will include additional observations and incorporate any data revisions.) These results appear consistent with the visual assessment in Data Exploration Problem 3. 5. Economists sometimes exclude food and energy prices from the ―headline‖ consumer price index and use the resulting ―core‖ price measure to assess inflation prospects. For the period since 1990, plot on one graph the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL) and the percent change from a year ago of the consumer price index excluding food and energy (FRED code: CPILFESL). Visually compare the variability of these two measures of inflation. Why might inflation, excluding food and energy, be a better predictor of future inflation than headline inflation? (LO4)

Answer: The data plot is:

Link that updates automatically: https://fred.stlouisfed.org/graph/?g=197oW.

Because food and energy prices are relatively volatile, the ―core‖ measure of inflation is less variable than the ―headline‖ measure. Volatility tends to mask the trend of an economic indicator by adding statistical ―noise‖ to the trend. Consequently, examining core inflation can reveal the underlying trend of inflation. If that trend is stable, it can be useful in anticipating inflation prospects.

Chapter 7 The Risk and Term Structure of Interest Rates X.

1. Conceptual and Analytical Problems 1. Consider a firm that issued a large quantity of commercial paper in the period leading to a financial crisis. (LO1) a. How would you expect the credit rating of the commercial paper to evolve as the crisis unfolds? b. Would you alter your prediction if, rather than commercial paper, the firm was instead issuing asset-backed commercial paper? Answer: a. Commercial paper is generally issued without collateral, so that its rating will depend on the creditworthiness of the issuer, which faces downgrade risk in a crisis.

b. If the commercial paper is asset-backed, the probability of a downgrade would depend on the creditworthiness of the collateral.

2. Suppose that a major foreign government defaults on its debt. What, if anything, will happen to the position and slope of the U.S. yield curve? (LO1) Answer: If Treasury debt is a substitute for the foreign government debt, then the U.S. yield curve would shift downward, reflecting a flight to quality. If the holders of the foreign government debt were concentrated at the short end of the maturity spectrum, then the U.S. yield curve would shift down and become more steeply sloped; if the holders were concentrated at the long end of the maturity spectrum, then the U.S. yield curve would shift down and become flatter.

3. What was the connection between house price movements, the growth in subprime mortgages, and securities backed by these mortgages—on the one hand—and on the other hand—the difficulties encountered by some financial institutions during the 2007-2009 financial crisis? (LO1) Answer: The viability of many subprime mortgages—and in particular ARMs—depended on being able to refinance the loan before the interest rate reset to a higher level. When house prices began to fall in 2006, pushing home values below the loan amount for many of these mortgages, refinancing was no longer an option. Unable to pay the higher interest rates, borrowers began to default on these subprime mortgages at an increasing rate. This, in turn, led to significant falls in the prices of securities backed by subprime mortgages, causing difficulties for institutions that had sizable holdings of these securities.

4. Suppose that the interest rate on one-year bonds is currently 4 percent and is expected to be 5 percent in one year and 6 percent in two years. Using the expectations hypothesis, compute the yields on two- and three-year bonds and plot the yield curve. (LO3) Answer: Yield on one-year bond = 4% Yield on two-year bond = (4% + 5%)/2 = 4.5% Yield on three-year bond = (4% + 5% + 6%)/3 = 5%

Yield Curve

Yield (%)

5.5 5 4.5 4 3.5 0

Years to Maturity

5. *According to the liquidity premium theory, if the yield on both one-and two-year bonds are the same, would you expect the one-year yield in one-year’s time to be higher, lower or the same? Explain your answer. (LO3) Answer: According to the liquidity premium theory, the two-year yield (i2,t) is an average of this year’s and next year’s one-year yields (i1,t + ie 1, t +1) divided by 2 plus a risk premium (rp) to compensate for the inflation and interest-rate risk associated with the longer maturity. i2,t = rp + (i1,t + ie 1, t +1)/2 As we can see from the formula, if the current one-and two-year yields are the same and there is a risk premium included in the two-year yield, then next year’s one-year yield must be lower than this year’s.

6. You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.5 percent, 4.0 percent, and 4.5 percent, respectively. You expect that one-year interest rates will be 4 percent next year and 5 percent the year after that. Assuming annual compounding, compute the return on each of the three investments, and discuss which one you would choose. (LO3) Answer: Expected return for (i) = (1.035) × (1.04) × (1.05) – 1 = 13.02% Expected return for (ii) = (1.045)3 – 1 = 14.12% Expected return for (iii) = (1.04)2 × (1.05) – 1 = 13.57% The second and third options have higher expected returns than the first, but both options involve investing in longer-term bonds (three-year and two-year bonds, respectively). Longterm bonds have higher inflation risk and interest-rate risk; investors require compensation for this additional risk, which is why longer-term bonds generally have higher yields than would be suggested by the expectations hypothesis. In selecting an investment strategy, it is important to take these additional risks into account. An investor’s investment horizon is also important; to reduce interest rate risk, someone with a short-term horizon would be better off choosing the first option, while someone with a three-year horizon should probably choose the second option.

7. Suppose that the yield curve shows that the one-year bond yield is 3 percent, the two-year yield is 4 percent, and the three-year yield is 5 percent. Assume that the risk premium on the one-year bond is zero, the risk premium on the two-year bond is 1 percent, and the risk premium on the three-year bond is 2 percent. (LO3) a. What are the expected one-year interest rates next year and the following year? b. If the risk premiums were all zero, as in the expectations hypothesis, what would the slope of the yield curve be? Answer: a. With the one-year yield at 3 percent (or i1t = 0.03), the risk premium on the two-year bond at 1 percent (0.01), and with the two-year yield at 4 percent (or i2t = 0.04), the implied one-year rate next year will solve: i2t = 0.01 + (0.03 + i1,t +1) / 2 = 0.04, which implies that the one-year interest rate next year will be 0.03 or 3 percent. Using this result, with a risk premium on the three-year bond of 0.02, we have: i3t = 0.02 + (0.03 + 0.03 + i1,t +2) / 3 = 0.05 which implies that the one-year rate in two years will also be 0.03 or 3 percent. b. As the solutions in part (a) show, the current and prospective one-year rates are all 3 percent, so the expectations hypothesis yield curve would be flat.

8. *If inflation and interest rates become more volatile, what would you expect to see happen to the slope of the yield curve? (LO3) Answer: Investors are likely to demand a higher risk premium in the face of increased volatility. There is more uncertainty regarding the real return on investments and the price for which you could sell a bond before maturity. Assuming the uncertainty rises the longer the term to maturity, you should expect the yield curve to become steeper as investors demand a larger premium to compensate for inflation risk and interest rate risk.

9. Suppose your local government, threatened with bankruptcy, decided to tax the interest income on its own bonds as part of an effort to rectify serious budgetary woes. What would you expect to see happen to the yields on these bonds? (LO2) Answer: You would expect the yields to rise to compensate investors for the loss of the taxexempt status. These yields also would have to compensate investors for the heightened probability of default by the local government.

10. *Suppose the yields on tax-exempt local government bonds in Problem 9 initially were below the Treasury yields of the same maturity. If the tax-exempt status were then removed from the local government bonds, would you expect their yield spreads versus treasuries to narrow, to disappear, or to change sign? Explain your answer. (LO1, LO2)

Answer: We can attribute the lower yields on the local government bonds versus Treasury issues to their tax-exempt status, as investors would view the federal government as being at least as creditworthy as the local government. Given the serious budgetary woes of the local government, investors likely would regard these bonds as riskier than Treasury issues. The local bond yield also would have to compensate investors for the new tax obligation, so the spread would change sign.

11. Suppose the risk premium on U.S. corporate bonds increases. How might the change affect your forecast of future economic activity, and why? (LO4) Answer: An increasing risk premium can be a sign of an impending recession, so you would be more likely to forecast an economic downturn. During cyclical downturns, private companies have a more difficult time repaying their debt, while the U.S. Treasury typically is not affected, increasing the risk premium on company debt.

12. If regulations restricting institutional investors to investment grade bonds were lifted, what do you think would happen to the spreads between yields on investment grade and speculative grade bonds? (LO1) Answer: If institutional investors were willing to hold speculative-grade bonds in the absence of a legal restriction, the spread between speculative and investment-grade yields would narrow. Institutional demand for investment grade bonds would shift to the left as these investors switch to higher-yielding speculative bonds. Prices of investment grade bonds would decline, and the yields would rise. In addition, demand for speculative grade bonds would shift to the right, increasing prices and lowering the yields. As a result, the yield spread between speculative grade and investment grade bonds would narrow.

13. Consider a struggling emerging market economy where, in contrast to developed economies, the perceived risk associated with holding sovereign bonds is affected by the state of the economy. Suppose vast quantities of valuable minerals were unexpectedly discovered on governmentowned land. How might the government’s bond rating be affected? Using the model of demand and supply for bonds, what would you expect to happen to the yields on that country’s government bonds? (LO1, LO4) Answer: The ratings of the bonds would likely be upgraded, as the outlook for the economy would improve and the reduction in the perceived riskiness of the bonds would shift the demand curve to the right. Revenues from the minerals could also mitigate the government’s need to borrow, shifting the supply of bonds to the left. Bond prices would increase and yields would fall.

14. Select the circumstance in which the impact on government bond yields of a new source of revenue (such as a natural resource discovery) would be largest. Explain your choice. (LO1, LO4) a. Before the discovery, the government was heavily indebted with a crippling debtservice burden or b. Before the discovery, the government had a very low debt burden.

Answer: The impact would be larger in the case of a heavily indebted government, especially if the debt was denominated in another currency, such as U.S. dollars. These factors make the government more vulnerable to global interest rate and currency movements. The benefit of an additional source of revenue through taxing the mineral discoveries would be greater for a government at risk of defaulting due to high debt servicing costs than in a country where this risk was not an issue.

15. The misrating of mortgage-backed securities by rating agencies contributed to the financial crisis of 2007-2009. List some recommendations you would make to avoid such mistakes in the future. (LO1) Answer: In the run-up to the 2007-2009 crisis, the absence of data capturing a period of falling house prices at a national level caused models to underestimate the default risk of the mortgages underlying the mortgage-backed securities. Running tests to see what outcomes these models would predict in extreme circumstances (stress testing) may help avoid such underestimations in the future. Publishing data on the accuracy of various bond rating firms in anticipating bond defaults also could encourage more reliable ratings. Similarly, encouraging professional asset managers to develop their own risk assessments would diminish the influence of credit ratings in portfolio selection. Finally, changing the relationship between the rating agencies and the securities issuers could reduce potential conflicts of interest. These conflicts can arise from payments by the bond issuers to the credit rating agencies in return for having their bonds rated.

16. How do you think the abolition of investor protection laws would affect the risk spread between corporate and government bonds? (LO1) Answer: These laws were likely to be much more important in protecting purchasers of corporate bonds rather than purchasers of government bonds. Their abolition would raise the relative riskiness of corporate bonds, widening the spread between corporate and government bond yields.

17. You and a friend are reading The Wall Street Journal and notice that the Treasury yield curve is slightly upward sloping. Your friend comments that all looks well for the economy but you are concerned that the economy is heading for trouble. Assuming you are both believers in the liquidity premium theory, what might account for your difference of opinion? (LO3, LO4) Answer: The difference in opinion could reflect different views on the size of the risk premium. If the risk premium is large enough, a slightly upward-sloping yield curve could mean that interest rates are expected to fall, indicating a weak economy. However, if the risk premium is small, the slight upward slope could reflect expectations that interest rates will rise and that the economy is expected to be healthy.

18. Do you think the term spread was an effective predictor of the recession that started in December 2007? Why or why not? (LO4) Answer: An inverted yield curve (negative term spread) is often a sign that the economy is about to go into recession. Looking at the term spread (10-year yield minus the three-month

interest rate) in Figure 7.7, we see that the term spread did indeed turn negative in late 2006/early 2007. On the other hand, the severity of the recession was not predicted by the yield curve.

19. *Given the data in the accompanying table, would you say that this economy is heading for a boom or for a recession? Explain your choice. (LO4)

January February March April May

3-month Treasury-bill 1.00% 1.05% 1.10% 1.20% 1.25%

10-year Treasury bond 3.0% 3.5% 4.0% 4.3% 4.5%

Baa corporate 10-year bond 7.0% 7.2% 7.5% 7.7% 7.8%

Answer: The information in both the term structure and the risk structure point to a healthy economy. The term spread (the gap between the 10-year Treasury bond yield and the threemonth Treasury bill rate) is positive and widening. This tells us that the yield curve is upward sloping and getting more steeply upward sloping. This implies that interest rates are expected to continue to rise in the future—a sign that the economy is expected to do well. The risk spread (the gap between the Treasury and corporate 10-year bonds) is narrowing. This is a sign of a healthy economy as people do not require such a high-risk premium on corporate bonds.

20. Suppose regulatory reforms relating to credit rating agencies are perceived to improve the reliability and accuracy of credit ratings of corporate bond issues. Imagine further that you manage a corporation interested in issuing new bonds, in addition to past issues by the firm that already trade in the market. Identify one way in which your firm might lose and one way in which it might gain from these reforms. Explain your answer. (LO1) Answer: If, prior to the reforms, your bond issues enjoyed inflated credit ratings, you may receive a lower rating and therefore face higher borrowing costs if the reforms are successful in bringing about more accurate ratings. Core Principle 3 states that information is the basis for decisions. If, prior to the reforms, lack of investor confidence in credit ratings made it difficult or impossible to issue bonds, the reforms may improve market access. Put differently, if the reforms restore investor confidence in credit ratings, your corporation may be better able to issue new bonds at a reasonable price.

21. Consider a one-year taxable coupon bond with a face value of $1,000 and a coupon rate of 5 percent. The tax rate is 25 percent. What yield to maturity would you need to earn on a one-year tax-exempt bond with the same face value to make you indifferent between the two bonds? You should assume both bonds are selling at par. (LO2) Answer: To be indifferent between the two bonds, the after-tax yields should be the same. As the taxable bond is selling at par, the yield to maturity (TYTM) is equal to the coupon rate = 5 percent or $50. At a tax rate of 25 percent, $12.50 (= $50 × 0.25) is paid in tax, leaving an after-tax yield of $37.50, or 3.75%. Therefore, the tax-exempt yield would need to be 3.75%. We can confirm this by using the formula: Tax-exempt bond yield = (Taxable bond yield) × (1 - Tax rate) 3.75% = 5% (0.75)

22. Suppose you observe a rise in bond yields across the risk structure following a negative economic shock. The yield on the 10-year U.S. Treasury bond rose by 50 basis points, the AAA corporate yield rose by 75 basis points, and the BAA corporate yield rose by 90 basis points. Calculate the change in the AAA-Treasury spread and the change in the BAA-Treasury spread. Comment on which change is larger and explain why that might be the case. (LO1, LO4) Answer: Change in AAA yield – Change in Treasury yield = 75 – 50 = 25 basis points. Change in BAA yield – Change in Treasury yield = 90 – 50 = 40 basis points. The impact on the lower-rated bonds is greater, reflecting the greater likelihood of default associated with them in the face of this economic shock. In other words, it is more likely that the negative shock would tip the riskier bonds into default, prompting a rise in their required risk premium.

23. Suggest two reasons why the risk spread between 10-year corporate bonds and 10year U.S. Treasuries widened at the onset of the COVID pandemic. (LO1, LO4) Answer: As the risk spread measures the difference between two yields, a widening of the spread might reflect a relative fall in Treasury yields or a relative rise in corporate yields. With the onset of the pandemic and the uncertainty associated with it, Treasury yields fell due to a ―flight to quality‖ as investors sought a safe haven. Concerns about the economic outlook and the increased risk of default contributed to a rise in corporate bond yields. a)

* indicates more difficult problems

Data Exploration 1. Did the financial crisis of 2007-2009 affect financial and nonfinancial firms to the same extent? For the period beginning in 2006, plot the spread between the interest rates on three-month nonfinancial commercial paper (FRED code: CPN3M) and three-month Treasury bills (FRED code: TB3MS). Plot a similar spread using the interest rates on three-month financial commercial paper (FRED code: CPF3M) and Treasury bills (FRED code: TB3MS). Compare the evolution of these two spreads. (LO1) Answer: The spreads between commercial paper (CP) rates and the Treasury bill rate rose significantly in the second half of 2007 as the financial crisis began to unfold and spiked even higher in the latter part of 2008 in the wake of the collapse of Lehman Brothers. Before the onset of the crisis, these spreads were below 50 basis points (or 0.5 percent). Over most of the next 18 months, the spreads more than doubled. Concerns about the health of the financial system had a particularly severe impact on financial CP. The financial spread peaked at 2.52 percent in October 2008, reflecting both the liquidity shortage and heightened default risk. The narrowing of the CP spreads in 2009 marked an important turning point in the crisis. We also observe a spike in the spreads at the outset of the 2020 pandemic. An aggressive monetary policy is likely responsible for a return to pre-pandemic spreads.

Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1971v.

2. The Federal Reserve Bank of St. Louis publishes a weekly index of financial stress (FRED code: STLFSI4) that summarizes strains in financial markets, including liquidity problems. For the period beginning in 1994, plot this index and, as a second line, the difference between the weekly Baa corporate bond yield (FRED code: WBAA) and the weekly 10-year U.S. Treasury bond yield (FRED code: WGS10YR). Does the index STLFSI provide an early warning of stress? (LO4) Answer: The stress index deteriorated—rose in value—in 2007 shortly before the bond yield spread widened. Similarly, at the outset of the pandemic in 2020, the stress index rose rapidly and just prior to the rise in interest rate spread. It also improved—fell in value—in 2009 before the bond yield spread narrowed, a pattern also observed in early 2020. Movements in this stress index summarize 18 different weekly data series, including various interest rates, yield spreads, and volatility indexes, in order to capture stress from various parts of the financial system.

Moody’s, Moody's Seasoned Baa Corporate Bond Yield [WBAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WBAA Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1971O.

3. How did the Great Depression (1929-1933) and the Great Recession of 2007-2009 affect expectations of corporate default? To investigate, construct for each of those periods a separate plot of the corporate bond yield spread. For the depression period, plot from 1930 to1933 to the difference between the Baa corporate bond yield (FRED code: BAA) and the long-term government bond yield (FRED code: LTGOVTBD). For the Great Recession, plot from 2007 to 2009 the difference between the Baa yield (FRED code: WBAA) and the 10-year Treasury bond yield (FRED code: GS10). Compare the plots. (LO1) Answer: The two data plots are below. The patterns are quite similar, though the risk spread was modestly larger in the Great Depression than in the Great Recession. If investors view an expected return as equivalent to a certain return of the same magnitude (economists call such investors ―risk neutral‖), then these spreads imply that the probability of corporate default rose similarly in both episodes and remained above pre-crisis levels several years later.

Moody’s, Moody's Seasoned Baa Corporate Bond Yield [DBAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAA.

Moody’s, Moody's Seasoned Baa Corporate Bond Yield [WBAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WBAA.

4. How reliably does an inverted yield curve anticipate a recession? How far in advance? Plot from 1970 (as in Figure 7.7A) the difference between the 10-year Treasury yield (FRED code: GS10) and the three-month Treasury bill rate (FRED code: TB3MS). Discuss the variability of the time between an inversion of the yield curve and the subsequent recession. Do you think the shape of the yield curve in August 2019 anticipated the COVID pandemic recession of 2020? (LO3, LO4)

Answer: The data plot is as follows. The yield curve inverts when the term spread becomes negative, so we examine the spread for values around zero. Regarding the downturn in 1973 the yield curve appears to have inverted several months in advance of the recession. For the brief recession beginning in 1980, the inversion appears to occur about a year ahead of the onset. For the recession beginning in late 1981, the inversion is several months in advance. Prior to the 1990 recession, the yield curve did not invert, but it did flatten a year prior to the recession. The 2001 recession was preceded by an inversion over a year in advance that reversed itself just prior to the actual economic downturn. For the 2007-2009 episode, the yield curve inverted several years prior to the fall in real GDP and again reversed itself prior to the onset of the downturn. Finally, the yield curve inverted slightly in June 2019 and remained so through September 2019 though it is doubtful that this should be consider a recession signal. While the economy did enter a recession in March 2020, this pandemic-related downturn was not a typical recession arising from economic shocks but rather from a forced shutdown of parts of the economy to try to limit the strains on the medical system from a spreading virus. Finally, when the yield curve turned negative in November 2022, many forecasters viewed it as a sign of impending recession. Yet, as of this writing in September 2023, the post-pandemic expansion remains underway, and many observers no longer foresee an early recession. So, while the yield curve is a useful leading indicator of business cycles, this variability in timing makes it an imperfect one.

Link that updates automatically: https://fred.stlouisfed.org/graph/?g=19725.

5. Download the data used from the graph produced in Data Exploration Problem 4 and (a) find the most recent period for which the yield curve was (approximately) flat and (b) the longest time period for which yield curve was inverted. (LO3, LO4) Answer: Recent periods when the yield curve was approximately flat were in May 2007, when the spread was about 2 basis points and in February 2020, when it was -2 basis points. The most

prolonged period of yield curve inversion was the 17-month period between December 1978 and April 1980. However, the yield curve also turned negative in November 2022 and has remained so through this writing (as of September 2023).

Chapter 8 Stocks, Stock Markets, and Market Efficiency XI.

Conceptual and Analytical Problems 1. Explain why being a residual claimant makes stock ownership risky. (LO1) Answer: Stockholders do not receive dividends unless all of the firm’s creditors have been paid. If the firm does poorly, stockholders may receive nothing. The result is that returns to stockholders have high variance. In the event that the firm goes bankrupt, stockholders lose their entire investment.

2. Do individual shareholders have an effective say in corporate governance matters? (LO1) Answer: In principle, shareholders have a say on corporate affairs. They elect members of the company’s board of directors and can vote on important issues raised at the company’s annual meeting. Furthermore, they can offer resolutions to be voted on at the annual meeting. However, individual shareholders usually have one vote for each share owned. With large companies having millions of shares outstanding, the impact of a small shareholder is limited. In addition, while shareholders vote to elect directors, managers, rather than owners, often control the overall board.

3. Consider the following information on the stock market in a small economy. (LO2) Company

Shares Outstanding

Price, beginning of year

Price, end of year

1 2 3

100 1,000 10,000

$100 $20 $3

$94 $25 $6

a. Compute a price-weighted stock price index for the beginning of the year and the end of the year. What is the percentage change? b. Compute a value-weighted stock price index for the beginning of the year and the end of the year. What is the percentage change?

Answer: a. For a price-weighted index, we find the cost of buying one share of each company at the beginning of the year is $123 = $100 + $20 + $3. The cost of buying one share of each at the end of the year is $125 = $94 + $25 + $6. So the percentage change is 1.6%. b. The percentage change in a value-weighted index is given by percentage change in the sum of the values of the companies. At the beginning of the year, the value of the companies is given by $60,000 = $100(100) + $20(1,000) + $3(10,000). At the end of the year, the value is $94,400 = $94(100) + $25(1,000) + $6(10,000) So, the percentage change is 57.3%.

To raise wealth and stimulate private spending, suppose the central bank lowers interest rates, making stock market investment relatively attractive. Which stock market index would you monitor to judge the effectiveness of the policy: the Dow Jones Industrial Average or the S&P 500? Why? (LO2) Answer: Since the S&P 500 is a value-weighted index, it tracks the value of owning each of the companies in the index. Thus, it is a measure of stock market wealth. The DJIA, in contrast, is a price-weighted index that sums the cost of a single share of each of the stocks in the index. As such, it does not measure wealth.

5. Suppose you see evidence that the stock market is efficient. Would that make you more or less likely to invest in stocks for your 401(k) retirement plan when you get your first job? (LO4) Answer: Efficient markets suggest that all relevant information is incorporated into stock prices, and that changes in prices on a particular day reflect that day’s ―news.‖ In this view, prediction of stock prices into the future is equivalent to trying to forecast generally unknowable events. Your decision to invest in equities for retirement likely is based on other information, like your attitude toward risk and knowledge of the historical long-run performance of a diversified portfolio of stocks.

6. Professor Siegel argues that investing in stocks for retirement may be less risky than investing in bonds. Would you recommend this approach to an individual in their early 60s? (LO4) Answer: The closer an individual is to retirement, the less time is available for a portfolio to overcome downward shocks to its value. Consequently, allocating retirement funds to a stock portfolio is riskier for a 60-year old than for a 25-year old. Investment advisors often suggest that those close to retirement lower the fraction of their savings exposed to equities.

7. How do venture capital firms, which specialize in identifying and financing promising but highrisk businesses, help the economy grow? (LO5) Answer: New companies often have difficulty finding financing to put their plans into action. Venture capital firms specialize (say, in one particular industry) in identifying promising firms and providing early-stage funding. As a result, companies with productive uses of funds that could not get start-up loans from traditional intermediaries may succeed in bringing their good

or service to the economic marketplace. The resulting shift of resources to more productive activities boosts incomes and economic growth.

8. *What are the advantages of holding stock in a company versus holding bonds issued by the same company? (LO1) Answer: Stocks represent a share of ownership in the company and give the holder a share in the future profits of the company. If the company, for example, makes a great discovery, invents the next great product, etc., stockholders get to participate in those gains, whereas a bond holder receives only the specific payments associated with the bond (related to any coupon payments and the principal) regardless of such achievements. For stockholders, the potential upside is unlimited while, like bond holders, the potential loss is limited to the initial investment made in the company. The right to vote at annual meetings is another advantage of holding stock rather than bonds in a company.

9. If Professor Siegel is correct that stocks are less risky than bonds, then the risk premium on holding stock may be quite small. Consider the extreme case where the risk premium on stock is zero. Assuming that the risk-free interest rate is 2½ percent, the growth rate of dividends is 1 percent and the current level of dividends is $70, use the dividend-discount model to compute the level of the S&P 500 that is warranted by the fundamentals. Compare the result to the current S&P 500 level, and comment on it. (LO4) Answer: If the current dividend is $70, the risk-free rate is 2.5 percent and the growth rate of dividends is 1 percent, the value of the S&P 500 index warranted by fundamentals is: P = $70(1.01) / (0.025 – 0.01) = $4,713.33 On July 21, 2023, the S&P 500 was at 4,538.35. This suggests that, based on the assumptions in the question, either the equity risk premium is positive, or, if it is zero, that the stocks in the index are slightly undervalued.

10. *Why is a booming stock market not always a good thing for the economy? (LO5) Answer: If stock prices are rising for reasons that are not related to economic fundamentals, there may be a misallocation of resources in the economy. Companies invest in projects that may not be the most productive and do not add to economic growth. As investors’ wealth increases, they change their consumption patterns, leading to increased demand for certain goods and services that cannot be sustained when the stock market readjusts.

11. The financial press tends to become excited when the Dow Jones Industrial Average rises or falls sharply, measuring the changes in points. After a particularly steep rise or fall, media outlets may publish tables ranking the day’s results with other large advances or declines. What do you think of such reporting? If you were asked to construct a table of the best and worst days in stock market history, how would you do it, and why? (LO2)

Answer: This type of reporting can be misleading because it ignores the level of the index itself. A 100-point rise or fall means one thing when an index is at 5,000, but quite something else when it is at 10,000. Expressing performance as percentage changes is the best solution.

12. You are thinking about investing in stock in a company. (LO3) a. The stock paid a dividend of $10 this year and you expect dividends to grow at 4 percent a year. The risk-free rate is 3 percent and you require a risk premium of 5 percent. If the price of the stock in the market is $200 a share, should you buy it? b. Suppose your cousin is also considering investing. She requires the same risk premium as you and has access to the same information. However, she is more pessimistic about the prospects of this company and expects dividends to grow at 2 percent a year. Should she buy the stock? Answer: a. Yes. Using the dividend discount model, you are willing to pay: P = 10(1.04)/(0.08 – 0.04) = $260 per share. Note that i is calculated by combining the risk-free rate and the risk premium. As the asking price in the market is below this, you should buy the stock. b. No. Again, using the dividend discount model, she is willing to pay: P = 10(1.02)/(0.08 – 0.02) = $170 per share. As the asking price in the market is above this, she should not buy the stock.

13. *Suppose you use the dividend discount model to calculate the price you are willing to pay for a stock and find that this differs from the market price. What might account for the difference in the market price of the stock and the price you are willing to pay for the stock? (LO3) Answer: If, for example, the market price were below the price you are willing to pay for the stock, the difference could reflect the fact that you require a lower risk premium than the market in general or that you think that dividends for this company are going to grow faster than the market in general. It could also reflect market pessimism, pushing the price below the fundamental value.

14. You are trying to decide whether to buy stock in Company X or Company Y. Both companies need $1,000 capital investment and will earn $200 in good years (with probability 0.5) and $60 in bad years. The only difference between the companies is that Company X is planning to raise all of the $1,000 needed by issuing equity while Company Y plans to finance $500 through equity and $500 through bonds on which 10% interest must be paid. Construct a table showing the expected value and standard deviation of the equity return for each of the companies. (You could use Table 8.3 as a guide.) Based on this table, in which company would you buy stock? Explain your choice. (LO3) Answer: % Equity

% Bonds

Required Payment on Bonds

Pay to equity holders

Equity return

Expected Value of Equity

Standard Deviation of Equity

Return Return Co.X 100 0 0 60-200 6-20% 13% 7% Co.Y 50 50 50 10-150 2-30% 16% 14% (Remember, for Company Y, the expected value of the equity return is calculated as a % of 500 —the amount put into equity.)

Which company you choose depends on your attitude toward risk. If you are willing to take on extra risk by buying stock in Company Y, you get a higher expected return. If you are more risk averse, you may want to opt for the lower —but safer —return of company X.

15. Your brother has a $1,000 and a one-year investment horizon and asks your advice about whether he should invest in a particular company’s stock. What information would you suggest he analyze when making his decision? Is there an alternative investment strategy to gain exposure to the stock market you might suggest he consider? (LO4) Answer: You should explain that the return on his investment will depend on the dividend he may be paid and the movement in the stock price over the year. You could show him how to use the dividend discount model to assess whether the stock is he considering is over- or undervalued relative to fundamentals to help predict his chances of making a capital gain. You should mention that stocks are a relatively risky investment over a short-run investment horizon. You could suggest that he invest his $1000 in a mutual fund or exchange-traded fund, thus spreading the risk over a portfolio of stocks.

16. Given that many stock market indices across the world fell and rose together during the financial crisis of 2007-2009, do you think investing in global stock markets is an effective way to reduce risk? Why or why not? (LO2) Answer: While it is true that movements in stock market indices across the world have become more highly correlated over time, as long as they are not perfectly correlated, there are benefits from spreading your investments. (Recall how spreading reduces risk from Chapter 5.)

17. Do you think a proposal to abolish limited liability for stockholders would be supported by companies issuing stock? (LO1) Answer: No. The obvious downside would be that stocks would become much less attractive as an investment, making it much costlier for firms to raise funds by issuing stock. The potential benefit would be that bondholders and creditors might find the company more attractive, as in the event of bankruptcy they could pursue stockholders for what they are owed. Practically speaking, however, this is unlikely to be a feasible option.

18. You peruse the available records of some public figures in your area and notice that they persistently gain higher returns on their stock portfolios than the market average. As a believer in efficient markets, what explanation for these rates of returns seems most likely to you? (LO3) Answer: Your first instinct is that the public officials have access to inside information, which they use to guide their investment decisions. Other possibilities are that these public figures have simply been lucky or that they have a higher than average appetite for riskier investments that have being doing well.

19. The initial adverse impact of the COVID pandemic on the U.S. stock market was quickly reversed and the stock market performed strongly in the years immediately following this shock. Suggest some factors that could explain the stock market performance over this period. (LO5) Answer: The restrictions on economic activity and associated rise in unemployment at the onset of the pandemic put downward pressure on stock prices. The prospects for many companies took a turn for the worse, depressing expected dividend growth. While the COVIDrelated recession was one of the deepest on record, it was also one of the briefest. As the economy recovered sharply, so did the stock market. Moreover, the nature of the pandemic gave rise to new economic opportunities and to fiscal policy actions to combat the pandemic that bolstered the spending power of consumers, improving the outlook for companies. In addition, the monetary policy response to the pandemic helped to lower both nominal and real interest rates, contributing to the strength of the stock market.

20. Based on the dividend-discount model, what do you think would happen to stock prices if there were an increase in the perceived riskiness of bonds? (LO3) Answer: If investors perceive bonds are more risky, then the relative riskiness of stocks will fall. Stocks would become relatively more attractive, requiring a smaller risk premium than before. From the dividend discount model, we can see that a fall in the risk premium (which is in the denominator) would lead to a rise in stock prices.

21. *Use the dividend-discount model to explain why an increase in stock prices is often a good indication that the economy is expected to do well. (LO3) Answer: How well investors expect the economy to do is reflected in the expected growth rate of dividends, g. When investors are optimistic about the future, they will expect dividends to grow at a faster rate, which increases the price they are willing to pay for stocks. From the dividend discount formula for the stock price, we can see that g enters the numerator positively and the denominator negatively, so if g increases, the stock price increases.

22. Memories of the 2007-2009 financial crisis have made you more risk averse, doubling the risk premium you require to purchase a stock. Suppose that your risk premium before the crisis was 4 percent and that you had been willing to pay $412 for a stock with a dividend payment of $10 and expected dividend growth of 3 percent. Using the dividend discount model, with unchanged risk-free rate, dividend payment and expected dividend growth, what price (rounded to the nearest dollar) would you now be willing to pay for this stock? (LO3) Answer: First, use the dividend discount model formula to calculate the risk-free rate.

interest

Ptoday = Dtoday (1 + g)/(rf + rp – g) $412 = 10(1.03)/(rf + 0.04 – 0.03) This gives rf = 0.015, or 1.5% Using this information, calculate the price you would be willing to pay with rp =

0.08.

Ptoday= 10(1.03)/(0.015 + 0.08 – 0.03) = $158.4615 = $158 23. Suppose a shock to the financial system were to disproportionately hit corporate bond markets, making it much harder for companies to raise new funds via bond issuance. As a result, the proportion of equity financing rises significantly. What impact would you anticipate this would have on (i) the expected return on holding stocks and (ii) the volatility of equity returns? (LO3) Answer: i) As the proportion of a company’s financing via equity versus debt rises, the company’s leverage falls. While this shift reduces the expected return to equity holders, it also reduces the standard deviation of equity returns. ii) The decline in volatility of equity returns reflects the residual claimant status of stockholders. With a smaller proportion of bondholders to be paid ahead of equity holders, the standard deviation of equity returns is lower.

24. *The growth of private equity markets in the United States expands the options available to firms to raise funds, as well as the investment choices available to some investors. Why do you think private equity investing tends to be confined to institutional investors and high net worth individuals? (LO4) Answer: Private equity is not subject to the same regulatory requirements as public issues, including requirements about the disclosure of information. According to Core Principle 3, information is the basis for decisions, and large, sophisticated investors would be in a much stronger position to acquire the needed information and bear the costs of doing so. Private equity investments would also be less liquid than publicly listed stocks, likely reducing their appeal for smaller investors. Moreover, private equity markets are often chosen as a route to raise funds for start-up ventures whose capital tends to be difficult to value, adding to the riskiness of these investments. In addition, often small firms' goals are to merge with larger companies rather than to remain independent, as an IPO would require. * indicates more difficult problems

Data Exploration: 1. How well does the stock market anticipate the behavior of the economy? Plot on a monthly basis since 1972 the percentage change from a year ago of the Wilshire 5000 index (FRED code: WILL5000PR). Is the index a reliable predictor of business cycle downturns (depicted in the graph by vertical, shaded bars)? Did it anticipate the COVID pandemic recession of 2020? (LO5)

Answer: The data plot is:

Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR. Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1972e

Among various measures of financial conditions, a broad index of the stock market is one of the best predictors of economic downturns and upturns because investors are forward-looking and know that future profits and dividends depend on prospective economic activity. In the case of the Wilshire 5000, the index fell below the year-ago level before the recessions of 1973 and 2001 (recessions appear as vertical gray bars in the graph). And, it fell below the year-ago level in the first or second month of the recessions of 1981, 1990, 2008, and 2020. However, the index also fell below the year-ago level in the absence of a subsequent economic downturn once in the 1970s, twice in the 1980s, once in the 2000s, and again twice in the 2010s. It also fell below the year-ago level in 2022 but then rebounded without a recession (as of this writing in September 2023). Accordingly, a famous economist once quipped decades ago: ―The stock market forecast nine of the past five recessions.‖ After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. How well does the stock market anticipate the behavior of the economy? Plot on a monthly basis for the past 10 years the percentage change from a year ago of the S&P 500 index (FRED code: SP500). Is the index a reliable predictor of business cycle downturns (depicted in the graph by vertical, shaded bars)? (LO5) Answer: The data plot is:

2. Why might the stocks of small firms outperform large firms over long periods of time? Will this hold over short periods of time, too? Plot since 1979 the stock indexes for small firms (FRED code: WILLSMLCAP) and large firms (FRED code: WILLLRGCAP) using annual data scaled to a common base year of 1979 = 100. (LO3) Answer: The data plot is:

Wilshire Associates, Wilshire US Small-Cap Total Market Index [WILLSMLCAP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILLSMLCAP . Wilshire Associates, Wilshire US Large-Cap Total Market Index [WILLLRGCAP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILLLRGCAP. Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1972A.

Because risk requires compensation, we expect the stocks of small firms (that have a higher probability of failure) to offer higher returns than the stocks of large firms. However, this pattern need not hold over any short-term period. For example, the out-performance of large-cap stocks in the late 1990s probably reflects the ―dot.com‖ equity bubble. In that period, technology companies that initially were classified as ―small cap‖ were reclassified as ―large cap‖ as the boom proceeded, and then saw their values plunge when the boom went bust. After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem is not possible. This problem will be deleted in future releases of the book.

3. The Nasdaq stock market index (FRED code: NASDAQCOM) is comprised of stocks that tend to be relatively small, new, and focused on technology, while the Wilshire 5000 (FRED code: WILL5000PR) includes all actively traded stocks in the United States. Which do you think is more volatile? Plot on a monthly basis from 1980 the percent change from a year ago of these two indexes and discuss whether your intuition was correct. (LO5) Answer: The data plot is:

NASDAQ OMX Group, NASDAQ Composite Index [NASDAQCOM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NASDAQCOM. Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR. Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1972J.

Answer: The components of the Nasdaq hint that this index would be more volatile than the broader Wilshire 5000. This was clearly true in the ―dot.com‖ boom of the 1990s that culminated in the bust at the turn of the century. Since then, the volatility of the two has been more similar. In part, this similarity reflects the large number of stocks in each index (Nasdaq has about 3,000 stocks and the Wilshire 5000 less than 4,000). Moreover, the largest proportion of equities in the Wilshire 5000 are Nasdaq stocks, suggesting that their statistical properties should be broadly similar. After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. With some notable exceptions, the Nasdaq stock market index (FRED code: NASDAQCOM) is comprised of stocks that tend to be relatively small, new, and focused on technology, while the S&P 500 (FRED code: SP500) includes a broader (less technology-focused) array of largecapitalization, actively traded stocks in the United States. Which do you think is more volatile? Plot on a monthly basis for the past 10 years the percent change from a year ago of these two indexes and discuss whether your intuition was correct. (LO5) Answer: The data plot is:

Answer: The components of the Nasdaq hint that this index would be more volatile than the broader S&P 500, and that is indeed what we observe over the past decade. This pattern holds despite the larger number of stocks in the Nasdaq index (more than 2,500). It also holds despite the presence in both indexes of some of the very largest stocks by market capitalization, including Apple, Microsoft, NVIDIA, Amazon, Meta, and Alphabet.

4. To see the impact of the bubble in Internet stocks on household wealth, plot on a monthly basis since 1980 the Nasdaq stock index (FRED code: NASDAQCOM) on the left axis against the market value of nonfarm nonfinancial corporations (FRED code: NCBEILQ027S) on the right axis. Comment on the impact of the bursting of the bubble on this measure of equity wealth. Aside from the Nasdaq decline, what else might have caused it to drop? (LO5) Answer: The plot is:

NASDAQ OMX Group, NASDAQ Composite Index [NASDAQCOM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NASDAQCOM. Link that updates automatically: https://fred.stlouisfed.org/graph/?g=19730.

Wealth as measured by the value of corporations fell along with the Nasdaq index, but by a smaller percentage. On a monthly basis, the Nasdaq peaked at a value of 4802 in March 2000. In the first quarter of that year, the market value of corporations was $15,923 billion. By September 2002, the Nasdaq had fallen to 1251, a plunge of about 74%. The value of corporations had fallen to $8,408 billion in the third quarter of 2002, a decline of 47%. The Nasdaq was dominated by new internet companies. When their stock prices collapsed, their values fell by more than those of established, stable firms that are included in the broad wealth measure. Nonetheless, the impact on wealth of the bursting of the bubble was sizable. Wealth may also have declined due to falling income in the recession of 2001 that also diminished the value of firms not included in the Nasdaq. Also note that the strong stock market performance since 2016 has propelled the Nasdaq index at a faster pace than the rise of overall wealth.

5. Have stock dividends become a more important source of income to U.S. households? Plot on a quarterly basis since 1959 the share of dividend income (FRED code: B703RC1Q027SBEA) in personal disposable income (FRED code: DSPI). Can you explain the 50-year trend? (LO5) Answer: The data plot is:

Link that updates automatically: https://fred.stlouisfed.org/graph/?g=1973b.

Several factors may explain the rise in dividend income as a proportion of disposable income. Ownership of equity has become much more widespread over this period. Part of that shift may reflect demographics, as a larger share of the population saves for retirement. Another part may reflect the gradual migration of firms’ pension programs from traditional defined-benefit schemes toward defined-contribution plans (including so-called 401(k) plans). Advisers of these pension plans often encourage workers to hold their retirement accounts partly in stocks. The improved liquidity of stocks likely also has encouraged the trend. Finally, the decline in top marginal tax rates probably made dividends relatively more attractive to investors over time. The temporary plunge in 2020 may be due to suspension of dividend payments at some firms as the pandemic downturn created uncertainty over cash flows at many firms. As the economy recovered, many firms reinstated dividend payments.

6. What factors determine whether firms issue publicly traded stock to finance investment? Plot the number of publicly listed companies per million people in the United States (FRED code: DDOM01USA644NWDB) since 1996. Describe the trend and discuss what might explain it. (LO5)

Answer: The data plot is:

World Bank, Number of Listed Companies for United States [DDOM01USA644NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDOM01USA644NWDB

At least two factors may account for the decline in publicly traded stocks. First, it is costly to issue shares of stock into public markets. Initially there are costs for filing for eligibility to be listed on exchanges (for example, lawyers’ fees and charges by investment banks). On an ongoing basis, firms must comply with a variety of regulations and issue reports, prepared using generally accepted accounting practices, to be filed with the Securities and Exchange Commission on a periodic basis). Second, rather than being listed on an exchange, experts employed by private equity and venture capital firms can better assess the value of a new firm and perhaps arrange its sale to, or merger with, an established company. For example, it is not unusual for major software companies to purchase promising startups. Assessment of value is relatively difficult when new companies have substantial intangible capital such as intellectual property rather than tangible capital such as factories and machines.

Chapter 9 Derivatives: Futures, Options, and Swaps Conceptual and Analytical Problems 1. An agreement to lease a car can be thought of as a set of derivative contracts. Describe them. (LO2)

Answer: When someone leases a car, he or she agrees to make a series of fixed monthly payments; this is like a forward contract. At the end of the lease, the lessee can purchase the car; this is like an option.

2. How is entering into a forward contract similar to barter? Can you think of costs associated with forward contracts that are minimized or eliminated with futures contracts? (LO2) Answer: As in barter, when you engage in a forward contract, you must establish a ―double coincidence of wants;‖ that is, you must find someone who ―has what you want and wants what you have.‖ While barter usually is an immediate trade of one item for another, in a forward contract you must also agree on the timing of the transaction. Compared to futures contracts, forward contracts also are illiquid and involve default risk that is reduced when a centralized clearinghouse is the counterparty.

3. The E-mini S&P 500 futures contract is one-fifth the size of the standard futures contract and can be traded on the 24-hour CME Globex electronic trading system. What might be some of the advantages of a futures contract with these properties? (LO1) Answer: The size of the contract allows small investors to purchase it. The fact that the contracts can be traded 24 hours a day makes the contract more liquid and allows investors to speculate using current information from markets around the world. It also makes it more convenient for foreign investors to trade the contracts.

4. A hedger buys a futures contract, taking a long position in the wheat futures market. What are the hedger’s obligations under this contract? Describe the risk that is hedged in this transaction and give an example of someone who might enter into such an arrangement. (LO1) Answer: The hedger has taken the long position, promising to purchase the wheat at a fixed price on a future date. They are hedging against the risk that the price of wheat will rise. Someone who anticipates needing wheat in the future, such as a miller or a maker of breakfast cereals, might enter into such a transaction.

5. A futures contract based on a payment of $250 times the S&P 500 Index is traded on the Chicago Mercantile Exchange. At an index level of 1,000 or more, the contract calls for a payment of over $250,000. It is settled by a cash payment between the buyer and the seller. Who are the hedgers and who are the speculators in the S&P 500 futures market? (LO1) Answer: Hedgers are investors who own funds composed of stocks from the S&P 500; they will sell futures contracts to hedge against the risk that the market falls. Speculators are trying to profit from movements in the market; they will sell futures if they expect the market to fall and buy futures if they expect the market to rise.

6. Explain why trading derivatives on centralized exchanges rather than in over-the-counter markets helps to reduce systemic risk. Can you think of a way in which more trading on centralized exchanges might increase risk? (LO1)

Answer: The presence of a centralized counterparty (CCP) increases transparency, as the CCP has the ability and the incentive to monitor whether a trader is taking a large position on one side of a trade. This reduces the vulnerability of the financial system to the weakness of any one participant. The CCP reduces its own risk through economies of scale. With large volumes of transactions on both sides of a trade, its net exposure is relatively small. The standardization of contracts traded through CCP also increases transparency, while the practice of marking to market quickly exposes a counterparty’s inability to pay, allowing for a timely resolution of the problem and the avoidance of knock-on effects. Any possibility of the temporary failure of an exchange will increase risk. Because the failure of a large CCP can transmit shocks around the world, the resilience of the CCPs is critical for financial stability. Even temporary disruptions may undermine the well-being of CCP clearing members and their clients. However, the move to trading on centralized exchanges concentrates risks in the exchanges themselves.

7. What are the risks and rewards of writing and buying options? Are there any circumstances under which you would get involved? Why or why not? (Hint: Think of a case in which you own shares of the stock on which you are considering writing a call.) (LO3) Answer: Because option buyers incur no obligations, their losses are limited to the price paid for the option. Their potential gains, however, can be large. Sellers must buy or sell the underlying asset at the strike price if the option is exercised, so their losses are unlimited. When writing a call option, the seller can lose money if the price of the underlying asset rises; however, if the seller owns the asset, then he or she is insured against these potential losses and issuing a call option is not very risky.

8. Suppose XYZ Corporation's stock price rises or falls with equal probability by $30 each month, starting where it ended the previous month. What is the value of a three-month at-the-money European call option on XYZ’s stock if the stock is priced at $100 when the option is purchased? (LO3) Answer: Value of option = Option price = Intrinsic value + Time Value of the Option Intrinsic value = $0 as the option is at the money. To calculate the time value of the option, list all the possible outcomes for the stock price movement and identify those where the price goes up. If the stock price falls, the option will not be exercised. Month 1 +30 +30 +30 -30 +30 -30

Month 2 +30 +30 -30 +30 -30 +30

Month 3 +30 -30 +30 +30 -30 -30

Total +90 +30 +30 +30 -30 -30

-30 -30

-30 +30

-90 -30

Each of the outcomes is equally likely and so occurs 1/8 of the time. Focusing on the first four where the price goes up, Time Value of the Option = Option price = intrinsic value + time value of the option = $0 + $22.50 = $22.50

9. *Why might a borrower who wishes to make fixed interest rate payments and who has access to both fixed- and floating-rate loans still benefit from becoming a party to a fixed-for-floating interest rate swap? (LO4) Answer: If the company has a comparative advantage in borrowing in the floating rate market, it can reduce its overall interest costs by borrowing at a floating interest rate and entering a swap agreement where it makes fixed payments and receives payments that fluctuate with the interest rate. The net effect is that its payments are fixed but, because it exploits its comparative advantage in the floating rate market where it can borrow relatively cheaply, the overall cost is lower than borrowing directly from the fixed rate market.

10. Concerned about possible disruptions of the supply of oil from the Middle East, the chief financial officer (CFO) of American Airlines would like to hedge the risk of an increase in the price of jet fuel. What tools could the CFO use to hedge this risk? (LO3) Answer: The CFO could buy oil futures contracts, giving the CFO a long position in oil and so protecting against a price increase. Alternatively, the CFO could buy oil call options, which would confer the right to buy oil at the strike price on or before the expiration date of the option. 11. *How does the existence of derivatives markets enhance an economy’s ability to grow? (LO1) Answer: The existence of derivative markets increases the economy’s capacity to carry risk by facilitating the transfer of risk to those best able to bear it. They allow risks to be hedged more efficiently and at a lower cost by those who do not wish to carry them. In the absence of these mechanisms to deal with risk, resources may not be allocated efficiently, hindering the ability of the economy to grow.

12. Credit default swaps provide a means to insure against default risk and require the posting of collateral by buyers and sellers. Explain how these ―safe-sounding‖ derivative products contributed to the 2007-2009 financial crisis? (LO4) Answer: Credit default swaps (CDS) are traded over the counter and financial institutions do not report their CDS purchases and sales. This contributed to a lack of transparency about who bears the default risk, making the financial system more vulnerable. (Recall Core Principle 3 from Chapter 1—information is the basis for decisions.) Traders could not identify who might have large one-sided positions, making the system vulnerable to the collapse of one institution.

During the 2007-2009 crisis, AIG was a large player in the market for credit default swaps. When the company’s credit rating was downgraded, the additional collateral requirements it faced brought it near to collapse, threatening the stability of the financial system as a whole and prompting the intervention of the Federal Reserve.

13. What kind of an option should you purchase if you anticipate selling $1 million of Treasury bonds in one year’s time and wish to hedge against the risk of interest rates rising? (LO3) Answer: You could purchase a put option that gives you (as the holder) the right but not the obligation to sell the bonds at a price determined today. Therefore, if interest rates rise and so the price of the bonds falls, you can exercise the option and sell the bonds at the pre-determined price. If, on the other hand, interest rates fall, you can let the option expire and enjoy the benefits of the increase in the price of the bonds.

14. You sell a bond futures contract and, one day later, the clearinghouse informs you that it had credited funds to your margin account. What happened to interest rates over that day? (LO2) Answer: Interest rates have risen. This reduced the price of the bonds and so as the holder of the short position you have gained. As the clearinghouse marks to market on a daily basis, this gain was posted to your margin account.

15. You are completely convinced that the price of copper is going to rise significantly over the next year and want to take as large a position as you can in the market but have limited funds. How could you use the futures market to leverage your position? (LO2) Answer: You should buy as many one-year copper futures contracts as you can afford. This will depend on the margin payment required. As the margin payment is a fraction of the value of the contract, you will leverage your exposure to market movements. The value of the futures contracts will rise in lockstep with the price of copper.

16. Suppose copper is selling at $3 a pound and the margin requirement for a futures contract for 25,000 pounds of copper is $8,000. (LO2) a. Calculate your return if you purchase one copper futures contract and copper prices rise to $3.10 a pound. b. How does this compare with the return you would have made if you have simply purchased $8,000 worth of copper and sold it a year later? c. Compare the risk involved in each of these strategies. Answer: a. At $3 a pound, a futures contract for 25,000 pounds of copper is worth $75,000. The contract specifies that you will take delivery of 25,000 pounds at $3 a pound in one-years’ time. If the price in the market has risen by then to $3.10, you make a profit of $2,500 ($0.10 × 25,000) on the $8,000 margin you posted. This represents a return of 31.25% on your investment.

b. If you purchased copper directly at $3 a pound, you could have afforded 2,667 pounds. If you sold it one year later for $3.10, you would have gained $267, a return of 3.3%. c. Speculating in the futures market can bring high returns (in this case returns almost ten times as large), but, as usual, these high returns come at the cost of bearing greater risk. Suppose, for example, your hunch about copper prices was incorrect and the price of copper fell to $2.90. You would have lost $2,500 over the year. If you were very unfortunate and the price of copper fell to $2.65, you would have wiped out your entire $8,000 and a bit more as well. In comparison, if you bought the copper at $3 and after a year you sold it at $2.90, you would have lost only $267. For your entire $8,000 to be wiped out, the price of copper would have to fall to zero! And, of course, once you own the copper (ignoring storage costs), you could always elect to hold onto it until the price rose again. 17. Suppose you were the manager of a bank that raised most of its funds from short-term variablerate deposits and used these funds to make fixed-rate mortgage loans. Should you be more concerned about rises or falls in short-term interest rates? How could you use interest rate swaps to hedge against the interest rate risk you face? (LO4) Answer: Given that you make interest payments based on short-term interest rates and receive fixed-rate interest payments, you should be most concerned about increases in short-term rates. You would have to make higher payments while the payments you receive remain the same. You could hedge against this risk by entering into a fixed-for-floating interest rate swap where you make payments based on a fixed interest rate and receive payments that fluctuate with a reference floating interest rate. When interest rates rise, you receive higher payments from the swap to offset the losses on your underlying banking business.

18. * The table below shows the yields on the fixed and floating borrowing choices available to three firms. Firms A and B want to be exposed to a floating interest rate while Firm C would prefer to pay a fixed interest rate. Which pair(s) of firms (if any) should borrow in the market they do not want and then enter into a fixed-for-floating interest rate swap. (LO4)

Fixed Rate

Floating Rate

Firm A

SOFR+50 bps

Firm B

12%

SOFR+150 bps

Firm C

10%

SOFR+150 bps

Note: SOFR, which stands for the Secured Overnight Financing Rate, is a floating interest rate that serves as a reference rate. Answer: Possible pairs: A and C or B and C. (As A and B both want floating, they won’t engage in a fixed-for-floating swap with each other.)

Next, look at who has the comparative advantage in which market. A versus C: A has a 3% advantage over C in the fixed rate market and a 1% advantage in the floating rate market. Therefore, A has a comparative advantage in the fixed rate market and wants floating. A and C can reduce their overall cost of funds by A borrowing fixed, C borrowing floating and then entering into a fixed-for-floating swap to exchange the exposures. B versus C: C has a comparative advantage in the fixed rate market and wants fixed rate exposure. Therefore, there is no benefit to the swap. A and C are the only pair that should engage in a fixed-for-floating swap. 19. * Suppose, prior to the European financial crisis, you were considering investing in Greek government bonds but had some concerns about the creditworthiness of the Greek government. Why, despite your concerns, might you still make such an investment? (LO1, LO4) Answer: Core Principle 2 states that risk requires compensation, so it is likely that you are attracted by a higher yield available on Greek government bonds compared to less risky investment alternatives. You might also transfer the risk associated with a default by the Greek governments by purchasing a credit default swap. While you would have to pay a fee for this insurance, the expected higher return on the investment might warrant it.

20. You and a colleague both follow the movements of the VIX, an index based on options prices that reflects investors’ expectations for stock market volatility. Suppose, according to the VIX, implied volatility is expected to be low for a protracted period. Your colleague sees this as unambiguously good news. Why might you disagree? (LO3) Answer: While you agree with your colleague that low levels of implied volatility might bring high stock valuations and a high level of stock market liquidity, you might be concerned that investors will become complacent and underestimate risk, causing risky assets to become mispriced and possibly destabilizing the financial system when prices correct. 21. What is the value of a put option with a strike prices of $150 if the option is at expiration and the market price is $140? What if, instead, the market price is $160? (LO3) Answer: A put option gives the holder the right but not the obligation to sell the underlying asset. The value of the option is the sum of the intrinsic value and the time value of the option: Value of option = Option price = Intrinsic value + Time Value of the Option As the option is just at expiration, the time value of the option = 0. Intrinsic value = Strike Price – Market Price, or zero, whichever is higher. When the market price is $140, the intrinsic value = 0. The option to sell the underlying asset at a price below what it could be sold for in the market is not valuable. In this case, the value of the put option is zero. When the market price is $160, the intrinsic value = value of the option = $10.

22. Explain why the VIX jumped to record levels in March 2020 with the onset of the COVID pandemic. (LO3) Answer: The VIX, often called the fear index, captures market expectations about volatility. It is a measure of the uncertainty and risk that investors see over the near future. The destabilizing impact of the pandemic on financial markets and the broader economy was reflected in the surge of the index. Typically, implied volatility captured by the VIX is high, when stock valuations are low. Recall from Chapter 8 that the stock market fell sharply in the first three months of 2020.

Data Exploration 1. Central banks occasionally engage in ―liquidity swaps‖ with each other. Plot and interpret the Fed’s provision of dollar liquidity swaps (FRED code: SWPT) to other central banks since 2007. To facilitate your interpretation, view the FRED ―Notes‖ about this data series. (LO4) Answer: The data plot is:

These liquidity swaps occur when foreign banks need additional U.S. dollars to fund their dollar-denominated activities. The Fed exchanges dollars with the foreign central banks, which then in turn lend them to their member banks. The Fed supplies dollars and accepts foreign currency at the current exchange rate. The swap agreement includes an arrangement to reverse the transaction at a later date, when the dollars are returned to the Fed (with interest) at the initial exchange rate (so there is no currency risk to the Fed). The data plot shows that these swaps occurred first in the financial crisis of 2007-2009. In that period, foreign commercial banks needed dollars for transactions their customers wanted to

undertake in U.S. currency. Normally, these banks would have borrowed from U.S. financial intermediaries, but interbank lending plummeted during the crisis – especially after the failure of Lehman in September 2008. As a result, foreign banks were compelled to seek dollardenominated loans from their own central banks that (in turn) obtained dollar liquidity swaps from the Fed (see Chapter 3). The second occurrence of large swap lines between the Fed and foreign central banks occurred in 2012 at an acute stage of the sovereign and banking crisis in the euro area (see Chapter 16). The third occurrence of large-scale swap arrangements was at the outset of the pandemic-induced recession in March 2020. In these cases, once the functioning of private markets improved, central bank liquidity swaps virtually disappeared.

2. Plot the Greek long-term yield (IRLTLT01GRM156N). How might an investor at the start of 2010, accustomed to the use of derivatives, have hedged interest rate risk over the next three years. How about default risk? (LO4) Answer: The data plot is:

Organization for Economic Co-operation and Development, Interest Rates: Long-Term Government Bond Yields: 10-Year: Main (Including Benchmark) for Greece [IRLTLT01GRM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01GRM156N, October 6, 2023

From January 2010 to June 2012, interest rates rose from 6.02 percent to a high of 29.24 percent in February 2012 before dropping for a period and rising again. An investor might choose to hedge interest rate risk for fixed rate bonds, or other assets whose price would drop as interest rates increased, by selling (shorting) interest rate futures contracts. The short position rises in value when interest rates increase, thus offsetting the interest losses in the underlying asset. This investor could also acquire put options on assets, giving her the option to sell at the strike price.

To hedge against default risk during a period of increasing interest rates, an investor can purchase a credit default swap, which is essentially buying insurance against a borrower defaulting. 3. Risk-averse investors care greatly about asset price volatility. Using the FRED ―Notes‖ about the data series, briefly define the VIX Volatility Index (FRED code: VIXCLS) of the Chicago Board Options Exchange (CBOE). Plot monthly since 2004 the VIX and the percent change from a year ago of the Wilshire 5000 stock market index (FRED code: WILL5000PR). Interpret the graph (LO3) Answer: The VIX infers stock market participants’ collective expectation of stock price volatility from options prices. Because the price of an option increases as the value of the underlying asset is more uncertain and volatile, a rise in the VIX reflects greater expected market variability. Consistent with this interpretation, we see that the VIX was rising gradually as the recession approached and then rose sharply at the time of the financial panic in September, 2008. A similar pattern occurred at the outset of the pandemic of 2020 and the associated government-imposed lockdowns of segments of the economy. Note also that the VIX is inversely related to the performance of the equity market index: expected volatility is low when the stock market rises (and vice versa). The VIX spike in 2008 followed the collapse of Lehman and at the outset of the pandemic of 2020. The data plot is:

Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS. Wilshire Associates, Wilshire 5000 Price Index [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR.

After publication, the Wilshire 5000 Price Index was discontinued. A replacement problem and solution are presented here. The next printing of the book will feature this replacement.

Risk-averse investors care greatly about asset price volatility, and can use option prices to judge how market participants view the likely evolution of volatility. For example, the CBOE NASDAQ 100 Volatility Index (FRED CODE: VXNCLS) measures ―the market’s implicit expectation of 30-day volatility implicit in the prices of near-term NASDAQ-100 options.‖ Plot monthly since 2001 the CBOE Nasdaq 100 Volatility Index (FRED CODE: VXNCLS) and the percent change from a year ago of the Nasdaq 100 stock market index (FRED code: NASDAQ100). Interpret the chart. (LO3) Answer: The data plot is:

The chart highlights that expected volatility typically surges when stock prices plunge, while rising stock prices are usually associated with low expected volatility. However, this relationship is imperfect. For example, stock prices did not fall (from year-ago levels) during the brief COVID pandemic of 2020, even though expected volatility temporarily jumped. Similarly, expected volatility rose only moderately in 2022 when stock prices plunged. 4. Is the VIX volatility index (FRED code: VIXCSL) an indicator of broader financial market volatility? Using weekly data ending on Fridays, plot from 1994 the VIX, with its scale on the left axis, and the St. Louis Federal Reserve Bank index of financial stress (FRED code: STLFSI), with its scale on the right axis. Describe the financial stress index and comment on how closely related it is to the VIX. (LO3) Answer: The St. Louis Fed’s financial stress index is based on eighteen data series, including seven interest rates, six yield spreads, and five other indicators. To the extent that options traders’ behavior reflects the assessments of financial market conditions embedded in these indicators, the co-movement between the VIX and the stress index is perhaps not surprising. Note that the two series appear to be especially closely related at the onsets of the financial crisis of 2007-2009 and the pandemic in early 2020. Note also that both episodes were preceded by periods of relatively low volatility that tempted investors and users of funds to take

greater risk. The VIX has become a major focus of attention because it is, arguably, the single most important (and timely) indicator of financial stress.

Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS. Federal Reserve Bank of St. Louis, St. Louis Fed Financial Stress Index: STLFSI4, retrieved from FRED. https://fred.stlouisfed.org/series/STLFSI4

* indicates more difficult problems

Chapter 10 Foreign Exchange XII.

Conceptual and Analytical Problems 1. If the U.S. dollar-British pound exchange rate is $1.30 per pound, and the U.S. dollar-euro exchange rate is $1.12 per euro: (LO1) a. What is the pound-per-euro rate? b. How could you profit if the pound-per-euro rate were above the rate you calculated in part a? What if it were lower? Answer:

a. If the U.S. dollar-British pound exchange rate is $1.30 per pound, and the U.S. dollar-euro exchange rate is $1.12 per euro, the pound-per-euro rate is pound $1.12   £0.86/€ $1.30 euro

b. If the pound per euro rate were above £0.86/€, you could profit by converting dollars to euros, euros to pounds, and then pounds to dollars. For example, if the rate were £0.90/€ and you started with $112, you could exchange the $112 for €100. Then you could exchange €100 for £90, and £90 for $117, making a profit of $5. If the pound per euro rate were below £0.86/€, you could make a profit by converting dollars to pounds, pounds to euros, and then euros to dollars.

2. A video game costs $65 in the United States and £55 in United Kingdom. Look up the current dollar-pound exchange rate and use it to calculate the real ―video game‖ exchange rate. Interpret your answer. (LO1) Answer: As of July 25, 2023, the dollar-pound exchange rate was $1.287648 per pound. The real video game exchange rate is $65/(£55 × 1.287648) = 0.92. This is the ratio of the cost of a video game in the United States to the cost of a game in the United Kingdom. Since the real video game exchange rate is less than one, it implies that this game is cheaper in the United States than in the United Kingdom; you can exchange one U.S. video game for 0.92 of a U.K. video game. Put another way, $65 buys you one video game in the United States, but you would need $70.82 to buy a video game in the United Kingdom.

3. Suppose the euro-dollar exchange rate moves from $0.90 per euro to $0.92 per euro. At the same time, the prices of European-made goods and services rise 1 percent, while prices of American-made goods and services rise 3 percent. What has happened to the real exchange rate between the dollar and the euro? Assuming the same change in the nominal exchange rate, what if inflation were 3 percent in Europe and 1 percent in the United States? (LO2) Answer: In the first case there is (approximately) no change in the real exchange rate because inflation in the U.S. is 2 percent higher than in Europe and the dollar has depreciated about 2 percent against the euro. In this case, assume that initially the cost of goods in the U.S. is $100 and that the cost of goods in Europe is 100€. The real exchange rate is:

So, we would have 100 / (100 × 0.90) = 1.11 as the real exchange rate at the initial exchange rate. If prices in the U.S. rise by 3 percent and those in Europe by 2 percent while at the same time the dollar price of the euro changed to $.92, then the real exchange rate would be 103 / (101 × 0.92) = 1.108, about the same. Using similar computations, it can be shown that in the second case the real dollar/euro exchange rate has risen by 4 percent.

4. The same laptop computer costs $600 in the United States, €450 in France, £300 in the United Kingdom, and ¥100,000 in Japan. If the law of one price holds, what are the euro-dollar, pounddollar, and yen-dollar exchange rates? Why might the law of one price fail? (LO1) Answer: If the law of one price holds, then the euro/dollar exchange rate should be €450/$600 = €0.75/$, the pound/dollar exchange rate should be £300/$600 = £0.5/$, and the yen/dollar exchange rate should be ¥100,000/$600 = ¥166.67/$. The law of one price may fail because of transportation costs, tariffs, and technical specifications.

5. *What does the theory of purchasing power parity predict in the long run regarding the inflation rate of a country that fixes its exchange rate to the U.S. dollar? (LO2) Answer: According to the theory of purchasing power parity, changes in exchange rates are tied to differences in inflation from one country to another. If, as in the case of a fixed exchange rate, there are no exchange rate changes, it predicts that the inflation rate in that country should be the same as the U.S. rate of inflation in the long run.

6. *Can purchasing power parity help predict short-term movements in exchange rates? (LO2) Answer: Purchasing power parity doesn’t hold on a day-to-day basis or even on a month-tomonth or year-to-year basis. It tells us how exchange rates will move over long periods like decades. In the short run, exchange rates can deviate substantially from their purchasing power parity levels. In the short run, exchange rates are determined by a host of factors affecting supply and demand for currencies and are effectively unpredictable.

7. You need to purchase Japanese yen and have called two brokers to get quotes. The first broker offered you a rate of 125 yen per dollar. The second broker, ignoring market convention, quoted a price of 0.0079 dollar per yen. To which broker should you give your business? Why? (LO1) Answer: An exchange rate of 0.0079 dollars per yen is equivalent to 126.58 yen per dollar (¥1/$0.0079 = ¥126.58/$), so you should get yen from the second broker. 8. During the 1990s, the U.S. Secretary of the Treasury often stated, ―a strong dollar is in the interest of the United States.‖ (LO4) a. Is this statement true? Explain your answer. b. What can the Secretary of the Treasury actually do about the value of the dollar relative to other currencies? Answer: a. When the dollar is strong, foreign goods are relatively cheap for consumers in the United States. This helps keep inflation in check. A strong dollar also attracts foreign investment. However, when the dollar is strong, U.S. goods are more expensive for foreigners, and U.S. exports fall. So, a strong dollar benefits some people and hurts others. What is more beneficial is a stable dollar, so that there is not much exchange rate risk.

b. Without the cooperation of the Federal Reserve, the Secretary of the Treasury can’t do anything about the value of the dollar. They can buy and sell foreign currencies, but this is not usually effective in changing the value of the dollar because it does not influence the interest rate. And it is the interest rate that influences investors’ demand for and supply of dollars. 9. The following table gives selective data on nominal exchange rates, price levels, and real exchange rates for Country A and several other countries. Country A uses the dollar (A$) as its currency. Fill in the blanks in the table. (LO1) Nominal Exchange Rate (A$ per unit of other currency) Country B

$1.25 per unit of currency B

Country C Country D

$0.55 per unit of currency D

Price Level in Country A

Price Level in Other Country

114.5

88.3

114.5

95.6

114.5

Real Exchange Rate

1.23

0.80

Answer:

Country B Country C Country D

Nominal Exchange Rate (A$ per unit of other currency) $1.25 per unit of currency B 114.5/(95.6 × 1.23) = $0.973/unit of currency C $0.55 per unit of currency D

Price Level in Country A

Price Level in Other Country

114.5

88.3

114.5

95.6

114.5

114.5/(.80 × $0.55) = 260.23

Real Exchange Rate 114.5/(88.3 × 1.25) = 1.04 1.23

0.80

10. If the price (measured in a common currency) of a particular basket of goods is 10 percent higher in the United Kingdom than it is in the United States, which country’s currency is undervalued, according to the theory of purchasing power parity? (LO2) Answer: According to the theory of purchasing power parity, the real exchange rate should equal 1. If we look at the ratio of the cost of the basket of goods in the United States to the cost in the United Kingdom, that ratio (which is the real exchange rate taking the United States to be the home country), is less than one. For example, if the price of the basket $100 in the United States and $110 in the United Kingdom, the real exchange rate would be 0.91. The $110 price in

the United Kingdom is calculated by multiplying the pound price of the basket by the nominal exchange rate (dollars per pound). The U.S. dollar is therefore undervalued. If the dollar were to strengthen, (i.e. the number of dollars per pound would fall), the dollar price of the U.K. basket of goods would fall, bringing the real exchange rate back towards 1.

11. *You hear an interview with a well-known economist who states that she expects the U.S. dollar to strengthen against the British pound over the next 5 to 10 years. This economist is known for her support of the theory of purchasing power parity. Using an equation to summarize the relationship predicted by purchasing power parity between exchange rate movements and the inflation rates in the two countries, explain whether you expect inflation in the United States to be higher or lower on average compared with that in the U.K. over the period in question. (LO2) Answer: The economist’s comments were about exchange rate movements in the long run. Purchasing power parity tells us that, in the long run, changes in exchange rates are related to inflation rate differentials across countries. (Take a look at Figure 10.4). We can represent this idea by the equation: Change in exchange rate (dollars per pound) = Inflation (U.S.) – Inflation (U.K.) If the dollar is expected to strengthen, this means it takes fewer dollars to purchase a pound, so the change in the exchange rate is negative. Therefore, inflation in the United States is expected to be lower than in the U.K.

12. Using the model of demand and supply for U.S. dollars, what would you expect to happen to the U.S. dollar exchange rate if, in light of a worsening geopolitical situation, Americans viewed foreign bonds as more risky than before? (You should quote the exchange rate as number of units of foreign currency per U.S. dollar.) (LO3) Answer: If Americans view foreign bonds as riskier than before, they will reduce their demand for these bonds. There will be a fall in the supply of dollars Americans use to purchase foreign assets, shifting the supply curve to the left. The exchange rate, quoted as the number of units of foreign currency per U.S. dollar, will rise, reflecting an appreciation of the U.S. dollar.

13. Suppose that the Chinese central bank has been intervening in the foreign exchange market, buying U.S. dollars in an effort to keep its own currency, the renminbi (measured in yuan),

weak. Use the model of demand and supply for dollars to show what the immediate effect would be on the Chinese yuan-U.S. dollar exchange rate of a decision by China to allow its currency to float freely. (LO3) Answer: Suppose initially that the Chinese central bank had maintained the exchange rate at E0 in the diagram below. If the Chinese central bank then stopped purchasing U.S. dollars in the market, there would be a shift to the left in the demand curve for dollars, leading to a fall in the number of yuan per dollar in equilibrium. In other words, the Chinese currency would appreciate against the U.S. dollar and the dollar will depreciate.

14. If the Chinese renminbi appreciated against the U.S. dollar, what would you expect to happen to a. U.S. exports to China? b. U.S. imports from China/ c. the U.S. trade deficit with China? Explain your answers. (LO4) Answer: a. U.S. exports to China should increase. The appreciation of the Chinese renminbi would make U.S. exports more competitive in China, as the amount of yuan that would have to be given up for any given dollar price of a good would fall. b. U.S. imports from China should fall. The appreciation of the Chines renminbi would make imports from China more expensive in the U.S., as more dollars would have to be given up to purchase the yuan needed for the imports. c. The trade deficit measures the excess of imports from China over exports to China from the U.S. With exports rising and imports falling, the trade deficit should narrow.

15. Suppose that, driven by waves of national pride, consumers across the world (including in the United States), decide to buy home-produced products where possible. Explain how the demand and supply for dollars would be affected. What can you say about the impact on the equilibrium dollar exchange rate? (LO3)

Answer: A fall in foreign demand for U.S. goods would shift the demand curve for dollars to the left while the fall in U.S. demand for foreign goods would shift the supply curve for dollars to the left. The overall impact on the dollar exchange rate depends on which shift dominates. As the economy of the world outside the U.S. is larger than the U.S. economy, you might expect the demand shift to dominate, leading to a depreciation of the dollar. S1

Foreign Currency per dollar

E0 E1

D0 D1 Quantity of dollars traded

16. Suppose an Italian bank has short-term borrowings of 400 million euro and 100 million U.S. dollars and made long term loans of 300 million euro and 250 million U.S. dollars. The eurodollar exchange rate is initially $1.50 per euro. (LO3) a. Ignoring other assets and liabilities, place each item on the appropriate side of the bank’s balance sheet. b. List the risks that this bank faces. c. If the euro-dollar exchange rate moved to $1.60 per euro, would the bank gain or lose? Provide calculations to support your answer. Answer: a. In addition to other assets and liabilities, the items appear on the balance sheet as:

b. In addition to the usual default risk, the bank faces both currency risk and rollover risk arising from the currency and maturity mismatches between its assets and liabilities. The gap between the bank’s lending and borrowing in foreign currency — its currency mismatch — is $150 million. The maturity mismatch arises because its long-term lending is financed by short-term borrowing, giving rise to risk associated with its ability to rollover this short-term borrowing as it matures. This rollover risk adds to the currency risk: in the event the bank cannot rollover its dollar borrowings, it would have to sell dollar loans or borrow euro.

c. The bank has more dollar-denominated assets than dollar-denominated liabilities, so when the dollar weakens (the euro strengthens), the bank loses. At the initial exchange rate of $1.50 per euro, the currency gap is 100 million euro. If the euro appreciates to $1.60 per euro, the bank loses 6.25 million euro. The loss due to the currency movement is found by converting the dollar entries to euros at the initial exchange rate and finding the net value of the dollar assets in euros, and then re-computing the net value at the new exchange rate.

17. *Suppose government officials in a small open economy decided they wanted their currency to weaken in order to boost exports. What kind of foreign exchange market intervention would they have to make to cause their currency to depreciate? What would happen to domestic interest rates in that country if its central bank doesn’t take any action to offset the impact on interest rates of the foreign exchange intervention? (LO4) Answer: The government officials would have to sell domestic currency in exchange for foreign currency in order for their domestic currency to weaken. This increases the supply of domestic currency, pushing down domestic interest rates. 18. Suppose the interest rate on a one-year U.S. bond is 10 percent and the interest rate on an equivalent Canadian bond is 8 percent. If the interest rate parity condition holds (see the appendix to Chapter 10), is the U.S. dollar expected to appreciate or depreciate relative to the Canadian dollar over the next year? Explain your choice. (LO3) Answer: You would expect the U.S. dollar to depreciate. If the interest parity condition holds, the return on the two bonds should be equal. The holder of the Canadian bond must gain on the exchange rate to compensate for the lower interest rate to equate the two returns. 19. Most countries do not attempt to manage their exchange rates with intervention in the foreign currency markets, but some do. Under which circumstances is such an intervention likely to be ineffective? (LO4) Answer: First, the intervention may fail if the government lacks sufficient resources to maintain the intended exchange rate. For example, it may need a large quantity of foreign exchange if it wishes to convince foreign exchange market participants that its exchange rate commitment is credible. Second, the exchange rate policy will likely fail if it is offset by the central bank’s interest rate policy. Put differently, the central bank must be willing to allow interest rates to adjust consistently with the exchange rate objective. 20. Suppose you see the following news headline: ―Japan’s Finance Ministry Sells Yen for U.S. Dollars.‖ What is the objective of this policy? If the policy goal is achieved, what will happen to the prices of Japanese imports to the United States? What will happen to the prices of U.S. goods purchased by residents of Japan? (LO4) Answer: The policy intervention by the Ministry aims to lower the value of the yen versus the U.S. dollar by increasing the quantity of yen relative to dollars in the foreign exchange market. For this policy to work over any sustained period of time, Japan's central bank would have to be willing to lower its policy interest rate (otherwise, the central bank would reverse the Ministry's market intervention). A depreciation of the yen (or appreciation of the dollar) will make

Japanese goods cheaper in the United States and will make U.S. goods more expensive for residents of Japan.

21. Immediately following the June 2016 U.K. referendum vote to leave the European Union, the value of the British pound plummeted versus the U.S. dollar. Using a demand and supply framework for British pounds, identify two factors that might have contributed to this decline by shifting the demand curve for British pounds. Illustrate the shift graphically. (LO3) Answer: Two factors that may have shifted the demand curve for British pounds to the left are: i) an increase in the perceived riskiness of U.K. assets (relative to foreign assets) and ii) an expected future depreciation of the British pound. The leftward shift of the demand curve results in a lower equilibrium exchange rate, as measured by the amount of foreign currency that one must give up to acquire a British pound.

22.

Suppose events elsewhere in the world lead to an increase in demand for Japanese yen, as investors seek a ―safe haven‖ for their funds. How would this development affect Japanese exporters and Japan’s immediate economic growth prospects? What currency policy tool might Japan’s Ministry of Finance utilize to counter these effects? Is it likely to be effective? (LO4) Answer: A rising yen due to this increase in demand would hurt the competitiveness of Japanese exports and consequently dampen Japan’s immediate growth prospects. Japan’s Ministry of Finance could choose to intervene in the foreign exchange market, selling yen in exchange for a foreign currency such as the U.S. dollar. However, this kind of policy intervention is unlikely to be effective without the support of monetary policy easing by the Bank of Japan.

23. If we express the Indian rupee-U.S. dollar exchange rate as X rupees = $1, write down (in terms of X) how you would calculate: (LO1) a. the number of rupees you would have to exchange to purchase an item that costs $250. b. the number of dollars you would have to exchange to purchase an item that costs 1,000 rupees c. Look up the current Indian rupee-U.S. dollar exchange rate and calculate the answers to a and b.

Answer: a. X rupees = $1 ? rupees = $250 ? rupees = 250*X b. X rupees = $1 Taking the reciprocal, we can express this as 1/X dollars per rupee 1 rupee = $1/X 1000 rupees = $1000/X = ? c. On 25 July, 2023, the Indian rupee - US dollar exchange rate was 82 INR = $1 For a. if X = 82, the $250 item costs 250*82 = 20,500 rupees For b. if X = 82, the 1000 rupees item costs 1000/82 = $12.20 24. Use the supply and demand model of exchange rate determination to illustrate and explain the following COVID pandemic-related impacts on the U.S. dollar exchange rate: (LO3) a. International investors’ preferences for U.S. assets increased amid a ―flight to quality‖ response to the onset of the pandemic. b. U.S. consumers increased their net purchases of foreign goods. Answer: a. An increase in demand for U.S. assets from international investors increases the demand for U.S. dollars, shifting the demand curve to the right and increasing the equilibrium exchange rate. The strengthening of the U.S. dollar versus the British pound and the Euro around March 2020 is evident in Figures 10-2 and 10-3 in the textbook. (Note these figures measure dollars per unit of foreign currency. Therefore, the lines in the figures are falling as the dollar strengthens, as fewer dollars are needed to purchase one unit of the foreign currency.)

Foreign Currency per Dollar

E1 E0

Quantity of Dollars Traded

An increase in net purchases of foreign goods by U.S. consumers increases the supply of dollars in the market, shifting the supply curve to the right. This decreases the equilibrium exchange rate. Figures 10-2 and 10-3 in the textbook show the U.S. dollar depreciating in 2021 against the British pound and the Euro. (The lines in the figures are rising as the dollar depreciates, as more dollars are needed to purchase one unit of the foreign currency.)

Foreign Currency per Dollar

E0 E1

D0 Quantity of Dollars Traded

Data Exploration 1. Exchange rates can exhibit sudden changes as well as long-run patterns. (LO1) a. Plot the daily U.S. dollar-British pound exchange rate (FRED code: DEXUSUK) for the first half of 2016 and identify the short-term spike. What caused this spike? Which currency is appreciating when the plotted exchange rate falls? b. Plot since 1971 the monthly Japanese yen-U.S. dollar exchange rate (FRED code: EXJPUS) without recession bars. Which currency is appreciating when the plotted exchange rate falls? Answer:

a. The plot for the U.S. dollar-British pound is below. The spike at the end of June 2016 followed the vote by the British people in a referendum to leave the European Union, popularly known as ―Brexit.‖ Concerns about the impact on the British economy diminished the value of the pound; its sharp drop is mirrored by an appreciation of the U.S. dollar.

b. The plot for the Japanese yen-U.S. dollar exchange rate is below. Periods of sudden changes include the sharp downward movement in 1973 and again in 1985 and 1986. A long downward trend appears over the entire period through the mid-1990s. Downward movements in the plot represent appreciations of the Japanese yen and depreciations of the dollar. For example, in the early 1970s, it took nearly 360 yen to buy one U.S. dollar; as of mid-2024, it took about 150 yen to buy one U.S. dollar. NOTE: In part (a), downward movement represents a U.S. dollar appreciation; in (b) downward movement represents a U.S. dollar depreciation. It is important to note which currency is in the numerator of the exchange rate.

Board of Governors of the Federal Reserve System (US), Japanese Yen to U.S. Dollar Spot Exchange Rate [EXJPUS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/EXJPUS, September 26, 2023.

2. Plot since 1999, without recession bars, the real exchange rate between U.S. goods and euroarea goods according to equation (2) in the text. Use the consumer price index (divided by 2.37 to set a common base year of 2015 = 100 for the U.S. and euro-area indexes) for the price of U.S. goods (FRED code: CPIAUCSL). Use the harmonized index of consumer prices for the euro area goods (FRED code: CP0000EZ19M086NEST), and the U.S. dollar-euro exchange rate (FRED code: EXUSEU). Why might this measure of the real exchange rate be persistently below unity since 2003? (LO1) Answer: A plot of the data is below. Several reasons may explain the persistent appearance that U.S. goods were cheap compared to euro-area goods. First, non-traded goods and services— such as haircuts and restaurant meals—are included in the price indexes. Second, industrial goods are excluded from the indexes of consumer prices. Third, euro-area consumer prices are affected by relatively high value-added taxes. Nevertheless, it is worth noting that the real exchange rate, measured in this way, recently has been closer to unity.

Eurostat, Harmonized Index of Consumer Prices: All Items for Euro area (19 countries) [CP0000EZ19M086NEST], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CP0000EZ19M086NEST. Board of Governors of the Federal Reserve System (US), U.S. Dollars to Euro Spot Exchange Rate [EXUSEU], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/EXUSEU, September 27, 2023. U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL, September 27, 2023.

3. Write in algebraic form a calculation of U.K pounds per euro that uses U.S. dollars per U.K pound (FRED code: EXUSUK) and U.S. dollars per euro (FRED code: EXUSEU). Then plot since 1999 (without recession bars) the exchange rate of U.K. pounds per euro using these two U.S. dollar exchange rates. What happened to the exchange rate in 2016? (LO1) Answer: To find the indicated exchange rate, pay attention to the units in the computation. The British pound-euro exchange rate can be found by dividing the number of dollars per euro by the number of dollars per pound to find the number of pounds per euro. Symbolically, = The data plot is below.

Note that the British pound depreciated versus the euro in 2016. One cause was the uncertainty about the British economic outlook both before and after the June vote to exit the European Union.

4. Examine an episode of large-scale interventions by the Bank of Japan (BoJ) in the yen-dollar foreign exchange market. Plot between January 2009 and January 2013 a measure of BoJ intervention (FRED code: JPINTDUSDJPY). Do positive values of the intervention indicator reflect purchases or sale of yen by the BoJ? What was the BoJ’s policy objective? To investigate whether the intervention was effective, add the Japanese yen-U.S. dollar exchange rate (FRED code: EXJPUS) to the chart, but scaled on the right axis. (LO5) Answer: The data plot is below. Positive values for the intervention mean that the Bank of Japan was buying U.S. dollars (selling yen) in the foreign exchange market, with large purchases in September 2010 and in March, August and November of 2011 (left scale). The objective was to cause a depreciation of the yen and stimulate demand for Japanese goods. Despite these interventions, the yen continued to appreciate (right scale). The yen then depreciated briefly at the outset of 2012, returned to its value at the beginning of the year in the fall, and then began a sustained depreciation in September 2012.

Bank of Japan, Japan Intervention: Japanese Bank purchases of USD against JPY [JPINTDUSDJPY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPINTDUSDJPY.

5. How can we assess the impact of exchange rate fluctuations on the competitiveness of U.S. exporters? Plot since 1980 the narrow effective exchange rate for the U.S. (FRED code: RNUSBIS). When was the index more than 10 percent above its February 2020 (pre-COVID) level? How far is it today from the February 2020 level? (LO1) Answer: An appreciation of the dollar implies that foreign-produced goods become cheaper for U.S. purchasers and U.S.-produced goods become more expensive for overseas buyers. Other things given, U.S. exporters become less competitive as their goods become more expensive compared with similar goods produced elsewhere in the world. The index was more than 10 percent above its February 2020 level from September 1984 through September 1985, and again for a few months in 2022. As of April 2024, the value was 104.96, about 6 percent above its February 2020 level. The data is plotted here:

Bank for International Settlements, Real Narrow Effective Exchange Rate for United States [RNUSBIS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RNUSBIS.

* indicates more difficult problems

XIII. XIV.

Chapter 11

The Economics of Financial Intermediation

Conceptual and Analytical Problems 1. Describe a problem arising from asymmetric information that an employer may face in hiring a new employee and suggest a solution. Give an example of a problem due to asymmetric information that might persist after the person has been hired. What solutions can you think of? (LO2) Answer: Prior to hiring a new employee, an employer may have difficulty identifying candidates who would do the best job — that is, there are difficulties in screening candidates in the face of asymmetric information. Probationary periods, during which the new employee can be terminated, are a simple solution to this problem. After someone has been hired, the employer may not know whether that person is working hard due to problems with monitoring. Salaries based on performance can mitigate the problem by providing the employee with the incentive to work hard without constant monitoring.

2. In some cities, media outlets publish a weekly list of restaurants that have been cited for health code violations by local health inspectors. What information problem is this feature designed to solve, and how? (LO2) Answer: This solves both adverse selection and moral hazard. People who dine out at restaurants may have a difficult time identifying restaurants that don’t meet certain health standards. Because of this, some people may not want to eat out at all. Also, restaurants don’t have an incentive to follow health regulations if diners can’t distinguish restaurants that meet the health standards from those that don’t. However, publishing the names of restaurants cited for health code violations allows people to identify unsanitary restaurants and thus holds restaurants accountable for following health regulations.

3. In 2009, Bernard Madoff was sentenced to 150 years in prison for executing what was likely the largest Ponzi scheme in history. What problem associated with asymmetric information was central to Madoff’s success in cheating so many investors for so long? (LO2) Answer: The Madoff fraud is an example of a moral hazard problem that arises from the absence of perfect monitoring. Investors with Bernard Madoff did not adequately monitor his behavior to ensure that he was using their funds as they expected. Perhaps they assumed that earlier investors had carried out this monitoring and so they did not need to incur the cost. They may also have assumed that the oversight of the SEC was sufficient to safeguard their funds.

4. Financial intermediation is not confined to bank lending but is also carried out by non-bank firms such as mutual fund companies. How do mutual funds help overcome information problems in financial markets? (LO1) Answer: Mutual funds, like other financial intermediaries, are specialists at screening and monitoring. They assess companies when deciding what stocks and bonds to include in their funds and monitor these companies on behalf of individual investors. By making these choices, the mutual funds affect prices, guiding resources in the economy to their most productive uses.

5. In some countries it is very difficult for shareholders to fire managers when they do a poor job. What type of financing would you expect to find in those countries? (LO3) Answer: When shareholders can’t fire managers, people will be less willing to purchase equity because there is no way to discipline managers who fail to act in the interests of the shareholders. Companies in those countries are more likely to issue bonds or seek bank loans to obtain funding.

6. Define the term economies of scale and explain how a financial intermediary can take advantage of such economies. (LO1) Answer: Economies of scale occur when average costs fall as production increases. By using standardized forms for gathering information about potential borrowers and for issuing loans, financial intermediaries can take advantage of economies of scale.

7. The Internet can have a significant influence on asymmetric information problems. (LO2) a. How can the Internet help solve information problems? b. Can the Internet compound some information problems? c. On which problem would the Internet have a greater impact, adverse selection or moral hazard? Answer: a. The Internet provides people with a wealth of information, whether they are evaluating a company before deciding whether to purchase its stock or doing a ―Google‖ search on someone before going out on a date. b. Not all of the information available is accurate, which can make the problem of adverse selection worse. c. The Internet provides information to reduce adverse selection, but isn’t very helpful in reducing moral hazard, although in some circumstances it might provide a less costly means of monitoring.

8. The financial sector is heavily regulated. Explain how government regulations help solve information problems, increasing the effectiveness of financial markets and institutions. (LO1) Answer: The government requires firms to disclose information. For example, public financial statements prepared according to standard accounting practices are required by the Securities and Exchange Commission. Investors can feel more secure in assessing the financial health of a firm given this government-mandated and standardized information, thus reducing problems associated with adverse selection. Since they know they are required to disclosure certain information, firms may be less willing to engage in excessively risky behavior, reducing problems associated with moral hazard.

9. One of the solutions to the adverse selection problem associated with asymmetric information is the pledging of collateral. However, the collateral may be riskier than initially thought. As an example, explain why the collateral did not work adequately to mitigate the mortgage securitization problems associated with the financial crisis of 2007-2009? (LO2) Answer: The ultimate collateral behind the mortgage-backed securities were the houses purchased with the mortgages underlying these securities. When house prices fell, the value of the collateral was not sufficient to cover the investments. If the collateral is riskier than thought, the loans are mispriced. The lender should ask for a larger down payment, charge a higher interest rate, or both. 10. *Deflation causes the value of a borrower’s collateral to drop. Define deflation and explain how it reduces the value of a borrower's collateral. How might a lender who anticipates deflation alter the terms of a loan? (LO2) Answer: Deflation is a fall in the overall price level. A borrower’s liabilities will remain the same since loan repayment is usually specified in nominal terms. But, the value of the borrower’s assets will decline, decreasing the net worth of the borrower. If the lender properly anticipates the deflation, and thus the falling net worth of the borrower, a higher interest rate

should be charged, or additional collateral should be required. At the margin, low net worth borrowers will find financing unavailable.

11. You are in charge of setting policies for implementing construction loans at a bank once the loan officer has approved the borrowers’ applications. (Construction loans finance the development of a structure during the building process and are later converted to mortgages.) How would you protect your bank’s interests? (LO3) Answer: The loan officer has addressed the adverse selection problem, so you are seeking a solution to a moral hazard problem. To protect the bank’s interests, you first would like the policy to specify collateral. In this case, the land upon which the structure is to be built might be an option for either a home construction project or a business structure. For a business, other options might be requiring collateral in terms of inventory or a requiring the borrowing firm to purchase a certificate of deposit. Second, you would likely release only a portion of the total loan when construction begins. Third, as construction proceeds, you could conduct periodic inspections to be sure that all relevant building codes and other design specifications were being followed prior to releasing additional funding.

12. *Your parents give you $3,000 as a graduation gift and you decide to invest the money in the stock market. If you are risk averse, should you purchase some stock in a few different companies through a web site with low transaction fees or put the entire $3,000 into a mutual fund? Explain your answer. (LO1) Answer: As a small investor, a mutual fund is the best way to reduce risk by diversifying your investment. By purchasing shares in a mutual fund, you can acquire fractions of shares in the large number of companies included in the fund. If you opt to buy individual shares, you will be limited to a handful of companies. Mutual funds offer investors a low-cost way to diversify a small sum across a wide range of companies.

13. Suppose a new website was launched providing up-to-date, credible information on all firms wishing to issue bonds. What would you expect to see happen to the overall level of interest rates in the bond market? (LO1) Answer: You would expect interest rates overall to fall. The web site would reduce the adverse selection problem by making it easier for investors to distinguish between firms of different levels of creditworthiness. Demand for bonds should rise, raising bond prices and reducing interest rates.

14. Suppose two types of firms wish to borrow in the bond market. Firms of type A are in good financial health and are relatively low risk. The appropriate premium over the risk-free rate for lending to these firms is 2 percent. Firms of type B are in poor financial health and are relatively high risk. The appropriate premium over the risk-free rate for lending to these firms is 6 percent. As an investor, you have no other information about these firms except that type A and type B firms exist in equal numbers. (LO2) a. At what interest rate would you be willing to lend if the risk-free rate were 5 percent?

b. Would this market function well? What type of asymmetric information problem does this example illustrate? Answer: a. The appropriate interest rate for type A firms’ bonds is 7 percent while that for type B firms’ bonds in 11 percent. As investors don’t know which type of firm they are dealing with and there is an equal probability of either type of firm, they will be only be willing to lend if they receive at least the average rate of 9 percent. b. No. The type A firms would not be willing to pay this interest rate and so would withdraw from the market, leaving only type B firms. This is an example of an adverse selection problem. Only the less desirable firms are willing to borrow.

15. Suppose you are the financial advisor to a firm that is in good financial health. What suggestions would you make to the firm’s management about obtaining borrowed funds if both financially healthy and financially unhealthy firms are trying to borrow in the bond market? (LO2) Answer: One suggestion would be to provide as much information as possible about the firm to potential investors in order to identify itself as a financially healthy firm. Ideally, the information should come through someone other than the firm for credibility, so this suggestion might be difficult to implement. Another suggestion would be to utilize the services of a financial intermediary rather than issuing debt directly in the bond market. If the firm has been banking with the same institution for a while, that institution will have evidence of the firm’s quality from its existing accounts and would likely be willing to lend to the firm at a more favorable rate.

16. Consider a small company run by a manager who is also the owner. If this company borrows funds, why might a moral hazard problem still exist? (LO2) Answer: Even when the owner and the manager of the firm are the same person, when they borrow money there is an incentive to take on excessive risk. The downside is limited to the collateral posted while the upside is unlimited. The owner/manager receives all the profits above the loan repayment.

17. *The island of Utopia has a very unusual economy. Everyone on Utopia knows everyone else and knows all about the firms they own and operate. The financial system is well developed on Utopia. Everything else being equal, how would you expect the mix on Utopia between internal finance (where companies use their own funds such as retained earnings) and external funding (where companies obtain funds through financial markets) to compare with other countries? What role would financial intermediaries play in this economy? (LO1) Answer: As Utopia doesn’t suffer from asymmetric information problems to the same degree as other countries, you would expect external finance to be more important. Although overcoming information problems is a key function of financial intermediaries, they also reduce transaction costs and therefore would still have a role in this economy. For example, financial intermediaries could pool savings from small depositors to make a large loan more cheaply than

a group of islanders trying to identify those with surplus funds and those needing to borrow in the absence of an intermediary.

18. You and a friend visit the headquarters of a company and are awestruck by the expensive artwork and designer furniture that graces every office. Your friend is very impressed and encourages you to consider buying stock in the company, arguing that it must be really successful to afford such elegant surroundings. Would you agree with your friend’s assessment? What further information (other than the usual financial data) would you obtain before making an investment decision? (LO2) Answer: The luxurious surroundings could be a result of the principal-agent problem, where managers who do not own the company they run have different objectives than the shareholders. You should find out if there is a separation between ownership and management and if so, if there is any evidence of a pattern of lavish and unnecessary spending by the management. If there is evidence of a clear disconnect between the objectives of the management and the best interests of the shareholders, buying stock in this company is probably not your best option.

19. Under what circumstances, if any, would you be willing to participate as a lender in a peer-topeer lending arrangement? (LO1) Answer: Your willingness will likely be influenced by how well you believe the problems associated with asymmetric information can be dealt with. For example, the ability to review credit scores and other financial information of potential borrowers and the accuracy of that information for predicting default should reduce your concerns about adverse selection. The ability to spread your lending across a group of borrowers rather than lend to just one would also reduce the risk associated with choosing one poor-quality borrower. Moral hazard concerns might be alleviated by a commitment from the peer-to-peer lending site you use to report missed payments by borrowers to credit bureaus. You might also consider the time you have available to monitor the loan yourself for signs of trouble.

20. Upon graduation, both you and your roommate receive your first credit cards with identical features. You use your card extensively to make purchases, always paying your credit card balance in a timely manner so that you incur no interest cost. Your roommate pays for everything in cash, reserving the credit card only for an emergency that never happened. After two years, you both look for a new credit card. Explain why you are offered a new card at a much lower interest rate than your roommate, despite both of you working in similar jobs for the same income. (LO2) Answer: This scenario illustrates the problem of adverse selection. When you and your roommate applied for a credit card at graduation time, you likely had little or no credit history, so the credit card company assumes, in the absence of information to the contrary, that you represent a high default risk. After two years of establishing a credit history through borrowing and timely repayments, your behavior provides the credit card company with information that allows them to revise that assessment. In contrast, even though your roommate behaved in a safe manner, her behavior did not provide sufficient new information to the credit card company to warrant a revised assessment to the same degree.

21. What would you expect to happen to the mix between internal and external financing for new investment projects in a country that experiences a large increase in financial market uncertainty? (LO2) Answer: You would likely see a rise in the share of projects financed from retained earnings, as the increased market uncertainty would raise the cost of external financing (either direct or indirect), making it relatively less attractive or even unattainable.

22. Use a core principle from Chapter 1 to explain why, everything else being equal, a software company might find it more expensive to issue debt than a furniture store? (LO1) Answer: According to Core Principle 2, risk requires compensation. The furniture store’s capital is more likely to be tangible while that of the software company is likely to be predominantly intangible. Tangible capital can be re-sold and so can serve as collateral, reducing the risk of lending and so lowering the cost of issuing debt for the furniture store.

23. Suppose you have recently been appointed as a policymaker in a country that has a rapidly evolving financial system. Why might you have concerns about the dynamic and innovative nature of the financial system? How might you mitigate these concerns? (LO2) Answer: When the financial system is rapidly evolving, it is likely that problems associated with asymmetric information, particularly moral hazard, will worsen. One reason is that it becomes more difficult to monitor and therefore easier to commit fraud. The wave of crypto failures, including the collapse of FTX, in 2022 is a case in point. Improving disclosure requirements and adapting regulatory and supervisory structures to account for innovations can help.

Data Exploration 1. Financial intermediaries connect savers and borrowers. Examine growth in intermediation from the following perspectives. (LO1) a. Total credit market debt is the sum of debt securities (FRED code: ASTDSL) and loans (FRED code: ASTLL). Plot the ratio of total credit market debt owed to population (FRED code: POP). (Hint: Because credit market debt is expressed in millions and population in thousands, multiply credit market debt by 1,000 to correct for the difference in units.) Interpret the plot. b. Plot the ratio of total credit market debt to nominal GDP (FRED code: GDP). Interpret the plot. c. Plot the ratio to nominal GDP of the value added by financial corporate business (FRED code: A454RC1Q027SBEA). Multiply the ratio by 100 to express it in percent. Interpret the plot since 2005. Answer: a. The plot of per capita credit market debt is:

Per capita debt accelerated in the 1980s and again in the 1990s until the onset of the financial crisis of 2007-2009. Following the crisis, per capita debt briefly fell as agents deleveraged, but soon began rising again. With the pandemic, per capita debt surged. Notably, much of this debt is not the direct obligation of individuals; corporations and the public sector have issued a significant portion of this debt. b. The plot of total credit market debt relative to GDP is shown below. Financial innovations beginning in the 1980s, such as the popularization of money market mutual funds, facilitated intermediation. As a result, a dollar’s worth of GDP now ―supports‖ a larger volume of debt. The economy also is more highly leveraged. Note the sharp rise in the second quarter of 2020, reflecting borrowing, to a large extent by the public sector, to support a sharply declining economy at the outset of the pandemic. Following the second quarter of 2020, the ratio declined, as nominal GDP accelerated.

c. The ratio to nominal GDP of the value added by financial corporate business is shown below. The long-term trend of financial deepening that began in the 1950s largely ended by 2000. Since then, large—but temporary—fluctuations have been associated with the financial crisis of 2007-2009 and the COVID pandemic

2. How has the use of credit evolved in key sectors of the economy? Plot as ratios to total credit market debt outstanding (FRED code: ASTDSL and ASTLL) the debt of: (a) nonfinancial corporate businesses (FRED code: BCNSDODNS); and (b) the domestic financial sector (FRED code: TCMDODFS). What do the patterns during the financial crisis in the nonfinancial and financial sector ratios mean in terms of leverage? (LO1) Answer: The data plot for the sector ratios is below. Until the financial crisis of 2007-2009, financial firms used an increasing share of outstanding debt in support of intermediation., The post-2007 downturn in the financial sector reflects the process of deleveraging. While the nonfinancial sector showed a declining share between 1970 and the end of the financial crisis, there is little discernable trend in the 2010s and beyond.

3. Financial crisis is often associated with rising, and then persistently high, unemployment rates. Plot the U.S. unemployment rate during the Great Depression until the end of the 1930s (FRED code: M0892AUSM156SNBR). Compare the U.S. experience then with unemployment rates in Spain (FRED code: LRUN64TTESQ156S), Greece (FRED code: LRUN64TTGRQ156S), Italy (FRED code: LRUN64TTITQ156S), and Portugal (FRED code: LRHUTTTTPTQ156S) since the beginning of the financial crisis in 2007. (Turn off the recession bars for the European data plot.) (LO3) Answer: The plot of the unemployment rate in the U.S. in the Great Depression is shown below. Notice that after the unemployment rate rose to about 25 percent in the depths of the Depression, it stayed at elevated levels throughout the 1930s.

National Bureau of Economic Research, Unemployment Rate for United States [M0892AUSM156SNBR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M0892AUSM156SNBR.

The post-2007 plot of the unemployment rate in selected European countries is shown below. European employment conditions deteriorated through 2013: in both Greece and Spain, the unemployment rate surpassed 26 percent, while the unemployment rate rose above 17 percent in Portugal and above 11 percent in Italy. As in the United States in the 1930s, unemployment in these European countries remained high for years after the euro-area financial crisis began in earnest in 2009 before slowly declining.

Organization for Economic Co-operation and Development, Unemployment Rate: Aged 15-64: All Persons for Spain [LRUN64TTESQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTESQ156S. Organization for Economic Co-operation and Development, Unemployment Rate: Aged 15-64: All Persons for Greece [LRUN64TTGRQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTGRQ156S. Organization for Economic Co-operation and Development, Unemployment Rate: Aged 15-64: All Persons for Italy [LRUN64TTITQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRUN64TTITQ156S. Organization for Economic Co-operation and Development, Harmonized Unemployment Rate: Total: All Persons for Portugal [LRHUTTTTPTQ156S], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LRHUTTTTPTQ156S.

4. The rise of securities markets and the expansion of intermediation by nonbanks has come partly at the expense of commercial banks. Plot the ratio of bank credit (FRED code: TOTLL) to debt securities owed (FRED code: ASTDSL) and comment on the trend. (LO1) Answer: Relative to total credit market debt, banks’ share has eroded dramatically since the 1970s. Part of this shift reflects the increased access of nonfinancial borrowers to global investors through securities markets. In addition, financial innovations allowed nonbank intermediaries to compete effectively in the supply of credit. Some of these institutions also are more lightly regulated than depositories, as well as being more highly leveraged.

5. Deflation raises the real burden of repaying fixed-rate debt. Until recently, Japan has recently experienced a long deflation. (LO3) a. Plot the percent change from a year ago of consumer prices in Japan (FRED code: JPNCPIALLQINMEI) and discuss the long-term patterns of inflation and deflation. (Turn off the recession bars.) b. Plot on a new graph the percent change from a year ago of the GDP deflator in Japan (FRED code: JPNGDPDEFQISMEI). How does it compare with the post-1994 evolution of consumer prices? (Turn off the recession bars.) (Hint: The GDP deflator is a price index for all final goods and services produced domestically. It is a broader measure than the price index for goods and services consumed by households in part a.) c. Why might deflation become self-perpetuating? Answer: a. The plot of inflation based on consumer prices in Japan appears below. Japan experienced moderate to high consumer price inflation in the 1960s and 1970s. From the mid-1990s until nearly 2020, Japan endured continuing deflationary pressures. Until the post-COVID period, significantly positive inflation readings in Japan typically were temporary responses to repeated hikes in the nation’s consumption tax `

Organization for Economic Co-operation and Development, Consumer Price Index of All Items in Japan [JPNCPIALLQINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLQINMEI. b.

The plot of inflation based on Japan’s GDP deflator is below. While this index is available only since 1994, it has fallen significantly more than consumer prices in this period, highlighting the breadth and persistence of deflation in Japan. (Note the differing vertical scales on the two plots.) Like consumer prices, until the post-COVID period, significant pickups were temporary and were associated with repeated hikes in the nation’s consumption tax

Organization for Economic Co-operation and Development, GDP Implicit Price Deflator in Japan [JPNGDPDEFQISMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNGDPDEFQISMEI.

c. When debtors have loans denominated in fixed nominal terms, the declining price level raises the real cost of repayment. If borrowers did not anticipate these higher real costs, they may be forced to cut other spending, helping to sustain deflationary pressures. A shift toward expected deflation also raises the real interest rate, diminishing the incentive to spend on consumption or investment, reinforcing downward pressure on prices.

XV. XVI.

Chapter 12

Depository Institutions: Banks and Bank Management

Conceptual and Analytical Problems 1. Explain how a bank manager uses Core Principles 1, 2 and 3 (Time Has Value, Risk Requires Compensation, and Information Is the Basis for Decisions) to select assets and issue liabilities consistent with shareholder preferences. (LO1) Answer: The manager evaluates the return and risk of each asset and liability prior to adding it to the balance sheet. These evaluations depend on the timing and risk associated with the payments, using core principles 1and 2, and usually require collection and processing of information, using core principle 3. On the asset side, for example, does the interest rate on auto loans provide sufficient compensation for the risk of default? To make this judgment, the loan officer must collect and process information to judge whether prospective borrowers are able and willing to repay. On the liability side, will the interest rate offered on certificates of deposit

attract funds sufficient to support the bank’s assets? The risk and return of the overall balance sheet also should be evaluated according to the owners’ risk preferences. For example, riskaverse shareholders may wish the manager to hold a relatively large proportion of government securities and a relatively low proportion of loans. 2. Consider a bank with the following balance sheet. You read online that the bank’s return on assets (ROA) was 1 percent. What were the bank’s after-tax profits? (LO2) Bank Balance Sheet (in millions) Assets Reserves

Liabilities $2,000

$200 Deposits

Loans

$950 Borrowing

Securities

$950 Bank Capital

$100

Answer: Since the return on assets is defined as ROA 

Net profit after taxes Bank assets

with ROA reported as 0.01 and assets of $2.1 billion, after-tax net profit would be ROA × (Bank assets) = 0.01 × ($2,100,000,000) = $21,000,000

3. Based on the information provided below about Banks A and B, compute for each bank its return on assets (ROA), return on equity (ROE) and leverage ratio. (LO2) a. Bank A has net profit after taxes of $1.8 million and the balance sheet below: Bank A (in millions) Assets Reserves Loans Securities

$5 Deposits $45 Borrowing $45 Bank Capital

Liabilities $75 $10 $10

b. Bank B has net profit after taxes of $1 million and the balance sheet below: Bank B (in millions) Assets Reserves Loans Securities

$8 Deposits $50 Borrowing $22 Bank Capital

Liabilities $80 $2 $8

Answer: For both banks, we will compute ROA as ROA 

Net profit after taxes Bank assets

and ROE as ROE 

Net profit after taxes Bank capital

As a check, we note that ROA × Leverage Ratio = ROE  Bank Assets   is the leverage ratio, the value of assets divided by the owner’s equity. where   Bank Capital   

a. Bank A has net profit after taxes of $1.8 million. Given assets of $95 million, its ROA was (1.8 / 95) = .0189 or 1.89%. Since bank capital is $10 million, its ROE is (1.8 / 10) = .18 or 18%. Its leverage ratio is (95 / 10) = 9.5. As a check, we should find that: ROA × (Leverage Ratio) = ROE

In this case, with ROA of 1.89% and leverage of 9.5, ROE of 18% is correct. b. Bank B had net profit after taxes of $1 million. Its ROA is (1 / 80) = .0125 or ROE is (1 / 8) = .125 or 12.5%; and its leverage ratio is (80 / 8) = 10.

1.25%; its

Banks hold more liquid assets than do most businesses. Explain why. (LO1) Answer: Banks are required to meet depositors’ demands for cash. In order to be able to do this, they need to hold assets that are relatively liquid. Most businesses do not need to be able to come up with cash on short notice, so they do not need to hold as many liquid assets. 5. Explain why banks’ holdings of cash have increased significantly as a portion of their balance sheets since the financial crisis of 2007-2009. (LO1) Answer: Banks hold cash for liquidity purposes—to meet immediate withdrawal requests from customers. Holding cash can be costly for banks, however, due to the interest foregone on holding alternative assets. With the onset of the financial crisis, banks’ desire for liquidity led them to dramatically increase their cash holdings, as the possibility of bank runs rose, and other assets became less liquid. Falling interest rates in response to the financial crisis also reduced the opportunity cost of holding cash. In the 2021-23 period, interest rates rose but—because the Federal Reserve now pays interest on bank reserves—the opportunity cost of holding cash in this form remained low even as interest rates rose. (The Federal Reserve began paying interest on bank reserves in October 2008, at the height of the 2007-09 financial crisis.)

6. Why have demand deposits accounts become a less important source of funds for commercial banks in the United States in recent decades? (LO2) Answer: Financial innovation has reduced the importance of demand deposits in the day-to-day business of banking. The reason for their decline is that demand deposit accounts pay little to no interest; they are a low-cost source of funds for banks but a low-return investment for depositors. As interest rates rose through the 1970s and remained high into the 1990s, individuals and businesses realized the benefits of reducing the balances in their demand deposit accounts and began to look for ways to earn higher interest rates. Banks obliged by offering innovative accounts whose balances could be shifted automatically when the customers’ demand deposit accounts ran low.

7. The volume of commercial and industrial loans made by banks has declined over the past few decades, while the volume of real estate loans has risen. Explain why this trend occurred and how it contributed to banks’ difficulties during the financial crisis of 2007-2009. (LO2) Answer: The rise of the commercial paper market enabled businesses to raise funds directly, diminishing their need to borrow from banks. The creation of mortgage-backed securities meant that banks did not have to hold the relatively illiquid mortgage loans they originated on their balance sheets. However, banks purchased a large amount of these mortgage-backed securities and so suffered a significant decline in the value of their assets when MBS prices plummeted.

8. *Why do you think that U.S. banks are prohibited from holding equity as part of their own portfolios? (LO3) Answer: If a bank owns equity in a company to which it extends a loan, the fact that it is a part owner of the company can give rise to a conflict of interest. If the company were to run into trouble with the loan, the bank may be tempted to treat that company differently. Any perceived financial trouble for the company may reduce the value of its stock and so adversely impact the value of the bank’s equity investment.

9. Explain how a bank uses liability management to respond to a deposit outflow. Why do banks prefer liability management to asset management in this circumstance? (LO1) Answer: Banks can respond to a deposit outflow by borrowing from another bank or from the Federal Reserve or by issuing large-denomination time deposits. During the financial crisis of 2007-2009, banks found it difficult to raise funds through many of the usual channels and the Federal Reserve introduced additional lending programs to help banks manage their liquidity. Banks prefer liability management to asset management because asset management shrinks the size of a bank’s balance sheet, while liability management does not.

10. A bank with a two-year horizon has issued a one-year certificate of deposit for $50 million at an interest rate of 3 percent. With the proceeds, the bank has purchased a two-year Treasury note that pays 5 percent interest. What risk does the bank face in entering into these transactions? What would happen if all interest rates were to rise by 1 percent? (LO3)

Answer: The bank faces the risk that the short-term interest rate will rise before the second year, increasing the amount of interest the bank has to pay on the CD, but leaving the interest income that the bank receives from the Treasury note unchanged. With an interest rate of 3 percent for the CD and 5 percent for the Treasury note, the bank’s annual interest income is (.05) × $50 million = $2.5 million and the bank’s annual interest expenses are (.03) × $50 million = $1.5 million. The bank makes a profit of $2.5 million – $1.5 million = $1 million. If the interest rate rises 1 percent, the bank’s profit in the second-year falls to [(0.05 × $50 million) – (0.04 × $50 million)] = $500,000.

11. *In response to changes in banking legislation, recent decades have seen a significant increase in interstate branching by banks in the United States. How do you think a development of this type would affect the level of risk in banking business? (LO3) Answer: The increase in interstate branching increases the ability of banks to diversify their loans across different geographic areas and often different industries. This would reduce the credit risk banks face. 12. Consider the partial balance sheets of Bank A and Bank B. Suppose that reserve requirements are 10 percent of transaction deposits and both banks have equal access to the interbank market and funds from the Federal Reserve. a. Which bank appears to face a greater liquidity risk? b. Which bank appears to face a greater risk of default? What other information might you use to assess the risk of default of these banks? Explain your answers. (LO3)

Bank B (in millions)

Bank A (in millions) Assets Reserves

$50

Securities

$920 Other Deposits

Loans

$250

Assets Reserves

$30

$600

Securities

$920 Other Deposits

$600

$100

Loans

$50 Borrowings

$100

Liabilities Demand Deposits $200

Borrowings

Liabilities Demand Deposits $200

Answer: i) On the basis of the information given, Bank B has the greater liquidity risk. The liability sides of the balance sheets are the same, so the analysis should focus on the asset side. Bank A has a higher level of excess reserves and is therefore better able to meet unexpected withdrawals by depositors. In addition, Bank A has a higher level of securities which are generally more liquid than loans. Bank A could sell these securities in the marketplace if funds were needed immediately. ii) Bank A has net worth (bank capital) of $320 million while Bank B has net worth of $100 million. Bank A has more of a cushion against interest rate movements and so, on the basis of the information available, Bank B runs the greater risk of default. More information on the interest-rate sensitivity of the assets and liabilities of the two banks would be helpful in further assessing their default risk, as would information on each bank’s off-balance sheet commitments.

13. Bank Y and Bank Z both have assets of $1 billion. The return on assets for both banks is the same. Bank Y has liabilities of $800 million while Bank Z’s liabilities are $900 million. In which bank would you prefer to hold an equity stake? Explain your choice. (LO2) Answer: Your choice will depend on your preference for return versus risk. If the two banks have $1 billion in assets and have the same return on assets, then net profit after taxes must be the same for both banks. Bank Y has bank or equity capital of $200 million while Bank Z has equity capital of $100 million, so the return on equity is higher for Bank Z. Bank Z has a higher leverage ratio than Bank Y, however, as a higher portion of its assets is financed from borrowed funds. Therefore, Bank Z represents a riskier investment.

14. *You are a bank manager and have been approached by a swap dealer about participating in fixed for floating interest rate swaps. If your bank has the typical maturity structure, which side of the swap might you be interested in paying and which side would you want to receive? (LO3) Answer: A typical bank has liabilities that are shorter-term than its assets – or has floating rate liabilities and fixed rate assets. Because the bank receives fixed interest payments and has to make floating interest payments, it is at risk when interest rates rise. To hedge against this risk, the bank should pay fixed and receive floating in the interest rate swap. That way, when interest rates rise, the receipts from the swap will increase to offset the higher rates the bank must pay its depositors. 15. If lines of credit and other off-balance sheet activities do not, by definition, appear on the bank’s balance sheet, how can they influence the level of liquidity risk to which the bank is exposed? (LO3)

Answer: With lines of credit, customers pay a fee to the bank for the right to borrow at their behest. It is the customer, not the bank that determines when the loan is made and becomes an asset on the bank’s balance sheet. The bank is obligated to honor its commitment whenever the customer requests the loan and will need to finance that loan regardless of its liquidity situation at that point in time. This increases the liquidity risk faced by the bank.

16. Suppose a bank faces a gap of -20 between its interest-sensitive assets and its interest-sensitive liabilities. What would happen to bank profits if interest rates were to fall by 1 percentage point? You should report your answer in terms of the change in profit per $100 in assets. (LO2) Answer: A gap of -20 means that the bank has more interest-sensitive liabilities than assets. When interest rates fall, therefore, its profits will rise as it gains more on paying less on its liabilities than it loses in receiving less on its assets. The gap of -20 implies that profits will rise by 20 cents per $100 of assets.

17. *Duration analysis is an alternative to gap analysis for measuring interest rate risk. (See footnote 7 on page 275.) The duration of an asset or liability measures how sensitive its market value is to a change in the interest rate: the more sensitive, the longer the duration. In Chapter 6, you saw that the longer the term of a bond, the larger the price change for a given change in the interest rate. Using this information and the knowledge that interest rates increases tend to hurt banks, would you say that the average duration of a bank’s assets is longer or shorter than that of its liabilities? (LO1) Answer: When interest rates increase, the market value of assets such as bonds fall. If interest rate increases hurt banks, then the average value of assets must fall by more than the average value of liabilities. Given that duration is a measure of the sensitivity of the market value to a change in interest rates, this implies that the average duration of bank assets is longer than that of its liabilities.

18. Suppose you were the manager of a bank with the following balance sheet. Bank Balance Sheet (in millions) Assets Reserves Securities Loans

Liabilities $30 $150 $820

Demand Deposits $200 Other Deposits Borrowings

$600 $100

You are required to hold 10 percent of demand deposits as reserves. If you were faced with unexpected withdrawals of $30 million from other deposits, would you rather: a. Draw down $10 million of excess reserves and borrow $20 million from other banks? b. Draw down $10 million of excess reserves and sell securities of $20 million? Explain your choice. (LO1)

Answer: Option (a) is preferable to option (b) because it doesn’t shrink the size of the balance sheet. In normal market conditions, banks would prefer not to reduce the size of their balance sheets as that lowers their profits.

19. Suppose you are advising a bank on the management of its balance sheet. In light of the financial crisis of 2007-2009 and the failure of some mid-sized banks in 2023, what arguments might you make to convince the bank to hold additional capital? (LO2) Answer: The financial crisis of 2007-2009 resulted in projected losses of nearly $1 trillion in U.S. bank assets. In the absence of substantial government support, many banks would have become insolvent. Having sufficient capital (the difference between the value of a bank’s assets and liabilities) is crucial for maintaining the bank’s solvency. While having sufficient capital is costly to the bank, there is a trade-off between that cost and the benefit of securing the solvency of the bank.

20. The financial crisis compelled banks to reduce their leverage sharply. Consider the following two views of the balance sheet of a bank before and after the financial crisis. Which balance sheet view is more likely to be that of the bank after the financial crisis? Support your choice with calculations. (LO2) Bank Balance Sheet – View 1 (in millions) Assets

Liabilities

Reserves

$30

Deposits

$800

Securities

$150

Other Borrowed Funds

$90

Loans

$820

Bank Capital

$110

Bank Balance Sheet View 2 (in millions) Assets

Liabilities

Reserves

$30

Deposits

$800

Securities

$150

Other Borrowed Funds

$110

Loans

$820

Bank Capital

$90

Answer: We can calculate the leverage ratio for each of the views: Leverage Ratio = Total Assets / Bank Capital. For View 1, we get 1,000/110 = 9.09 For View 2, we get 1,000/90 = 11.1

If banks reduced their leverage after the crisis, it is more likely that View 1 represents the postcrisis balance sheet. Note, you could also calculate the leverage ratio as Debt / Equity + 1. For View 1, we get 890/110 = 8.09 + 1 = 9.09 For View 2, we get 910/90 = 10.1 + 1 = 11.1

21. Suppose you operate a bank in a country where the central bank is expected to embark on a series of interest rate increases. Based on gap analysis, would this scenario be more likely to hurt or help your bank’s profitability, assuming your bank’s liabilities are more interest sensitive than its assets? What steps might your bank take to prepare for this scenario? (LO3) Answer: Given your bank has a negative gap—i.e. more interest sensitive liabilities than assets, it is more likely that a series of interest rate hikes would hurt profits. This is because the additional interest the bank would have to pay on its interest sensitive liabilities would be greater than the additional interest it would earn on its assets. The bank could try to reduce the gap between the interest sensitivity of its assets and liabilities as this would lessen the impact on profits, everything else being equal. The bank also could engage in hedging activities to manage this interest rate risk, such as engaging in interest rate swaps.

22. Cyber risk has been recognized as a growing source of operational risk for financial institutions. Why might managing this risk at an individual firm level not be adequate? (LO3) Answer: The costs associated with a cyberattack are usually not borne by a single institution, as data breaches involve spillovers that create systemic risk. While good operational practices at a firm level are a crucial part of protecting against cyber attacks, decisions by individual firms weighing only the private costs and benefits of decisions are not likely to lead to optimal outcomes due to these externalities.

23. In March 2020, the Federal Reserve reduced the reserve requirement ratio to zero, eliminating reserve requirements for all depository institutions. How, if at all, would this action change the way you assess liquidity risk? (LO3) Answer: Even in the absence of formal reserve requirements, banks will hold some assets as reserves as part of their risk management strategy. Assessing the liquidity risk of a bank would be based on the same principles. In recent times, banks have tended to hold levels of reserves far in excess of those needed to comply with required reserve ratios, so the elimination of such requirements is unlikely to have a big impact. 24. Explain how rising interest rates can pose a risk to the health of a bank’s balance sheet. (LO3) Answer: Rising interest rates can increase the cost of floating rate sources of funds to banks. At the same time, they reduce the value of their liabilities, as security prices are inversely related to interest rates. The decline in the net interest margin between fixed rate assets and floating rate liabilities reduces profitability. Moreover, falling asset prices erode bank capital and can lead to

insolvency. Reflecting these problems, the rising interest rate cycle initiated by the Federal Reserve in March 2022 was associated with the failure of several mid-sized banks in 2023.

Data Exploration 1. Are U.S. banks increasing in size? Plot since 1984 on a quarterly basis the number of U.S. commercial banks (FRED code: QBPQYNUMINST) and, on the right scale, the volume of their deposits (FRED code: DPSACBM027SBOG). Download the data and compute the average deposit size of banks in the first quarters of 1984 and 2019. Do these sizes accurately portray a typical commercial bank? (LO1) Answer: The data plot is:

There are many very small banks, and a few very large banks, so the ―average‖ is not very representative. What is the average? Using quarterly data, at the beginning of 1984, there were 17,884 commercial banks and deposits of $1,489 billion, resulting in an average deposit level of about $83 million. In the first quarter of 2019, the number of banks had fallen to 5,362 while deposits had risen to $12,468 billion, yielding an average deposit level of $2,325 million. it would be misleading to call this level the ―typical‖ size of a bank. It is the few large banks that account for most of the deposits (or assets) in the banking system. For example, the ratio of deposits in the small number of large domestically chartered commercial banks (FRED code: DPSLCBM027SBOG) to deposits in all domestically chartered commercial banks (FRED code: DPSDCBM027SBOG) was about 67% in 2024. Similarly, as of 2021, the five largest U.S. banks alone held about 50 percent of bank assets (see World Bank, 5-Bank Asset Concentration for United States; FRED code DDOI06USA156NWDB).

2. Commercial banks have become increasingly involved in the real estate market. Plot the percent change from a year ago of real estate loans made by commercial banks (FRED code: REALLN) and discuss the relationship between the booms and busts in real estate lending and the expansions and recessions of the U.S. economy. (LO3) Answer: The cycles in real estate lending, plotted below, appear to coincide closely with business expansions and recessions. Real estate lending often grows strongly in expansions and slows prior to and during recessions. Figure 12.1 shows that commercial banks increased their exposure to real estate over several decades, so the unanticipated downturn in housing prices after 2006 exposed the commercial banking sector to substantial risk. Since early 2012 real estate lending at commercial banks has again experienced positive growth, consistent with a recovery from the housing plunge during the Great Recession of 20072009.

3. Banks sometimes manage liquidity risk by issuing large, marketable certificates of deposit when other deposits decline. How important is this practice? Plot the share of large time deposits (FRED code: LTDACBM027SBOG) in total deposits (FRED code: DPSACBM027SBOG). Explain how this share evolved over the long run and after 2004. (LO3) Answer: The plot below shows that bank borrowing in the ―wholesale‖ money market has been cyclical. Since 2004, the importance of attracting large deposits peaked prior to the

financial crisis and then plummeted. Part of the post-crisis decline reflects bank efforts to deleverage (and reduce their balance sheets). In addition, risk-averse investors may have preferred Treasury debt to a bank deposit, while near-zero interest rates may have encouraged others to seek higher returns in other financial instruments. Similarly, large time deposits declined significantly following the onset of the pandemic, partly due to declining interest rates that began to rise again in 2023.

4. What share of U.S. banks fail? Using a bar graph format, plot since 2000 the fraction (in percent) of bank failures (FRED code: BKFTTLA641N) relative to the number of banks (FRED code: QBPQYNUMINST). Comment on the timing and the proportion of failures. Were most of the failing banks large or small? (LO3) Answer: The plot below shows that bank failures in the United States rose with a lag as the Great Recession proceeded and peaked after the recovery began. Moreover, failures remained elevated (compared to the pre-recession period) for years after the recovery began. The largest banks are few in number and several were supported during the financial crisis by the injection of additional capital from taxpayers (through the U.S. Treasury). So, most (but not all) of the failing banks were relatively small institutions that did not pose a threat to the financial system when they failed. Reflecting the enormous policy support for the economy and the banking system during and after the pandemic, there were few bank failures in this period. Again, reflecting support by banking regulators, the midsized bank panic of 2023 resulted in a only a few failures, but these included the second, third and fourth largest failures in U.S. history.

* indicates more difficult problems XVII. Chapter 13

Financial Industry Structure (i) Conceptual and Analytical Problems

1. For many years you have been using your local, small-town bank. One day you hear that the bank is about to be purchased by Bank of America. From your vantage point as a retail bank customer, what are the costs and benefits of such a merger? (LO1) Answer: The benefits are that you will be able to use your bank for a larger scope of financial services. You may also enjoy accessing a wider network of ATMs. However, you will likely receive less personal service. Economies of scale mean that larger banks have lower per-unit costs; and economics of scope mean that banks with a broader array of services have lower costs as well, so the costs of the services you use are likely to fall. If there are no other local, competing banks, the larger bank could try to use its market power to charge higher fees. However, with many financial services available at low cost on the Internet, such local market power may be limited.

2. Why have technological advances hindered the enforcement of legal restrictions on bank branching? (LO1)

Answer: Most people don’t go into a physical bank building to withdraw cash from their accounts or make a deposit; some may go to an ATM. ATMs do not qualify as ―branches‖ of a bank, so a bank can expand its customer base across a larger geographic area without violating branching regulations. The location of bank buildings has become even less relevant with the growth of electronic and mobile banking.

3. How did the financial crisis of 2007-2009 affect the degree of concentration in the U.S. banking industry? (LO1) Answer: The spate of bank failures along with mergers between large banks and other depository institutions as a result of the crisis has increased the level of concentration in the industry. The top four commercial banks now account for about 40 percent of domestic deposits.

4. Depository institutions have been losing their advantage over other financial intermediaries in attracting customers’ funds. Why? (LO2) Answer: Other financial firms now exist that provide individuals with services typically performed by banks. Money market mutual funds offer customers access to financial instruments that usually pay a higher rate of interest than bank deposits, yet are still very liquid and can easily be converted into a means of payment. Depository institutions no longer have such a large advantage in screening loan applicants because of the ease with which individuals can transmit information, so a customer who needs a loan can go online to get price quotes instead of going to the local bank. Discount brokerage firms provide individuals with low-cost access to the financial markets.

5. An industry with a large number of small firms is usually thought to be highly competitive. Is that supposition true of the banking industry? What are the costs and benefits to consumers of the current structure of the U.S. banking industry? (LO1) Answer: When the banking industry consisted of a large number of small firms, the industry was less competitive than it is today. A bank in a small town or rural area may have had a monopoly within its geographic area. As large banks branch across the country and technology such as mobile banking brings additional access to banking services, consumers benefit by having access to a larger network of ATMs and by being able to engage in a wider range of financial activities through their banks. Costs to consumers have fallen as a result of increased competition, but the level of personal service that consumers receive has declined.

6. *What was the main rationale behind the separation of commercial and investment banking activities in the Glass-Steagall Act of 1933? Why was the act repealed? (LO1) Answer: The Glass-Steagall Act was enacted in the wake of widespread bank failures during the Great Depression. It was widely believed that many commercial banks took on excessive risk and suffered from conflicts of interest due to their securities-related activities. By separating commercial and investment banking activities and so restricting how commercial banks could

use the funds they raised, the act sought to protect depositors from excessive risk taking by these banks. While the Act sought to protect depositors, it also limited the ability of financial institutions to take advantage of economies of scale and scope. The potential benefits were evidently believed to outweigh the risks to depositors in the financial environment of the late 1990’s and the act was repealed.

7. Explain what the phrase too-big-to-fail means in reference to financial institutions. How did the policy responses to the financial crisis of 2007-2009 affect the too-big-to-fail problem? (LO1) Answer: The phrase too-big-to-fail refers to firms that are so big relative to the financial system as a whole that investors and counterparties assume that if these firms got into trouble the Federal Government would have to bail out their creditors to save the system. The bailouts of systemically important financial institutions in the financial crisis confirmed that these institutions were indeed too-big-to-fail and have focused attention on finding policy remedies. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 designated certain institutions to be systemically important and therefore subject to additional regulatory oversight.

8. Discuss the problems life insurance companies will face as genetic information becomes more widely available. (LO2) Answer: Insurance companies can’t predict when a particular person will die, but when they pool together a group of individuals with uncorrelated risks, they can predict fairly accurately the outcome for the group as a whole. However, if the companies have access to genetic information, they will be able to estimate with some accuracy when each individual is likely to die. Companies either won’t want to issue insurance or will charge very high premiums to individuals who will probably die soon. Individuals who are likely to remain healthy will buy less insurance, though they may still want coverage for accidental death. Overall coverage would probably fall.

9. When the values of stocks and bonds fluctuate, they have an impact on the balance sheets of insurance companies. Why is that impact more likely to be a problem for life insurance companies than for property and casualty insurance companies? (LO2) Answer: Property and casualty insurance companies have a different investment horizon compared to life insurance companies. Because property and casualty insurance companies are likely to have to make a large number of payments in the near future, they invest primarily in short-term assets, like money market instruments. Payments from life insurance companies don’t occur until far into the future, so they invest in longer-term instruments, predominately stocks and bonds. Life insurance companies face the risk that they will have to sell stocks or bonds when prices are low in order to pay policyholders’ claims.

10. Compare and contrast the structures of bank holding companies, financial holding companies and universal banks. (LO1)

Answer: Bank holding companies typically own several banks, while financial holding companies own banks and other financial intermediaries (such as investment banks and insurance companies). In both instances, there usually remain legal and regulatory separations among the subsidiaries. Universal banks own a variety of intermediaries (with fewer legal and regulatory separations compared to financial holding companies) as well as nonfinancial firms. Increased diversification from holding a portfolio of firms lowers the risk to firm owners.

11. What are the benefits of collaboration between a large appliance retailer and a finance company? (LO2) Answer: The appliance retailer has customers walk in the door who will need financing to make purchases. Meanwhile, the finance company has access to funds in financial markets. So, there are economies of scope that the two can exploit through collaboration.

12. Why did government-sponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae have substantially higher leverage ratios than the average U.S. bank in the years preceding the financial crisis of 2007-2009? Explain how this made the enterprises more vulnerable to the house-price declines that precipitated the crisis. (LO2) Answer: High leverage ratios resulted from the implicit guarantee behind these enterprises. Although their debt was not guaranteed by the government, there was widespread belief that the government would support the GSEs should they get into difficulties and therefore they didn’t have the need to hold as much capital as other institutions. The fall in house prices increased the rate of mortgage defaults, reducing the value of the assets of the GSEs. With high leverage ratios, the GSEs had small capital cushions and so when the value of their assets fell, they encountered solvency problems.

13. Consider two countries with the following characteristics. Country A has no restrictions on bank branching and banks in Country A are permitted to offer investment and insurance products along with traditional banking services. In Country B, there are strict limits on branch banking and on the geographical spread of a bank’s business. In addition, banks in Country B are not permitted to offer investment or insurance services. (LO1) a. In which country do you think the banking system is more concentrated? b. In which country do you think the banking system is more competitive? c. In which country do you think, everything else being equal, banking products are cheaper? Explain each of your choices. Answer: a. Country A is likely to have a more concentrated banking system, as fewer banks could service the entire country. In Country B, branching restrictions are likely to give rise to a large number of smaller banks. b. The experience in the United States with the McFadden Act would suggest that the banking system would be more competitive in Country A. Although banking restrictions are often intended to prevent concentration and monopoly power in the banking system, the outcome

in the United States was a range of small inefficient banks that faced little competition in the geographic area in which they operated. c. In Country A, banks can take better advantage of economies of scale and scope and so banking products are likely to be cheaper.

14. You examine the balance sheet of an insurance company and note that its assets are made up mainly of U.S. Treasury bills and commercial paper. Is this more likely to be the balance sheet of a property and casualty insurance company or a life insurance company? Explain your answer. (LO2) Answer: This is more likely to be a property and casualty insurance company. This type of company tends to hold liquid assets such as the short-term instruments described in order to meet sudden claims. Life insurance companies hold assets of longer maturity, as most of their payments will be made well into the future.

15. *Statistically, teenage drivers are more likely to have an automobile accident than adult drivers. As a result, insurance companies charge higher insurance premiums for teenager drivers. Suppose one insurance company decided to charge teenagers and adults the same premium based on the average risk of an accident for all drivers. Using your knowledge of the problems associated with asymmetric information, explain whether you think this insurance company will be profitable. (LO2) Answer: This insurance company is unlikely to be profitable because of the problem of adverse selection. The insurance premium based on the average risk of an accident in a pool of both teenagers and adults will be higher than the premium for the relatively low-risk adults alone and lower than the premium for teenagers alone. Therefore, adults will not choose to be insured by this company, but teenagers will. The premium charged based on the average risk of teenagers and adults would not be sufficient to cover the claims of a teenage-only pool and so the company would not be profitable.

16. Use your knowledge of the problems associated with asymmetric information to explain why insurance companies often include deductibles as part of their policies. (LO2) Answer: The presence of deductibles helps to reduce moral hazard. In the case of car insurance, for example, the insured faces a cost associated with an accident and so will likely be more careful when driving.

17. Suppose you have a defined-contribution pension plan. As you go through your working life, in what order would you choose to have the following portfolio allocations: (a) 100 percent bonds and money-market instruments, (b) 100 percent stocks, (c) 50 percent bonds and 50 percent stocks? (LO2) Answer: You should choose (b), (c) and (a). Early in your working life, investing in stocks makes sense as they generally earn a relatively high rate of return and are relatively safe when held over the long term. As you approach retirement and the need to use your long-term

savings, you should reduce the share of assets allocated to stocks, eventually focusing on fixedincome and liquid financial instruments.

18. As an employee, would you prefer to participate in a defined-benefit pension plan or a definedcontribution pension plan? Explain your answer. (LO2) Answer: If you are a risk-averse person and plan to stay in the same job for a significant portion of your working life, you may prefer a defined benefit plan. The longer you work for a company, the higher the pension benefits. In addition, your employer bears the risk associated with making future payments of a certain size to you. However, if you plan to change jobs regularly and are confident about making investment decisions about your retirement savings, you may prefer a defined-contribution plan.

19. In the aftermath of the financial crisis of 2007-2009, there were calls to reinstate the separation of commercial and investment banking activities that were removed with the repeal of the Glass-Steagall Act, but this did not happen. What might be some of the benefits and shortcomings of segmenting financial activities for reducing systemic risk? (LO1) Answer: Separating commercial and investment banking activities into different institutions may remove some conflicts of interest for banks across their different activities and may protect against excessive risk taking with depositors’ funds. On the other hand, this type of separation may not mitigate the ―too-big-to-fail‖ problem. It also limits the benefits from economies of scope. A more effective way to reduce systemic risk might be through capital and liquidity requirements.

20. Suppose a well-known financial holding company agreed to be the underwriter for a new stock issue. After guaranteeing the price to the issuing company but before selling the stocks, a scandal surrounding the business practices of the holding company is revealed. How would you expect this scandal to affect (a) the financial holding company and (b) the issuing company? (LO1) Answer: Because the financial holding company relies on its reputation to place the stock issue with investors, it is likely to find it much more difficult to sell the stock at the price it has planned upon. It will lose on the deal as it has already agreed a price with the issuing firm. The issuing firm will not be directly affected in that its funds from this issue are already guaranteed. It may, however, suffer indirect adverse consequences by association.

21. Consider three possible health insurance programs with the following characteristics: Program A: Participation in the program is voluntary and the policy premium charged varies with an individual’s health status, with those in relatively better health paying less. Program B: Participation in the program is voluntary and the policy premium is the same for everyone, based on the nation’s average cost of health care per person

Program C: Participation in the program is mandatory and the policy premium is the same for everyone, based on the nation’s average cost of health care per person Which of the three programs is least likely to be viable? Explain your answer. (LO2) Answer: Program B is the least likely to be viable due to adverse selection. If you can purchase health insurance at the same price regardless of your health status, in the case of voluntary participation, relatively healthy people would be less likely to participate than those in poorer health. This would result in relatively higher insurance payouts, which is not likely to remain viable. The mandatory element of Program C that would ensure participation by relatively healthy people makes it more viable, while the ability to price discriminate on the basis of health status makes Program A less likely to fail.

22. Suppose a U.S. bank is considering providing its services abroad. List one possible advantage and one possible disadvantage of expanding via the acquisition of a controlling interest in a foreign bank versus the establishment of an international banking facility (IBF)? (LO1) Answer: Once possible advantage of acquiring a controlling interest in a foreign bank relates to information costs. By retaining existing local staff and records of existing customers, the U.S. bank could reduce information costs relative to the alternative. One possible disadvantage of that approach would be giving up economies of scale in terms of being able to employ management and administrative systems already used by the U.S. bank.

23. The Secured Overnight Financing Rate (SOFR) has replaced LIBOR as the U.S. benchmark for short-term interest rates. SOFR is a reference rate that is free of default risk. Why might that create risk for banks using SOFR-based derivative products to hedge their funding risks? (LO2) Answer: Bank funding costs comprise two components – the risk-free rate and a premium to compensate for default risk. SOFR-based hedging would only protect against movements in the first component. During times of crisis, in particular, increases in the second component can have a large impact on bank funding costs.

24. Big Tech companies, such as Amazon, are now offering financial products. Why might a small eCommerce company that sells on the Amazon platform accept a loan from Amazon rather than seeking one from a traditional bank? (LO2) Answer: Core Principle 3—information is the basis for decisions—provides one possible answer. Because the company trades on its platform, Amazon has access to information about it that lowers the costs of screening and monitoring. Amazon may therefore be willing to lend to a company that might have trouble accessing a traditional loan, or one at an attractive interest rate, from a traditional bank. The company might also find it convenient to have their loan payments automatically deducted from their account with Amazon, a practice that reduces the risk that the lender faces from non-payment.

Data Exploration 1. One aspect of the 2007-2009 financial panic was a run on some money-market mutual funds (MMMFs). Plot weekly data (without recession bars) for 2008 on institutional MMMF deposits (FRED code: WIMFSL) and identify the timing of the run visually. Next, download the data

and report the size of the deposit outflow in the week that the run peaked. Why did this run end? (LO1) Answer: The run on MMMFs occurred in September 2008; the data plot is below. Data for several weeks before and after the run are listed below the graph, showing that about $87 billion fled money funds in the week ending September 22, 2008. The Federal Reserve guaranteed the liabilities of these funds on September 19 (the middle of the reporting week), so the deposit outflow earlier in the week may have been larger. Soon after the intervention, fund deposits began to rise again.

For the key period of 2008, the data on Institutional Money Funds (WIMFSL), Billions of Dollars, Weekly, Seasonally Adjusted is:

2008-07-14 2008-07-21 2008-07-28 2008-08-04 2008-08-11 2008-08-18 2008-08-25 2008-09-01 2008-09-08 2008-09-15 2008-09-22 2008-09-29 2008-10-06 2008-10-13

2314.6 2310.3 2308.3 2320.1 2334.5 2339.6 2323.6 2332.0 2353.7 2333.2 2246.5 2232.0 2236.2 2250.7

2008-10-20 2008-10-27

2294.1 2307.3

Plot the monthly average of daily transactions volume in the secured overnight financing rate (FRED code: SOFRVOL). (Hint: after plotting SOFRVOL at its daily frequency, specify ―Monthly‖ in the ―Modify Frequency‖ dropdown box and then choose ―Average‖ in the ―Aggregation Method‖ dropdown box.) Describe the pattern after 2021. Explain the advantages of using as a benchmark an interest rate that is determined in a market with a high volume of transactions. Compared to its discontinued predecessor, LIBOR, might SOFR have any disadvantages for use by banks? (LO1) After publication, this problem was completely reworked. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. How might financial developments influence the willingness to work? Plot retirement income before taxes for age 65 or over (CXURETIRINCLB0407M) on a quarterly basis on the left axis, and the employment-population ratio for the population over 65 (LNU02375379) on the right axis. What may have contributed to the increases in the employment rate in the over 65 population following the financial crisis of 2007-2009? What about the impact of the pandemic? Answer: The chart shows that retirement income grew slowly and unevenly in the years after the Great Recession. In addition, recall that housing and other forms of wealth declined during the crisis. Together, these changes may have diminished the confidence of retirees regarding their ability to sustain their lifestyles without employment income. In contrast, during and after the 2020 pandemic, policy support resulted in continued strong growth of retiree incomes even as employment plunged. Even well after the pandemic, the employment-population ratio for those over 65 did not recover to its pre-pandemic level.

ICE Benchmark Administration Limited (IBA), 1-Week London Interbank Offered Rate (LIBOR), based on U.S. Dollar [USD1WKD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD1WKD156N.

3. How did competition from money market-mutual funds affect traditional savings institutions that provided mortgages at fixed interest rates? Plot the 30-year fixed mortgage rate (FRED code: MORTGAGE30US) beginning in 1971. In a separate graph, plot the retail money-market mutual funds (FRED code: RMFSL) beginning in 1981. Why were money funds favored over traditional savings instruments in the 1980s and 1990s? (LO1) After publication, this problem was completely reworked. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. How do changes in the financial system affect how it functions when short-term interest rates rise and fall? Plot since 1975 on a monthly basis the 30-year fixed mortgage rate (MORTGAGE30US) on the left axis, and the scale of retail money-market mutual funds (FRED code: RMFSL) in billions of dollars on the right axis. Why did money funds attract great interest in the 1980s and 1990s? What impact did this have on the financial system and on mortgage finance (LO1) Answer: The data plot is below. When short-term interest rates rose in the 1980s, revenues from existing fixed-rate mortgages did not. By investing in short-term financial instruments, money market mutual funds were able to pay higher rates to their investors, so funds flowed from traditional savings institutions to these mutual funds. This competition compelled traditional savings institutions to pay higher rates on deposits, squeezing their profits and leading many to fail. Eventually, mortgage finance evolved away from a dependence on these traditional savings institution. More generally, savings typically flow into money market funds when short-term interest rates rise, while these funds stagnate when interest rates are low. However, the impact of these changing flows on mortgage finance is no longer as powerful as it was in the 1980s and 1990s. The reason is that most mortgages now are packaged into mortgage-backed bonds which are sold in a broad and deep global bond market. Consequently, there are many potential buyers who operate far more flexibly than the traditional savings institutions of the 1980s and 1990s.

4. Mutual funds allow small savers to pool their resources and purchase diversified portfolios of assets with low transaction costs. To see whether savers have taken advantage of these (and other) benefits, plot since 1980 mutual fund holdings (FRED code: HNOMFAQ027S) as a percentage of GDP (FRED code: GDP). Explain the pattern. (LO2) Answer: The plot below shows that mutual funds have become increasingly important. The combination of diversification at low cost and tax protection offered by various retirement savings approaches strongly encouraged wealth accumulation through mutual fund holdings. The initial surge may reflect in part the introduction of traditional Individual Retirement Accounts or IRAs). The subsequent proliferation of another popular retirement saving instrument, 401(k) accounts offered by many employers, helped sustain the rising trend, as have more recent variations on the original IRA. Of course, the variability of mutual fund holdings reflects the variability of the stock market and of other long-term assets in general.

5. Both U.S. and foreign banks are active in the United States. To compare them, plot the share (in percent) of foreign banks’ assets (FRED code: TLAFRIM027SBOG) in the assets of all commercial banks (FRED code: TLAACBM027SBOG). Describe the trend since the 1970s and explain how the trend might have arisen. (LO1) Answer: The globalization of the world’s in the final decades if the 20th century boosted transactions for both goods and services and financial instruments. To meet the rising need, U.S. banks established subsidiaries offshore that were not subject to reserve requirements or deposit insurance. Thus, these banks could more cheaply serve their customers who undertake international transactions. Similarly, foreign banks established a presence in the U.S. financial markets to compete with U.S. financial institutions. In general, the level of world economic activity and the volume of this activity across borders continues to support the presence of foreign banks in domestic banking markets. Notably, however, the foreign share of banking in the United States is now similar to wat it was 30 years ago. Consistent with a new ―steady state‖ in the role of foreign banks. The data is plotted as follows:

* indicates more difficult problems XVIII. Chapter 14 XIX.

Regulating the Financial System

XX. XXI. Conceptual and Analytical Problems 1. Explain how a bank run can turn into a bank panic. How might this explain why authorities employed emergency powers in response to the run on some midsized banks in March 2023? (LO1) Answer: Bank runs occur when people fear that their bank has become insolvent. Depositors rush to their bank to withdraw their funds. Depositors at other banks become concerned about their own bank’s solvency, so they also hurry to withdraw their funds. Bank runs can turn into system-wide bank panics because customers have a difficult time distinguishing insolvent banks from solvent ones. Concerns about the risk of such contagion contributed to the decision of the Federal Deposit Insurance Corporation (FDIC) in March 2023 to protect all deposits, even those that were uninsured, at Silicon Valley Bank and Signature Bank, when those banks suffered runs.

2. Current technology allows large bank depositors to withdraw their funds electronically at a moment’s notice. They can do so all at the same time, without anyone’s knowledge, in what is called a silent run. When might a silent run happen, and why? (LO1)

Answer: Depositors may have their accounts set up so that funds are automatically withdrawn under certain conditions. If the value of the depositors’ other assets decreases (because of a fall in the stock market, for example), the depositors may have difficulty meeting their liabilities and will need to have funds withdrawn from their deposit accounts. Depositors are likely to need to withdraw funds at the same time, leading to a silent run.

3. Explain why financial institutions such as pension funds and insurance companies are not as vulnerable to runs as money market mutual funds and securities dealers. (LO1) Answer: Like deposit-taking institutions, money market mutual funds and securities dealers have liquid liabilities backing illiquid assets and can suffer from a loss of liquidity similar to a deposit withdrawal from a bank at any time. In contrast, liability holders of pension funds and insurance companies cannot withdraw funds whenever they want. Therefore, even though their assets tend to be illiquid, they are not as vulnerable to runs.

4. Explain the link between falling house prices and bank failures during the financial crisis of 2007-2009. (LO1) Answer: Falling house prices led to a higher rate of mortgage defaults (as some customers could not re-finance to a lower interest rate as they had planned, for example). These mortgage defaults, along with falling values of mortgage-backed securities held by banks, reduced the value of bank assets and so lowered bank capital. (Recall that bank capital is the difference between the value of its assets and liabilities.). In some cases, bank capital was wiped out and so the bank failed. 5. Discuss the regulations that are designed to reduce the moral hazard created by deposit insurance. (LO3) Answer: Regulators can restrict competition so that banks are not under as much pressure to engage in risky investments. They can also prohibit banks from making certain types of risky loans and from purchasing particular securities. U.S. banks are not allowed to hold common stock or bonds that are below investment grade. Their bond holdings from a single issuer or loans to single borrowers cannot exceed a certain percent of their capital (15 to 25 percent in the case of a loan to a single borrower). Regulators have also developed minimum capital requirements based on the value and riskiness of a bank’s assets and the riskiness of its operations.

6. Why did recent crises, starting with the financial crisis of 2007-2009, spur a significant broadening of the Federal Reserve’s lender of last resort function? What potential problem might be associated with this? (LO2) Answer: The evolution of the financial system in recent decades included a greater role for nonbank intermediaries. Traditionally, the lender of last resort (LOLR) function was limited to banks, but given the changing character of the financial system, lending only to banks was no longer sufficient to ensure financial stability. In response to the financial crisis for 2007-2009 and the financial turmoil associated with the COVID pandemic, the Fed expanded its toolkit to provide LOLR support to nonbanks.

While the expansion of the Fed’s toolkit helped to stabilize the financial system, the resulting expectation that the Fed will bail out financial market participants that get into trouble can lead to greater risk taking. This moral hazard problem may be a particular concern for nonbanks, as they often are subject to less strict regulatory oversight than the depository institutions which usually borrow under the LOLR mechanism.

7. *Why is the banking system much more heavily regulated than other areas of the economy? (LO3) Answer: The banking system, by its nature, is fragile, and banks play a crucial role in the economy. Therefore, the government provides a safety net to banking customers to ensure the smooth functioning of this part of the economy. The provision of the safety net, however, compounds moral hazard problems and so heavy regulation and supervision are required to prevent bank managers from assuming excessive risk. 8. *Explain why, in seeking to avoid financial crises, the government’s role as regulator of the financial system does not imply it should protect most individual institutions from failure. (LO2) Answer: Failure of less competitive, less efficient institutions or firms is part of the competitive process that promotes the health of the industry as a whole. The role of the regulator is to provide a framework to prevent contagion effects adversely affecting efficiently run institutions.

9. Explain how macro-prudential regulations work to limit systemic risk in the financial system. (LO3) Answer: Macro-prudential regulations aim to safeguard the financial system by promoting better risk management by firms and reducing the financial system’s vulnerability to the failure of any single firm. To this end, macro-prudential regulations seek to make intermediaries internalize the costs associated with their behavior by imposing a systemic capital surcharge on institutions that contribute most to systemic risk based upon the riskiness of their balance sheets and on how interconnected they are to other firms. Capital requirements could also vary with the business cycle, making the system more stable by building up capital buffers in good times that could be drawn upon to lend to good quality borrowers in lean times. Regulators could also require banks to purchase catastrophe insurance that would replenish its capital in times of crisis.

10. Why were runs during the financial crisis of 2007-2009 not limited to institutions with large exposures to sub-prime mortgage lending? (LO1) Answer: Banks and shadow banks are highly interconnected with one another and so problems in one institution can quickly spread to others, making otherwise healthy institutions vulnerable.

11. Suppose you have two deposits totaling $280,000 with a bank that has just been declared insolvent. Would you prefer that the FDIC resolve the insolvency under the payoff method or the purchase-and-assumption method? Explain your choice. (LO2)

Answer: You would prefer the purchase and assumption method, because under the payoff method, you would lose any funds above the insurance limit. Currently, the limit is $250,000, so you would lose $30,000. The insurance is per depositor not per account, so the balances on your deposits will be added together and insured up to a maximum of $250,000. Under the purchase-and-assumption method, the bank would simply reopen under new ownership and depositors would not suffer a loss.

12. *In the absence of limits on the behavior of large intermediaries, how might the perception of institutions being ―too-big-to-fail‖ lead to increased concentration in the banking industry? Why might you expect the U.S. banking system to continue to become more concentrated? (LO2) Answer: By depressing the risk premium for default, the perception of being ―too big to fail‖ allow large intermediaries to attract funds at an advantageous cost, and encourages them to engage in risky behavior. This, in turn, puts small banks at a competitive disadvantage and may drive these smaller institutions out of the market, leading to an increase in concentration. Moreover, when smaller banks experience trouble, the perception that larger banks are safe drives depositors to shift their funds to them. You might expect the banking system to continue to become more concentrated for several reasons. First, if customers perceive larger institutions to be ―too big to fail‖, they will favor them. Second, the still-large number of small and medium-sized banks in the U.S. system suggests that there remain profitable opportunities for consolidation, continuing a decades-long trend. Third, the resolution of failing banks typically involves having them acquired by larger institutions.

13. One goal of the regulatory reforms that followed the 2007-2009 financial crisis was to address the ―too-big-to-fail‖ problem associated with large institutions. How did the reforms try to address this problem? Why might they not be sufficient? (LO3) Answer: The Dodd-Frank Act attempted to limit the mechanisms for government bailouts. It contains provisions that: (1) constrain Federal Reserve lending to individual nonbanks; (2) limit the FDIC’s guarantee powers; (3) subject large institutions to regular ―stress tests‖ and (4) require systemically important financial institutions (SIFIs) to have living wills and to meet higher capital requirements. The government’s implicit willingness to bail out the creditors of a large intermediary causes the too-big-to-fail (TBTF) problem, contributing to moral hazard. For example, if investors believe that an institution has TBTF status, they perceive relatively less risk when lending to it. Thus, the TBTF intermediary can borrow more cheaply and take on more risk. However, given the size and interconnectedness of designated SIFIs, investors may doubt the willingness of the government to let them fail in a crisis. If so, these firms would have continued access to relatively low funding costs and the moral hazard problems associated with TBTF would persist. Moreover, all four of the nonbank intermediaries that were initially designated as SIFIs were de-designated, so some nonbanks may believe they can take greater risks without being designated as SIFIs. Finally, regulatory decisions in 2019 that followed 2018 legislative changes raised the asset threshold at which strict scrutiny is imposed on midsized banks. In the wake of those decisions,

the banks at the center of the 2023 financial turmoil grew rapidly with relatively limited supervisory scrutiny. When depositors ran on these banks in March 2023, regulators felt compelled to use emergency tools to restore stability. Even so, deposits shifted to the largest banks that were viewed by many as TBTF. Moreover, it was the largest U.S. bank that acquired the largest of the banks that failed during this episode.

14. A government can overcome the challenge of time consistency only if it is both able and willing to make credible commitments. With this in mind, how might the U.S. laws and procedures for bankruptcy affect the too-big-to-fail problem? (LO2) Answer: Existing bankruptcy procedures are not designed for the speedy resolution of large, complex financial intermediaries like SIFIs. If these procedures impede creditors from using their assets to make payments, the failure of one SIFI can trigger a cascade of failures of its otherwise healthy creditors. Consequently, investors may doubt a government promise not to bail out a failing SIFI. Streamlining bankruptcy procedures to minimize systemic risks when a SIFI fails could enhance the credibility of the no-bailout commitment. Diminished expectations of a bailout would encourage creditors to require appropriate compensation – in line with Core Principle 2 – for loans to risk-taking SIFIs. The resulting market discipline would diminish SIFIs’ incentives to pursue risky strategies, making the financial system as a whole less vulnerable. For these reasons, legal scholars and experts are exploring the creation of a special U.S. bankruptcy code (sometimes called ―Chapter 14‖) for large intermediaries. However, these ideas have not succeeded in making it through the complete legislative process. 15. If banks’ fragility arises from the fact that they provide liquidity to depositors, as a bank manager, how might you reduce the fragility of your institution? (LO1) Answer: You could reduce the risk of large-scale unexpected withdrawals by increasing the portion of your liabilities accounted for by deposits that have restrictions on withdrawals, such as increasing time deposits, and reducing demand deposits as a percentage of liabilities. You could increase the excess reserves you hold on the asset side of the balance sheet so that you are prepared in the event of unexpected withdrawals. You could also hold a higher portion of assets in the form of liquid securities that could be sold easily to meet withdrawals.

16. *Why do you think bank managers are not always willing to pursue strategies to reduce the fragility of their institutions? (LO1) Answer: Strategies to reduce a bank’s vulnerability to sudden withdrawals are likely to adversely affect the bank’s profits. Demand deposits often pay zero or very low rates of interest and so represent and relatively inexpensive source of funds for banks. On the asset side of the balance sheet, holding excess reserves or liquid assets that pay relatively low rates of interest is also likely to reduce profit margins.

17. Regulators have traditionally required banks to maintain capital-asset ratios of a certain level to ensure adequate net worth based on the size and composition of the bank’s assets on its balance sheet. Why might such capital adequacy requirements not be effective? (LO3)

Answer: The importance of off-balance sheet activities of banks has been increasing and the nature of these activities, such as engagement in derivative markets, facilitate a high level of risk taking by banks that is not apparent from the institution’s balance sheet. In addition, banks learn over time to evade existing rules. For example, in the years preceding the financial crisis of 2007-2009, banks carried U.S. mortgage-backed securities because they had high ratings and thus lowered the banks’ risk-weighted capital requirements. Capital requirement rules also have notable shortcomings. For example, ahead of the run on some midsized banks in March 2023, these banks made large purchases of long-term Treasury securities and other Government guaranteed debt. While these asset acquisitions increased the banks’ leverage and maturity risks, they carried a zero weight for the risk-weighted measure of capital because they were free of default risk. Put differently, the risk-weighted measure that is used for capital requirements ignores interest rate risk. Another shortcoming relates to accounting rules. For example, banks are allowed to value at purchase cost those securities on their balance sheet which are designated to be ―held to maturity.‖ This accounting practice ignores the negative impact on asset values when interest rates rise, and can lead (as it did in the case of some midsized banks in 2022-23) to enormous differences between official regulatory measures of capital and actual net worth on a ―markedto-market‖ basis.

18. You are the lender of last resort and an institution approaches you for a loan. You assess that the institution has $800 million in assets, mostly in long-term loans, and $600 million in liabilities. The institution is experiencing unusually high withdrawal rates on its demand deposits and is requesting a loan to tide it over. Would you grant the loan? (LO2) Answer: Based on the information given, you should grant the loan. The institution has positive net worth (assets are greater than liabilities) and so is solvent. It appears to be experiencing a short-term liquidity problem and a loan could prevent this otherwise healthy institution from failing.

19. You are a bank examiner and have concerns that the bank you are examining may have a solvency problem. On examining the bank’s assets, you notice that the loan sizes of a significant portion of the bank’s loans are increasing in relatively small increments each month. What do you think might be going on and what should you do about it? (LO3) Answer: This may be a case where the bank has a large portion of non-performing loans. When the loan payments are not made, the bank may be rolling the payment and associated interest costs into the principal of the loan, thus causing the loan size to increase incrementally. As an examiner, you need to establish which loans may eventually be repaid and which should be written off to assess the impact on the solvency of the institution.

20. Deflation is the rate of decline in the aggregate price level. Why might deflation be of particular concern to someone managing a bank? (LO1) Answer: Deflation is associated with falling net worth of borrowers, as the nominal value of their assets fall but the dollar amount of their liabilities does not. This can lead to reduced lending as asymmetric information problems worsen and the associated downturn in economic

activity can increase defaults. This, in turn, leads to a deterioration in the quality of the bank’s balance sheet and may eventually lead to insolvency.

21. Explain how regulations that require banks to finance a greater portion of their activities with equity capital might hinder economic growth. How might such regulations help economic growth? (LO3) Answer: Requiring greater equity capital raises bank funding costs, and may limit their willingness to supply credit, thereby limiting economic activity. On the other hand, overextending credit to poor-quality borrowers can be detrimental to economic growth. Wellcapitalized banks tend to lend to healthier borrowers, contributing to a more stable financial system and a more efficient allocation of resources, supporting stronger economic growth.

22. Why is it unlikely that a regulatory system focused exclusively on entities such as banks, security firms and insurers will be sufficient to achieve a safe and efficient financial system in the future? (LO3) Answer: The financial system has evolved to the point that financial activities are carried out not only by nontraditional entities, but even by methods that may not involve a legal entity (―decentralized finance‖ or DeFi). As part of this process, new fintech firms, as well as nonfinancial firms, are fundamentally altering the provision of financial services. These changes also are affecting the impact of financial risks. As a result, ―activity-based‖ regulation (as opposed to ―entity-based‖ regulation) is increasingly important for delivering a safe and efficient financial system.

Data Exploration 1. When banks failed in the 1929-1933 period, the lack of deposit insurance meant that depositors experienced sizable losses. How big were these losses? For September 1929 through February 1933, plot the deposits in suspended banks (FRED code: M09039USM144NNBR). Download the data and sum the deposits lost to bank failures in 1931. Using this total, compute its ratio to 1931 gross national product of $77.4 billion. Using that ratio, how large would the losses be compared to first-quarter 2016 nominal GDP of $18.3 trillion. (LO1) Answer: The data plot is below. In 1931, the cumulative loss was $1,690 million, about 2.2 percent of nominal GDP. Based on early-2016 GDP of $18.3 trillion, the comparable loss would be about $403 billion. Bank runs are costly.

National Bureau of Economic Research, Deposits of Suspended Banks, All Banks--Members and Non-Members of the Federal Reserve System for United States [M09039USM144NNBR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M09039USM144NNBR.

2. How frequently are the payoff and the purchase-and-assumption methods used by the FDIC? Plot the total number of institutions receiving such assistance (FRED codes: BKTTPIA641N for purchase-and-assumption; BKTTPOA641N for the payoff method). On the same graph, plot as a second line the purchase-and-assumption data separately (so that your graph will show one line with the total and a second line with the purchase-and-assumption data only). Describe the evolution over the long run. From what you know about the total number of depository institutions, does the total number of resolutions seem high or low? (LO2) Answer: Until the late 1980s, the payoff method was used to restore the balances to depositors at failing banks. The FDIC only began to use the purchase-and-assumption method thereafter, but it came to dominate the payoff method. As a result, on a de facto basis, the FDIC came to guarantee all the deposits in the banking system, not just the insured deposits. At the same time, the overall number of resolutions is relatively low. At the recent peak in 2009, 114 institutions out of a total of 6,978—or 0.15%–were resolved. At the peak in 1989, the number of institutions resolved was 71. This represented 0.56% of 12,869 then-existing institutions.

3. Starting in 2015, plot the ratio of deposits to liabilities both for small domestically chartered banks (FRED codes: DPSSCBW027SBOG and TLBSCBW027SBOG) and for large domestically chartered banks (FRED code: DPSLCBW027NBOG and TLBLCBW027SBOG). Analyze and compare these ratios over the period to the end of 2021, as well as during the episode that began with the March 2023 bank runs. Was the impact of the pandemic recession temporary or persistent? In 2023, why might depositors’ attitudes have differed for large and small banks? (LO3) After publication, this problem was completely reworked. A replacement problem and solution are presented here. The next printing of the book will feature this replacement. How important are deposits at small and large banks? Compare on a monthly basis from 2000 the percent of total liabilities represented by deposits at small domestically chartered banks (FRED codes: DPSSCBW027SBOG and TLBSCBW027SBOG) and at large domestically chartered banks (FRED codes: DPSLCBW027NBOG and TLBLCBW027SBOG). What has changed during this period, which involved the 2020 pandemic and the 2023 mid-sized bank runs? Answer: Generally, banks depend heavily on deposits. Historically, small banks’ liabilities included a larger share of deposits than large banks’ liabilities. Following the 2007-2009 financial crisis, however, large banks turned increasingly to deposits as a reliable, low-cost source of funds, so that the historical differences have disappeared. In 2022-23, when short-term interest rates rose, deposits tended to flow out of banks toward money-market funds, reflecting the usual cyclical pattern. This pattern was somewhat more

pronounced for small banks, which also faced somewhat greater pressures during the midsized bank panic of 2023

4. How important was the lender-of-last-resort function of the Federal Reserve in the financial crisis of 2007-2009? Beginning in 2000, plot the ratio of (in percent) of borrowing from the Fed (FRED code: TOTBORR) to its asset holdings (FRED code: WRESCRT). What happened to the borrowing ratio during the 2007-2009 financial crisis and during the March 2023 bank run? (LO2) Answer: The data plot is below. Usually, discount window borrowing is a negligible portion of the Fed’s holding of assets, as it was even during the recession of 2001. During the crisis, discount window borrowing reached a record level in absolute terms and approached 25 percent of the value of its assets. Note that the 2008 surge in discount borrowing includes lending to nonbanks (such as credit extended to American International Group, the largest U.S. insurer at the time). In addition to these loans through the discount window, the Fed also auctioned term credit to depository institutions for periods of up to 84 days during the financial crisis. As part of the efforts by the Federal Open Market Committee to maintain liquidity in financial markets, discount lending rose at the onset of the pandemic of 2020, , but other, newer tools for providing liquidity became much more important in this episode. Similarly, in response to the March 2023 midsize bank runs, the Fed created the Bank Term Funding Program (BTFP) that provided banks with one-year collateralized loans to ensure the provision of liquidity. As a result, the discount window again played a less important role.

5. Shadow banks typically fund their assets by issuing liabilities of shorter maturity that are close substitutes for bank deposits. The maturity mismatch between their assets and liabilities creates rollover risk that can trigger fire sales and systemic disruption. Plot the outstanding level of one such liability—asset-backed commercial paper (FRED code: ABCOMP)—from the start of 2002 to the end of 2007. Based on the plot, discuss how the use of asset-backed commercial paper influenced the financial crisis of 2007-2009? (LO1) Answer: The plot appears below. From 2005 to the summer of 2007, shadow banks increasingly relied on the issuance of asset-backed commercial paper (ABCP) to fund their asset purchases. In August 2007, investors became highly uncertain about the value of subprime mortgage securities and other instruments that were used as collateral for ABCP. Investors’ inability to distinguish good collateral from bad collateral (a ―lemons problem‖ as discussed in Chapter 11) suddenly diminished the demand for any ABCP, forcing shadow banks that could no longer roll over their ABCP issues to sell their assets or to bid aggressively for other sources of funding. These fire sales and the scramble for liquidity both catalyzed and then aggravated the crisis. Having disappeared suddenly in 2007, the market for ABCP remains depressed as of August 2016, with ABCP outstanding stagnating below $300 billion, down by more than 75 percent from the 2007 peak.

* indicates more difficult problems

Chapter 15 Central Banks in the World Today Conceptual Problems 1. In 1900, there were 18 central banks in the world; today, there are about 180. Why does nearly every country in the world now have a central bank? (LO1) Answer: A central bank plays a vital role in any nation’s or region’s economy. By controlling monetary policy, the central bank is able to affect inflation and economic growth. Moreover, the central bank often plays a crucial role in maintaining a stable financial system.

2. The power of a central bank is based on its monopoly over the issuance of currency. Economics teaches us that monopolies are bad and competition is good. Would competition among several central banks be better? Provide arguments both for and against. (LO1) Answer: Competition could force central banks to become more efficient and would increase accountability. However, the central bank’s monopoly over the issuance of currency is what allows it to control money growth and inflation.

3. Explain the costs of each of the following conditions and explain who bears them. (LO1) a. Interest-rate instability b. Exchange-rate instability c. Inflation d. Unstable growth Answer: a. Interest-rate instability makes output unstable. It also increases risk and therefore the risk premium on bonds. With a higher risk premium, it is more costly for firms to borrow. Firms will decrease their investments, which will hurt economic growth. b. Exchange-rate instability makes the revenue from exports and the costs of imports unpredictable. This hurts individuals engaged in foreign trade. This problem is particularly severe in emerging economies. c. Inflation creates uncertainty, which reduces investment and hurts growth. When inflation is higher than expected, the real value of the payments received by lenders falls. Someone on a fixed salary is also hurt by higher than expected inflation. d. When growth is unstable, people are less sure about their future incomes and less willing to borrow. Another reason for the decrease in borrowing is that the uncertainty associated with unstable growth increases the risk premium and makes borrowing more costly. Lower levels of borrowing reduce investment and hurt future growth.

4. Provide arguments for and against the proposition that a central bank should be allowed to set its own objectives. (LO2, LO3) Answer: One could argue that a central bank should be able to set its own objectives so as to be free from political influence. However, this would reduce accountability, since the central bank would be able to change its objectives in accordance with the monetary policy it is following at any particular time.

5. A euro-area country that runs very large public deficits or shows a persistently high and rising debt-to-GDP ratio violates the provisions of a 2012 treaty aimed at promoting fiscal stability. Explain how such fiscal violations pose a challenge for the ECB in the form of moral hazard. (LO4) Answer: Violating the provisions of the treaty poses a moral hazard problem for the ECB because, if the country defaults (or is in danger of defaulting) on its debt, it affects the ECB’s ability to carry out its mandate. One obvious response would be for the ECB to buy the bonds of the violator. However, that action risks signaling to other countries that they, too, would receive central bank support if they violate the provisions. In addition, private-sector bond buyers may view central bank purchases as insuring them against the default risk of countries that run poor fiscal policies. Default risk premia that are persistently too low encourage governments to take greater fiscal risks.

6. How does the time consistency problem apply to the conduct of monetary policy? How might long terms of office for central bankers help overcome this? (LO4) Answer: To make monetary policy time consistent, central bankers need to credibly commit to implementing that policy in the future. Long appointments allow central bankers to resist reneging on desirable long-run policies for short-term gains. Long terms also allow central bankers to develop reputations that enhance policy credibility.

7. What problems does a central bank face in a country with inefficient methods of tax collection? (LO4) Answer: If the government cannot efficiently collect tax revenues, it may pressure the central bank to buy its debt. A central bank that persistently monetizes government debt risks high and rising inflation.

8. The Maastricht Treaty, which established the European Central Bank, states that the governments of the countries in the euro area must not seek to influence the members of the central bank’s decision-making bodies. Why is freedom from political influence crucial to the ECB’s ability to maintain price stability? (LO3) Answer: Because politicians are elected for short terms, they have an incentive to create shortterm prosperity at the expense of future inflation. If they can influence the central bank, they will push for expansionary monetary policy that increases economic growth in the short run but leads to inflation in the long run.

9. Transparency is a key element of the monetary policy framework. (LO3) a. Explain how transparency helps eliminate the problems that are created by central bank independence. b. In what way did the financial crisis of 2007-2009 and the economic and financial turmoil associated with the COVID pandemic emphasize the importance of central bank transparency? c. Since 1993, the Bank of England has published a quarterly Inflation Report. Find a copy of the report on the bank's website, www.bankofengland.co.uk. Describe its contents briefly and explain why the bank might publish such a document. Answer: a. Central bank independence takes significant power away from elected politicians and gives it to a set of appointed officials. By requiring central bankers to communicate regularly with the public and explain exactly what they are doing and why, transparency makes central bankers more accountable, consistent with representative democracy. b. In volatile, uncertain times, central bank transparency helps reduce uncertainties that arise from the central bank’s own policies and actions. During the 2007-2009 financial crisis and the COVID pandemic, the Federal Reserve’s transparency in communicating to the public its rapidly evolving policy approach and expanded toolset made policy more predictable and effective.

c. The U.K. Inflation Report describes current economic conditions and makes projections for the future. It also explains the reasoning behind the Bank of England’s interest rate setting. Publishing the report makes it more difficult for the Bank of England to deviate from its focus on keeping inflation low and stable. By encouraging time-consistent monetary policy, publication of the report makes the central bank’s anti-inflation commitment more credible and helps to anchor inflation expectations.

10. *While central bank transparency is widely accepted as a desirable, too much openness may have disadvantages. Discuss what some of these drawbacks might be. (LO3) Answer: Disclosing too much information may, in fact, obscure the key message the central bank is trying to get across. Disclosing details of the debate that took place to make a policy decision or having different policy makers air conflicting views might undermine the commitment to and credibility of the policy eventually agreed upon. Knowing that the minutes of policymaking meetings will be made public might stifle open and productive discussions to form the basis of policy decisions.

11. Which do you think would be more harmful to the economy—an inflation rate that averages 5 percent a year that has a high standard deviation or an inflation rate of 7 percent that has a standard deviation close to zero? (LO2) Answer: Inflation rate of 5 percent with a high standard deviation is likely to be more harmful to the economy. The less predictable inflation is, the more it distorts economic decisions and the more systematic risk it creates.

12. Suppose the central bank in your country has price stability as its primary goal. Faced with a choice of having monetary policy decisions made by a well-qualified individual with an extremely strong dislike of inflation or a committee of equally well-qualified people with a wide range of views, which choice would you recommend? (LO3) Answer: In general, decision-making by committee is considered a better choice as it allows for the pooling of knowledge and experience and reduces the risk that policy will be dictated by one person’s quirks. Given that the individual in question is not democratically elected, it is also more legitimate to entrust monetary policy decisions to a group rather than an individual.

13. Suppose the president of a newly independent country asks you for advice in designing the country’s new central bank. For each of the following design features, choose which one you would recommend and briefly explain your choice: (LO3) a. Central bank policy decisions that are irreversible or central bank policy decisions that can be overturned by the democratically elected government. b. The central bank has to submit a proposal for funding to the government each year or the central bank finances itself from the earnings on its assets and turns the balance over to the government. c. The central bank policymakers are appointed for periods of four years to coincide with the electoral cycle for the government or the central bank policymakers are appointed for 14year terms.

Answer: a. You should choose irreversible central bank decisions as the priorities of the central bank tend to be longer term than those of politicians who may be tempted to reverse any central bank decisions that could hurt their chance of reelection. b. You should choose for the central bank to be free to control its own budget. Otherwise, politicians who hold the purse strings could use this power to influence central bank decisions to their own benefit. c. You should choose to elect central bank policymakers for long terms in office to enable them to pursue the long-term goals of the central bank. 14. ―A central bank should remain vague about the relative importance it places on its various objectives. That way, it has the freedom to choose which objective to follow at any point in time.‖ Assess this statement in light of what you know about good central bank design. (LO3) Answer: This statement is inaccurate. In order for the central bank to be credible, it needs to communicate clearly its policy goals and the trade-offs between them. This allows the public to know how the central bank will react in various situations and helps to keep inflationary expectations under control. Put differently, narrowing the central bank’s scope for policy discretion can add to the credibility of its policy commitments, helping to overcome the challenge of time consistency.

15. *The list of a central bank’s goals includes the stability of interest rates, low and stable inflation, and high employment and real growth. You look on the central bank website and note that the central bank has increased interest rates repeatedly at their policy meetings over the last year. Reading the financial press, you note references to concerns about how the central bank’s policy actions are likely to slow economic growth and even possibly lead to a recession and rising unemployment. How could you reconcile this behavior with the central bank pursuing its objectives? (LO2) Answer: This behavior makes sense in the context of a central bank that has a single policy instrument and multiple objectives. Often, there are trade-offs to be made among competing objectives. Increasing interest rates may have been necessary to curb emerging inflationary pressures even if that came at a cost to real growth and employment. It is important for central bankers to communicate clearly about these trade-offs and the priorities they are assigning to specific goals as part of a well-designed policy framework.

16. While there is strong consensus among economists in favor of central bank independence, political support has not always been as resolute. What factors may have contributed to the rise in the political threat to the Federal Reserve’s independence in recent decades? What economic consequences might ensue? (LO3) Answer: Policy actions by the Federal Reserve in response to the financial crisis of 2007-2009 and again in 2020, including bailouts and use of emergency powers, contributed to a political backlash against the independence of the Federal Reserve. In 2018, in the context of a more contentious political climate, the U.S. President began engaging in an unusual degree of public criticism regarding Federal Reserve officials and Federal Reserve policy decisions that raised

interest rates. In 2021-2022, surging inflation raised doubts about Federal Reserve credibility and led to criticism for not having raised interest rates earlier. Economic research supports a link between central bank independence and better macroeconomic performance, including lower and more stable inflation: undermining the Fed’s independence would likely have adverse macroeconomic consequences. For example, politicians have time-horizons that extend only to their next reelection, so they will likely pressure the central bank for policies that provide short-term prosperity, but long-term instability in the economy. Moreover, undermining the Fed’s independence likely would lead investors to demand a higher risk premium on a wide range of U.S. assets, depressing their prices and raising the cost of capital.

17. Suppose in an election year, the economy started to slow down. At the same time, clear signs of inflationary pressures were apparent. How might the central bank with a primary goal of price stability react? How might members of the incumbent political party who are up for reelection react? (LO2) Answer: In this case, the appropriate monetary policy is to tighten monetary policy, increasing interest rates to curb the emerging inflationary pressures in pursuit of the long-run goal of price stability. In contrast, it is likely that the politicians due for reelection would be more concerned with the slowdown in the economy and be in favor of a cut in interest rates. In the absence of influence over an independent central bank, they may push for immediate increases in government spending or reductions in taxes.

18. Assuming that they could, which of the following governments do you think would be more likely to pursue policies that would seriously hinder the central bank’s pursuit of low and stable inflation? Explain your choice. (LO4) a. A government that is considered highly creditworthy both at home and abroad in a politically stable country with a well-developed tax system, or b. A government of a politically unstable country which is heavily indebted and considered an undesirable borrower in international markets. Answer: The government described in b) would more likely be tempted to force the central bank to buy its bonds to finance increased spending. In a politically unstable country, collecting taxes or raising funds by selling bonds to citizens or borrowing in international markets will be relatively more difficult than in a politically stable nation with a government that is considered highly creditworthy both at home and abroad with a well-developed tax system. Getting the central bank to print money may be the only option to increase spending. The increase in the quantity of money in circulation would lead to higher inflation in conflict with the central bank’s goal.

19. *Suppose the government is heavily in debt. Why might it be tempting for the fiscal policymakers to sell additional bonds to the central bank in a move that it knows would be inflationary? (LO4) Answer: In this case, inflation would benefit the fiscal policymakers, as it would erode the real value of its outstanding debt, making it easier to repay. Inflation also increases nominal income and the tax revenues collected at a given tax rate, again making it easier to repay debt.

20. In 2012, the Federal Reserve joined many other central banks by making explicit a numerical target for inflation. Explain how stating that an annual inflation rate of 2 percent over the long run is most consistent with its mandate can help the Federal Reserve fulfill that mandate? (LO2, LO3) Answer: The Federal Reserve stating its objective explicitly can help anchor inflationary expectations. A credible central bank will be expected to alter policy in the future to keep inflation near its target. Announcing the target raises the cost of reneging on the central bank’s commitment to price stability, making the policy time consistent. As inflation expectations inform firms’ pricing and wage decisions, stabilizing inflation expectations around 2 percent prevents actual inflation from deviating too far from this level for long, thus helping the achieve the goal of price stability.

21. Consider the following data for Country A and Country B:

Primary Budget Surplus/GDP Sovereign Debt/GDP Nominal GDP Growth Rate Nominal Interest Rate on Debt

Country A 2.8% 90% 2% 5%

Country B 1.5% 60% 4% 7%

Use these data to show that the ratio of public debt to GDP is expected to stabilize in Country A but not in Country B. How might this impact monetary policy in Country B? (LO4) Answer: For the debt/GDP ratio to stabilize, the following condition must be met: Ratio of Primary Budget Surplus to GDP ≥ [i – g] × (Ratio of Debt to GDP) where i is the nominal interest rate and g is the nominal GDP growth rate. Country A The right-hand side is (5 – 2) × 0.09 = 2.7% compared with a primary surplus/GDP ratio of 2.8%, so the condition is met.

Country B The right-hand side is (7 – 4) × 0.6 = 1.8% compared with a primary surplus/GDP of 1.5%, so the condition is not met. In the face of highly unsustainable debt dynamics, monetary policy makers will face rising inflationary expectations and will not be able to control inflation. The central bank may also come under pressure to purchase Government bonds, fueling inflation and resulting in a situation known as fiscal dominance.

22. While central banks are not involved in fiscal policymaking, fiscal policy decisions can have significant consequences for monetary policy. In response to the COVID pandemic, fiscal

policymakers in the U.S. engaged in extensive fiscal stimulus. How might that have affected the Fed’s subsequent monetary policy decisions? (LO4) Answer: The fiscal stimulus probably contributed to rising U.S. inflation in 2021-2022, requiring a stronger monetary policy response from the Fed in pursuit of its price stability goal.

Data Exploration 1. New Zealand in the 1970s and 1980s combined high inflation with relatively little central bank independence. In 1989, New Zealand became the first country to adopt an inflation target. How did this policy regime shift affect inflation? Plot the inflation rate based on New Zealand’s ―core‖ consumer price index (FRED code: CPGRLE01NZQ659N) beginning in 1970. Was inflation after 1990 lower and more stable than before? Download the data and compute the average and the standard deviation of inflation for: (a) the period through 1989 and (b) the period from 1990 to the present. (LO1) Answer: The data plot below confirms that inflation was higher and more variable prior to the policy shift in New Zealand. In the 1970-1989 period, inflation averaged 11.8 percent with a standard deviation of 4.4 percent. From 1990 through the first quarter of 2024, inflation averaged 2.3 percent with a standard deviation of 1.5 percent.

Organization for Economic Co-operation and Development, Consumer Price Index: OECD Groups: All Items Non-Food and NonEnergy for New Zealand [CPGRLE01NZQ659N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPGRLE01NZQ659N.

2. Financial stability is a goal of most central banks. To see this, plot the European Central Bank’s assets (FRED code: ECBASSETSW) as a percent of nominal GDP (FRED code: EUNNGDP).

(Note: to match units, divide the ratio by 4.) Based on this chart, how important was this goal of financial stability for the ECB (a) before 2007, (b) during the crisis period of 2007-2009, and (c) when the euro-area crisis intensified in 2011-2012, and (d) in the period following 2013 as the euro-area crisis subsided? (LO2) Answer: (a) Prior to 2007, ECB assets rose largely in line with GDP , reflecting tranquil economic conditions. (b) Following the Lehman failure in 2008, central bank assets surged quickly as the ECB sought to counter financial market disruptions. (c) Beginning in late 2011, the ECB again expanded its balance sheet rapidly to counter the runs on banks in several euroarea countries. (d) The largest increases (relative to GDP) occurred in the periods 2015-2017 and 2020-2021, as the ECB undertook ―quantitative easing‖ (acquiring a large volume of assets; see chapter 18) in order to stimulate economic growth and to raise inflation toward its official target of close to, but less than 2 percent. Beginning in 2023, the ECB began to shed some assets (known as ―quantitative tightening‖) in its effort to counter the surge of inflation that followed the pandemic and Russia’s invasion of Ukraine. NOTE: The wrong FRED code: ECBASSETS was mistakenly printed in the book. It should be replaced with ECBASSETSW. Future printings will feature the corrected FRED code.

European Central Bank, Central Bank Assets for Euro Area (11-19 Countries) [ECBASSETSW], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/ECBASSETSW.

3. Interest rate stability is a common goal of central banks. When has the Federal Reserve been relatively successful at keeping interest rates stable? Compare quarterly changes since 1965 of the federal funds rate (FRED code: FEDFUNDS) with the level of inflation based on the percentage change from year-ago levels of the consumer price index (FRED code: CPIAUCSL). Are stable interest rates associated with high or low inflation? Why? (LO2)

Answer: Higher inflation prior to 1985 was associated with volatile interest rates. Why? The first reason is that the goal of low, stable inflation is a higher policy priority than the goal of stable interest rates. Consequently, when inflation is high, the goal of lowering it makes the Fed willing to tolerate volatile interest rates. Another reason is that inflation itself often is more volatile when it is high, resulting in more volatile policy rates. A third reason is that low inflation expectations make it easier to keep inflation stable without large changes in nominal interest rates: Stable inflation means that a small change in the nominal interest rate also changes the real interest rate that influences economic activity. It is worth noting that temporary return of high inflation in 2022-2023 also prompted the sharpest increase of the federal funds rate in several decades, but the relative stability of long-term inflation expectations limited that rise compared to the pre-1985 era.

4. To what extent has the Federal Reserve ―monetized‖ government debt? Plot since 1970 the change from a year ago (measured in billions of dollars) in gross federal debt (FRED code: FYGFD) and the change from a year ago (measured in billions of dollars) in the federal debt held by the Federal Reserve System (FRED code: FDHBFRBN). (LO4) Answer: By examining the annual change in the gross federal debt, we are evaluating new Treasury borrowing (net of redemptions) in the credit market. Similarly, the annual changes in the Federal Reserve holdings represent net purchases by the Fed during the year. In the aftermath of the 2007-2009 crisis, Fed purchases of government debt issues reached record levels and also were large as a share of new federal debt. The recent spike in Federal Reserve holdings of federal debt reflects policy actions taken as its initial response to the pandemic of 2020. Fiscal spending at the outset of the pandemic in response to lockdowns of many sectors of the economy sharply increased both the gross federal debt and Federal Reserve holdings of this

debt in 2020. Notably, federal debt continued to rise sharply in 2023-24, but the Federal Reserve began to reduce its holdings of government debt and allowed its balance sheet to shrink, consistent with other policy efforts—especially increases in the federal funds rate—to lower inflation (see also ―quantitative easing‖ and ―quantitative tightening‖ in Chapter 18).

5. Plot the ratio of U.S. federal debt to GDP (FRED code: GFDEGDQ188S). Describe the pattern over recent decades, focusing on debt sustainability and on the sensitivity to a rise of the interest rate on debt (all other things unchanged). (To guide your analysis, review the Money and Banking Blog box: Fiscal Sustainability on pages 363–364.) Answer: The chart shows that the Federal debt-to-GDP ratio has surged twice in the recent past: first, in response to the financial crisis of 2007-2009, and then during the brief COVID pandemic recession of 2020. Compared to the decade of the 1990s, when the debt ratio usually was around 60% of GDP, the current ratio of about 120% of GDP means that the Federal balance sheet is roughly twice as sensitive to a rise of the interest rate. More specifically, it would require an increase in the primary budget surplus that is twice as large (1.2% of GDP versus 0.6% of GDP) just to keep the debt ratio from rising further in the face of a onepercentage point increase in the interest rate on the debt.

* indicates more difficult problems Chapter 16 The Structure of Central Banks: The Federal Reserve and the European Central Bank

Conceptual and Analytical Problems 1. What are the Federal Reserve’s goals and who established them? How are Fed officials held accountable for meeting them? Explain why the chair is the most influential Fed official. (LO1) Answer: Congress mandates the Federal Reserve to ―maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The Fed releases large amounts of information in order to maintain accountability. After each Federal Open Market Committee (FOMC) meeting, the target interest rate range is announced immediately, along with a brief statement. The chair also holds a press conference. Meeting minutes are available after three weeks and transcripts after five years. A Summary of Economic Projections of FOMC participants is published with meeting materials for every

other meeting. Members of the FOMC give public speeches and the chair reports to Congress twice a year. In 2012, the Fed introduced a numerical inflation objective (based on the price index of personal consumption expenditures) and in 2020 it reviewed and clarified its strategy as one of ―average inflation targeting.‖ This transparency allows the public to assess the Fed’s performance in meeting its congressionally mandated goals. Finally, as leader of the FOMC, the Fed chair influences policy by controlling (i) the staff of the Board of Governors that produces the material distributed to FOMC members prior to meetings, (ii) the agenda of FOMC meetings, (iii) the order in which people speak, and (iv) the policy alternatives from which the Committee chooses. 2. Go to the Federal Reserve Board's website and locate the Federal Open Market Committee’s (FOMC’s) most recent statement. What policy decision did the committee members make at their last meeting regarding the target range for the Federal funds rate? What did they say about the two goals of price stability and sustainable economic growth? (LO2) Answer: In a statement released on July 26, 2023, the FOMC decided to raise the target range for the Federal funds rate by one-quarter percentage point (25 basis points) to 5.25 – 5.5 percent, a 22-year high. It stated: ―Recent indicators suggest that economic activity has been expanding at a moderate pace. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated.‖ The statement also made reference to monitoring indicators of ―labor market conditions, inflation pressures and inflation expectations, and financial and international developments‖ in assessing the appropriate stance of policy.

3. Periods of high inflation are likely to be brought under control more quickly when monetary policy is conducted by a central bank that is independent of political influence. Provide an explanation in favor of this statement. (LO2). Answer: Because politicians are elected for relatively short terms, they often favor expansionary monetary policy that will boost economic growth in the short run, but might fuel inflation. Similarly, they may be averse to contractionary monetary policy that slows growth and increases unemployment, even when such a policy is needed to bring down high inflation. A central bank that is pursuing a price stability goal, independent of political influence, is more likely to pursue the contractionary appropriate policy to contain high inflation. For example, some people have argued that the high inflation of the late 1970s was a consequence of the responsiveness of then-Federal Reserve Board chair Arthur Burns to the political influence of President Richard Nixon. 4. How might the ECB’s pursuit of price stability as its primary objective have restricted its response to the sovereign debt crisis in the euro area in 2010? (LO3) Answer: A short-term solution to the sovereign debt crisis could have been for the ECB to buy all the bonds of the highly indebted countries that they are unable to sell to private investors (until the governments can repair their national balance sheets). However, an

unlimited purchase of bonds would have increased the money supply in the euro area and could have led to higher inflation and a loss of ECB credibility. 5. Evaluate the following statement: ―The Maastricht Treaty helped solve the time consistency problem in monetary policy but not fiscal policy.‖ (LO3) Answer: The time consistency problem for monetary policy was addressed by establishing a highly independent central bank. Independence resulted from features such as long terms (without reappointment) for Executive Board members, irreversible policy decisions, and the need for a treaty modification to alter the ECB structure or its price stability mandate. However, the Treaty lacked credible ways to ensure good fiscal performance in each country. In some countries, fiscal policy operated with limited regard for the long-run implications of rising debts. Perhaps more important, fiscal well-being was undermined by unforeseen risks, such as the need in several countries to recapitalize their banking systems. 6. How did the response to the financial crisis of 2007–2009 alter the appointment process of presidents of the regional Federal Reserve Banks? (LO1) Answer: The bailouts of financial institutions during the crisis fueled a public perception that the regional reserve banks are too sympathetic to the private banks, in part because presidents of regional Feds often are selected from the ranks of private bankers. As part of the Dodd-Frank Act, Congress decided that the three bank representatives on the ninemember boards of each Federal Reserve Bank would no longer have a vote in selecting the bank president. This change was modest compared to earlier proposals, one of which would have made the bank presidents direct appointees of the U.S. President (subject to approval by the U.S. Senate), similar to the members of the Federal Reserve Board.

7. What are the goals of the ECB? How are its officials held accountable for meeting them? (LO3) Answer: The primary goal of the ECB is to maintain price stability, which the ECB defines as an annual inflation rate of less than, but close to, two percent using the Harmonized Index of Consumer Prices. Like the Federal Reserve, the ECB is held accountable through releases of information, including its target interest rate, the explanatory statements that follow its meetings, regular reports to the European Parliament, frequent publications, and public speeches.

8. During the euro-area sovereign debt crisis, why did the sovereign debt problems of Greece—a country that accounts for less than 2 percent of euro-area GDP—threaten the banking system throughout the euro area? (LO3) Answer: Banks throughout the euro area held Greek government debt. When its value fell, bank capital at these banks declined, making banks throughout the region riskier than before. More important, concerns about sovereign default and about a possible exit of Greece from the euro area proved contagious, leading the prices of sovereign debt in several euro-area economies (especially, Ireland, Italy, Portugal, and Spain) to plummet. Sharp

declines in these bond prices aggravated the hit to capital in the euro-area banking system. Partly as a result, banks became more cautious about lending to each other (a version of the ―lemons‖ problem). Finally, the spreading sovereign debt and banking crisis was associated with a prolonged and deep economic recession that damaged other assets on the banks’ balance sheets (including, for example, real estate-related loans). In some countries—such as Greece and Spain—the recessions resulted in Great Depression-level unemployment.

9. Go to the ECB's website and locate the most recent introductory statement made by the president of the ECB at the press conference following a Governing Council meeting. What was the Governing Council’s policy decision? How was it justified in the context of the ECB’s goals? (LO3) Answer: In the introductory statement at the press conference following the Governing Council's meeting on 27 July 2023, Christine Lagarde, President of the ECB stated the Governing Council had decided to raise the three key ECB interest rates by 25 basis points (one quarter of a percentage point). The decision reflected concerns about inflation: ―The rate increase today reflects our assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission. The developments since our last meeting support our expectation that inflation will drop further over the remainder of the year but will stay above target for an extended period. While some measures show signs of easing, underlying inflation remains high overall.‖

10. Do you think the FOMC has an easier or a harder time agreeing on monetary policy than the Governing Council of the ECB? Why? (LO3) Answer: The FOMC and ECB have similar numerical inflation objectives. However, the presence of national biases may make agreement among members of the Governing Council of the ECB more difficult. By contrast, the Federal Reserve has very little regional bias. Also, a group of 12 (the number of voting FOMC members) is likely to have an easier time coming to a decision than a group of 26 (the current number of ECB Governing Council members). 11. Why did the ―no-bailout‖ clause of the Maastricht Treaty come under stress during the financial crisis of 2007-2009? (LO3) Answer: Large fiscal deficits in some euro-area countries threatened the ability of those governments to borrow. A disruption to sovereign borrowing in one country would not only cause economic and banking difficulties in that country but would likely threaten the economies and banking systems of other euro area members due to their strong interlinkages.

12. Do you think the current procedures for appointing members to the Board of Governors are consistent with the principles of good central bank design? Explain your answer. (LO1) Answer: The length of the terms and the fact they are staggered reduces the opportunity for political influence on the selection of the governors and so these procedures are consistent with central bank independence. However, the governors are still appointed by the president

and confirmed by the Senate. These practices can be interpreted as a pragmatic way of institutionalizing central bank independence in a democratic society.

13. *Currently, all the national central banks in the Eurosystem are involved with the day-to-day implementation of monetary policy. What do you think the advantage would be of centralizing the conduct of these day-to-day interactions with financial markets at the ECB in Frankfurt? Are there any disadvantages you can think of? (LO3) Answer: The main advantage would be in terms of efficiency. Conducting these interactions at 20 different national central banks is more cumbersome than having one central point of contact with financial markets. Having one center would also promote the treatment of the Eurosystem as a single integrated market as opposed to a collection of separate national market segments. A possible disadvantage would be the loss of local market knowledge, although this issue should become less and less important over time.

14. If you were charged with redrawing the boundaries of the Federal Reserve districts, what criteria would you use to complete the task? (LO1) Answer: Ideally, the districts should reflect a diverse range of economic interests. Other factors to consider might include the levels of population, of economic activity, and of financial activity.

15. Why do you think the statement released after each Federal Open Market Committee meeting retains the same basic structure? (LO2) Answer: Maintaining the same structure for the statement promotes transparency and is thought to be a good communication strategy. The market knows what information it will be getting. If the structure of the statement constantly changed, the markets might misinterpret these changes as signals about the stance of policy that the committee did not intend to give.

16. Do you think, in the interest of transparency, the chair of the Federal Reserve Board should explain in detail the subtleties surrounding policy decisions? Why or why not? (LO2) Answer: Since 2012, the Fed chair has conducted quarterly press conferences following those FOMC meetings where members’ quantitative economic and policy rate forecasts are published. This practice mirrors the communications strategy of the ECB, which conducts a press conference (led by its President and Vice President) following each Governing Council meeting. However, there can be tradeoffs between transparency and effective communication strategy. Being more open about how policy decisions are arrived at enhances transparency, but it can lead to confusion and uncertainty when the decisions themselves are unclear or contentious.

17. Suppose a fellow student in your money and banking class made the following statement: ―Since the Federal Reserve introduced a specific numerical target for inflation in 2012 but does not have one for maximum employment, it has, in effect, a hierarchical mandate like

the ECB, placing primacy on the price stability part of its mandate.‖ On what basis could you disagree with this student? (LO1, LO3) Answer: Expressing a numerical target for inflation but not for the maximum employment element of the mandate does not imply that greater importance is placed on the former. As the monetary authority, the Fed exerts control over inflation over the long run, but it does not control output and employment over the long run. The absence of a numerical target for the latter reflects this reality. Following a review of its monetary policy strategy in 2020, the Fed made two shifts in strategy that impact how they approach the two goals: the first was the adoption of average inflation targeting; the second a change from limiting deviations from maximum employment to an asymmetric focus on limiting shortfalls relative to maximum employment. While these changes still focus on both elements of the Fed’s dual mandate, they also reflect a reduced willingness to respond preemptively to inflation risks. At the same time, the Fed has stated that if the goals of limiting employment shortfalls and inflation deviations come into conflict, it will take a ―balanced approach‖ between these two goals.

18. Compare the communication strategies of the Federal Reserve and the ECB. In what ways are they similar? Identify two key elements of the Fed’s strategy that are not part of the ECB’s strategy and discuss whether you think the ECB is justified in omitting each of them. (LO1, LO3) Answer: The communication strategies of the Fed and the ECB share many common elements: they both immediately release the target interest rate with a statement after policy meetings and hold periodic press conferences. They both release an account of their policy meetings with a short lag, report periodically to a democratically elected body, give public speeches and disseminate data and research. In contrast to the ECB, the Fed makes public the individual vote counts of the members of its policy-making committee while the ECB does not. The Fed also publishes lightly edited transcripts of its meetings after a five-year lag while the ECB only issues a written account of Governing Council meetings. Not publishing votes of Governing Council members can be justified on the basis that it makes it more feasible for members who represent individual countries to base their vote on the needs of the economy of the euro area as a whole (as they are charged to do) rather than on the basis of a narrower, national perspective. This rationale could be stretched to also justify the absence of published transcripts, but this argument is significantly weaker because a transcript could be published with a long lag.

19. During the euro-area crisis, interest rate spreads between the sovereign debt of peripheral countries and Germany widened most sharply when it was feared that one or more countries might leave the euro area. These spreads narrowed when ECB actions restored confidence in the monetary union. What accounts for this pattern? (LO3) Answer: The widening of spreads reflects an increased risk premium on the bonds of the peripheral countries, as investors required compensation for the possibility they might leave

the euro area (Core Principle 2). As ECB actions reduced or eliminated those fears, the required risk premia fell, and the spreads narrowed. In 2022, as financial markets came under strain following Russia’s invasion of Ukraine, the ECB created a new policy tool that facilitates the purchase of Euro-area government bonds by the ECB in order to keep sovereign interest rate spreads from becoming too large.

20. Like most central banks around the world, the Federal Reserve currently does not provide deposit accounts for individuals. Suppose the Fed decided to issue digital currency by offering unlimited access to interest-paying deposit accounts for individuals. What problems might this cause for the financial system? (LO2) Answer: Interest-paying deposits at the Fed would likely be considered more attractive (less risky) than equivalent deposits at private-sector institutions. The change could re-direct a substantial volume of depository institutions’ sources of funds out of the private sector, compromising its ability to fund loans and other sources of credit. This could lead to pressure for the Fed to become a major supplier of credit. Moreover, if the Fed became a major deposit account provider, it would need to develop related functions, including compliance and risk management.

Data Exploration 1. How large are the public debt burdens of key euro-area economies? Are they rising or falling? Plot the debt-to-GDP ratios of Germany (FRED code: GGGDTADEA188N), Italy (FRED code: GGGDTAITA188N). Extend each line (matching its color) using the projections of the International Monetary Fund (FRED codes: GGGDTPDEA188N and GGGDTPITA188N, respectively). Are these ratios consistent with the Maastricht Treaty’s public debt-to-GDP guideline of 60 percent? (LO3) Answer: In 2020, both countries experienced a surge in the public debt-to-GDP ratio associated with the COVID pandemic. However, the IMF projects that the German debtGDP ratio will retreat back to the Maastricht Treaty’s 60-percent guideline within a few years. In contrast, the IMF projects that Italy’s ratio, which is more than double the Treaty guideline, will rise gradually further in coming years.

International Monetary Fund, General government gross debt for Germany [GGGDTADEA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTADEA188N International Monetary Fund, Projection of General government gross debt for Germany [GGGDTPDEA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTPDEA188N International Monetary Fund, General government gross debt for Italy [GGGDTAITA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTAITA188N International Monetary Fund, Projection of General government gross debt for Italy [GGGDTPITA188N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GGGDTPITA188N

2. The European Central Bank (ECB) has translated its primary objective of price stability into an explicit, quantitative goal of keeping euro-area annual inflation to 2 percent over the medium term. Plot the percent change from a year ago of the euro-area price level called the harmonized index of consumer prices (FRED code: CP0000EZ19M086NEST). Evaluate the performance of the ECB on average since 2000 and over shorter intervals. Download the data and compute the average inflation rate for the full period and for the periods 2000-2019 and 2020--present. (LO3) Please note the time period was changed after publication. These time periods will appear in future printings. Answer: The plot is shown below. Over short periods measured inflation varies significantly as a result of temporary price disturbances that do not affect the trend of inflation. Moreover, monetary policy changes influence inflation only with a lag. As a result, monetary policy cannot reasonably be expected to hold average inflation at a specified numerical value over intervals much less than two years. Over the full period since 2000, euro-area inflation has averaged 2.2 percent through April 2024. However, most of the overshoot occurred only in the aftermath of the 2020 COVID pandemic and the 2022 Russian invasion of Ukraine. From 2000 to 2019, inflation averaged 1.7 percent, consistent with the ECB’s goal of close to, but less than 2 percent. Since 2020, inflation averaged 4.0 percent, more than double the ECB’s target. The pandemic and geopolitical disruptions boosted inflation temporarily above 10% in 2022, the

highest level since the introduction of the euro. Not surprisingly, the ECB began pursuing contractionary policies in 2022 to bring inflation back under control.

3. In 2012, the Federal Reserve announced an inflation objective of 2 percent ―over the longer run‖ for the personal consumption expenditures price index (FRED code: PCEPI). However, many analysts focus on the ―core‖ price index (FRED code: PCEPILFE), which omits the volatile food and energy components. For the Fed’s horizon, does this difference matter? Plot the percent change from a year ago for both inflation measures since 2000. Download the data and compute the averages and standard deviations over that period. What do you conclude? (LO2) Answer: The core index is relatively useful for examining the trend of inflation, because volatile components of the headline price index can mask its underlying trend. Over long periods of time, however, such temporary disturbances fade, so these measures should be more alike, unless food and energy prices deviate from other prices on a trend basis. From January 2000 to April 2024, headline inflation averaged 2.2 percent, while core inflation averaged 2.0 percent. Clearly, food and energy prices rose somewhat faster over this period than other prices. Yet, because the gap between the two measures is reasonably stable over the long term, the headline reading can usefully serve as a target. At the same time, the standard deviation of the core inflation rate was only 1.0 percent (versus 1.4 percent for the headline rate). The smaller standard deviation of the core measure means that it is usually a more reliable signal of the underlying inflation trend, which is important for setting monetary policy.

4. Its statement of March 20, 2019, the FOMC indicated it would pursue policies to meet its objectives of ―maximum employment and price stability.‖ Plot since 2009 the evolution of the FOMC’s longer run projection for the unemployment rate (FRED code: UNRATECTMLR), the actual unemployment rate (FRED code: UNRATE), and the percent change from a year ago of the core for personal consumption expenditures price index (FRED code: PCEPILFE). Summarize the description provided by FRED (beneath the plot) of the FOMC longer-run unemployment projection. Then use the plot to explain why the March 2019 statement indicated that the FOMC ―will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.‖ (LO2) Answer: The midpoint of the projections of members of the FOMC reflects the median estimate of the ―normal‖ unemployment rate consistent with ―maximum employment.‖ By mid-2016, the actual unemployment rate had reached that level and then continued to fall below the projections. Historically, the FOMC had raised the federal funds rate to preempt inflation in the face of falling unemployment. However, from its perspective in March 2019, unemployment had been falling persistently since late 2009 without any notable inflation or inflation volatility; inflation over the period from 2009 through March 2019 had averaged 1.6 percent with a standard deviation of 0.3. Thus, the FOMC believed that it could afford to be ―patient‖ regarding any movements in the federal funds rate. Note that the sharp rise in the unemployment rate in early 2020 was the result of business lockdowns in the face of the pandemic of 2020 with the rate then declining sharply as the lockdowns began to be lifted. In 2022, the unemployment rate again had fallen below the FOMC projections and stayed there through mid-2024.

5. To restore financial stability in a crisis, the Federal Reserve acts as a lender of last resort. Starting in 2007, plot total borrowings from the Federal Reserve (FRED code: BORROW). What does the pattern suggest about the relative intensity of the financial disruptions during the crisis of 2007-2009, the COVID pandemic of 2020, and the runs on midsized banks in 2023? Then add to your plot (on the right axis) the percentage change from a year ago of real GDP (FRED code: GDPC1), and discuss how your analysis of borrowing during these episodes compares with their actual impact on economic activity. (LO2) Answer: The financial disruptions during the 2007-09 financial crisis looked far worse than the pandemic. Borrowing peaked at nearly $700 billion in November 2008. By contrast, early in the COVID pandemic, borrowing only reached $125 billion. Looking at April 2023, we can see that borrowing rose above $300 billion. So, if we were to use this as the only indicator of financial stress, we would rank the fall of 2008 as the worst, then spring 2023, and finally spring 2000. Turning to economic activity, we see that there was a severe and protracted recession starting in December 2007 and ending in mid-2009. For the four-quarter period ending in June 2009, real GDP declined by roughly -4 percent. The COVID panic was far more acute (real GDP plunged by 7.5% in the year to June 2020), but also much shorter. Unlike the period following the financial crisis, when economic growth was relatively subdued, the economy expanded rapidly in 2021 (with yearto-year growth rising by nearly 12 percent as of the April-June 2021 period). And, remarkably, the 2023 banking turmoil was not associated with any slowdown in growth. In 2020 and (to a lesser extent) 2023, other policies (monetary, fiscal or both) played key roles in restoring (or sustaining) economic growth.

* indicates more difficult problems

Chapter 17

The Central Bank Balance Sheet and the Money Supply Process Conceptual and Analytical Problems 1. Outline the step-by-step impact of a $100 open market purchase by the Federal Reserve through the first two banks involved and calculate the overall impact on deposits in the banking system using the simple deposit expansion multiplier if banks wish to hold excess reserves equal to 1 percent of deposits. Assume that banks have no reserve requirement. Compare the overall impact on deposits to the case where the excess reserve ratio is 10 percent and comment on the difference. (LO3) Answer: Bank A sells securities of $100 and increases its reserves by $100. It is now holding excess reserves, so it will make a loan of $100, crediting the deposit account of the borrower $100. The borrower draws down this $100, so both deposits and reserves at Bank A fall by $100. The overall impact on Bank A is that its liabilities are unchanged, but the composition of its assets changes—securities are $100 lower, and loans are $100 higher than the starting point. When the borrower spends the $100, the recipient of those funds places them on deposit in their bank—Bank B, increasing deposits and reserves at Bank B by $100. With an excess reserve ratio of 1 percent, and no required reserves, Bank B makes a loan of $99 (1-.01*($100)), starting the cycle again. This cycle continues, with each new

deposit created being 1-.01 times the previous deposit. The overall impact on deposits in the banking system of the $100 open market purchase calculated using the simple deposit expansion multiplier is: $100/.01 = $10,000 If the excess reserve ratio was 10 percent instead of 1 percent, the overall impact of the $100 open market purchase would be: $100/.1 = $1,000. The higher the excess reserve ratio, the lower the overall impact on deposits of an open market purchase of a given size and the impact is proportional. In this case, an excess reserve ratio that is 10 times higher results in an impact on overall deposit of one-tenth as much.

2. Suppose a major bank needs to borrow $20 billion overnight that it cannot obtain from private creditors. The Fed is willing to make a discount loan of $20 billion to this bank as long as doing so will not alter interbank lending rates. What might the Fed do to avoid affecting interbank rates if it makes this loan? (LO1) Answer: The Fed could make the $20 billion loan to the bank and simultaneously sell $20 billion of securities to the rest of the banking system. These two operations would keep the aggregate supply of reserves to the banking system unchanged; the $20 billion rise in reserves offered to the borrowing bank is offset by the $20 billion withdrawal of reserves from other banks, as they pay for the securities by drawing down their reserve accounts.

3. Compute the impact on the money multiplier of a fall in the currency-to-deposit ratio from 10 percent to 8 percent when the reserve requirement is 10 percent of deposits, and banks’ desired excess reserves are 3 percent of deposits. (LO3, LO4) Answer: When desired currency holdings = 10% of deposits, m =

1  0.1  4.78 0.1  0.1  0.03

1  0.08  5.14   0 . 08 0 . 1 0 . 03 When desired currency holdings = 8% of deposits, m =

4. Does the Federal Reserve frequently purchase or sell gold or foreign exchange as part of its efforts to change the money supply? (LO2)

Answer: No. Fed transactions in foreign exchange and gold are infrequent, and are not used to alter the money supply. The Fed usually purchases and sells foreign exchange only when it implements Treasury decisions to intervene in currency markets. It typically offsets these actions with a separate open market operation. While the Fed holds gold, it rarely alters its gold holdings, and it does not adjust the value of these holdings in response to changes in the market price of gold.

5. Consider an open market purchase by the Fed of $5 billion of Treasury bonds. What is the impact of the purchase on the bank from which the Fed bought the securities? Compute the impact on M2 assuming that: (1) the required reserve ratio is zero (2) all banks in the banking system maintain excess reserves of 10 percent of deposits; and (2) the currencydeposit ratio is zero. (LO2, LO3) Answer: The bank’s securities fall by $5 billion and its reserves rise by $5 billion. Assuming the banking system maintains an excess reserve ratio of 10 percent, and the public does not wish to hold currency: Change in M2 =

× Change in Monetary Base

Change in M2 = × 5 = $50 billion The value of deposits, and M2will rise by $50 billion. 6. When you withdraw cash from your bank’s ATM, what happens to the size of the Fed’s balance sheet? Is there any reason for the Fed to react to your action? (LO2) Answer: The reserves held by your bank at the Fed decline, but there is a larger volume of currency in the hands of the nonbank public. These changes are offsetting, so there is no impact on the Fed’s total liabilities (or, equivalently, on the size of its balance sheet). However, your action has raised the currency-to-deposit ratio and can lead to a change in the money supply. The Fed may choose to alter policy to offset the impact on the money supply if the withdrawal is large enough.

7. *Why is currency circulating in the hands of the nonbank public considered a liability of the central bank? (LO1) Answer: The fact that the central bank must repay holders of currency represents an obligation for the central bank; therefore, currency held by the nonbank public appears on the liabilities side of the central bank's balance sheet. The central bank is obliged to pay back the holder of the currency. If the currency were backed by gold, for example, the central bank would be obliged to exchange gold for currency. With fiat money, however, the central bank is obliged only to exchange currency for more currency. 8. How did its response to the COVID pandemic that began in 2020 affect the size and composition of the balance sheet of the Federal Reserve? (LO1) Answer: Between December 2019 and December 2021, the size of the Fed’s balance sheet more than doubled to $8.8 trillion, with most of the expansion accounted for by a rise in the Fed’s holdings of securities, both Treasuries and mortgage-backed securities. There was also an increase in loans, although loans played a smaller role in the response to the COVID crisis compared with the financial crisis of 2007-2009. The expansion of assets was financed on the liability side by a doubling of bank reserves and a significant increase in assets held at the Fed by nonbanks (included in ―other liabilities‖ on the balance sheet).

9. Suppose the currency-to-deposit ratio is 0.25, the excess reserve-to-deposit ratio is 0.05, and the required reserve ratio is 0.10. Which will have a larger impact on the money multiplier: a rise of 0.05 in the currency ratio or in the excess reserves ratio? (LO4) Answer: Initially, the money multiplier is m=

1  0.25  3.13 0.25  0.10  0.05

If the currency-to-deposit ratio rises to 0.30, the multiplier falls to m=

1  0.30  2.89 0.30  0.10  0.05

If, instead, the excess reserve-to-deposit ratio rises, the multiplier will be m=

1  0.25  2.78 0.25  0.10  0.10

So, the multiplier falls by more with the increase in the excess reserve-to-deposit ratio.

10. Is the money multiplier model still useful for policymakers in the United States? If not, why not? (LO4) Answer: In recent decades, model has been of limited use for policymakers. The reason is that the ratios to deposits of currency and excess reserves--the terms in the multiplier that are beyond the control of the central bank–have become unstable. Consequently, the central bank can no longer predict accurately the level of the money supply when it provides a specific amount of monetary base.

11. Based on Figure 17.10, explain the behavior of the money multiplier at the onset and in the wake of the financial crisis of 2007–2009 and at the onset of the COVID pandemic. (LO4) Answer: The money multiplier plummeted during the financial crisis of 2007-2009 as banks hoarded excess reserves in the face of the liquidity crisis. Confronted with the possibility of not being able to roll over debts or sell securities when necessary, banks were willing to forego the extra profits from lending out these reserves, especially given the prevailing low interest rates. When the Federal Reserve began paying interest on reserves in 2008, the opportunity cost of holding excess reserves fell, so banks continued to hold these excess reserves even as the crisis receded. Consequently, the multiplier remained low. When the COVID pandemic hit, the multiplier fell again as banks increased excess reserve holdings in the face of liquidity concerns, although the impact was far less dramatic compared with the financial crisis.

12. The U.S. Treasury maintains accounts at commercial banks. What would be the consequences for the money supply if the Treasury shifted funds from one of those banks to the Fed? (LO2) Answer: The balance sheet for the bank would reflect a decrease in reserves and a decrease in deposits. The decrease in reserves would also appear on the Fed’s balance sheet; however, it would be offset by an increase in the government’s account. The response of the banking system to the decline in bank reserves would be a decline in the quantity of money.

13. *Explain how an incomplete understanding at the Federal Reserve of the relationship between the central bank’s balance sheet and the money supply contributed to the Great Depression. How did the Fed’s behavior during the financial crisis of 2007–2009 and the 2020 pandemic illustrate that it had learned a valuable lesson from the Great Depression? (LO4) Answer: During the Great Depression, the central bank was increasing the monetary base at a significant rate. Conditions in the economy and the banking system, however, meant that the money multiplier was declining, so the overall impact was a fall in the quantity of money. This contributed to the contraction of the economy. In contrast, when declines in the money multiplier emerged during the more recent crises, the Fed rapidly expanded the supply of reserves, preventing a collapse of the money supply like that seen in the 1930s. In fact, during the pandemic, M2 grew at the most rapid pace since record-keeping began in 1959.

14. Suppose you examine the central bank’s balance sheet and observe that since the previous day, reserves had fallen by $100 million. In addition, on the asset side of the central bank’s balance sheet, securities had fallen by $100 million. What activity did the central bank carry out earlier in the day to lead to these changes in the balance sheet? Do you think the central bank was aiming to increase, decrease, or maintain the size of the money supply? (LO2, LO3, LO4) Answer: The central bank conducted an open market sale of $100 million with a commercial bank. The sale of the securities would involve $100 million of securities being removed from the central bank’s balance sheet. The commercial bank would have paid for the securities from its reserve account, thus leading to a fall of $100 million in reserves on the central bank balance sheet. It is most likely that the central bank was aiming to decrease the money supply. An open market sale reduces reserves on the central bank’s balance sheet and so reduces the monetary base. Assuming the money multiplier remains unchanged, this would decrease the money supply. 15. Suppose you observe a fall in reserves of $100 million on the central bank’s balance sheet as well as a fall of $100 million in securities held by the central bank. Do you think the size of the banking system’s balance sheet would be affected immediately by these changes to the central bank’s balance sheet? Explain your answer. (LO2) Answer: No. Reserves and securities both appear on the asset side of the balance sheet of the banking system, so their offsetting changes would affect the composition but not the size of its balance sheet. Over time, the banking system may try to shrink its assets and liabilities in response to the decline of reserves.

16. Do you think the Federal Reserve successfully carried out its role as lender of last resort in the wake of the terrorist attacks on September 11, 2001? Why or why not? (LO2) Answer: Yes. The Fed successfully acted as lender of last resort and prevented the financial system from collapsing in the wake of the attacks. By purchasing large volumes of U.S. Treasury securities and extending loans, the Fed provided huge amounts of liquidity to enable banks to meet their commitments.

17. *In carrying out open market operations, the Federal Reserve usually buys and sells U.S. Treasury securities. Suppose the U.S. government paid off all its debt. Could the Federal Reserve continue to carry out open market operations? (LO2) Answer: In theory, yes. In the absence of Treasury securities, the Federal Reserve would have to switch to other assets to carry out its open market operations. If these alternative assets traded in deep, highly active markets, the Fed could avoid imposing market distortions when conducting open market operations. 18. In which of the following cases will the size of the central bank’s balance sheet change? (LO2) a. The Federal Reserve conducts an open market purchase of $100 million of U.S. Treasury securities.

b. A commercial bank borrows $100 million from the Federal Reserve. c. The amount of cash in the vaults of commercial banks falls by $100 million due to withdrawals by the public. Answer: The size of the central bank’s balance sheet will rise in cases (a) and (b). On the liability side in both these cases, reserves rise by $100 million. On the asset side, securities rise by $100 million in case (a) while loans rise by $100 in case (b). In case (c), the composition of liabilities changes, with a shift from reserves to currency, but the overall size of the balance sheet remains unchanged.

19. *You read a story reporting a major scandal about the Federal Deposit Insurance Corporation that is likely to undermine the public’s confidence in the banking system. What impact, if any, do you think this scandal might have on the relationship between the monetary base and the money supply? (LO4) Answer: The scandal is likely to increase the public’s desire to hold currency as the safety of their deposits comes into question; the currency-to-deposit ratio is likely to rise. In addition, banks are likely to hold a higher level of excess reserves in anticipation of the public’s reaction, thus increasing the excess reserve-to-deposit ratio. The changes in both these ratios would reduce the money multiplier, thus reducing the stock of money for a given monetary base.

20. Use your knowledge of the money multiplier to explain why the massive increase in bank reserves related to the 2007-2009 financial crisis did not result in uncontrolled inflation. Why might the increase in bank reserves at the onset of the COVID pandemic have fueled inflationary concerns?(LO4) Answer: While the increase in reserves in response to the 2007-2009 financial crisis expanded the monetary base, this did not translate into a massive increase in the money supply because the money multiplier plunged. The two most important causes of the decline in the money multiplier were: (1) impairment of the banking system during the crisis boosted banks’ demand for excess reserves; and (2) the payment of interest on excess reserves reduced the opportunity cost of holding them. The increase in the excess reserve ratio depressed the money multiplier, limiting the impact of the reserve increase on the money supply. Even after the crisis, the low opportunity cost of holding reserves has supported banks’ demand for them, so the multiplier has remained low. In contrast to the experience of the financial crisis, in the case of the COVID pandemic response in 2020, the rise in reserves was accompanied by a rapid expansion of the broad money supply, helping to fuel inflationary concerns. 21. Explain the distinction between the ―zero lower bound‖ and the ―effective lower bound‖ on nominal interest rates. If interest rates were pushed below the effective lower bound, what would be the likely impact on the money multiplier and the supply of bank credit? (LO3, LO4) Answer: If there were no transactions costs associated with using cash, its zero rate of return would impose a zero lower bound on nominal interest rates. However, on occasion, nominal rates have declined somewhat below zero in several countries. This is possible because of

the costs associated with storing, transferring and insuring cash. The effective lower bound can be defined as the zero lower bound minus those costs. If nominal rates were pushed below the effective lower bound, we would expect depositors to withdraw funds from the banking system in favor of holding cash. This would increase the cash/deposit ratio, which would reduce the money multiplier. As a result, trying to push the interest rate below the effective lower bound would be contractionary because it would diminish the supply of bank credit.

22. Assuming normal financial and economic conditions, what are the main advantages of a central bank maintaining low-risk, short-term assets on its balance sheet? (LO2) Answer: A key advantage is that this minimizes liquidity and maturity risk. If the assets are predominantly Government issued and so free of credit risk, this would lead to a virtually riskless portfolio. By holding such a minimal-risk portfolio, the central bank distorts relative asset prices as little as possible and maintains its ability to respond to crises when they arise.

Data Exploration 1. Plot on a weekly basis the ratio of currency (FRED code: WCURRNS) to checkable deposits (FRED code: TCD) from the start of 2000 through 2002 and then remove the recession bar. Download the data and identify the week of the downward spike in the graph. Do you think the spike reflects the currency term in the numerator or the deposits term in the denominator? Explain your reasoning. (LO2) Answer: In the plot below, the downward spike occurred during the week including September 11. Examining the downloaded data, you will see it is due to a sharp, temporary rise in checkable deposits. The rise and subsequent fall in checkable deposits is the result of the disruption to the check-clearing process when airspace throughout the United States was closed. Checks in the clearing process that had been credited to accounts of check recipients were debited to the accounts on which they were drawn only after air travel resumed.

2.* Figure 17.10 shows a sharp decline of the M2 money multiplier in 2008. What caused the drop? Using the indicators for currency (FRED code: CURRSL), total reserve balances maintained (FRED code: RESBALNS), reserve balances required (FRED code: RESBALREQ), and checkable deposits (FRED code: TCDSL), plot from 2000 to 2019 the currency-to-deposit ratio and the excess reserve-to-deposit-ratio. Which one caused the M2 money multiplier to plunge? (Hint: To estimate excess reserves, subtract reserves balances required (FRED code: RESBALREQ) from total reserve balances maintained (FRED code: RESBALREQ). Divide RESBALREQ by 1,000 to convert the units to billions of dollars.) (LO3)

Answer: Prior to the financial crisis, excess reserve holdings as a percentage of checkable deposits were negligible. In the crisis, the Federal Reserve massively expanded the supply of excess reserves, partly to meet panic-level liquidity demands. While the currency-to-deposit ratio was gradually falling, it cannot account for the abrupt change in the multiplier. Note that the data on required reserve balances is discontinued after March 2020, so the plot ends at 2019.

3. In the Great Depression, the Fed allowed the money supply to decline. To confirm that the Federal Reserve learned from this lesson, plot since 2000 the M2 multiplier—the ratio of M2 (FRED code: M2SL) to the monetary base (FRED code: BOGMBASE)—and, on the right axis, the level of M2. Explain how the Fed was conducting policy in order to sustain the expansion of M2 through both the financial crisis of 2007-009 and the COVID pandemic of 2020. (Note: In calculating the M2 multiplier, divide BOGMBASE by 1,000 to convert it from millions to billions of dollars.) (LO4) Answer: The plot is below. M2 is the product of the M2 multiplier and the monetary base, M2 = m × MB. M2 can rise if a decline in the value of the multiplier is offset by a sufficiently large rise of the monetary base. During the financial crisis of 2007-2009, the Fed’s expansion of the monetary base – through its short-term lending programs and largescale asset purchases – was sufficient to support the continued rise of M2 (unlike the Great Depression). And, in the case of the 2020 pandemic, the Fed’s expansion of the monetary base was so large and rapid that it propelled M2 sharply higher even as the M2 multiplier declined.

4. Prior to the financial crisis of 2007-2009, the Fed seldom reduced its holdings of Treasury securities. Plot since 2007 the percent share of the Fed’s Treasury holdings (FRED code: TREAST) and its total assets (FRED code: WALCL) . Comparing the crisis of 2007-2009, the COVID pandemic of 2020, and the midsized bank runs of 2023, what does the evolution of this Treasury holdings share suggest about the Fed’s practices? Why might the Fed’s behavior have differed during these episodes? (Hint: Examine Table 17.1 to help with your response.) (LO2) Answer: The data plot is below. In the first half of 2008, the Fed allowed its short-term Treasury securities to mature without replacement in order to offset the impact on its asset holdings of rapid increases in loans and purchases of other assets (including mortgagebacked securities and other Federal agency debt). After the Lehman failure, however, the Fed initiated the first round of quantitative easing (QE1), sharply expanding the size of its asset holdings.

5. Thousands of the data series on FRED are provided directly by the Board of Governors of the Federal Reserve System, including hundreds of indicators from the Fed’s weekly balance sheet report (H.4.1 Factors Affecting Reserve Balances). How does this balance sheet transparency affect the conduct of monetary policy? (LO1) Answer: Public disclosure of information about the balance sheet is crucial for the credibility of a central bank. The Fed’s detailed, high-frequency disclosures add meaningfully to its credibility as manager of the nation’s monetary affairs. The data allow outside observers to see clearly if the Fed’s deeds (in terms of balance sheet changes) match its words (including FOMC statements, congressional testimony, and speeches). Consistency of words and deeds is essential for credibility.

* indicates more difficult problems

Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Conceptual and Analytical Problems 1. Explain how the Federal Reserve would implement a rise in the target range for the federal funds rate. How does its action influence the market federal funds rate? (LO1) Answer: The Federal Reserve would increase the interest rate on reserve balances (IORB), an interest rate that it controls directly. This raises the minimum rate at which banks would be

willing to lend to other institutions because they can earn the IORB rate risk-free by depositing those funds with the Fed. An increase in the IORB rate also raises the rate at which banks would be willing to borrow in the money markets from nonbank participants that cannot earn interest on deposits at the Fed. The increase in the IORB rate therefore puts upward pressure on the market federal funds rate to bring it into the new higher target range.

2. Using a graph of the market for bank reserves, show how, in the post-2008 environment, the Federal Reserve can control independently both the price and quantity of aggregate bank reserves. (LO1) Answer: Figure 18.4 can be used to illustrate this point. The Fed can control the price of aggregate reserves in the market for reserves by changing the interest rate it pays on reserves. When the Fed pays a higher rate, for example, banks would be willing to pay a higher rate to borrow from nonbank participants in the federal funds market in order to deposit these funds at the Fed. This process does not change the supply of aggregate reserves. It is reflected in an upward shift in the flat portion of the reserve demand curve for reserves.

Because there is an abundance of reserves in the banking system, banks’ demand for reserves is not sensitive to changes in reserve supply within a certain range (the flat portion of the reserve demand curve). In this range, the Fed can change the supply of reserves without influencing their price.

3. Why might the market federal funds rate deviate from the interest rate on reserve balances (IORB)? (LO1) Answer: One reason that the market federal Funds rate might deviate from the interest rate on reserve balances (IORB rate) is that some participants in the market for federal funds are not depository institutions and so are not eligible to earn the IORB rate. These participants include governmentsponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae and the Federal Home Loan Banks. Because they do not have the option to place excess funds on deposit at the Fed as reserves and earn the IORB rate, they may be willing to lend those funds at a lower rate than the IORB rate in the federal funds market. Another reason is that the distribution of reserves among the banks may be unbalanced, so that some banks are willing to bid for federal funds at a rate above the IORB rate.

4. A targeted asset purchase (TAP), such as the acquisition of mortgage-backed securities, is a balance sheet adjustment tool that the Federal Reserve used in response to both the financial crisis of 2007-2009 and the 2020 COVID pandemic. How does TAP differ from quantitative easing (QE) and how is it intended to work? (LO4) Answer: A targeted asset purchase involves the Fed buying specific assets, such as mortgagebacked securities, to change the interest rate in that market relative to the interest rate on other assets, such as Treasurys. During both the financial crisis and the COVID pandemic, the Fed was concerned with supporting market function to ensure the availability of credit at reasonable rates to healthy borrowers. Policymakers also had a specific interest in supporting the housing market, because plunging house prices were undermining the balance sheets of households and intermediaries alike. Quantitative easing expands the overall size of the Fed’s balance sheet, helping to reduce the general level of interest rates. In contrast, TAP changes the composition of the Fed’s balance sheet, changing relative interest rates across different assets that are imperfect substitutes.

5. The strategy of inflation targeting, which seeks to keep inflation close to a numerical goal over a reasonable horizon, has been referred to as a policy framework of ―constrained discretion.‖ What features of the inflation targeting framework make this an appropriate description? (LO2) Answer: Under inflation targeting, central banks conduct policy to attain the inflation goal. However, officials may specify an acceptable range around the central target. In addition, the strategy typically aims to achieve the inflation objective over an extended period of time, which allows policymakers some leeway in determining the pace at which the target should be achieved. Still, the announcement of a target constrains policymakers’ choices, because policy credibility is diminished if the central bank fails persistently to achieve the target. 6. The charge given by Congress to the Federal Reserve is to ―promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.‖ Discuss whether the Taylor rule conforms to this mandate. (LO3) Answer: The mandate given to the Federal Reserve by Congress is embedded in the Taylor rule. First, if the inflation target π*, is low, the inflation gap term satisfies the ―stable price‖ component of the congressional mandate. Second, employment generally rises and falls as output fluctuates around its long-run trend given by potential output. If employment is at its ―normal‖ or ―maximum sustainable‖ level when output (real GDP) is at its ―normal‖ (potential) level, then the output gap term incorporates the employment mandate. Finally, if inflation is low and near the target, then long-term interest rates should be ―moderate.‖

7. Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 3 percentage points. (LO3) Target federal funds rate = Natural rate of interest + Current inflation + ½(Inflation gap) +½(Output gap) Answer:

If actual inflation goes up by 3 percentage points, the target (nominal) federal funds rate goes up by 4.5 percentage points (3 percentage points due to the direct impact of inflation and another 1.5 percentage points due to an increase in the inflation gap). To calculate the impact on the real interest rate, we can use the Fisher equation Nominal interest rate = Real interest rate + Expected inflation So, if the nominal rate increases by 4.5 percentage points and expected inflation increases by 3 percentage points, the real interest rate must have increased by 1.5 percentage points.

8. *The traditional Taylor rule places weights of one-half on the inflation gap and the output gap, corresponding to the ―dual mandate‖ of the U.S. central bank. Taking into account what you know about the policy goals of the ECB, how might you amend the Taylor rule to better approximate policymaking behavior by the ECB? (LO3) Answer: The ECB has a hierarchical mandate where price stability is accorded greater importance that other policy goals. Consequently, a weight on the inflation gap greater than onehalf (and a weight on the output gap less than one-half) may be more appropriate in the ECB’s case. Although the primary objective of the ECB is to maintain price stability, the central bank is sensitive to output fluctuations, so the weight on the inflation gap should remain less than 1. 9. *Use your knowledge of the problems associated with asymmetric information to explain why, prior to the change in the Federal Reserve’s discount lending facility in 2002, banks were extremely unlikely to borrow from the facility despite funds being available at a rate below the target federal funds rate? (LO1) Answer: Participants in the federal funds market do not have full information about each other, so signals about the well-being of borrowers played a very important role. If a bank borrowed from the discount window, it could be interpreted by other banks as a signal of trouble, even if the borrowing bank is sound. In this case, other participants in the federal funds market would be unwilling to make uncollateralized loans. To avoid sending a signal of fragility, borrowing banks were willing to pay higher interest rates for funds in the marketplace.

10. Based on the liquidity premium theory of the term structure of interest rates, explain how forward guidance about monetary policy can lower long-term interest rates today. Be sure to account for both future short-term rates and for the risk premium. How does the effectiveness of forward guidance depend on its time consistency? (LO4) Answer: The liquidity premium theory expresses the long-term interest rate as the sum of average expected future short-term rates and a liquidity risk premium:

When credible, forward guidance influences expectations about future short-term rates. For example, if policymakers credibly express intent to keep interest rates low for several years, this forward guidance can lower the numerator of the first term on the right-hand side of the equation. A credible intention to keep rates steady also can lower the risk premium (the second

term on the right-hand side of the equation) by reducing interest rate risk. However, if forward guidance lacks time consistency, it also would lack credibility, making it ineffective. Instead of lowering market interest rate expectations, investors may simply expect the central bank to renege on the policy commitment to keep rates low and steady in the future.

11. With the policy interest rate at the effective lower bound, how might a central bank counter unwanted deflation? (LO4) Answer: Several other policy options exist, including forward guidance, quantitative easing, and targeted asset purchases. These can be used individually or in combination. For example, combining forward guidance and quantitative easing, the central bank might commit to expanding its asset holdings (say, through large-scale asset purchases) until inflation reaches an acceptable level. Or, to stimulate spending, it might announce its willingness to tolerate inflation temporarily above its medium-term objective, hoping to lower the expected real interest rate. 12. *Outline and compare the ways in which the Federal Reserve and the ECB added to or adjusted their monetary policy tools in response to recent crises—including the financial crisis of 2007–2009, the subsequent financial crisis in the euro area, and the 2020 COVID pandemic. (LO4) Answer: While the Federal Reserve still focuses on the federal funds rate as its primary monetary policy tool, it has altered some policy practices in response to the crises. In 2008, the Fed moved from a target point to a target range for the federal funds rate. That same year, the Fed began to pay interest on reserve balances. During both the financial crisis and the COVID pandemic response, the Fed employed quantitative easing (QE), targeted asset purchases (TAP), and forward guidance. The ample reserves environment that accompanied these other monetary policy actions required the Fed to change how it influences the Federal funds rate: since 2008, it uses changes in the interest rate paid on reserve balances (IORB rate) rather than open market operations. Reserve requirements are ineffective in the ample reserves environment and the Fed set the required reserve ratio to zero in 2020. In response to the financial crisis, the Fed set up a host of lending facilities to enable them to lend to more counterparties against a wider range of collateral for longer periods and to intervene directly in more markets. It revived these programs as part of its response to the COVID pandemic and added other facilities to counter dysfunction in private capital markets. The ECB also made changes to how it manages its key policy interest rates. In the latter part of 2008, the ECB switched from using variable rate tenders to fixed rate tenders for its main refinancing operations. Over time, it widened markedly the range of acceptable collateral and lengthened the term of key refinancing arrangements to as long as three years. The ECB also engaged in quantitative easing and TAP by buying covered mortgage bonds, albeit to a lesser extent than the Fed. The ECB also made limited open-market purchases of bonds issued by governments on the periphery of the euro area to limit yield spreads between these sovereign bonds. In September 2012, it promised to purchase without limit the short-term debt (up to three years in maturity) of euro-area governments that accept a restrictive program of fiscal supervision.

The ECB’s actions also resulted in an ample reserves environment. Unlike the Fed, the ECB maintains a non-zero reserve requirement ratio (currently 1%) but it is not a binding constraint on banks. Unlike the Fed, the ECB set key interest rates below zero as part of its response to the crises. For example, the deposit rate was in negative territory between 2014 and 2022.

13. The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it was not low enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009 and the 2020 COVID pandemic, what might you advise this central bank to do? (LO4) Answer: You should advise the central bank to use other monetary policy tools beyond its traditional interest rate tool. This could include expanding its balance sheet significantly, providing aggregate reserves beyond the level needed to lower the policy rate to zero (quantitative easing). It might alter the composition of its balance sheet, purchasing risky assets that are creating bottlenecks for intermediaries (targeted asset purchases). It could also inform markets of its commitment to keep interest rates low (forward guidance). To counter market dysfunction, it might intervene directly in markets in which the central bank is not usually active, such as the commercial paper market. If it has the authority, it also could lend directly to nonbank institutions.

14. *Suppose ECB officials ask your opinion about their operational framework for monetary policy. You respond by commenting on their success at keeping short-term interest rates close to target but also express concern about the complexity of their process for managing the supply of reserves. What specific changes would you suggest the ECB should make to its system in the future? (LO3) Answer: As national markets become more integrated, and the euro-area financial crisis recedes, you might suggest that the ECB concentrate its operations in Frankfurt instead of having to coordinate these operations at all the national central banks simultaneously. This integration would greatly simplify the process. You might also suggest that the ECB narrow the list of institutions that qualify as counterparties to open market operations and reduce the range of assets it accepts as collateral for these operations. You could mention that the need for such changes will become more urgent as more countries join EMU.

15. The interest rate paid by the European Central Bank (ECB) on reserves declined below zero in 2014 and remained there until 2022. What was the rationale behind this move to a negative deposit rate, and why would banks be willing to pay to keep deposits with the ECB? (LO1) Answer: The ECB cut the rate in an effort to provide further monetary accommodation. The deposit rate acts as a floor for the ECB’s target refinancing rate, so lowering it below zero allowed the policy rate to move further downward. Banks are willing to pay a fee to keep their reserves on deposit at the ECB because the alternative of holding their reserves in the form of cash in their vaults also is costly. The transactions costs of using cash include storage, transportation, and insurance.

16. Suppose, immediately after the European Central Bank (ECB) began charging banks a fee for holding their reserves, the banks switched to holding cash in their vaults (rather than holding reserves), and also began charging customers for holding their deposits. Do you think the ECB would have kept the deposit rate in negative territory? Explain your answer. (LO2) Answer: No. At the time, the ECB’s intent was to loosen monetary policy and stimulate economic activity. If the banks responded by switching to holding cash and drove the public to do the same to avoid being charged for deposits, the economic impact would be contractionary—the opposite of the intended effect. A rise of the currency/deposit ratio— lowering the monetary multiplier—would be evidence of this contractionary effect.

17. Some observers have proposed that central banks target the level of prices or of nominal GDP, or the average of inflation over some time period. In practice, most central banks target the level of inflation. Provide a reason why you think this is the case. In 2020, the Fed shifted to an average inflation targeting regime. What advantage might arise from this shift? (LO2) Answer: In the short run, inflation could be more variable and less predictable under price level targeting or nominal GDP targeting, adding to uncertainty for consumers and businesses. In addition, big price-level or nominal GDP overshoots could require the central bank to aim temporarily at deflation that would make its traditional interest rate tool less useful for restoring stability. Average inflation targeting can be thought of as a hybrid between inflation level targeting and price level targeting where some parts of past misses are made up rather than leaving bygones be bygones, as under inflation level targeting. This can enhance policymakers’ ability to stabilize the economy when policy rates have hit the effective lower bound, since a credible average-inflation targeting framework would temporarily raise expected inflation, lowering real interest rates and stimulating economic activity.

18. You have been asked about the appropriate use of data in policy decisions by officials from a new central bank in a country that is economically similar to the United States. These officials currently use non-seasonally adjusted GDP to gauge the state of economic activity in real time. What advice would you offer these policymakers? (LO2) Answer: First, you might encourage them to focus on seasonally adjusted data, to avoid being misled by the large changes in unadjusted GDP that occur each quarter. Second, you could explain that relying on GDP as a cyclical indicator is problematic. In a large, complex economy, GDP will be available only with a lag. It also will be subject to frequent and often substantial revision. Rather than relying on the initial estimates of GDP, you might recommend that they augment their cyclical analysis with more timely, high-frequency indicators such as measures of the labor market, retail sales, and housing starts.

19. Suppose you were given the following information about two inflation–targeting economies. - Economy A has been volatile historically with the unemployment rate fluctuating widely around the natural rate, with the neutral real interest rate estimated to be around 1.5 percent. Despite the economic volatility, the well-designed central bank has enjoyed many decades of credibility.

- Economy B has seen unemployment rates stay relatively close to the natural rate, with the neutral real interest rate estimated to be around 3 percent. Despite the stable unemployment rate, the credibility of the central bank is somewhat fragile. Based on this information, assuming everything else equal, which economy would be more likely to benefit from a higher inflation target? Explain your answer. (LO3) Answer: Economy A would likely benefit more from a higher inflation target. This would give more scope to adjust interest rates in response to the swings in the labor market before hitting the effective lower bound (ELB). The combination of a volatile unemployment rate and a lower neutral real interest rate in Economy A would also mean that—for a given set of shocks and inflation target—the ELB would be hit more frequently than in Economy B. Given its track record, the threat to central bank credibility of raising the inflation target also may be lower in Economy A. However, raising the inflation target may still not be worth it for Economy A. Potential costs include more inflation volatility, reduced credibility and rising inflationary expectations.

20. An article you read in the financial press is highly critical of quantitative easing, blaming the balance sheet expansions of both the Federal Reserve and the ECB in response to the COVID pandemic for the subsequent surge in inflation in both jurisdictions. What counterargument could you make to the assertion made in this article? (LO2, LO4) Answer: While quantitative easing did sharply increase the monetary bases in both jurisdictions in 2020, the extent to which this drove the subsequent inflation is unclear. There were many other potential contributing factors, including other monetary policy actions, fiscal policy actions and supply-side shocks associated with the pandemic and the Russian invasion of the Ukraine.

Data Exploration 1. Plot the Taylor Rule since 1990 on a quarterly basis (similar to Figure 18.7). For the output gap, use the percent deviations of real GDP (FRED code: GDPC1) from potential output (FRED code: GDPPOT). For inflation, use the percent change from a year ago of the price index for personal consumption expenditures (FRED code: PCEPI). Assume that the long-run risk-free rate is 2 percent and the target inflation rate is 2 percent. When complete, compare the Taylor Rule rate against the actual federal funds rate (FRED code: FEDFUNDS) after 2007. During which economic recovery did the Taylor rule rate exceed the federal funds rate by the largest margin – following the financial crisis of 2007-2009 or following the COVID pandemic recession of 2020? What does this pattern imply for inflation prospects? (LO3) Answer: The data plot is:

Notice that the Taylor rule turns sharply negative in 2009 and 2010 and again in 2020, but the federal funds rate does not sink below zero. The effective lower bound on nominal rates helps explain why the Federal Reserve employed unconventional monetary policy tools, including forward guidance, quantitative easing and targeted asset purchases. Notice also that the excess of the Taylor Rule rate over the actual federal funds rate peaked after the COVID pandemic recession of 2020. This pattern is consistent with the Fed at least temporarily tolerating the high inflation of 2021-2022.

2. On Wednesday, March 16, 2022, the FOMC began to raise the target range for the federal funds rate over a series of steps that continued for more than a year. To see the impact, plot on a daily basis from the start of 2022 to the end of 2023 the interest rate on reserve balances (FRED code: IORB) and the effective federal funds rate (FRED code: DFF). Explain the plot, noting the impact of the FOMC decisions on these two rates. In light of what you learned from answering Data Exploration question 1, why do you think that the FOMC made several relatively large rate hikes during 2022? (LO4) Answer: The data are plotted below. No bank will lend below the IORB rate when it can earn the risk-free IORB rate by making deposits at the Fed. However, some financial intermediaries like government-sponsored enterprises (GSEs) are not eligible to earn interest from the Fed, so they generally are willing to lend overnight in the federal funds market at a rate modestly below the IORB rate. As is clear from the chart, however, when the FOMC hikes the IORB rate, the market federal funds rate rises accordingly, and stays close to (if slightly below) the IORB rate. We learned in Data Exploration question 1 that, when the FOMC began hiking rates in 2022, the policy rate initially was far below the Taylor Rule rate, suggesting that monetary policy was actually contributing to the rapid rise of inflation. As a result, the FOMC judged that the multiple, large rate hikes in 2022-23—resulting in the sharpest tightening of monetary policy in decades— were necessary to bring inflation down closer to its 2% target. To get a sense of the policy drama, consider that most policy rate changes prior to this episode were about 25 basis points in scale, with

a 50-basis-point change considered to be large. Against this background, the series of four 75-basis point hikes in the IORB rate during 2022 rate was unprecedented. It reflected the FOMC’s new view that high inflation would not recede sufficiently on its own without monetary policy restraint.

3. Assess the impact of targeted asset purchases by plotting since 2003 on a monthly basis the Federal Reserve’s holdings of mortgage-backed securities (FRED code: WSHOMCB) and (on the right scale) the average yield on 30-year fixed-rate mortgages (FRED code: MORTGAGE30US). Discuss how these purchases might support both the housing market and the banking system. (LO4) Answer: The data plot below shows the mortgage rate for several years prior to the onset of this targeted asset program. As the Fed purchases these bonds in early 2009, mortgage rates gradually fall. Lower mortgage rates stimulate the housing market by making home purchases more affordable. The program also benefits banks by raising the prices of real estate-related assets that they hold, buttressing their capital positions.

Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US.

4. In 2002, the Federal Reserve began to set the discount rate above the federal funds rate, reversing its previous practice of keeping the discount rate below the funds rate. To assess the impact, plot on a monthly basis from 1990 to 2007 the difference between the federal funds rate and the discount rate before (FRED codes: FEDFUNDS and MDISCRT) and after the policy shift (FRED codes: FEDFUNDS and WPCREDIT), using the same line color. On the right scale, plot the level of discount window borrowing (FRED code: DISCBORR). Did the new penalty rate for discount loans significantly diminish borrowing? What might account for the behavior of discount window borrowing? (LO1) Answer: Prior to 2002, the federal funds rate was above the discount rate, but banks borrowed relatively little from the Fed. Moreover, the volume of borrowing did not change meaningfully after the discount rate was set above the federal funds rate. The explanation must be due to other factors (―nonpecuniary factors‖) that influence banks’ willingness to borrow from the Fed or from the open market. Even when the discount rate is relatively low, banks are reluctant to borrow from the Fed because they fear the ―stigma‖ of being identified as a fragile institution with a weak balance sheet. That perception among a bank’s counterparties could reduce its access to market funding or make it prohibitively expensive.

5. Examine the real interest rate in Japan, plotting since 2000 the nominal interest rate on Japanese long-term government bond years (10-year) (FRED code: IRLTLT01JPM156N), the inflation rate based on the percent change from a year ago of Japan’s consumer price index (FRED code: JPNCPIALLMINMEI), and an estimate of the real interest rate based on the difference between these two indicators. Comment on the lengthy period of positive real rates before 2014 and the role of deflation in determining the real rate. Discuss the risks that deflation poses in an economy with the nominal interest rates at the effective lower bound. (LO1) Answer: If expected inflation is equal to the inflation rate measured as the percentage change from a year ago of the consumer price index, then the red line is a measure of the real interest rate. Recall that in the Fisher equation, the real rate rises when deflation worsens. Such a rise of the real interest rate can trigger a vicious circle of declining economic activity, intensifying deflation, and further increases in the real interest rate. To avoid this vicious circle, a central bank may adopt unconventional policy tools to lower the real interest rate and stimulate economic activity. In 2014, a consumption tax hike temporarily boosted the measured inflation rate in Japan; as a result, with nominal rates remaining low, the measured real rate temporarily appeared very negative. However, the subsequent retreat of inflation raised the measured real interest rate. Since 2016, the measured real interest rate remained large in a range between plusone and minus-one percent. Aside from the large pandemic disruption in 2020, this has mostly been a period of restoring economic growth in Japan.

Organization for Economic Co-operation and Development, Consumer Price Index: All Items: Total for Japan [JPNCPIALLMINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLMINMEI, October 13, 2023. Organization for Economic Co-operation and Development, Interest Rates: Long-Term Government Bond Yields: 10-Year: Main (Including Benchmark) for Japan [IRLTLT01JPM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01JPM156N, October 13, 2023.

* indicates more difficult problems

Chapter 19 Exchange-Rate Policy and the Central Bank Conceptual and Analytical Problems 1. Explain the mechanics of a speculative attack on the currency of a country with a fixed exchange-rate regime. (LO4) Answer: Assume that Country A has a fixed exchange rate, and that its central bank holds a specific volume of foreign currency reserves. Investors come to believe that Country A will have to let its currency depreciate. To benefit from the prospective depreciation, investors borrow that currency in the country’s financial market and take the proceeds of the loan to the central bank to exchange them for some other currency (normally, the U.S. dollar, euro, or yen). If this process happens on a large scale, the central bank will deplete its foreign currency reserves, and be forced to devalue its currency or abandon its fixed exchange rate entirely. Knowing that the central bank has limited foreign exchange resources, investors can put great

pressure on the central bank of Country A that leads to depreciation. After the devaluation or abandonment of the peg, investors profit by repaying their loans with the depreciated currency.

2. Country A frequently experiences large business cycle swings. Under what conditions might it be appropriate for Country A to dollarize? (LO4) Answer: If Country A’s business cycle is synchronized with the U.S. cycle, then U.S. monetary policy also would suit Country A because it would be stimulative when the economy is weak and contractionary when it is strong. However, if Country A’s business cycle differs significantly from the U.S. cycle in timing, then U.S. monetary policy may aggravate Country A’s cyclical swings (by contracting when stimulus is needed, and vice versa). So, dollarizing is most likely to succeed when the business cycles are closely aligned.

3. In the first half of 1997, the Bank of Thailand maintained a fixed exchange rate of 26 Thai baht to the U.S. dollar, but Thai interest rates were substantially higher than those in the United States and Japan. Thai bankers were borrowing money in Japan and lending it in Thailand. (LO3) a. Why was this transaction profitable? b. What risks were associated with this method of financing? c. Describe the impact of a depreciation of the baht on the balance sheets of Thai banks involved in these transactions.

Answer: a. Bankers could borrow money in Japan at a low rate and lend in Thailand at a high rate. Because the exchange rate was fixed, they profited from the difference in the interest rates. b. There was the risk that the baht could depreciate, making it more costly to repay the money borrowed in Japan. In addition, there was risk that borrowers in Thailand could default on their loans. c. When the baht depreciated, the costs to the Thai banks of repaying their loans rose, which caused their reserves to shrink.

4. During the time of the currency board in Argentina from 1991-2001, Argentinean banks offered accounts in both dollars and pesos, but loans were made largely in pesos. Describe the impact on banks of the collapse of the currency board. (LO4) Answer: The Argentinean banks had to pay interest payments in dollars on the dollardenominated accounts, but the interest revenues they received were in pesos. When the currency board collapsed and the peso depreciated, it became more costly for banks to make the dollardenominated interest payments.

5. Consider a scenario where investors become nervous just before a key government election. As a result, the risk premium on sovereign debt in that country increases dramatically and its currency depreciates significantly. (LO1)

a. How could concern over an election drive up the risk premium? b. How is the risk premium connected to the value of the currency? Answer: a. Investors could be concerned that the policies supported by one of the candidates could cause the country to default on its debt if that person was elected. b. When the country’s government bonds become more risky relative to alternatives, demand for the bonds falls. This also reduces demand for the currency, leading to a depreciation.

6. Explain why a well-capitalized domestic banking system might be important for the successful maintenance of a fixed exchange rate regime. (LO4) Answer: In order for a fixed exchange rate regime to be successful, investors must believe that the central bank will manage interest rates in a manner consistent with the currency peg. If the banking system is not sufficiently capitalized, there may be pressure on the central bank to ease monetary policy to deal with problems in the banking sector. 7. *Explain why, in the absence of the time consistency problem, you might expect a central bank to be effective at holding the value of its domestic currency at an artificially low level for a sustained period but not at an artificially high level. (LO3) Answer: To boost the value of its domestic currency, the central bank would have to sell foreign currency in exchange for domestic currency. The central bank can only continue to do this until it runs out of foreign exchange reserves. In contrast, in order to hold down the value of the domestic currency, the central bank would need to sell the domestic currency in return for foreign currency in the foreign-exchange market. As it is the monopoly supplier of the domestic currency, it can create as much of the domestic currency as it needs and so is likely to be able to pursue this latter policy for a longer period than the former. In the long run, however, the latter policy will lead to inflationary pressures in the economy.

8. Describe how the time consistency challenge for monetary policy can make it difficult for a central bank to cap the value of its domestic currency. (LO3) Answer: As the Swiss National Bank learned during the euro-area crisis, a commitment to supply an unlimited quantity of its own currency may not prove sustainable. In the Swiss case, political controversy encouraged speculators to doubt this commitment. Eventually, as its balance sheet expanded, the SNB abandoned its efforts to cap the Swiss franc and allowed it to rise in response to strong demand.

9. Why might sterilized foreign exchange market intervention have a greater impact on the exchange rate in times of financial stress than in times of normal market conditions? (LO2)

Answer: When markets are functioning normally, the shift in central bank assets associated with a sterilized intervention is extremely small in relation to the volume of overall trade in the market and therefore does not have a significant impact on the price of the currency. In times of stress, however, market activity is often substantially reduced and so the size of the central bank intervention may be significant.

10. When asked about the value of the dollar, the Chair of the Federal Reserve Board answers, "The foreign exchange policy of the United States is the responsibility of the Secretary of the Treasury; I have no comment." Discuss this answer. (LO1) Answer: Since the U.S. Treasury is technically responsible for exchange rate policy or decisions about exchange rate intervention, the Federal Reserve does not comment on the value of the dollar. But since the value of the dollar is closely tied to interest rates and monetary policy, there is something misleading about this. The Fed Chair might instead say that the focus is on monetary policy and its impact on the domestic U.S. economy, and in formulating such policy the FOMC does take the exchange value of the dollar into consideration.

11. *Explain why a consensus has developed that countries should either allow their exchange rates to float freely or adopt a hard peg as an exchange rate regime. (LO4) Answer: The widespread removal of capital controls and advances in technology have facilitated the integration of international markets while the development of increasingly sophisticated financial instruments has provided speculators with new and effective ways to leverage their positions. The consensus view is that factors like these have made it impossible for a central bank, even with substantial levels of foreign exchange reserves, to withstand a speculative attack. Therefore, soft pegs are no longer a sustainable option. 12. Dollarizing and joining a monetary union both involve giving up a country’s own currency, but there are key differences between these two options. Identify one factor that might lead a country to dollarize (rather than join a monetary union) and one factor that could lead to the opposite choice. (LO4) Answer: A country might opt for dollarization if there were not a group of countries with which it is politically and economically feasible to form a monetary union. Being a member of a monetary union involves shared governance that may not always be possible. Where joining a monetary union is feasible, a country may prefer it because monetary union members still have a voice in monetary policy decisions for the bloc and receive a share of the seignorage associated with issuing the common currency. Under dollarization, the country would have no say in the monetary policy of the currency.

13. You observe that two countries with a fixed exchange rate have current inflation rates that differ from each other. You check the recent historical data and find that inflation differentials have been present for several months and that they have not remained constant. How would you explain these observations in light of the theory of purchasing power parity? (LO1) Answer: Purchasing power parity (PPP) tells us about the relationship between inflation rate differentials and exchange rate movements over long periods such as decades. On a month-to-month or even year-toyear basis, there can be significant deviations from the theory. In this example, foreign exchange market intervention could be sustaining the fixed exchange rate in the short run in the face of market pressures. 14. Assuming the country is fully open to international capital flows, which of the following combinations of monetary and exchange rate policies are viable? Explain your reasoning. (LO1) a. A domestic interest rate as a policy instrument and a floating exchange rate. b. A domestic interest rate as a policy instrument and a fixed exchange rate. c. The monetary base as a policy instrument and a floating exchange rate.

Answer: Combinations a. and c. are both viable as they both represent independent domestic monetary policy combined with a floating exchange rate. Option b. is not viable as any foreign exchange market interventions to hold the exchange rate fixed would change reserves and therefore the domestic interest rate. The pursuit of an independent interest rate policy would be impossible. 15. Show the impact on the Federal Reserve’s balance sheet of a foreign exchange market intervention where the Fed purchases $5,000 worth of foreign exchange reserves. Explain what impact, if any, the intervention will have on the domestic money supply. Under what circumstances, if any, will this unsterilized intervention impact the dollar exchange rate? (LO2) Answer: Central Bank Balance Sheet

Purchasing foreign exchange reserves in exchange for dollars will increase foreign currency reserves on the asset side of the balance sheet. On the liability side, bank reserves rise, as the bank that sells the FX to the Fed has its reserve account at the Fed credited. The rise in bank reserves leads to a rise of the monetary base. If bank reserves are relatively scarce, this will result in lower domestic interest rates, which in turn, make U.S. investments relatively less attractive. The associated decline in demand for the dollar would cause the dollar to depreciate. If bank reserves are abundant, this interest rate mechanism no longer operates. In a deep market, the additional supply of dollars associated with this intervention likely would not affect the exchange rate.

16. Suppose that a central bank that is operating on the downward-sloping portion of the reserve demand curve decides to purchase $1,000 worth of foreign exchange reserves and then sterilize this foreign exchange market intervention. Show the impact on the central bank’s balance sheet. What would the overall impact be on the monetary base? What would be the impact, if any, on the exchange rate? Assume that the intervention took place in a deep, well-functioning foreign exchange market. (LO2)

Answer: If the central bank decides to sterilize an foreign exchange market intervention, it will carry out an open market operation to offset the impact of the foreign exchange intervention on the monetary base. The foreign exchange intervention increases foreign exchange reserves on the asset side of the central bank’s balance sheet and increases bank reserves on the liability side. Therefore, in this case, the central bank will carry out an open market operation where it sells $1,000 of domestic securities. This will reduce domestic securities by $1,000 on the asset side of the balance sheet and reduce bank reserves by $1,000 on the liability side of the balance sheet. The bank that purchases the securities from the central bank pays for them with bank reserves, thus reducing bank reserves. The overall impact on the balance sheet is shown below. On the asset side, there is a

compositional change between foreign exchange and domestic securities while on the liability side there is no change. The rise in bank reserves as a result of the foreign exchange intervention is exactly offset by the fall due to the open market sale. That is what is meant by ―sterilization.‖ There is no change in the monetary base or money supply and therefore no change in domestic interest rates, even when reserves are relatively scarce, and the central bank operates on the downward-sloping portion of the reserve demand curve. In the absence of a move in the domestic interest rate, there is no impact on the exchange rate.

17. *Consider a small open economy with a wide array of trading partners all operating in different currencies. The economy’s business cycles are not well synchronized with any of the world’s largest economies, and the policymakers in this country have a well-earned reputation for being fiscally prudent and honest. In your view, should this small open economy adopt a fixed exchange rate regime? (LO3) Answer: In this situation, fixing the exchange rate does not look like a good idea. Given that the country’s trading partners operate in different currencies, fixing against one currency would not help with problems associated with exchange rate volatility versus the others. (A possible option would be to fix against a trade-weighted basket of exchange rates.) Fixing your exchange rate to another currency involves adopting the other country’s interest rate policy. To reap the benefits of exchange rate stability, countries usually opt to fix their currency to that of a large economy, such as the dollar or the euro. Given that this small open economy’s business cycles are not well synchronized with those of the world’s large economies, the monetary policy decisions of the large country could exacerbate business cycle fluctuations. Fixing the exchange rate ties the hands of local policymakers who can often help to gain credibility where there has been a history of poor policymaking or corruption. This external discipline doesn’t appear to be necessary in this country.

18. A small Eastern European economy asks your opinion about whether it should pursue the path to joining the European Economic and Monetary Union (EMU) or simply ―euroize‖ (i.e., dollarize by using the euro for all domestic transactions). What advice would you give? (LO4) Answer: Joining the EMU has many advantages over ―euroization‖. The economy would have a say in monetary policy decisions and share in the seignorage revenue from the printing of the euro. Its national central bank would also be more able to act as lender of last resort in making euro loans.

19. In the face of increased short-run synchronization of global stock markets, what strategies could you employ to continue to benefit from international diversification? (LO1) Answer: If you employ a ―buy and hold‖ strategy, you are more likely to reap the benefit of diversification as stock markets are less likely to move in unison over long periods. If you have a shorter-term investment horizon, you could invest in a portfolio of stocks that were denominated in different currencies (that were not fixed relative to one another) so that short-term exchange rate movements could provide a diversification benefit.

20. In an increasingly integrated financial world, under what circumstances might you support the imposition of capital controls? (LO1) Answer: While open capital markets bring many benefits, they also pose risks. These risks are particularly acute in emerging market countries with relatively underdeveloped and fragile financial systems. In the absence of capital controls, such countries are vulnerable to sudden stops or capital flow reversals that can have severe consequences for the real economy. In these circumstances, some capital controls might make sense. A country might employ capital controls in order to manage its exchange rate while maintaining some monetary policy autonomy. For example, in 2022, China was able to cut interest rates when the Fed was raising rates in the U.S. without triggering a speculative attack on the currency due to some capital controls being in place.

Data Exploration 1. Panama, Ecuador, and El Salvador began using the U.S. dollar as their domestic currency in 1904, 2000, and 2001, respectively. How do you expect their inflation rates to compare with U.S. inflation? Plot since 1960 to 2017 the percent change from a year ago of consumer prices in Panama (FRED code: DDOE02PAA086NWDB), Ecuador (FRED code: DDOE02ECA086NWDB), El Salvador (FRED code: DDOE01SVA086NWDB) and the United States (FRED code: PCEPI). Download these data and (starting with the country’s date of dollarization), compare the average inflation rate in each country with U.S. inflation. (LO4) Answer: The data is plotted below. Broadly speaking, the inflation rates of these countries after dollarization are similar to U.S. inflation. Panama’s inflation averaged 2.8 percent from 1961 to 2017, compared to 3.3 percent in the United States. In Ecuador, inflation plunged from 96 percent in 2000 to 8 percent in 2003 and has averaged 3.5 percent thereafter. Starting in 2001, El Salvador experienced average inflation of 2.5 percent, compared to the 1.8% average in the United States. In each case, adopting the U.S. dollar resulted in an inflation rate similar to that of the United States over an extended period of time.

World Bank, Consumer Price Index for Panama [DDOE02PAA086NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDOE02PAA086NWDB. World Bank, Consumer Price Index for Ecuador [DDOE02ECA086NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDOE02ECA086NWDB. World Bank, Consumer Price Index for El Salvador [DDOE01SVA086NWDB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DDOE01SVA086NWDB.

2. Did the September 2000, currency intervention by the United States and other countries influence the dollar-euro exchange rate? Plot for the September-October 2000 period the daily dollar-euro exchange rate (FRED code: DEXUSEU) and, on the right scale, the Fed’s sales of dollars for euros (FRED code: USINTDMRKTDM). Was the intervention successful? If not, why not? (LO2) Answer: The data is plot is below. The intervention appears to have boosted the euro only for a brief period, with the euro returning to its pre-intervention value and sinking further after several weeks. Because the FOMC had not changed the target federal funds rate, the Open Market Trading Desk sterilized the currency intervention (by selling Treasury bonds). Absent a change in the policy interest rate, currency interventions have little sustained impact on exchange rates in deep, liquid currency markets.

3. Some claim that adoption of a gold standard would contribute to price stability. Was price stability a feature of the U.S. gold standard that prevailed prior to World War I (see Applying the Concept on page 474)? Based on a plot of the general price level (FRED code: M04051USM324NNBR), discuss U.S. price developments from 1880 to 1914. (LO4) Answer: The data plot is below. Over the 30-year period from 1882 to 1914, the price level increased from a value of 87 to 100, implying average annual inflation of less than one-half percent. However, this apparent stability masks persistent price swings: The price level trended lower from the early 1880s until the mid-1890s, and then began to rise. To the extent that it was unanticipated, the deflationary episode raised the real burden of repaying debt (especially for farmers with falling crop prices). Japan’s two-decade experience with deflation after 1994 highlights the risks to economic well-being posed by an unexpected, sustained period of falling prices.

4. Does purchasing power parity (PPP) hold in the long run? Does it hold in the short run? Following equation (3) on page 524, plot for Japan and the United States beginning in 1972 the percent change from a year ago of the Japanese yen/U.S. dollar exchange rate (FRED code: EXJPUS) minus the annual inflation rate in Japan (FRED code: JPNCPIALLMINMEI) plus the annual inflation rate in the United States (FRED code: CPIAUCSL). If PPP holds in the long run, what should this expression equal on average? Download the data and compute the average for the full period. Is the result consistent with long-run PPP? Observing the plot, does PPP seem to hold in the short run? (LO1) Answer: The data is plotted below. If PPP holds, the computed expression should average to zero. For Japan and the United States, the data do fluctuate around zero, with the average value for the data around 0.1 percent through June 2021. This appears reasonably consistent with long-run PPP. Over shorter periods, however, there are large deviations from zero that persist for several years. This is not consistent with short-run PPP.

Organization for Economic Co-operation and Development, Consumer Price Index of All Items in Japan [JPNCPIALLMINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLMINMEI.

5. In September 1992, a speculative attack compelled the United Kingdom to devalue the British pound versus the German currency (the deutsche mark). How did monetary policies in both countries influence this outcome? Plot from 1990 to 1992 the discount rates in the United Kingdom (FRED code: INTDSRGBM193N) and Germany (FRED code: INTDSRDEM193N), and (on the right scale) the exchange rate of German marks per British pound [obtained by multiplying the number of U.S. dollars per pound (FRED code: EXUSUK) by the number of deutsche marks per U.S. dollar (FRED code: EXGEUS)]. What do you conclude? (LO3) Answer: The plot appears below. In the early 1990s, the re-unification of west and east Germany triggered an economic boom, prompting the German central bank to raise interest rates. But the Bank of England was lowering interest rates as the U.K. economy slowed and entered a slump. Speculators sold the pound because they doubted that U.K. policymakers would hike interest rates during a recession to defend the fixed exchange rate. This is a classic problem of time consistency; speculators knew that U.K. policymakers had a strong incentive to renege on their promise to maintain the fixed exchange rate, because upholding that promise could trigger a deeper recession.

International Monetary Fund, Interest Rates, Discount Rate for Germany© [INTDSRDEM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRDEM193N. International Monetary Fund, Interest Rates, Discount Rate for United Kingdom© [INTDSRGBM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRGBM193N.

* indicates more difficult problems

Chapter 20 Money Growth, Money Demand, and Modern Monetary Policy Conceptual and Analytical Problems 1. Why is inflation higher than money growth in high-inflation countries and lower than money growth in low-inflation countries? (LO1) Answer: At very high levels of inflation, the velocity of money rises dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is offset by economic growth.

2. * Explain why giving an independent central bank control over the quantity of money in the economy should reduce the occurrences of periods of extremely high inflation, especially in developing economies. (LO1)

Answer: Inflation is a monetary phenomenon and independent central banks are more likely than governments (who may be looking for a way to finance spending, for example) to consider the consequences for inflation when deciding how much money to print. Central bank independence may be difficult to maintain in developing economies, however, if government is unable to efficiently collect tax revenues. The central bank may face pressure to monetize government debt and risk high and rising inflation.

3. If velocity were constant at 1.5 while M2 rose from $11 trillion to $12 trillion in a single year, what would happen to nominal GDP? If real GDP rose by 2.09 percent, what would be the level of inflation? (LO2) Answer: Money growth + velocity growth = growth of nominal GDP, so nominal GDP would rise by [(12 – 11)/11] × 100 percent + 0 percent = 9.09 percent. Nominal GDP growth = inflation rate + real growth, so inflation = 9.09 percent – 2.09 percent = 7 percent.

4. According to Irving Fisher, when velocity and output are fixed, the quantity theory of money implies that inflation equals money growth. What does the quantity theory imply for inflation in the long run in an economy with growing output and stable velocity? (LO2) Answer: Equation (4) states that %∆M + %∆V = %∆P + %∆Y, if velocity is constant, then inflation is the excess of money growth over real output growth: %∆P = %∆M – %∆Y.

5. If velocity were predictable but not constant, would a monetary policy that fixed the growth rate of money work? (LO2) Answer: We know that money growth + velocity growth = inflation + real growth. If velocity is not constant, then fixing the growth rate of money will result in either rising or falling inflation. However, if velocity is predictable, policymakers could change money growth at the same rate (but opposite direction) as the fall in velocity in order to stabilize inflation.

6. Describe the impact of financial innovations on the demand for money and velocity. (LO2, LO3) Answer: Financial innovations reduce the demand for money and increase velocity. By making alternatives to money more liquid, individuals need less money as a means of payment. By providing a broader array of financial instruments that can be used as stores of wealth; innovations have reduced the use of traditional money as a store of wealth. Since we never know exactly when the innovations will occur, it is difficult to predict the path of velocity over short-run periods.

7. Suppose that expected inflation rises by 2 percent at the same time that the yields on money and on nonmoney assets both rise by 2 percent. What will happen to the demand for money? What if expected inflation rose instead by 3 percent? What if the yield on nonmoney assets rose instead by 4 percent? (LO3)

Answer: Money demand depends in part on its opportunity cost, the difference between the real yield on nonmoney assets and the real yield on money. If expected inflation rises by 2 percent as the yields on money and on nonmoney assets also rise by 2 percent, the expected real yields on money and on nonmoney assets are unchanged and the demand for money will not be affected. If expected inflation rises by 3 percent, the expected real yields on money and on nonmoney assets both fall by 1 percent, the demand for money will once again be unaffected. However, if the yield on nonmoney assets rises by 4 percent while the yield on money rises by only 2 percent, then the return to alternative investments relative to the return on money rises, regardless of the level of inflation. This reduces the portfolio demand for money. 8. *Explain how money growth reduces the purchasing power of money. (LO2)

Answer: By increasing the supply of money, holding demand for money constant, the value of each dollar relative to goods and services in the economy will fall. The price of money in terms of goods and services has fallen. 9. Provide arguments both for and against the Federal Reserve’s adoption of a target growth rate for M2. What assumptions would be necessary to compute such a target rate? ( LO4) Answer: In the long run, inflation is tied to money growth. However, in the short run, the velocity of money is volatile, and controlling the growth rate of money does not necessarily translate to control over inflation. If the Fed were to compute a target rate, it would need to make assumptions about the velocity of money. It would also need to predict the behavior of both banks and consumers in order to make assumptions about the money multiplier—between the monetary base and the quantity of M2.

10. Explain why we observed a fall in the velocity of M2 during the financial crisis of 2007–2009. (LO3) Answer: The increase in uncertainty during the financial crisis drove investors to hold a larger portion of their assets in the form of money. Increased money holding relative to the level of economic activity means that each dollar has to be used fewer times, lowering velocity.

11. Comment on the evolution of the role given to money in the monetary policy strategy of the ECB. (LO1, LO3) Answer: When the ECB was first established, it initially gave a relatively prominent role to money in its monetary policy strategy. For example, it set a quantitative reference for the growth rate of the broad monetary aggregate, M3. The ECB has progressively downgraded this role over time. The ECB’s 2021 statement of policy strategy stresses its policy decisions are based on ―an integrated assessment of all relevant factors‖, underscoring the move away from the special role that money growth was initially assigned. It is now only one of many economic and financial indicators used by ECB policymakers. As a result, there is little difference anymore between the policy approaches of the Fed and the ECB with regard to the stock of money.

12. Countries A and B both have the same money growth rate, and in both countries real output is constant. In Country A velocity is constant while in Country B velocity has fallen. In which country will inflation be higher? Explain why. (LO2)

Answer: Using the equation of exchange: Money growth + Velocity growth = Inflation + Real growth, we see that inflation will be higher in Country A. The fall in velocity reflects an increase in money demand in Country B, which offsets some of the inflationary pressures from the rise in the supply of money.

13. Consider a country where the level of reserves fluctuates widely and unpredictably. Would such a country be a good candidate for a money growth rule to guide monetary policy? Explain your answer. (LO4) Answer: This country would not be a good candidate. One requirement for a money growth rule to be effective at controlling inflation is for there to be a stable link between the monetary base and monetary aggregates, such as M1 and M2. This would not be the case here, as the volatile excess reserve-to-deposit ratio would cause fluctuations in the money multiplier.

14. Draw a graph of money demand and money supply with the nominal interest rate on the vertical axis and money balances on the horizontal axis. Assume the central bank is following a money growth rule where its sets the growth rate of money supply to zero. Use the graph to illustrate how fluctuations in velocity imply that targeting money growth results in greater volatility of interest rates. (LO4) Answer: Changes in velocity are reflected in shifts in the money demand curve. For example, if financial innovation causes money demand to be lower (and so velocity to be higher) at a given interest rate, this will shift the demand curve to the left and the interest rate will decline. If velocity falls, the money demand curve will shift right and the interest rate will rise. If the central bank is following a zero growth rule for the money supply, then the money supply curve does not respond to the changes in money demand, and the interest rate must adjust to maintain money market equilibrium.

Interest rate

Money Supply

Money Demand Money

15. In a chart of money demand and money supply with the nominal interest rate on the vertical axis, show how a central bank could use its control over the quantity of money to target a particular interest rate in the face of changes in velocity. (LO4) Answer: Suppose that velocity falls, shifting the money demand curve to the right. The central bank could increase the supply of money in the economy (shifting the supply curve to the right) to keep the interest rate at its target.

Money Supply

16. Why might targeting the money supply lead to lower output growth than targeting the rate of interest? (LO4) Answer: Targeting the money supply in the face of shifting money demand results in interest rate volatility (see Figure 20.7 for an example of increased interest rate volatility when the Fed targeted reserves). Targeting the interest rate instead keeps interest rates less volatile and allows the money supply to adjust to changes in velocity, for example. Volatility of interest rates poses risks to investors in long-term assets that should be compensated in the form of a higher risk premium (Core Principle 2). The increase in the risk premium lowers the value of long-term assets, including bonds, stocks, business plant and equipment, and real estate. As a result, this volatility tends to reduce investment and slow economic growth.

17. Which of the following factors would increase the transactions demand for money? Explain your choices. (LO3) a. Lower nominal interest rates. b. Rumors that a computer virus had invaded the ATM network. c. A fall in nominal income. Answer: Both (a) and (b) would increase the transactions demand for money. Lower nominal interest rates lower the opportunity cost of holding money and so money demand will be higher. A computer virus in the ATM network would lead to worries about the system closing down and so increase money demand. Option (c), a fall in nominal income, would lead to a fall in the transactions demand for money as people spend less on goods and services.

18. Which of the following factors would increase the portfolio demand for money? Explain your choices. (LO3) a. A new website allows you to liquidate your stock holdings quickly and cheaply. b. You expect future interest rates to rise. c. A financial crisis is looming. Answer: Both options (b) and (c) would increase the portfolio demand for money. If future interest rates are expected to rise, bond prices will drop, leading to a capital loss for bondholders. This makes money relatively more attractive. The prospect of a financial crisis will increase the relative riskiness of alternative assets, thus increasing the portfolio demand for

money. Option (a), on the other hand, will increase the relative liquidity of alternative assets and so reduce the portfolio demand for money.

19. *Suppose a central bank is trying to decide whether to target money growth. Proponents of the move are confident that the new policy would be successful as, under the existing policy regime, they observe a stable statistical relationship between money growth and inflation. What warning might you issue to the central bank when they ask your advice? (LO4) Answer: You should point to Robert Lucas’s observation in the 1970s and warn the central bank that altering its policy framework may alter people’s economic decisions. As a result, the relationships observed under the old policy framework may not hold under a new one (the Lucas Critique). Economic decisions are based on expectations about the future, which include expectations about what the central bank will do. 20. If ―inflation is always and everywhere a monetary phenomenon,‖ why did the huge expansions of central bank money by the Federal Reserve, the ECB, and the Bank of Japan between 2007 and 2015 not result in high inflation in those economies? (LO2, LO3) Answer: The massive expansion of central bank money (currency plus reserves) did not translate into high growth rates in the broad monetary aggregates that are more closely linked to inflation. The financial crisis altered the behavior of banks, whose role in lending and deposit creation is critical for transmitting changes in the monetary base to broad money. To a large extent, banks responded to the increase in the monetary base by hoarding excess reserves rather than increasing lending. As a result, broad money growth was muted. Put differently, the money multiplier fell drastically in these economies as banks became unwilling or unable to convert reserves into credit.

21. Explain, making reference to both the transactions demand and the portfolio demand for money, why velocity fell dramatically with the onset of the COVID pandemic in 2020. (LO3) Answer: Several factors contributed to an increase in the transactions demand for money, including a low opportunity cost of holding money amid low interest rates, large fiscal transfers, and increased uncertainty for households and businesses regarding the scale of transactions they would need to carry out. The portfolio demand for money likely rose due to increased riskiness of alternative assets such stocks and bonds. The increase in the demand for money relative to economic activity lowered velocity.

Data Exploration 1. A scatterplot may reveal a relationship between two indicators. Construct a scatterplot of annual data beginning in 1959 for inflation and money growth. Measure these as the percent change from a year ago of consumer prices (FRED code: CPIAUCSL) and M2 (FRED code: M2SL), respectively. Then, display a second scatterplot of annual data beginning in 1959 for inflation (measured as before) and the federal funds rate (FRED code: FEDFUNDS). Which indicator is more closely linked to inflation: money growth or the interest rate? Does that tell us which policy instrument is the better? (LO2)

Answer: The scatter plots are below. The federal funds rate appears far more closely linked to inflation. However, this information is insufficient to determine the correct monetary policy tool. Correlation is not necessarily causation, so while the interest rate may be more highly correlated with inflation than M2 growth, the reason may be that inflation changes cause interest rate movements, rather than vice versa. Moreover, if the interest rate were not the current policy tool, then switching to a new policy regime of using the interest rate as a tool may result in the observed correlation breaking down. Consequently, the relatively close link in the interest rateinflation scatter plot is just a starting point for evaluating the interest rate as a policy tool. By itself, it does not prove that the interest rate is the superior policy instrument.

2. Plot the percent change from a year ago of the velocity of money (FRED code: A14187USA163NNBR) between 1922 and 1939. Compare the typical scales of the velocity declines during the recessions of this interwar period and the velocity declines during the recessions shown in Panel B of Figure 20.3. Were the 1929-33 and 2007-2009 periods special? What role might wealth have played in these two episodes? (LO3) Answer: The data plot for the interwar period is below. Aside from the Great Depression and the 2007-2009 financial crisis, the declines in velocity during recessions averaged about 5 percent in both the interwar period and in the period shown in Panel B of Figure 20.3. In the 1929-1933 and 2007-2009 episodes, the velocity declines exceeded 10 percent. In the 19291933 period, the plunge in stock market wealth preceded the banking crisis, while the drop in housing wealth preceded the 2007-09 financial crisis. In both cases, loss of wealth and financial turmoil led to falling nominal (and real) GDP. Heightened risks and risk aversion encouraged additional demand for money, depressing velocity.

3. Plot annually since 1950 the reciprocal of the consumer price index (FRED code: CPIAUCSL) to see how inflation erodes the purchasing power of money. To start with an initial value of 1.0, in the Units dropdown box in FRED, select the option ―Index (Scale to value to 100 for the chosen date)‖ and then apply the formula ―(1/a) × 100‖. If a dollar bought one unit of goods and serves in 1950, as of which year did the dollar buy only one-half unit? As of 2024, how many units of goods and services did a dollar buy? (LO1) Answer: The data is plotted below. The dollar purchased about one-half unit of goods around 1974. As of May 2024, it purchased only about 7.5 percent of the goods that it would have purchased in 1950.

4. In Figure 20.1, which compares money growth and inflation over an extended time period, would Mexico be above or below the 45-degree line? Plot from 1987 to 2016 a quarterly basis the percent change from a year ago of the consumer price index (FRED code: MEXCPIALLQINMEI) and M2 (FRED code: MYAGM2MXM189N) in Mexico. Then download the data and calculate the averages of these inflation and money growth measures. Where would Mexico appear on Figure 20.1? Were there episodes since 1987 when Mexico was on the other side of the 45-degree line? If so, why? (LO2) Answer: The plot appears below. The average of the annual inflation rate was 19 percent, while the average rate of annual money growth was 26 percent. So, Mexico would appear below the 45-degree line on Figure 20.1B. Inspecting the plot below, money growth persistently exceeded inflation since the late 1990s. In the 1980s and briefly in the mid-1990s, however, Mexico experienced periods of very high inflation (notably 1987:Q1 through 1988:Q2 and 1995:Q1 through 1996:Q1) when its money lost value so rapidly that people rushed to spend it quickly (as in the children’s game of ―hot potato‖). This spending behavior raised velocity and (as the quantity theory implies) temporarily pushed inflation above the rate of growth of money.

5. In theory, the velocity of money should rise with the cost of holding it. To assess the theory, plot the opportunity cost of holding M2—defined as the difference between the three-month Treasury bill rate (FRED code: TB3MS) and the interest rate on M2 components (FRED code: M2OWN)—and (on the right scale) the percent change from a year ago of M2 velocity (FRED code: M2V). What do you conclude? (LO4) The plot appears below. The opportunity cost of holding M2 appears to rise in advance of recessions and fall during recessions, consistent with the cycles of M2 velocity. After the early 1980s, and especially after the mid-1990s, M2 velocity appears more closely linked than earlier to the opportunity cost of holding it. That change in sensitivity also is evident in Figure 20.4. However, with the Treasury bill rate close to zero after 2010, the relationship weakened. Perhaps the Treasury bill rate in this period is not a good proxy for the opportunity cost of holding M2. [NOTE: M2OWN is discontinued after mid-2019.]

* indicates more difficult problems

Chapter 21 Output, Inflation and Monetary Policy Conceptual and Analytical Problems 1. Explain the determinants of potential output growth. (LO1) Answer: Potential output is what the economy can produce when its resources are used at a normal rate. Growth of potential output depends on the growth of these resources and on changes in the technology used to transform those resources into output. In simple models, potential output growth depends on the growth rate of the capital stock, the growth rate of the labor force, and the rate of technological improvement.

2. *Explain how a recessionary output gap would emerge in an economy where the long-run aggregate supply curve is persistently shifting to the right. (LO1) Answer: Shifts to the right in the long-run aggregate supply curve reflect growth in the potential output of the economy. A recessionary gap would arise if actual output grew more slowly than potential output.

3. Describe the determinants of the long-run real interest rate, r*, and speculate on the sort of events that would make it fluctuate. (LO1) Answer: The long-run real interest rate (r*) equates aggregate expenditure with potential output. If a component of aggregate expenditure that it not sensitive to changes in the interest rate such as government spending rises, aggregate expenditure rises above potential output at the original real interest rate. If potential output remains unchanged, r* must rise to reduce interest-sensitive expenditures such as investment to offset the increase in interest-insensitive spending. Potential output can rise because of improvements in technology. In order for aggregate expenditure to rise with potential output when there is no change in an interest-insensitive component of spending, r* will fall so that interest-sensitive components rise. As a result, in the model of dynamic aggregate demand and aggregate supply, potential output and r* are negatively related. 4. Assuming that government purchases aren’t sensitive to rate changes, explain how and why the components of aggregate expenditure depend on the real interest rate. Be sure to distinguish between real and nominal interest rates and explain why the distinction matters. (LO2) Answer: The real interest rate equals the nominal rate minus expected inflation; when firms and households make economic decisions their decisions are based on the real interest rate. Aggregate expenditure equals consumption plus investment plus government spending plus net exports. Higher real interest rates increase the cost of borrowing and the rewards to saving, reducing consumption. A higher real cost of borrowing lowers the profitability of potential investments, reducing the investment component of aggregate demand. Higher real interest rates make U.S. financial assets more attractive to foreigners, increasing demand for the dollar and raising its value. A rise in the inflation-adjusted value of the dollar makes U.S. exports more expensive to foreigners and makes foreign imports cheaper to U.S. consumers, lowering net exports. Changes in the real interest rate have little effect on government spending and so can be ignored.

Suppose that the aggregate expenditure curve for an economy can be expressed algebraically as AE = 4,500 – 3,000r, where AE is aggregate expenditure and r is the real interest rate expressed as a decimal. If the level of potential output in this economy is 4,485, what is the long-run real interest rate, r*? (LO2) Answer: The aggregate expenditure curve shows the real interest rate at each level of desired spending, including the interest rate associated with potential output. The long-run real interest rate is the interest rate where aggregate expenditure equals potential output.

To find that rate, set AE equal to 4, 485 and solve for r: 4,485 =4,500 – 3,000r or 3,000r =15. Solving for r gives r* = 0.005, or 0.5%.

6. Suppose the U.S. economy is in equilibrium at the long-run real interest rate (r*) that prevails when aggregate expenditure equals potential output. Draw a diagram of aggregate expenditure showing this initial equilibrium. Then suppose that foreign demand for U.S. exports falls due to a recession abroad. Show how r* will change and explain your results. (LO2) Answer: The fall in U.S. exports reduces U.S. aggregate expenditures at each level of the real interest rate. Thus, the AE curve shifts to the left to AE' and r* declines from r* to r*'.

7. The European Central Bank’s primary objective is price stability. Policymakers interpret this objective to mean keeping inflation below, but close to, 2 percent, as measured by a euro-area consumer price index. In contrast, the Fed has a dual objective of price stability and maximum sustainable employment. How might you expect the monetary policy reaction curves of the two central banks to differ? Why? (LO2) Answer: You might expect the ECB to be more aggressive in targeting inflation than the Fed, everything else being equal. For a given deviation in current inflation from target inflation, that means the ECB would change the real interest rate by a greater amount than the Fed. Therefore, the monetary policy reaction curve of the ECB would be steeper than the monetary policy reaction curve of the Fed.

8. *Explain why the short-run aggregate supply curve is upward sloping. Under what circumstances might it be vertical? (LO3) Answer: The short-run aggregate supply curve is upward sloping due to stickiness in the prices of inputs into production, such as wages. As output prices rise, firms can earn higher profits by increasing their production. If all input prices were perfectly flexible and adjusted instantly whenever demand shifted, there would be no profit opportunity from increasing output. As a result, the short-run aggregate supply curve would be vertical, like the long-run aggregate supply curve.

9. Assume the short-run aggregate supply curve can be expressed algebraically as Ys = 4,200 + 4,000π where YS is aggregate supply, and the dynamic aggregate demand curve can be written as Yd = 4,300 – 1,000π. where Yd is aggregate demand. Find the numerical values for equilibrium output, Y, and the equilibrium inflation rate, π in the short run. (LO4) Answer: The answers require that you solve these two simultaneous equations. There are many ways to do this. One way to start would be with the observation that, in equilibrium Yd = Ys. Therefore, you can set the right-hand sides of the two equations equal to one another to solve for π. 4,200 + 4000(π) = 4,300 – 1,000(π) Rearranging, we get 5,000(π) = 100 Solving, we get π = 0.02 or 2% - short-run equilibrium inflation. Substitute this value for inflation back into either equation to find Ys = 4,200 + 4000(0.02) = 4,280 or Yd = 4,300 – 1,000(0.02) = 4,280 – short run equilibrium output. 10. Consider Panel B of Figure 21.16 where, at the initial short-run equilibrium point 0, current inflation is below expected inflation and output is below potential output. Suppose that the initial inflation target was at the level corresponding to point 1, but the central bank chooses to stimulate demand to speed the adjustment to long-run equilibrium. What action must the central bank take and what are the costs and benefits of such a policy? (LO4)

Answer: The central bank must raise its inflation target, shifting both the monetary policy reaction curve and the aggregate demand curve to the right. The cost is higher inflation and the

benefit is that the output loss may be eliminated more quickly if the policy returns output to Yp faster than if the central bank waited for production costs to fall.

11. Suppose the real interest rate unexpectedly falls in the absence of other economic changes. What would you expect to happen to (a) consumption, (b) investment, and (c) net exports in the economy? (LO2) Answer: a. Consumption will rise as borrowing to purchase consumer durables becomes less costly. In addition, the reward to saving falls, reducing saving and increasing consumption. b. Investment will rise as more projects will be profitable at the lower real interest rate. c. Net exports will rise as the dollar will depreciate in the face of a fall in foreign investor demand for U.S. assets given the lower return. This makes U.S. exports less expensive to foreigners and imports more expensive for American consumers, increasing net exports.

12. * Economy A and Economy B are similar in every way except that in Economy A, 50 percent of aggregate expenditure is sensitive to changes in the real interest rate and in economy B, 70 percent of aggregate expenditure is sensitive to changes in the real interest rate. (LO2) a. Which economy will have a steeper aggregate expenditure curve? b. How would the dynamic aggregate demand curves differ given that the monetary policy reaction curve is the same in both countries? Explain your answers. Answer: a. Economy A will have a steeper aggregate expenditure curve. For a given fall in the real interest rate, aggregate expenditure will increase more in Economy B than it will in Economy A; therefore, Economy B’s curve is flatter than in Economy A. b. Economy A will also have a steeper dynamic aggregate demand curve. As the two countries have the same monetary policy reaction curves, an increase in inflation will result in the same increase in the real interest rate in both countries. This change in the real interest rate will result in a bigger change in aggregate output in Economy B, resulting in a flatter dynamic aggregate demand curve.

13. Given the expected relationship between the real interest rate and investment, how would you explain a scenario where investment continued to fall despite low or even negative real interest rates? (LO2) Answer: Changes in the level of investment depend both on the level of real interest rates and on business prospects that drive expected internal rates of return. If firms are pessimistic about the economic outlook, investment may remain weak despite low or negative real interest rates. We can see this most dramatically during the recession that started in December 2007; investment continued to fall as a percentage of GDP (Figure 21.6), reflecting falling investment in absolute terms, while real interest rates were negative (Figure 21.2).

14. State whether each of the following will result in a movement along or a shift in the monetary policy reaction curve and in which direction the effect will be. (LO2) a. Policymakers increase the real interest rate in response to a rise in current inflation. b. Policymakers increase their inflation target. c. The long-run real interest rate falls. Answer: a. This would result in a movement up along the monetary policy reaction curve. b. This would result in a shift in the monetary policy reaction curve to the right as the real interest rate equals r* at a higher level of inflation. c. This would result in a shift in the monetary policy reaction curve to the right. There is a lower real interest rate at every level of inflation. 15. Suppose a natural disaster wipes out a significant portion of the economy’s capital stock, reducing the potential level of output. What would you expect to happen to the long-run real interest rate, r*? What impact would this have on the monetary policy reaction curve and the dynamic aggregate demand curve? (LO2) Answer: The reduction in the potential level of output in the economy would lead to an increase in r*. The higher real interest rate would drive down the interest-sensitive components of aggregate expenditure to equate aggregate expenditure with the new lower level of potential output. The monetary policy reaction curve would shift to the left, as a higher real interest rate would now be associated with each level of inflation. As the real interest rate is now higher at each level of inflation, the level of output is lower and so the dynamic aggregate demand curve shifts to the left.

16. Suppose there were a wave of investor optimism in the economy. What would the impact be on the dynamic aggregate demand curve? (LO2) Answer: A wave of investor optimism would increase investment and therefore aggregate expenditure at each real interest rate. This would be reflected in a shift to the right of the dynamic aggregate demand curve. 17. Explain how each of the following affects the short-run aggregate supply curve. (LO3) a. Firms and workers reduce their expectations of future inflation. b. There is a fall in current inflation. c. There is a fall in oil prices. Answer a. A reduction in inflationary expectations means that nominal wages will rise by less, lowering costs and thus increasing production at each level of current inflation. The short-run aggregate supply curve will shift to the right. b. There will be a movement down along the short-run aggregate supply curve. c. With lower costs, production will increase at each level of inflation and so the short-run aggregate supply curve will shift to the right.

18. Suppose the economy is in short-run equilibrium at a level of output that exceeds potential output. How would the economy self-adjust to return to long-run equilibrium? (LO4) Answer: The expansionary gap exerts upward pressure on costs, shifting the short-run aggregate supply curve to the left until the economy reaches the long-run equilibrium point where aggregate demand, short-run aggregate supply and long-run aggregate supply all intersect. At this point, the economy has returned to the potential level of output.

19. Why do you think the surge in oil prices in 2007–2008 had a much smaller impact on inflation expectations compared with the oil price shocks of the 1970s? (LO4) Answer: The response of inflation expectations to changes in economic conditions depends to a large extent on the credibility of the monetary policymaker. If the central bank is credible due, for example, to a long record of matching its actions with its words, then long-term inflation expectations are well-anchored and transitory changes in input costs do not undermine expectations that inflation will remain under control. The smaller impact of the 2007-2008 surge in oil prices compared with those in the 1970s reflects the greater credibility of the central bank.

20. *You read a news article that blamed the central bank for pushing the economy into recession. The article goes on to mention that not only had output fallen below its potential level, but that inflation had also risen. If you were to respond defending the central bank, what argument would you make? (LO4) Answer: You should state that monetary policy actions by the central bank affect the dynamic aggregate demand curve and that shifts in the aggregate demand curve move output and inflation in the same direction. The situation described in the news story is one where inflation rises when output falls. This is most likely the result of a shock that shifted the short-run aggregate supply curve to the left.

21. For each of the following economies, select the term—inflation, deflation, or disinflation—that best describes what the economy is experiencing. (LO1)

Annual percent change in the consumer price index Economy A Economy B Economy C

March

April

May

-1.5% 3.2% 1.5%

-1.5% 2.3% 1.5%

-1.5% 0.8% 1.5%

Answer: Economy A is experiencing deflation, as the price level is falling each period.

Economy B can be best described as experiencing disinflation, as there is a slowdown in the pace of inflation. Economy C is experiencing inflation, as the price level is rising each period.

22. As a monetary policymaker, would you be more concerned if the aggregate price level were persistently rising by 2 percent or persistently falling by 1 percent? Explain your answer. (LO3) Answer: The deflation scenario, where the price level is falling, should be of more concern, as monetary policy interest rate tools are less effective in the face of deflation. For example, assuming the effective lower bound on nominal interest rates is around zero, the real interest rate could fall to -2 percent in the scenario where inflation is 2 percent but would be bounded at +1 percent in the face of deflation. Moreover, due to downward rigidity of nominal wages, deflation pushes up real labor costs, making it more difficult for monetary policymakers to achieve their objectives when output is below the long-run equilibrium.

23. A Phillips curve postulates a negative relationship between inflation and economic slack. However, the relationship between wage inflation and lagged unemployment appeared more negative in the 1960s than in the period since 2000. In the macroeconomic model presented in this chapter, which curve would be altered by this ―flattening‖ of the Phillips curve? (LO3) Answer: The slope of the Phillips curve is captured in the slope of the short-run aggregate supply (SRAS) curve in the model presented in the chapter. The SRAS and the Phillips curve capture the same economic idea—that there is a relationship between inflation and economic slack. The Phillips curve measures economic slack through a measure of the unemployment rate, whereas the SRAS curve uses an output-based measure. 24. The COVID pandemic was associated with multiple economic shocks and policy responses that affected the aggregate expenditure curve and dynamic aggregate demand curve. For each of the following, state the impact, if any, on both these curves and explain your reasoning. a. Widespread shutdowns across the economy associated with the pandemic resulted in a fall in consumer spending. b. U.S. fiscal policymakers introduced legislation that included a significant increase in government spending. c. Firms became more pessimistic about their future income and sales due to pandemic-related disruptions. (LO2) Answer: a. The fall in consumer spending reduced the level of aggregate expenditure at every level of the real interest rate, shifting the aggregate expenditure curve to the left and the dynamic aggregate demand curve to the left. b. The increase in government spending raises the level of aggregate expenditure at every level of the real interest rate, shifting the aggregate expenditure curve to the right and the dynamic aggregate demand curve to the right. c. Firms’ pessimism drove down investment at every level of the real interest rate, shifting the aggregate expenditure curve to the left and the dynamic aggregate demand curve to the left.

Data Exploration

1. Are long-term inflation expectations ―well anchored?‖ Using monthly data since 2003, plot a measure of long-term inflation expectations based on the difference between the yields on a five-year Treasury bond (FRED code: GS5) and a five-year Treasury Inflation Protected Securities (TIPS) bond (FRED code: FII5). What do you conclude? How did the financial crisis of 2007-2009 affect the measure? (LO1) Answer: Based on this measure, long-term inflation expectations were reasonably consistent with the Fed’s 2-percent inflation target for the decade through 2019. The key exception was during the financial crisis, when a flight by investors to the most liquid Treasury instruments (the nominal bonds, not the TIPS) combined with temporary fears of deflation resulted in a temporary downward spike of the measure. When aggressive Fed supply of liquidity normalized financial market conditions, the spike ended. Notably, spurred in part by the impact of the pandemic and Russia’s invasion of Ukraine, inflation expectations (by this measure) rose notably in 2021-2022, eventually prompting the Federal Reserve to raise interest rates at the most rapid pace in several decades. As of May 2024, this measure of inflation expectations was only modestly above the Fed’s 2 percent target.

2. Is investment sensitive to the real interest rate? Plot since 1990 a measure of the real interest rate—based on the difference between Moody’s Baa corporate bond yield (FRED code: DBAA) and a survey of expected inflation (FRED code: MICH) – and (on the right scale) the share of investment (FRED code: GPDIC1in real GDP (FRED code: GDPC1). Explain the cyclical pattern. (LO2) Answer: The data are plotted below, where falling real interest rates through the 1990s were associated with rising capital investment. Then, during the recession of 2001, investment fell as the real interest rate rose. Falling rates again saw rising investment until the financial crisis of

2007-2009. During the crisis, real rates rose sharply, and investment fell sharply. Since the end of the 2007-2009 recession, low or declining real rates are again generally associated with rising capital investment.

Moody’s, Moody's Seasoned Baa Corporate Bond Yield [DBAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DBAA. University of Michigan, University of Michigan: Inflation Expectation [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MICH.

3. How sensitive is private investment to risk? Plot since 2004 the share of real gross private domestic investment (FRED code: GPDIC1) in real GDP (FRED code: GDPC1) and (on the right scale) a measure of anticipated stock market volatility (FRED code: VIXCLS). Explain the pattern. What might account for the differences between the episodes associated with the financial crisis of 2007-2009 and the COVID pandemic of 2020?? (LO2) Answer: The data plot below is for a short horizon but suggests that expectations of rising stock market volatility (measured on the basis of stock options prices) are associated with falling capital investment. Firms become cautious about investment if they anticipate greater variability in economic activity that will make their return on investment more unpredictable and riskier. Similarly, low or falling stock market volatility has generally been associated with improved or rising capital investment since the financial crisis of 2007-2009. As of mid-2024, the share of investment in GDP remains high, and stock market volatility low, despite relatively high monetary policy rates.

Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS.

4. A recession may reflect declines in aggregate demand, aggregate supply, or both. Are swings in consumer sentiment characteristic of recessions? Plot a measure of sentiment (FRED code: UMCSENT) and discuss its evolution during the recessions since 1980? Explain why consumer sentiment is an important example of an aggregate demand shock. (LO2, LO3) Answer: Consumption is about 70 percent of U.S. GDP, so swings in household sentiment about the economy can have a major impact on the timing, depth, and duration of economic recessions. On the plot below, large declines in sentiment tend to precede (or occur simultaneously with) the onset of recessions. The same timing characterizes upturns in sentiment and economic recoveries. One notable exception is the sharp decline of sentiment in 2021-2022: presumably the sharp rise of inflation during this period raised doubts about the sustainability of the expansion and lowered confidence. As of mid-2024, in the absence of a recession, and with inflation receding, confidence had rebounded, but remained well-below preCOVID levels.

University of Michigan, University of Michigan: Consumer Sentiment [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT.

5. How often are negative supply shocks associated with recessions? Plot on a quarterly basis since 1971 the real price of oil—measured as the ratio of the nominal spot price of West Texas intermediate oil (FRED code: WTISPLC) to the U.S. consumer price index (CPIAUCSL). Identify recessions that may have been triggered in part by an oil price shock. Do your results square with the implication of Table 21.5 that, despite well-known supply disruptions, the COVID pandemic recession of 2020 was driven primarily by a decline of aggregate demand? (LO4) Answer: Sharp increases in the real price of oil preceded several U.S. recent recessions. The most obvious instances are the recessions that began in 1973, 1979, and 2007. In contrast, the sharp drop in the real price of oil at the outset of the pandemic-related recession in early 2020 occurred even as the pandemic (and related government-lockdowns) diminished economic activity and travel. In general, the evidence of falling inflation during the recessions shown in Table 21.5 suggests that demand shocks usually were larger than the supply shocks in past U.S. downturns.

* indicates more difficult problems

Chapter 22 Understanding Business Cycle Fluctuations Conceptual and Analytical Problems 1. Define the term stabilization policy and describe how it can be used to reduce the volatility of economic growth and inflation. Do stabilization policies improve welfare? (LO2) Answer: Stabilization policies are monetary or fiscal policies designed to stabilize inflation and output by counteracting the impact of shocks on the economy. Both monetary and fiscal policies can be used to shift the dynamic aggregate demand curve to at least partially offset the impact of economic shocks. While policymakers in principle can neutralize aggregate demand shocks, they cannot alter aggregate supply. Consequently, they cannot eliminate the effects of shifts in the short-run aggregate supply curve. According to Core Principle 5, stability improves welfare and so policies that promote economic stability improve welfare.

2. Explain why stabilization policies are usually pursued using monetary rather than fiscal policy. (LO3)

Answer: Fiscal policies can reduce a recessionary output gap by increasing government spending and/or cutting taxes. However, with the exception of large and obvious crises, it usually takes a long time for these policies to be enacted. Moreover, the effect of tax cuts is not immediate. Fiscal policymakers are also likely to support programs that would allow them to make political gains, regardless of whether those programs are best from an economic standpoint. Monetary policy can stabilize the economy more quickly and if the central bank is independent, it is not influenced by politics.

3. Explain why fiscal policy played a greater role than usual in the responses to both the financial crisis-related 2007–2009 recession and the 2020 recession associated with the COVID pandemic. (LO3) Answer: The extreme features of these crises-related recessions underscored the importance of using all possible means to help stabilize the economy. The depth and severity of the 2007-2009 meant that even after monetary policymakers cut interest rates to reach the effective lower bound, more support for the economy was needed to combat deflationary pressures. This support included significant fiscal stimulus. In the case of the short, but very deep recession that accompanied the onset of the pandemic, the government undertook a massive fiscal expansion when widespread shutdowns across the economy made fiscal support in the form of transfers and government spending a crucial element of the policy response, especially given that monetary policymakers had little scope to cut interest rates.

4. Explain why monetary policymakers cannot restore the original long-run equilibrium of the economy if, in the short run, the economy has moved to a point where inflation is above target inflation and output is below potential output. (LO2) Answer: If inflation is above target inflation and output is below potential output, the shortrun aggregate supply curve has shifted to the left. Monetary policymakers can only shift the dynamic aggregate demand curve. An expansionary monetary policy could restore output to its long-run equilibrium level, but this would come at the cost of permanently higher inflation.

5. Explain why the rise in oil prices in 2008 created a particularly difficult situation for Federal Reserve policymakers, who were trying to stabilize the financial system amid the 2007-2009 financial crisis. (LO2) Answer: The rise in oil prices and consequent upward pressure on inflation came at a time when the U.S. economy was weak. Uncertainty surrounding the extent of the impact of the financial crisis on the economy meant that any hikes in interest rates to combat inflation could be very damaging to the economy’s growth prospects. The Fed faced a trade-off between its goals: should it tighten policy to combat inflation or loosen it to spur growth?

6. Will changes in technology affect the rate at which the short-run aggregate supply curve shifts in response to an output gap? Why or why not? Provide some specific examples of how technology will change the rate of adjustment. (LO1) Answer: Technological advancements will make it easier to change prices in response to an output gap. For example, instead of placing price stickers on items in the supermarket, prices could be displayed on electronic screens on shelves in front of items and could be changed from a computer. If it becomes easier to change prices, the short-run aggregate supply curve will shift more quickly in response to an output gap. 7. After examining Figure 22.6, explain the potential link between innovations in financial markets and output volatility since the 1980s. You should consider both the ―Great Moderation,‖ the recession of 2007–2009, and the COVID pandemic in your answer. (LO1)

14 12

Change from Year Ago (%)

8 6 4 2 0 -2

-4 -6 -8 -10

Answer: From the early 1980s until the onset of the recession in 2007, there was a marked moderation in the volatility of output growth that became known as the ―Great Moderation‖. From the early 1980s many new financial products appeared that made it easier for households and businesses to borrow—which facilitated consumption smoothing and contributed to output stability. It transpired, however, that some of these new financial products facilitated increased levels of risky debt that led to unprecedented levels of personal credit defaults during the financial crisis of 2007–2009. The loss of credit availability during this period contributed to the depth and duration of the associated recession. In the years since the great recession, the economy appeared to have returned to a relatively stable path, though after the events related to COVID-19 in 2020, the future is somewhat uncertain.

8. *According to real-business-cycle theory, can monetary policy affect equilibrium output in either the short run or the long run? (LO3) Answer: According to real-business-cycle theory, business cycle fluctuations arise due to changes in potential output and the short-run aggregate supply curve shifts so rapidly that it is irrelevant. Equilibrium in both the short run and the long run is determined by the intersection of the dynamic aggregate demand curve and the long-run aggregate supply curve. Shifts in the AD curve do not influence the equilibrium level of output and so monetary policy cannot influence equilibrium output either in the short run or the long run.

9. The economy has been sluggish, so in an effort to increase output in the short run, government officials have decided to cut taxes. They are considering two possible temporary tax cuts of equal size in terms of lost revenue. The first would reduce the taxes on people with income above the median for one year. The second would cut taxes on people with incomes below the median for one year. Which change would shift the aggregate demand curve further to the right? Why? (LO2) Answer: Temporary tax cuts usually have little impact on the spending of taxpayers who are not liquidity or credit constrained. Put differently, higher-income taxpayers may save a temporary tax cut, rather than spend it, because they can use their savings or access to credit to smooth their spending across temporary income fluctuations. However, taxpayers who are liquidity or credit constrained are more likely to spend the tax cut, because it relaxes their funding constraint. For that reason, a tax cut focused on lower-income taxpayers may have a greater impact on aggregate spending.

10. Suppose that conflict over international trade leads to a fall in consumer confidence. Starting with the economy in long-run equilibrium, use the dynamic aggregate demand-aggregate supply framework to illustrate what would happen to inflation and output in the short run. Assuming the central bank takes no action to offset this decrease in confidence, what would happen to inflation and output in the long run? By taking no action, how has the central bank implicitly altered its policy goal? (LO2) Answer: A fall in consumer confidence would shift the dynamic aggregate demand curve (AD) to the left, reducing both inflation and output in the short run (point B). In the absence of a policy response, the economy will eventually self-adjust, with the short-run aggregate supply curve (SRAS) shifting to the right to restore long-run equilibrium at point C. At C, output has returned to Y* but inflation is lower than its original level. The central bank has implicitly reduced its inflation target.

11. If there is a fall in consumer confidence, what would happen to inflation and output in the long run if the central bank remained committed to its original inflation target and responded with an immediate policy change? Use the aggregate demand-aggregate supply framework to illustrate your answer, starting with the economy in long-run equilibrium. Compare the outcome to what the outcome would be if the central bank did not respond explicitly to the change in consumer confidence. (LO2) Answer: Starting at point A, a fall in consumer confidence would shift the dynamic AD curve to the left, decreasing both inflation and output in the short run. If the central bank eases policy immediately in response to the downward movement in inflation and output, the leftward AD curves shift due to the fall in confidence will immediately be offset. Output will remain at Yp and inflation will remain at the original target level (point C).

This contrasts to the situation where there is no explicit policy response to the initial leftward shift in the AD curve. In that case, the economy eventually adjusts through a rightward shift in the SRAS curve to restore long-run equilibrium. In that case, the central bank implicitly lowers its inflation target.

12. How would a shock that reduces production costs in the economy (a positive supply shock) affect equilibrium output and inflation in both the short run and the long run? Illustrate your answer using the aggregate demand–aggregate supply framework. You should assume that the shock does not affect the potential output of the economy. (LO2) Answer: A positive supply shock will shift the SRAS curve to the right. In the short run, equilibrium output will increase while equilibrium inflation will fall. In the absence of a policy response, the expansionary gap will put upward pressure on inflation, shifting the SRAS back to the left. In the long run, the initial levels of output and inflation will be restored.

13. Suppose the central bank took advantage of a temporary positive supply shock to lower its inflation target. Illustrate the impact of this change in the inflation target using an aggregate demand–aggregate supply diagram. Compare this with a chart of a situation where the central bank lowers its inflation target in the absence of a positive supply shock. (LO2) Answer: A temporary positive supply shock will shift the SRAS curve to the right. If the central bank uses this positive supply shock as an opportunity to lower its inflation target without inducing a recession, the rightward shift in the SRAS curve will be followed by a leftward shift in the AD curve. As a result, output returns to Y* at a lower inflation level.

In contrast, if the central bank lowers its inflation target in the absence of a positive supply shock, it first moves to point B where output falls below Y*. In the long run, the recessionary gap puts downward pressure on inflation, shifting the SRAS curve to the right to restore long-run equilibrium at point C as above.

14. *Suppose a natural disaster reduces the productive capacity of the economy. How would the equilibrium long-run real interest rate, r*, be affected? Assuming the central bank maintains its existing inflation target, illustrate the impact on the monetary policy reaction function and on equilibrium inflation and output both in the short run and in the long run. (LO2, LO3) Answer: As a result of a natural disaster that reduces the productive capacity of the economy, the long-run real interest rate, r*, would increase. Monetary policymakers respond by shifting the monetary policy reaction curve (MPRC) to the left, increasing the real interest rate for every level of inflation. In the aggregate demand–aggregate supply framework, both the SRAS and the LRAS curves would shift to the left as a result of the natural disaster, increasing inflation and reducing output in the short run (point B). The monetary policy tightening shifts the AD curve to the left and long-run equilibrium occurs at point C, where inflation is back at its target level and output is at the new lower potential level of output.

15. *Monetary policymakers observe an increase in output in the economy and believe it is a result of an increase in potential output. If they were correct, what would the appropriate policy response be to maintain the existing inflation target? If they were incorrect and the increase in output resulted simply from a positive supply shock, what would the long-run impact be of their policy response? (LO3) Answer: To maintain the existing inflation target, monetary policymakers should shift their MPRC to the right, shifting the AD to the right. This would restore long-run equilibrium at the existing inflation target and the new, higher level of potential output. If, however, the increase in output resulted simply from a positive supply shock, the expansionary monetary policy would increase the expansionary gap. In the long run, the SRAS curve would shift to the left and long-run equilibrium would occur at the original level of output but at a higher level of inflation.

16. *Consider a previously closed economy that opens up to international trade. Use the aggregate demand–aggregate supply framework to illustrate a situation where this would lead to lower inflation in the long run. (LO2) Answer: Opening up to international trade increases potential output and the SRAS and LRAS curves shift to the right. If monetary policymakers use this as an opportunity to reduce the inflation target and do nothing, the SRAS curve will shift farther to the right to close the recessionary gap. In the long run, output will be at the new higher potential level while inflation is lower.

17. *How could you use the aggregate demand–aggregate supply framework to explain the impact of the financial crisis of 2007–2009 on inflation and output in the economy? (LO2, LO3) Answer: You can think of the disruption in financial markets as an AD shock. Lack of access to credit by consumers and businesses and loss of consumer and investor confidence would shift the dynamic AD curve to the left. In the absence of other changes, this would put downward pressure on both output and inflation.

18. Changes in oil prices shift the short-run aggregate supply curve (SRAS). Consider how volatility in oil prices may influence the economy’s short-run equilibrium, which occurs at the intersection of the dynamic aggregate demand (AD) curve and the SRAS curve. (LO3) a. Suppose the monetary policy reaction curve is relatively steep. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation when the SRAS curve shifts? Explain. b. Suppose the monetary policy reaction curve is relatively flat. What does this imply about the slope of the AD curve? What does it imply about the variability of output and inflation when the SRAS curve shifts? Explain. Answer: a. In the diagram below, suppose that SRAS fluctuates between SRAS’ and SRAS‖, with a typical position at SRAS. The impact of these fluctuations on output and inflation in the short run depends on the slope of the dynamic aggregate demand (AD) curve. As shown in text Figures 22.12 and 22.13, the steeper the MPRC, the flatter the AD curve. With a relatively steep MPRC, a given rise in the inflation rate leads to a larger policy-driven rise in the real interest rate that triggers a bigger decline of interest-sensitive spending. That is, the rise in the inflation rate leads to a comparatively large fall in output demanded, so the dynamic AD curve is relatively flat. With a flat AD, the variability in output is fairly large, fluctuating between Y′ and Y″ in the diagram below. Note the relatively small variability in the inflation rate.

b. If the MPRC is relatively flat, a given rise in the inflation rate leads to a smaller policy-driven increase in the real interest rate, resulting in a smaller decline of interest-sensitive purchases. So, the same increase in the inflation rate as in part (a) leads to a smaller decline in the quantity of output demanded in the economy. Put differently, the AD curve in this case is relatively steep. As in the diagram below, the steep AD curve means that output volatility is smaller. Note, however, that relatively stable output is associated with larger inflation fluctuations.

19. *Suppose that a government imposes trade barriers that raise the domestic cost of production and lower potential output. What would you expect to happen to inflation and output in the short run and the long run, assuming monetary policymakers only recognize the fall in potential output with a lag and keep their inflation target unchanged? (LO1) Answer: The fall in potential output would be reflected in a shift to the left of both the SRAS and LRAS curves. In the short run, before policymakers realize that potential output has fallen, inflation will rise and output will fall as the economy moves to the new short-run equilibrium at the intersection of the new SRAS and the original AD curves. When policymakers realize potential output has fallen, in order to restore the initial inflation target, they would need to shift the monetary policy reaction curve to the left. This would shift the AD curve left until it intersected the new SRAS and LRAS at the original inflation target.

In the long run, the overall impact of the protectionist policies would be to lower output and leave inflation unchanged.

20. Suppose an economy is in long-run equilibrium and the government decides to cut spending. How might monetary policymakers react, assuming their inflation target remained unchanged? (LO1) Answer: The cut in government spending shifts the AD curve to the left, reducing inflation below expected inflation and below the inflation target. and lowering output below potential output. Realizing that the long-run real interest rate had fallen, monetary policymakers would respond by shifting the MPRC to the right. This, in turn, shifts the AD curve right, restoring AS-AD equilibrium with inflation at the original target level and output equal to potential output.

21. Suppose that the anemic growth of the U.S. economy following the financial crisis of 2007– 2009 was a result of ―secular stagnation.‖ Use the Fisher equation to explain why raising the

central bank’s inflation target could help boost economic growth in circumstances where nominal interest rates are close to the effective lower bound. (LO2) Answer: The Fisher equation links the nominal interest rate, the real interest rate and expected inflation according to the equation i = r + πe According to the secular stagnation hypothesis, post-crisis economic weakness reflected a persistent shortfall in aggregate demand, with the equilibrium long-run real interest rate (r*) having dropped well below zero. With the nominal interest rate at the effective lower bound, inflation expectations limit how far the real interest rate can fall. For example, if the effective lower bound on nominal interest rates is zero, then with a 2 percent inflation target, the real interest rate is bounded below 0, at -2 percent. If raising the inflation target from 2 percent to 3 percent is perceived as credible, the resulting higher inflationary expectations would lower the real interest rate by an additional one percent, providing further stimulus to growth.

22. Do you think GDP-linked bonds would be more useful in a relatively stable economy or in an economy that is frequently buffeted in the short run by demand and supply shocks, assuming these economies have similar sovereign debt burdens? Explain your choice. (LO2) Answer: Shocks to the AD and SRAS curves lead to deviations from long-run equilibrium output, so an economy prone to such shocks will experience more cyclical variation. This makes GDP-linked bonds more useful compared with a relatively stable economy, as it reduces debt payments in times of downturns when the government’s capacity to pay is lower. This cyclical variation of debt service reduces the risk of default and increases the maximum level of sustainable debt. It also provides more room for such an economy to use fiscal policy as a stabilization tool.

23. Suggest two factors associated with the COVID pandemic that might reduce the likelihood of a return to the economic stability and solid growth experienced during the ―Great Moderation‖. (LO1) Answer: First, the widespread supply disruptions associated with the pandemic may change the way firms manage their inventories, undoing some of the flexibility gains associated with ―just-in-time‖ supply management and causing a loss in operational efficiency. Second, the delayed monetary policy response to the heightened inflation that emerged may damage the credibility of central bankers’ commitment to price stability that supported the Great Moderation.

24. For each of the following effects associated with the COVID pandemic, state which curve(s) in the aggregate demand–aggregate supply framework would be affected and in which direction you would expect the curve(s) to shift. (You should ignore any subsequent policy response.) a. Supply-chain disruptions increased production costs for firms across the

economy. b. Monetary policymakers cut interest rates sufficiently to reduce the level of the real interest rate at every level of inflation c. Changing behavior of firms in response to pandemic disruptions reduced productivity, leading to a fall in potential output. (LO2) Answer: a. The increase in production costs shifts the SRAS curve to the left. b. The shift to the right of the monetary policy reaction shifts the dynamic AD curve to the right. c. A fall in potential output shifts both the SRAS and LRAS to the left.

Data Exploration 1. Display as a bar chart the periods since 1854 that are designated as U.S. recessions by the National Bureau of Economic Research (FRED code: USREC). Why has the frequency of recessions declined over time? Could improvements in monetary policy have played a role? Improvements in fiscal policy? Can you think of any other causes? (LO1)

Answer: The frequency of recessions has notably diminished, especially after the Great Depression. Monetary policy has improved over time, especially with the advent of a monetary policy framework stressing transparency, credibility and central bank independence. However, the short-run variability of both velocity and the money multiplier challenges even the best policy makers. Furthermore, while the frequency of recessions has fallen, the financial crisis of 2007-2009 makes clear that the severity has not.

Fiscal policy usually is more difficult to use to counter recessions because these downturns average less than one year in duration, while the time required to implement a fiscal policy change can be long. At least two other possibilities could explain the decline in the frequency of recessions. First, one hypothesis is that the data prior to World War II, and especially prior to World War I, is not sufficiently accurate to reliably capture the business cycle. Second, technological advances (including information and communications technology) may make markets more effective, allowing for better private decisions that restore equilibrium more quickly with policy interventions of smaller magnitudes. However, the weak recovery following the 2007-2009 recovery highlights the limits of the economy’s self-correcting forces.

2. In the past, policymakers occasionally became aware of a recession only well after it began. Can they do better? Plot the probability of a recession from a statistical model (FRED code: RECPROUSM156N). To what extent could the model help improve monetary or fiscal policy or both? As one example, recall the fears that the March 2023 runs on midsized banks would quickly trigger a recession. What does the probability model suggest about this episode? (LO3) Answer: The probabilities are plotted below. With the exception of the mild downturn in 2001, a recession occurs whenever the statistical probability rises above 50 percent. Furthermore, there are no ―false signals‖ with the available evidence. However, while the model may help monetary policy respond more quickly to an emerging recession, the probabilities do not always convey the depth or duration of the recession. Fiscal policy would benefit less given the long lags for implementation of new tax and spending policies. However, as we observed in 2020, the fiscal response to a recession can be rapid and powerful if there exists widespread consensus on the need to act. Looking at the 2023 episode, the probability model implies almost zero chance of a recession, and no change as the values in February and March 2023 are the same: 0.28 percent.

Piger, Jeremy Max and Chauvet, Marcelle, Smoothed U.S. Recession Probabilities [RECPROUSM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RECPROUSM156N.

3. Compare the frequency and timing of recessions in key European economies since 1960. Make separate bar charts for Germany (FRED code: DEURECM), Italy (FRED code: ITARECM), and Spain (FRED code: ESPRECM). Do their business cycles appear sufficiently well-aligned to make them operate easily in a single currency area with a common monetary policy? (LO3) Answer: Individual plots are below, followed by a plot of all three economies together. While there appears to be some overlap, the timing and duration of recessions in the European countries are not identical. These differences may reflect differing mixes of goods and services, different trade and financial patterns, and differing economic policies (aside from the common monetary policy after 1999). If the cycles differ sufficiently across countries, monetary policy that successfully smooths the business cycles in some countries may exacerbate the cycles in other countries. Put differently, when cycles differ, sharing a common monetary policy may not be optimal.

4. To keep inflation low and steady, central banks would like to keep output reasonably close to its potential level, but can they anticipate changes in potential GDP? Plot since 1960 the percent change from a year ago of the Congressional Budget Office’s estimate of potential GDP (FRED code: GDPPOT). Suppose that the FOMC assumed that the growth rate of

potential GDP remained permanently at its 1960s average. What would you expect to happen to inflation? Why? (LO1) Answer: The plot appears below. According to the CBO, potential GDP growth averaged 4.4 percent in the 1960s. From 1970 to the end of 2024, it averaged 2.7 percent. Had the FOMC assumed that potential GDP growth of 4.4 percent would persist, it would have accommodated unsustainably rapid economic expansion, leading to higher inflation, based on the AS/AD model. Research suggests that Fed overestimation of potential growth in the 1970s partly accounts for the rising inflation that it tolerated until 1979, when double-digit inflation prompted the FOMC (under its new leader, Federal Reserve Board Chairman Paul Volcker) to tighten monetary policy sharply. Note that real potential growth has been notably lower since 2010 than in previous decades.

5. The Taylor rule includes a resource gap that can be measured either as the percentage difference between actual and potential real GDP (FRED codes: GDPC1 and GDPPOT) or, alternatively, as the gap between the actual and natural unemployment rates (FRED codes: UNRATE and NROU). Plot these two measures of the resource gap since 1960. Show the unemployment gap as the difference between the actual and natural unemployment rates. Show the output gap as 100 times the difference between actual and potential real GDP, all divided by potential GDP. Compare the cyclical characteristics of these two measures. (LO3) Answer: The output gap and the difference between actual and natural unemployment rates roughly mirror each other. The output gap falls just before or coincident with recessions and rises as economic expansions begin. Similarly, the difference between actual and natural unemployment rates rises just before or coincident with the onset of recessions and falls as economic expansion begin. One key advantage of the unemployment measure for

policymakers who need to make timely decisions is that the labor market data are reported monthly and face limited revision after the first two months, while the GDP data are reported only quarterly and are frequently revised long after the initial report. The data is plotted below.

* indicates more difficult problems

Chapter 23 1.

Modern Monetary Policy and the Challenges Facing Central Bankers

Conceptual and Analytical Problems 1. Explain how an open market purchase of securities by a central bank affects the banking system’s balance sheet, and discuss the potential impact on the supply of bank loans. (You may wish to refer to Chapter 17 in answering this question.) (LO1) Answer: When the central bank carries out an open market purchase of securities, it increases the amount of reserves in the banking system. If the opportunity cost adjusted for risk (the difference between the interest rate on loans and the interest rate paid by the Fed on reserves) of holding excess reserves is sufficient, banks will increase the volume of loans they make.

2. How can the bank lending and balance sheet channels of monetary policy transmission help explain the relatively slow speed of the recovery from the 2007–2009 recession and the relatively fast speed of recovery from the 2020 COVID-related recession? (LO1) Answer: Recoveries from recessions precipitated from financial crises tend generally to be weaker. Banks tend to tighten credit standards in the wake of financial disruptions. Greater lending restraint makes it harder for firms—particularly small firms which are more bank dependent—and households to borrow. (Figure 23.2 provides supporting evidence.) Households’ demand for credit may also be weak as anxieties arising from the crisis spur higher rates of savings. The large government deficits in the wake of a crisis also may prompt an early turn to fiscal restraint. In the wake of the COVID recession, however, credit conditions remained far more favorable due to a combination of factors. Above all, aggressive fiscal and monetary policy actions lowered the probability of default by firms, encouraging banks to lend. In addition, due to post-financial-crisis reforms, banks were in a stronger capital position entering the COVID recession. Their healthier condition resulted in greater lending capacity. In essence, as a result of lessons from the financial crisis, the banking system was more resilient when the COVID recession hit, while aggressive policy actions improved the likelihood that borrowers could repay new loans.

3. *Explain why the traditional interest rate channel of monetary policy transmission from monetary policy actions to changes in investment and consumption decisions may be relatively weak. (LO1) Answer: External financing by firms is made difficult by problems associated with asymmetric information, weakening the impact of changes in the cost of external funds on investment. Interest-sensitive consumption decisions depend on longer-term interest rates and so the impact of policy changes on consumption depends on the extent to which changes in the short-term rate influence longer-term rates through the term structure of interest rates. 4. Explain why monetary policymakers’ actions in cutting the target range for the federal funds rate to 0 to ¼ percent were insufficient to boost economic activity in either the recession of 2007–2009 or the recession associated with the 2020 COVID pandemic. (LO2) Answer: The financial system is the key link between monetary policy and economic activity. When the financial system is disrupted, as it was in 2007-2009, so too is the mechanism that transmits monetary policy actions to the real economy. The financial crisis of 2007-2009 aggravated problems relating to asymmetric information, resulting in a feedback loop between worsening economic prospects and the deterioration of financial conditions that influence spending. Monetary policymakers had to resort to other tools such as quantitative easing, targeted asset purchases and forward guidance to influence financial conditions and contain the crisis. In the case of the 2020 COVID-related recession, policy interest rates were already at low levels entering the downturn, leaving little scope for cuts. The disruptions in critical financial markets—such as the Treasury market—also hampered the functioning of the monetary policy transmission mechanism.

5. When monetary policymakers hit the effective lower bound with their policy rate, they have the option to turn to other tools of monetary policy. How do these other monetary tools work? How might experience with these tools in response to the financial crisis of 20072009 and the 2020 COVID pandemic influence the likelihood of policymakers employing these tools? (LO2) Answer: Forward guidance, quantitative easing and targeted asset purchases are examples of these other tools. Forward guidance, where the central bank expresses the intent to keep interest rates low in the future, can influence long-term interest rates if it is credible. A policy of targeted asset purchases involves buying different assets than usual, such as longer-term Treasury bonds and mortgage-backed securities issued by government agencies, thereby altering the composition of the central bank’s balance sheet. Quantitative easing involves open-market purchases and lending that increase bank reserves beyond the level necessary to keep the policy rate at its target (typically near zero), expanding the size of the central bank’s balance sheet. Since policymakers have employed these tools in response to the two recent crises, it makes them more likely to do so in the future. Indeed, these tools that were once considered ―unconventional‖ have now become part of the standard toolkit. At the same time, there remains greater uncertainty surrounding their impact compared with interest rate tools. In addition, exiting can be difficult: for example, to maintain credibility, a central bank may feel obliged to sustain an earlier forward guidance commitment even when conditions no longer warrant doing so. In addition, in the case of targeted asset purchases, the central bank may suffer losses when it wishes to sell relatively illiquid assets. Large losses can foster the appearance that a central bank is more reliant on the government, potentially diminishing its credibility.

6. The government decides to place limits on the interest rates banks can pay their depositors. Seeing that alternative investments pay higher interest rates, depositors withdraw their funds from banks and place them in bonds. Will their action have an impact on the economy? If so, how? (LO1) Answer: If depositors withdraw their funds, banks will be forced to shrink the size of their balance sheets so the supply of loans will fall, with a special effect on small firms and households that cannot issue debt in the securities markets (the ―banking channel‖). However, the increase in the demand for bonds would drive their yields down, making it cheaper for larger firms to borrow. U.S. experience suggests that the net result of these two effects would be to limit investment.

7. New developments in information technology have simplified the assessment of individual borrowers’ creditworthiness. What are the likely consequences for the structure of the financial system? For monetary policy? (LO2) Answer: Innovations in information and finance have greatly increased the number of places borrowers can get funds beyond just banks. This means that the link between the amount of reserves in the banking system and the supply of loans is no longer as strong as it once was, weakening this channel of monetary policy transmission.

8. * Describe the theory of the exchange rate channel of the monetary transmission mechanism. How, through the exchange rate, does an interest rate increase influence output? Why is this link difficult to find in practice? (LO1) Answer: A rise in nominal interest rates will lead to a rise in real interest rates in the face of price stickiness. This makes domestic investments more attractive to foreign investors, leading to an increase in demand for domestic currency and an appreciation of the exchange rate. This appreciation makes exports more expensive for foreigners and imports less expensive for domestic consumers and so net exports fall, leading to a fall in output. In practice, there are many factors that affect the demand and supply for domestic currency, making it difficult to isolate the impact of monetary policy changes on the exchange rate and net exports.

9. Why might the effective lower bound on nominal interest rates lead policymakers to raise their inflation target? (LO2) Answer: Nominal interest rates cannot fall significantly below zero. If an economy experiences a deflationary shock when the nominal interest rate is zero, policymakers may have no way to restore their inflation target without using unconventional policy tools. Because of the dangers of a deflationary spiral, policymakers may feel safer with somewhat higher actual and expected inflation rates.

10. Considering the role of the U.S. house price bubble in the financial crisis of 2007–2009, how do you think monetary policymakers should respond to bubbles in asset markets? (LO2) Answer: Sharp changes in asset prices can be very damaging to the economy, creating large swings in consumption through wealth effects, facilitating booms and busts in investment and damaging the balance sheets of financial institutions. While monetary policymakers may wish to act to avoid or contain such bubbles, there is disagreement as to what they should (and indeed can) do. A major problem is that it is difficult to identify bubbles as they are emerging and so policymakers may not be in a position to act. Even if policymakers could identify an emerging bubble, you might argue that the interest rate is not the appropriate policy tool to use, because the extent to which rates would have to increase could be devastating to the economy. Macroprudential regulatory policy—such as rules linking capital requirements to the business cycle—might be more appropriate to deal with asset price bubbles.

11. For each of the following, explain whether the response is theoretically consistent with a tightening of monetary policy and identify which traditional channel of monetary policy is at work: (LO1) a. Firms become more likely to undertake investment projects. b. Households become less likely to purchase refrigerators and washing machines. c. Net exports fall. Answer:

a. This is not consistent with a tightening of monetary policy, which would make firms less likely to undertake investment projects through the interest-rate channel. b. This is consistent with a tightening of monetary policy. In the face of higher interest rates, households become less likely to borrow to purchase consumer durables such as refrigerators and washing machines. This effect works through the interest-rate channel. c. This is consistent with a tightening of monetary policy. When interest rates rise, there is an increase in investor demand for U.S. assets, leading to an appreciation of the dollar. This would increase demand for imports and reduce demand for exports, causing a fall in net exports through the exchange-rate channel.

12. In Country A suppose that changes in short-term interest rates translate quickly into changes in long-term interest rates, while in Country B long-term interest rates do not respond much to changes in short-term rates. In which country would you expect the interest rate channel of monetary policy to be stronger? Explain your answer. (LO1) Answer: Households’ decisions to buy cars and houses and firms’ decisions to engage in long-run investment projects generally depend on longer-term interest rates, so the interestrate channel is likely to be stronger in Country A.

13. Consider a situation where central bank officials repeatedly express concern that output exceeds potential output, implying that the economy is overheating. Although they haven’t implemented any policy moves as yet, the data show that consumption of luxury goods has begun to slow. Explain how this behavior could reflect the asset-price channel of monetary policy at work. (LO1) Answer: Policymakers expressing concern about the economy overheating may lead to expectations of future increases in interest rates. Stock prices may fall in anticipation of a rise in interest rates leading to a fall in consumer wealth and demand for luxury goods.

14. Do you think the balance sheet channel of monetary policy would be stronger or weaker if: (LO1) a. Firms’ balance sheets in general are very healthy? b. Firms have a lot of existing variable-rate debt? Answer: a. The balance-sheet channel is likely to be weaker if firms generally have high net worth and are not borderline in terms of being considered creditworthy. b. The balance-sheet channel is likely to be stronger if firms have high levels of existing variable-rate debt, as changes in monetary policy could significantly impact their net worth.

15. In the wake of the financial crisis of 2007–2009, would you expect the bank-lending channel to have become more or less important in the United States? Explain your answer. (LO2)

Answer: The financial crisis interrupted the trend toward securities market finance, reinforcing the importance of bank lending and the bank-lending channel. For example, even a decade after the crisis, the volume of asset-backed commercial paper was only a fifth of what it was at the onset of the crisis.

16. *Suppose there is an unexpected slowdown in the rate of productivity growth in the economy so that forecasters consistently overestimate the growth rate of GDP. If the central bank bases its policy decisions on the consensus forecast, what would be the likely consequences for inflation assuming it maintains its existing inflation target? (LO2) Answer: Suppose, for example, the consensus forecast was for positive productivity growth so that the long-run aggregate supply curve would be expected to shift to the right while actual productivity growth was zero, resulting in no change to the position of the LRAS curve. Thinking the LRAS curve was shifting to the right, the central bank’s appropriate policy response to maintain the existing inflation target would be to shift the dynamic aggregate demand curve to the right. But given that the LRAS is not really shifting to the right, the central bank's action would lead to increased inflation in the short run.

17. Suppose the policy interest rate controlled by the central bank and the inflation rate were both zero. Explain in terms of the aggregate demand–aggregate supply framework how the economy could fall into a deflationary spiral if it were hit by a negative aggregate demand shock. (LO2) Answer: A negative aggregate demand shock shifts the aggregate demand curve to the left, leading in the short run to output falling below potential output. In the absence of a policy response, this will eventually put downward pressure on prices. Starting with a situation where the nominal interest rate and the inflation rate are both zero, there cannot be a conventional monetary policy response to the shock as nominal interest rates cannot fall below zero. The subsequent fall in prices leads to deflation when we start from a position of zero inflation. Through the Fisher equation (i = r + пe), we can see that a fall in inflation expectations with the nominal interest rate at zero leads to a rise in the real interest rate. This reduces investment and consumption, pushing output further below its potential level. This, in turn, causes further deflation and further increases the real interest rate—a deflationary spiral. In these circumstances, a central bank focused on stabilizing inflation may wish to use unconventional monetary policy tools to counter the initial demand shock.

18. *Use the aggregate demand–aggregate supply framework to show how a boom in equity prices might affect inflation and output in the short run. Describe the long-run impact on inflation and output: (a) if the central bank implicitly allows its inflation target to rise and (b) if it retains its original inflation target. (LO2) Answer: The boom in equity prices would increase consumer wealth, boosting consumption. It would make financing cheaper for firms, boosting investment. The dynamic aggregate demand curve would shift to the right. In the short run (point B), inflation and output would both rise.

If the central bank does not take offsetting action to counter the demand curve shift, it is implicitly raising its inflation target. In this case, the SRAS curve would shift to the left until long-run equilibrium is restored (point C) at the original Y* but at a higher level of inflation. If the central bank maintained its original inflation target, monetary policy would tighten sufficiently to offset the initial shift in aggregate demand to AD’, returning the aggregate demand curve to its initial position. Output and inflation would both return to their initial values. SRAS’

LRAS

Inflation

SRAS C B πT

AD’ AD Y*

Output

19. Compare the impact of a given change in monetary policy in two economies that are similar in every way except that in Economy A the financial system has a large shadow banking system providing many alternatives to bank financing, while in Economy B bank loans account for almost all of the financing in the economy. (LO1) Answer: Given the reliance on bank loans in Economy B, the bank-lending channel would be stronger than in Economy A, leading to a larger shift in the dynamic aggregate demand curve in Economy B for a given change in monetary policy.

20. If the anemic growth experienced in the U.S. economy since the financial crisis primarily reflects slower growth of the labor force and slowing technological innovation, can monetary policy be used to address the problem? (LO2) Answer: No. For the most part, these factors (which influence aggregate supply) are not driven by aggregate demand. In the context of the AD/AS model, monetary policy can shift the dynamic aggregate demand curve, but not long-run aggregate supply, which reflects changes in potential output.

21. In which of the following economies do you think the bank lending channel would play a more important role, everything else being equal: an economy dominated by large, financially sophisticated firms, or an economy consisting of a large number of small firms. Explain your choice. (LO1) Answer: The bank lending channel is likely to play a more important role in b). The reason is that small firms are more bank dependent than larger firms, which also have the option to obtain funds in capital markets.

22. How might the concept of GDP at Risk help central banks pursue a financial stability objective? (LO2) Answer: GDP at Risk allows policymakers to take account of very bad, low-probability events. For example, quantifying it can provide central bankers with a way to anticipate the impact of their monetary policy decisions on financial stability. Policymakers can then assess the tradeoffs that may arise between securing stability in the short run and over a longer timeframe.

23. Recent financial regulatory reforms have eased capital requirements for banks. Under what circumstances might lowering capital requirements affect economic growth? (LO1) Answer: If capital requirements were constraining banks’ ability to lend to good quality borrowers, reducing these requirements could bolster bank lending, which in turn could support stronger economic activity. Alternatively, lowering capital requirements could raise the probability of a future financial crisis, diminishing average growth over the longer run.

Data Exploration 1. In conducting monetary policy, the European Central Bank (ECB) must balance the needs of euro-area countries with differing economic conditions. Plot since 1990 the yield spread between government bonds in Italy (FRED code: INTGSBITM193N) and Germany (FRED code: INTGSBDEM193N), along with the yield spread between government bonds in Spain (FRED code: INTGSBESM193N) and Germany. Discuss the yield spreads after 2008 and explain how they reflect policy challenges for the ECB. (LO2) After publication, the index codes were changed. The replacement problem and solution are presented here. The next printing of the book will feature this replacement. In conducting monetary policy, the European Central Bank (ECB) must balance the needs of euro-area countries with differing economic conditions. Plot from 1991 the yield spread between government bonds in Italy (FRED code: IRLTLT01ITM156N) and Germany (FRED code: IRLTLT01DEM156N), along with the yield spread between government bonds in Spain (FRED code: IRLTLT01ESM156N) and Germany. Discuss the yield spreads after 2008 and explain how they reflect policy challenges for the ECB. (LO2) Answer: The data are plotted below. Prior to the euro-area financial crisis, the yields on government bonds were nearly identical across the countries of the euro area. During the crisis, however, concerns emerged about the risks of default on the part of some governments (including Greece, Ireland, Italy, Portugal, and Spain) and about the solvency of their banking systems as their economies declined. In these countries, even as the ECB policy rate declined, bank lending rates to private borrowers remained relatively high (despite much lower central bank lending rates), reflecting both the banks’ incapacity to lend and the deteriorating creditworthiness of the borrowers. As the crisis intensified, fears also arose that some countries might depart from the euro area and re-introduce their own currencies to repay their euro-denominated debt in a currency of lesser value (―redenomination risk‖). In contrast, investors and depositors viewed Germany as a safe

haven; the resulting inflow of capital and bank deposits to Germany (and out of the sagging economies on the euro area’s geographic periphery) lowered its cost of funding, helping to widen the economic divergence across the euro area. While the yield spread have narrowed sharply since the peak of the crisis, the yield spreads for Spain and especially Italy remain elevated compared with the pre-crisis era, continuing to reflect some of the concerns noted above. The challenge for the ECB is to maintain price stability while designing a policy that addresses the diverging economic and financial conditions in both weak and strong economies and limits the threat to the euro as a viable currency. It is unclear that any central bank can achieve such multiple, conflicting goals without a high level of cooperation from fiscal authorities.

International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Italy [IRLTLT01ITM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01ITM156N. International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Germany [IRLTLT01DEM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01DEM156N. International Monetary Fund, Interest Rates, Government Securities, Government Bonds for Spain [IRLTLT01ESM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01ESM156N.

2. How important is the balance sheet channel of monetary policy? Plot since 1996 the net tightening of credit standards for consumer and credit card loans (FRED code: DRTSCLCC) and (on the right scale) household net worth (FRED code: TNWBSHNO). Do banks adjust lending conditions when household balance sheets improve or deteriorate? (LO1) Answer: Prior to the onset of the financial crisis of 2007-2009, rising net worth generally was associated with a loosening of lending standards. From the lender’s perspective, higher net worth means that a borrower is more creditworthy and that borrowing to increase spending is less risky. However, much of the increase in household net worth in the 2000s was due to the housing price surge. When housing prices began to decline, banks

dramatically tightened their lending standards on consumer loans and credit cards. Once wealth began rising again after the crisis, loan standards began to ease from a very restrictive level. Note that at the outset of the pandemic of 2020, as the unemployment rate rose dramatically to over 14 percent, household balance sheets were deteriorating, and lending standards tightened notably. However, these standards eased dramatically as the economy began a rapid recovery in 2020, and government support helped restore healthy household balance sheets. Beginning in 2022, lending standards tightened again as the Fed raised interest rates sharply to lower inflation from a 40-year high.

3. Among the challenges facing central banks around the world is the elevated level of public debt. Plot U.S. federal debt held by the public as a percent of gross domestic product (FRED code: FYPUGDA188S) and discuss the problems that government debt could pose for the Federal Reserve in the future. (LO2) Answer: The data are plotted below. The key issue is whether the Federal Reserve will come under political pressure to monetize the debt. As an independent central bank, the Fed can resist this pressure up to a point, but Congress and the President together can modify the Fed’s charter. Bowing to political pressure would harm the Fed’s credibility and undermine its ability to keep inflation and inflation expectations low and stable. As of mid-2024, inflation remains above the Fed’s target of 2% but inflation expectations appear reasonably well-anchored. However, many analysts are warning about the rapid increase in federal debt, which (in the absence of a clear change in fiscal policy) is poised to set a new record (relative to GDP) in coming years. Separately, the long-term real interest rate, which is determined by economic fundamentals rather than by the Federal Reserve, is unusually low both in the United States and around the world. A sustained rise in the public debt ratio eventually would be expected to put upward pressure on the long-term real interest rate, exacerbating the need for fiscal consolidation.

Some critics argue that the Federal Reserve stoked the housing price bubble after 2000 by keeping monetary policy too stimulative. To investigate, first plot from 2000 to 2007 on a quarterly basis the Taylor rule gap—the difference between the Taylor rule (as described in Chapter 18, Data Exploration Problem 1) and the federal funds rate. Add to this plot on the right scale an index of U.S. housing prices (FRED code: SPCS20RSA). Does the evidence support the critics’ claim? What other evidence might be sought? (LO1) Answer: The data, plotted below, shows that U.S. urban housing prices more than doubled in this period. It also shows that the FOMC set the federal funds rate well below the Taylor Rule after 2002 for several years. This accommodative monetary policy lowered mortgage interest rates – through the term structure of interest rates – contributing to housing demand. However, note that housing prices had begun to rise earlier in the decade even when the federal funds rate was reasonably close to the Taylor rule prescription. In short, this evidence is consistent with the view that Fed policy contributed to the housing price bubble but does not show that monetary policy is solely or primarily responsible for the bubble.

S&P Dow Jones Indices LLC, S&P/Case-Shiller 20-City Composite Home Price Index [SPCS20RSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SPCS20RSA.

5. Prior to the crisis, neither policymakers nor investors anticipated the impact of falling housing prices on the U.S. financial system. To see whether similar risks exist today, plot since 1990 U.S. real housing prices: namely, the Case-Shiller U.S. National Home Price index divided by the level of consumer prices (FRED code: CSUSHPISA and CPIAUCSL). Discuss the result and explain why housing matters so much for the financial system. (LO2) Answer: The data are plotted as follows:

S&P Dow Jones Indices LLC, S&P/Case-Shiller U.S. National Home Price Index [CSUSHPISA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CSUSHPISA.

As occurred in advance of the financial crisis of 2007-2009, over the past decade real housing prices have again risen sharply, especially in the immediate aftermath of the 2020 COVID pandemic when the real housing price reached a new high. At this elevated level, a recession that raised unemployment significantly would pose a risk of falling house prices and weakening household balance sheets. In a severe recession, financial institutions could again end up with delinquent mortgages, with the deterioration of their own balance sheets in turn lowering their ability to extend credit to qualified borrowers. Such a decline in credit intermediation likely would have further adverse consequences for the economy, compounding the downturn. 6. Many observers feared that the runs on midsized banks in March 2023 would soon lead to a recession. Through what mechanism(s) might that occur? To assess the impact of the banking panic on credit supply, plot the net percentage of domestic banks that tightened lending standards (FRED code: DRTSCILM). How did credit tightening in 2023 compare to prior episodes associated with the financial crisis of 2007–2009 and the COVID pandemic of 2020? Do the 2023 recession fears seem warranted? (LO2) Answer: The data are plotted as follows:

The transmission mechanism that many observers feared was through a reduced willingness of banks to supply credit to healthy borrowers. The idea was that the run on the mid-sized banks would compel them to constrain lending even to healthy borrowers. The Fed’s quarterly survey of bank lending practices showed that similar periods of restraint occurred in each of the four prior recessions (1990, 2001, 2007-09, and 2020). As it turned out, however, the midsized banking panic of 2023 did not lead to recession. First, some of the deposits that fled mid-sized banks flowed to large banks that were still viewed as safe (either because of their profitability or due to a too-big-to-fail perception), allowing them to continue lending. The economy’s resilience probably also reflected the ability of many profitable firms to finance their own investment needs, or to obtain funding from financial markets and nonbanks. This example highlights the complexity of the economy, which can respond flexibly to banking sector shocks in part because of the numerous options that profitable firms have to finance investment.

* indicates more difficult problems

Regulationofmetabolicpathwaysthroughenzymeactivityandgeneexpression.**EnergyEfficiencyandConservation**:DiscussionontheefficiencyofATPproductionthroughaerobicrespirationcomparedtoanaer obicpathways.Energyconservationstrategiesinbiologicalsystems.**EmergingTopicsinCellularEnergy**:Introductiontocurrentresearchtopicsandadvancementsincellularenergymetabolism,suchasmetaboli cdisorders,metabolicengineering,andbiofuels.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtoenergyforcells,reinforcingunderstandingoftheprinciplesgovernin genergyacquisition,utilization,andregulationinbiologicalsystems.Chapter7providesacomprehensiveexplorationofcellularenergyprocesses,highlightingtheinterconnectedpathwaysandregulatorymechanis msthatallowcellstomaintainlifeandrespondtotheirenvironment.Itbuildsuponfoundationalknowledgeofenergymetabolismandpreparesstudentsforfurtherexplorationintophysiologicalmechanisms,genetics,a ndecologicalinteractionscoveredinsubsequentchaptersofthetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter7,feelfreetoask! Chapter8:CellularReproductionChapter8of"EssentialsofBiology"bySylviaMaderandMichaelWindelspecht,titled"CellularReproduction,"typicallyfocusesontheprocessesofcelldivisionandreproduction. Here’sanoverviewofwhatyoumightfindinthischapter:**IntroductiontoCellularReproduction**:Definitionofcellularreproductionastheprocessbywhichcellsdivideandreproduce,essentialforgrowth,repair,an dmaintenanceofmulticellularorganisms.**TheCellCycle**:Detailedexplorationofthecellcycle,includingitsphases:**Interphase**:G1phase(cellgrowth),Sphase(DNAreplication),G2phase(preparationford ivision).**MitoticPhase**:Mitosis(nucleardivision)andcytokinesis(divisionofthecytoplasm).**RegulationoftheCellCycle**:Mechanismsandcheckpointsthatregulatethecellcycle,ensuringaccurateDNAre plication,mitosis,andpropercelldivision.**Mitosis**:Step-bystepexplanationofmitosis,includingprophase,metaphase,anaphase,andtelophase.Roleofmicrotubules,spindlefibers,andcentriolesinchromosomesegregationandnucleardivision.**Meiosis**:Overviewofme iosisasaspecializedformofcelldivisionthatproducesgametes(spermandeggs)withhalfthechromosomenumberoftheparentcell.ComparisonofmeiosisIandmeiosisII.**SexualandAsexualReproduction**:Comp arisonofsexualreproduction(involvinggametesandgeneticrecombination)andasexualreproduction(e.g.,binaryfission,budding).Advantagesanddisadvantagesofeachreproductivestrategy.**CellCycleRegul ationandCancer**:Explanationofhowdisruptionsincellcycleregulationcanleadtocancerousgrowth.Causesofcancer(mutations,environmentalfactors)andstrategiesforcancerpreventionandtreatment.**Regul ationofCellDivision**:Discussionontheroleofregulatoryproteins(cyclins,cyclindependentkinases)incontrollingthetimingandprogressionofthecellcycle.**StemCellsandDifferentiation**:Introductiontostemcells,theirproperties(pluripotent,multipotent)androlesindevelopment,tissuerep air,andregenerativemedicine.**CellularSenescenceandAging**:Overviewofcellularsenescence,telomeres,andtheirroleinagingandagerelateddiseases.Relationshipbetweencellularreproductionandlongevity.**EmergingTopicsinCellularReproduction**:Introductiontocurrentresearchtopicsandadvancementsincellularreproduction,suchasre productivecloning,inducedpluripotentstemcells,andregenerativemedicine.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtocellularreproduction,reinforcingund erstandingoftheprocessesandsignificanceofcelldivisioninbiologicalsystems.Chapter8providesacomprehensiveexplorationofcellularreproduction,highlightingthemechanismsandregulationofcelldivision,th eimportanceofgeneticdiversitythroughsexualreproduction,andtheimplicationsofcellcycleabnormalitiesinhealthanddisease.Itbuildsuponfoundationalknowledgeofcellstructureandmetabolismandpreparesst udentsforfurtherexplorationintogenetics,developmentalbiology,andphysiologicalmechanismscoveredinsubsequentchaptersofthetextbook.Ifyouhavespecificquestionsaboutanyofthesetopicsorwouldlikem oredetailedinformationonaparticularaspectofChapter8,feelfreetoask!Chapter9:MeiosisandtheGeneticBasisofSexualReproductionChapter9of"EssentialsofBiology"bySylviaMaderandMichaelWinde lspecht,titled"MeiosisandtheGeneticBasisofSexualReproduction,"typicallyfocusesontheprocessesofmeiosis,geneticvariation,andtherolestheseplayinsexualreproduction.Here’sanoverviewofwhatyoumig htfindinthischapter:**IntroductiontoMeiosis**:Definitionofmeiosisasaspecializedtypeofcelldivisionthatproduceshaploidgametes(spermandeggs)fromdiploidgermcells.**PurposeofMeiosis**:Explanatio nofthebiologicalsignificanceofmeiosisinsexualreproduction,includingthegenerationofgeneticdiversityandthereductionofchromosomenumber.**ComparisonofMeiosisandMitosis**:Contrastbetweenmitosi sandmeiosisintermsof:Numberofdivisions(oneinmitosis,twoinmeiosis).Productionofdaughtercells(geneticallyidenticalinmitosis,geneticallyvariableinmeiosis).Roleinmulticellularorganisms(growthandrep airinmitosis,gameteproductioninmeiosis).**PhasesofMeiosis**:Detailedexplanationofthestagesofmeiosis:**MeiosisI**:ProphaseI(crossingoverandsynapsis),metaphaseI,anaphaseI,telophaseI.**MeiosisII **:Similartomitosisbutwithhaploidcells.**GeneticVariationandCrossingOver**:Mechanismsthatcontributetogeneticdiversityduringmeiosis,includingcrossingover(exchangeofgeneticmaterialbetweenho mologouschromosomes)andindependentassortmentofchromosomes.**FertilizationandGeneticDiversity**:Howfertilizationcombinesgeneticmaterialfromtwoparentstogenerateuniquegeneticcombination sinoffspring.**MendelianGeneticsandMeiosis**:IntegrationofMendelianprinciples(lawsofsegregationandindependentassortment)withmeioticprocessestoexplaininheritancepatterns.**SexChromosomes andSexDetermination**:Explanationofsexdeterminationsystems,includingXX/XY(mammals),ZZ/ZW(birds,somereptiles),andenvironmentalfactors(temperaturedependentsexdetermination).**GeneticDisordersandChromosomalAbnormalities**:Overviewofgeneticdisorderscausedbyerrorsinmeiosis,suchasnondisjunction(failureofchromosomestoseparateproperly ),trisomies(e.g.,Downsyndrome),andmonosomies.**HumanReproductionandGametogenesis**:Overviewofhumanreproductiveanatomy,gameteproduction(spermatogenesisandoogenesis),andtherolesofh ormones(e.g.,testosterone,estrogen)inreproductivedevelopment.**EmergingTopicsinMeiosisandReproduction**:Introductiontocurrentresearchtopicsandadvancementsinmeiosis,reproductivetechnologies (e.g.,invitrofertilization,geneediting),andethicalconsiderations.**SummaryandKeyConcepts**:Thechapterconcludeswithasummaryofkeyconceptsrelatedtomeiosisandthegeneticbasisofsexualreproductio n,reinforcingunderstandingoftheprocessesthatunderpingeneticdiversityandinheritance.Chapter9providesacomprehensiveexplorationofmeiosis,geneticvariation,andthegeneticbasisofsexualreproduction.It buildsuponfoundationalknowledgeofcelldivision(coveredinChapter8)andpreparesstudentsforfurtherexplorationintogenetics,developmentalbiology,andevolutionaryprocessescoveredinsubsequentchapter softhetextbook.IfyouhavespecificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter9,feelfreetoask!Chapter10Chapter10typicallycovers"PatternsofInherit ance"inbiologyorgenetics.Here'sageneraloverviewofwhatthischapteroftenincludes:**MendelianGenetics**:ItstartswiththebasicprinciplesofinheritanceasdiscoveredbyGregorMendel,suchasdominantandr ecessivealleles,andthelawsofsegregationandindependentassortment.**ExtensionsofMendelianGenetics**:**IncompleteDominance**:Whereneitheralleleiscompletelydominant.**Codominance**:Wher ebothallelescontributetothephenotype.**MultipleAlleles**:Genesthathavemorethantwoalleles.**PolygenicInheritance**:Traitsinfluencedbymultiplegenes.**SexlinkedInheritance**:Inheritancepatternswheregenesarelocatedonthesexchromosomes(XandYchromosomes).**PedigreeAnalysis**:Howtointerpretfamilytreestodeducepatternsofinheritanceandpredictpr obabilitiesofgenetictraitsinoffspring.**NonMendelianInheritance**:IncludesexceptionstoMendel'slawssuchasepistasis(interactionbetweengenes)andenvironmentalinfluencesongeneexpression.**GeneticDisorders**:Examplesofgeneticdiseasesan ddisorders,andhowtheyareinherited.**GeneticCounseling**:theroleofgeneticcounselorsinhelpingindividualsandfamiliesunderstandandcopewithgeneticdisordersandriskfactors.Thischapteriscrucialinunde rstandinghowtraitsarepassedfromonegenerationtothenextandthecomplexitiesinvolvedingeneticinheritancebeyondthesimpledominantandrecessivetraitsinitiallydescribedbyMendel.Chapter11of"Essentials ofBiology"bySylviaMaderandMichaelWindelspecht,titled"TheInstructionsforLife:DNAandRNA,"typicallyexploresthemolecularbasisofgeneticinformationstorageandexpression.Here’sanoverviewofwh atyoumightfindinthischapter:**IntroductiontoDNAandRNA**:DefinitionofDNA(deoxyribonucleicacid)andRNA(ribonucleicacid)asnucleicacidsthatstoreandtransmitgeneticinformationinlivingorganism s.**StructureofDNA**:DetailedexaminationofthedoublehelixstructureofDNA,including:**Nucleotides**:CompositionofDNAnucleotides(adenine,thymine,cytosine,guanine)andtheircomplementarybase pairing.**SugarPhosphateBackbone**:Phosphodiesterbondslinkingnucleotides.**AntiparallelStrands**:OrientationofDNAstrandsinoppositedirections.**DNAReplication**:OverviewoftheprocessbywhichDNAmakesc opiesofitselfbeforecelldivision:**Enzymes**:Roleofenzymes(e.g.,DNApolymerase,helicase)inunwindingandreplicatingDNAstrands.**SemiconservativeReplication**:PreservationofoneoriginalDNAstrandineachnewdoublehelix.**RNAStructureandFunction**:ComparisonofRNAwithDNAintermsofstructureandfunction:**TypesofRNA**:m RNA(messengerRNA),tRNA(transferRNA),rRNA(ribosomalRNA),andtheirrolesinproteinsynthesis.**Transcription**:ProcessofsynthesizingmRNAfromaDNAtemplate(geneexpression).**GeneticCod eandProteinSynthesis**:Explanationofthegeneticcodeasthecorrespondencebetweennucleotidetriplets(codons)andaminoacids.Stepsinproteinsynthesis:**Transcription**:SynthesisofmRNAfromDNA.**T ranslation**:ConversionofmRNAsequenceintoaspecificsequenceofaminoacidsinaprotein.**RegulationofGeneExpression**:Mechanismsbywhichcellscontrolwhenandhowgenesareturnedonoroff,includin g:**PromotersandEnhancers**:DNAsequencesthatregulatetranscription.**TranscriptionFactors**:Proteinsthatbindtoregulatorysequencestocontrolgeneexpression.**EpigeneticModifications**:Changes ingeneexpressionwithoutalteringDNAsequence(e.g.,DNAmethylation,histonemodification).**MutationsandGeneticVariation**:Typesofmutations(e.g.,pointmutations,insertions,deletions)andtheireffect sonDNAsequenceandproteinfunction.Roleofmutationsinevolutionandgeneticdiversity.**DNATechnologyandGeneticEngineering**:ApplicationsofDNAtechnology,includingpolymerasechainreaction(P CR),genecloning,geneticmodificationoforganisms(GMOs),andgenetherapy.**GenomicsandPersonalizedMedicine**:Introductiontogenomicsasthestudyofwholegenomesanditsapplicationsinunderstandin gdiseases,predictingrisks,anddevelopingpersonalizedtreatments.**EmergingTopicsinDNAandRNA**:IntroductiontocurrentresearchtopicsandadvancementsinDNAandRNAresearch,suchasCRISPRCas9genomeediting,RNAinterference(RNAi),andsyntheticbiology.**SummaryandKeyConcepts**:ThechapterconcludeswithasummaryofkeyconceptsrelatedtoDNAandRNA,reinforcingunderstandingof themolecularbasisofgeneticinformationanditsexpression.Chapter11providesacomprehensiveexplorationofthemolecularmechanismsunderlyinggeneticinformationstorage,transmission,andexpression.Itbu ildsuponfoundationalknowledgeofcellularprocessesandpreparesstudentsforfurtherexplorationintomoleculargenetics,genomics,andbiotechnologycoveredinsubsequentchaptersofthetextbook.Ifyouhavespe cificquestionsaboutanyofthesetopicsorwouldlikemoredetailedinformationonaparticularaspectofChapter11,feelfreetoask!Chapter12Chapter12:BiotechnologyandGenomicsChapter12of"EssentialsofBi ology"bySylviaMaderandMichaelWindelspecht,titled"BiotechnologyandGenomics,"typicallydelvesintotheapplicationsandimplicationsofbiotechnologyinmodernbiology,withafocusongenomics.Here’sa noverviewofwhatyoumightfindinthischapter:**IntroductiontoBiotechnology**:Definitionofbiotechnologyastheuseofbiologicalsystems,organisms,orprocessestodevelopproductsorapplicationsforvariousp urposes.**ToolsofBiotechnology**:Overviewofkeytoolsandtechniquesusedinbiotechnology,including:**RecombinantDNATechnology**:TechniquesformanipulatingDNA,suchasgenecloning,PCR(Pol ymeraseChainReaction),andgeneediting(e.g.,CRISPRCas9).**DNASequencing**:MethodsfordeterminingthepreciseorderofnucleotidesinaDNAmolecule.**GenomicLibraries**:CollectionsofclonedDNAfragmentsrepresentinganorganism'sentiregenome.** ApplicationsofBiotechnology**:Explorationofpracticalapplicationsofbiotechnologyinvariousfields:**Medicine**:Genetherapy,personalizedmedicine,productionoftherapeuticproteins(e.g.,insulin).**Agr iculture**:Geneticallymodifiedorganisms(GMOs),cropimprovement,pestresistance.**Industry**:Bioremediation,biofuels,enzymeproduction.**Forensics**:DNAfingerprinting,forensicanalysis.**Geno micsandHumanHealth**:Introductiontogenomicsasthestudyofwholegenomes,including:

tomacroevolution, reinforcing understandingofthepatterns, processes, and implicationsofevolution at broader scales.Chapter 16 providesacomprehensive explorationofmacroevolutionary processes, including speciation, evolutionary trends, biogeography, and theintegrationofevolutionary biology with ecology and developmental biology. It builds upon foundational knowledgeofgenetics and microevolution, preparing students forfurther exploration into paleontology, evolutionary ecology, and interdisciplinary studiesinevolutionary biology coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 16, feel free toask!Chapter 17Chapter 17of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Viruses, Bacteria, and Protists," typically covers thediversity, structure, functions, and ecological rolesofthese microorganisms. Here’s an overviewofwhat you might findinthis chapter:**Introduction toMicroorganisms**:Definition and classificationofmicroorganisms as organisms that are too small tobe seen with thenaked eye, including viruses, bacteria, and protists.**Viruses**:Characteristicsofviruses:**Structure**: Viral components (nucleic acid core and protein coat).**Reproduction**: Viral replication using host cell machinery (lytic and lysogenic cycles).**RoleinDisease**: Viral infections and human health impacts.**Bacteria**:Overviewofbacterial diversity, structure, and functions:**Cell Structure**: Prokaryotic cell structure (cell wall, plasma membrane, cytoplasm, genetic material).**Metabolism**: Modesofnutrition (autotrophs vs. heterotrophs), oxygen requirements (aerobic vs. anaerobic).**Reproduction**: Binary fission and genetic recombination (transformation, conjugation, transduction).**Bacterial Diversity and Ecology**:Ecological rolesofbacteria:**Nutrient Cycling**: Decomposition and recyclingoforganic matter.**Symbiotic Relationships**: Mutualism, commensalism, and parasitism.**Pathogenic Bacteria**: Causesofbacterial diseases and mechanismsofinfection.**Protists**:Diversityofprotists:**Classification**: Protozoa (single-celled heterotrophs) and algae (photosynthetic protists).**Structure**: Protozoan and algal cell structures and adaptations.**Ecological Roles**: Rolesinaquatic ecosystems, symbiotic relationships (e.g., coral- algal symbiosis).**Life Cycles and ReproductionofProtists**:Reproductive strategies among protists:**Asexual Reproduction**: Binary fission, budding, and spore formation.**Sexual Reproduction**: Conjugation and other formsofgenetic exchange.**Ecological ImportanceofProtists**:Contributionofprotists toecosystems:**Primary Production**: Roleofphotosynthetic protistsinfood chains.**Symbiotic Relationships**: Protistsinmutualistic and parasitic interactions with other organisms.**Human Health and Disease**:Impactofmicroorganismsonhuman health:**Pathogenic Viruses and Bacteria**: Viral and bacterial diseases (e.g., influenza, tuberculosis).**Protozoan Diseases**: Malaria and other parasitic infections caused by protists.**Emerging Infectious Diseases**:Discussiononfactors contributing totheemergence and spreadofnew infectious diseases (e.g., zoonotic diseases, antibiotic resistance).**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related toviruses, bacteria, and protists, reinforcing understandingoftheir diversity, structures, functions, and ecological roles.Chapter 17 providesacomprehensive explorationofviruses, bacteria, and protists, highlighting their diversity, evolutionary relationships, ecological roles, and impactsonhuman health and ecosystems. It prepares students forfurther exploration into microbiology, infectious diseases, and environmental microbiology coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 17, feel free toask!Chapter 18: Plants and FungiChapter 18of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Plants and Fungi," typically covers thecharacteristics, diversity, adaptations, and ecological rolesofplants and fungi. Here’s an overviewofwhat you might findinthis chapter:**Introduction toPlants and Fungi**:Definition and classificationofplants and fungi as multicellular eukaryotic organisms with distinct characteristics and life cycles**Plant Diversity**:Overviewofplant diversity:**Non-Vascular Plants**: Characteristicsofmosses, liverworts, and hornworts.**Seedless Vascular Plants**: Characteristicsofferns and their relatives.**Seed Plants**: Gymnosperms (e.g., conifers) and angiosperms (flowering plants).**Plant Structure and Function**:Morphological and physiological adaptationsofplants:**Roots, Stems, and Leaves**: Functions and adaptations forabsorption, support, and photosynthesis.**Reproductive Structures**: Flowers, fruits, seeds, and pollen.**Plant Reproduction and Life Cycles**:Alternationofgenerationsinplants:**Gametophyte and Sporophyte**: Structures and functionsinthelife cyclesofmosses, ferns, gymnosperms, and angiosperms.**Pollination and Fertilization**: Mechanismsofpollen transfer and fertilizationinflowering plants.**Plant Physiology**:Physiological processesinplants:**Photosynthesis**: Light reactions and Calvin cycle.**Transport**: Water and nutrient uptake (xylem and phloem transport).**Hormonal Regulation**: Roleofplant hormonesingrowth, development, and responses toenvironmental stimuli.**EcologyofPlants**:Ecological roles and interactionsofplantsinecosystems:**Primary Production**: Roleofplants as primary producersinfood webs.**Plant-Animal Interactions**: Pollination, seed dispersal, and herbivory.**Plant Adaptations toEnvironmental Factors**: Adaptations tolight, water availability, temperature, and soil conditions.**Fungi Diversity**:Overviewoffungal diversity and classification:**Mycorrhizal Fungi**: Symbiotic relationships with plant roots.**Saprophytic Fungi**: Decomposition and nutrient recyclinginecosystems.**Pathogenic Fungi**: Fungal diseasesinplants and animals.**Fungal Structure and Function**:Morphological features and adaptationsoffungi:**Hyphae and Mycelium**: Structure and growth patterns.**Reproductive Structures**: Spores, sporangia, and fruiting bodies.**Fungal Reproduction and Life Cycles**:Modesofreproductioninfungi:**Asexual Reproduction**: Spore formation and budding.**Sexual Reproduction**: Fusionofhaploid hyphae, formationofdikaryotic and diploid stages.**Fungal Physiology**:Physiological processesinfungi:**Nutrient Absorption**: Extracellular digestion and absorptionofnutrients.**Mycorrhizal Associations**: Roleoffungiinnutrient uptake and exchange with plant roots.**Environmental Responses**: Fungal responses tolight, moisture, and pH levels.**EcologyofFungi**:Ecological roles and interactionsoffungiinecosystems:**Decomposition**: Roleinnutrient cycling and organic matter decomposition.**Symbiotic Relationships**: Mycorrhizal associations with plants, lichens (fungus-algae symbiosis).**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related toplants and fungi, reinforcing understandingoftheir diversity, structures, functions, and ecological roles.Chapter 18 providesacomprehensive explorationofplants and fungi, highlighting their structural diversity, physiological adaptations, reproductive strategies, and ecological interactions. It prepares students forfurther exploration into plant biology, mycology, ecology, and environmental sciences coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 18, feel free toask!Chapter 19Chapter 19of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Animals," typically covers thediversity, characteristics, adaptations, and ecological rolesofanimals. Here’s an overviewofwhat you might findinthis chapter:**Introduction toAnimals**:Definition and classificationofanimals as multicellular, heterotrophic organisms with diverse body plans and life cycles.**Animal Diversity**:Overviewofanimal diversity basedonmajor phyla:**Invertebrates**: Characteristics and examplesofmajor groups (e.g., sponges, cnidarians, mollusks, annelids, arthropods).**Vertebrates**: Characteristics and examplesofmajor groups (e.g., fish, amphibians, reptiles, birds, mammals).**Animal Form and Function**:Morphological and physiological adaptationsofanimals:**Body Plans**: Symmetry (radial vs. bilateral), segmentation, and cephalization.**Tissues and Organs**: Specialized structures and functions (e.g., nervous system, digestive system, circulatory system).**Skeletal Systems**: Endoskeletons, exoskeletons, and hydrostatic skeletons.**Animal Reproduction and Development**:Modesofreproductioninanimals:**Sexual Reproduction**: Internal and external fertilization, developmentofembryos.**Asexual Reproduction**: Regeneration, budding, and parthenogenesis.**Life Cycles**: Alternationofgenerations, metamorphosisininsects and amphibians.**Animal Behavior**:Behavioral adaptations and ecological interactions:**Feeding Behaviors**: Herbivores, carnivores, omnivores, and filter feeders.**Reproductive Behaviors**: Courtship rituals, mate selection, and parental care.**Social Behaviors**: Group behaviors, communication, and cooperation.**Animal Physiology**:Physiological processesinanimals:**Nutrition**: Digestive processes and nutrient absorption.**Respiration**: Respiratory structures and gas exchange mechanisms.**Circulation**: Circulatory systems and transportofgases, nutrients, and wastes.**Excretion**: Excretory organs and regulationofwater and electrolyte balance.**EcologyofAnimals**:Ecological roles and interactionsofanimalsinecosystems:**Predator-Prey Relationships**: Food webs and trophic interactions.**Symbiotic Relationships**: Mutualism, commensalism, and parasitism.**Migration and Movement**: Animal movements and their ecological significance.**Animal Adaptations toEnvironments**:Adaptations todiverse habitats and environmental conditions:**Desert Adaptations**: Water conservation and thermoregulation.**Aquatic Adaptations**: Marine and freshwater adaptations forbuoyancy, osmoregulation, and respiration.**Polar Adaptations**: Cold adaptation and insulation.**Human ImpactonAnimal Populations**:Impactofhuman activitiesonanimal populations and biodiversity:**Habitat Destruction**: Lossofhabitats and fragmentation.**Overexploitation**: Hunting, fishing, and wildlife trade.**Pollution and Climate Change**: Effectsonanimal habitats and ecosystems.**Conservation Biology**:Principles and practicesofconservation biology toprotect animal species and ecosystems:**Endangered Species**: Conservation strategies and restoration efforts.**Protected Areas**: National parks, reserves, and wildlife sanctuaries.**Sustainable Practices**: Sustainable development and habitat conservation.**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related toanimals, reinforcing understandingoftheir diversity, structures, functions, adaptations, and ecological roles.Chapter 19 providesacomprehensive explorationofanimals, highlighting their evolutionary diversity, physiological adaptations, behavioral strategies, and ecological interactions. It prepares students forfurther exploration into animal biology, ecology, behavior, and conservation sciences coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 19, feel free toask!Chapter 20Chapter 20of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Plant Anatomy and Growth," typically covers theinternal structure, tissues, growth processes, and adaptationsofplants. Here’s an overviewofwhat you might findinthis chapter:**Introduction toPlant Anatomy**:Overviewofplant anatomy as thestudyofinternal structures and tissuesofplants.**Plant Cells and Tissues**:Structure and functionsofplant cells and tissues:**Cell Types**: Parenchyma, collenchyma, sclerenchyma, xylem, phloem, epidermis, and guard cells.**Tissue Systems**: Dermal tissue, ground tissue, and vascular tissue.**Root Structure and Function**:Morphology and functionsofroots:**Root Anatomy**: Root hairs, root cap, cortex, and vascular cylinder (stele).**Functions**: Absorptionofwater and minerals, anchorage, and storage.**Stem Structure and Function**:Morphology and functionsofstems:**Stem Anatomy**: Epidermis, cortex, vascular bundles (xylem and phloem), and pith.**Functions**: Support, transportofwater and nutrients, and storage.**Leaf Structure and Function**:Morphology and functionsofleaves:**Leaf Anatomy**: Epidermis, mesophyll (palisade and spongy layers), stomata, and vascular bundles.**Functions**: Photosynthesis, gas exchange (transpiration and respiration), and storage.**Plant Growth and Development**:Processesofplant growth:**Meristems**: Apical, lateral (vascular and cork cambium), and intercalary meristems.**Primary Growth**: Lengtheningofroots and shoots.**Secondary Growth**: Thickeningofstems and roots due tovascular and cork cambium activity.**Plant Hormones**:Roleofplant hormonesingrowth and development:**Auxins**: Roleinapical dominance, phototropism, and root growth.**Gibberellins**: Stem elongation and seed germination.**Cytokinins**: Cell division and lateral bud growth.**Ethylene**: Fruit ripening and senescence.**Abscisic Acid**: Dormancy and stress responses.**Plant Responses toEnvironmental Stimuli**:Plant adaptations and responses toenvironmental factors:**Photoperiodism**: Flowering responses today length.**Tropisms**: Growth responses tolight (phototropism), gravity (gravitropism), and touch (thigmotropism).**Plant Movements**: Nastic movements and responses toenvironmental cues.**Plant Adaptations toEnvironmental Stress**:Adaptationsofplants toextreme environmental conditions:**Water Conservation**: Adaptationsindesert plants (e.g., succulence, CAM photosynthesis).**Cold and Heat Tolerance**: Adaptationsinpolar and desert plants.**Salt Tolerance**: Adaptationsinhalophytes.**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related toplant anatomy and growth, reinforcing understandingofplant structures, functions, growth processes, and adaptations.Chapter 20 providesacomprehensive explorationofplant anatomy and growth, highlighting thestructural diversity, physiological adaptations, and growth mechanisms that enable plants tothriveindiverse environments. It prepares students forfurther exploration into plant physiology, ecology, and agriculture coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 20, feel free toask!Chapter 21Chapter 21of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "Plant Responses and Reproduction," typically covers how plants respond toenvironmental stimuli and thevarious mechanismsofplant reproduction. Here’s an overviewofwhat you might findinthis chapter:**Plant Responses toEnvironmental Stimuli**:**Photoperiodism**: Plant responses today length, influencing flowering and other developmental processes.**Tropisms**: Directional growth responses toenvironmental stimuli:**Phototropism**: Growth towards or away from light.**Gravitropism**: Growth response togravity.**Thigmotropism**: Growth response totouch.**Plant Movements**: Nastic movementsinresponse toenvironmental cues (e.g., leaf movementsinMimosa pudica).**Plant Reproduction**:**Flowering Plants (Angiosperms)**:**Flower Structure**: Partsoftheflower (sepals, petals, stamens, carpels).**Pollination**: Transferofpollen from anther tostigma.**Fertilization**: Fusionofmale gamete (pollen) with female gamete (egg) toformazygote.**Seed Development**: Formationofseed from fertilized ovule.**Fruit Formation**: Developmentoffruit from mature ovary.**Seed Dispersal**: Mechanisms fordispersing seeds away from theparent plant (e.g., wind, water, animals).**Asexual ReproductioninPlants**:**Vegetative Propagation**: Asexual reproduction through plant parts (e.g., runners, bulbs, tubers).**Cloning**: Artificial methodsofasexual propagation (e.g., cuttings, tissue culture).**Plant Hormones and Growth Regulation**:**Auxins**: Roleinapical dominance, phototropism, and root growth.**Gibberellins**: Stem elongation and seed germination.**Cytokinins**: Cell division and lateral bud growth.**Ethylene**: Fruit ripening and senescence.**Abscisic Acid**: Dormancy and stress responses.**Plant Responses toStress**: Hormonal and physiological responses toenvironmental stresses (e.g., drought, salinity).**Plant Life Cycles and AlternationofGenerations**:**AlternationofGenerations**: Alternating between haploid (gametophyte) and diploid (sporophyte) generationsinplant life cycles.**Bryophytes**: Life cycleofmosses and liverworts.**Ferns and Seed Plants**: Life cycleofferns, gymnosperms, and angiosperms.**Reproductive StrategiesinNon-Flowering Plants**:**Seedless Plants**: Reproductioninferns and other seedless vascular plants.**Gymnosperms**: Life cycleofconifers and other gymnosperms.**Human ImpactonPlant Reproduction**:**Agricultural Practices**: Useofhormones and techniques forenhancing plant reproduction and yield.**Pollination Crisis**: Factors affecting pollinator populations and implications forcrop pollination.**Summary and Key Concepts**:The chapter concludes withasummaryofkey concepts related toplant responses and reproduction, reinforcing understandingofplant adaptations, reproductive strategies, and theroleofhormonesinplant growth and development.Chapter 21 providesacomprehensive explorationofhow plants respond totheir environment and thevarious mechanisms through which they reproduce, from flowering plants tonon- flowering plants. It prepares students forfurther exploration into plant physiology, ecology, and agriculture coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 21, feel free toask!Chapter 22Chapter 22of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "OrganizationoftheAnimal Body," typically covers thestructure, organization, and physiological systemsofanimals. Here’s an overviewofwhat you might findinthis chapter:**Introduction toAnimal Structure and Organization**:Overviewofanimal diversity and body plans.Introduction toanimal tissues and organs.**Animal Tissues**:Typesofanimal tissues:**Epithelial Tissue**: Functions, types (simple, stratified), and locations (e.g., skin, liningoforgans).**Connective Tissue**: Functions, types (e.g., loose connective tissue, adipose tissue, cartilage, bone), and extracellular matrix.**Muscle Tissue**: Types (skeletal, cardiac, smooth), functions, and contraction mechanisms.**Nervous

Tissue**: Neurons and glial cells, functions, and transmissionofnerve impulses.**Animal Organ Systems**:**Integumentary System**: Structure and functionsofskin and its appendages (e.g., hair, nails, glands).**Skeletal System**: Structure and functionsofbones, cartilage, and joints.

**Muscular System**: Typesofmuscles, functions, and muscle contraction.**Nervous System**: Structure (brain, spinal cord, nerves) and functions (sensory input, integration, motor output).**Endocrine System**: Glands (e.g., pituitary, thyroid, adrenal glands), hormones, and regulatory functions.**Cardiovascular System**: Heart, blood vessels (arteries, veins, capillaries), and blood circulation.**Lymphatic and Immune Systems**: Lymphatic vessels, lymph nodes, immune cells, and immune responses.**Respiratory System**: Structure and functionsofrespiratory organs (e.g., lungs, gills), gas exchange, and breathing mechanisms.**Digestive System**: Organs (e.g., mouth, stomach, intestines, liver), digestion, absorptionofnutrients, and waste elimination.**Excretory System**: Kidneys, urinary system, filtration, and regulationofwater and electrolyte balance.**Reproductive System**: Male and female reproductive organs, gamete production, and reproductive processes.**Homeostasis and Regulation**:Mechanismsofhomeostasis and feedback regulationinanimals:**Negative and Positive Feedback**: Examples and physiological control mechanisms.**Temperature Regulation**: Thermoregulationinendotherms and ectotherms.**Animal Development and Life Cycles**:Embryonic development and life cyclesofanimals:**Fertilization**: Fusionofgametes and formationofzygote.**Embryonic Development**: Cleavage, gastrulation, and organogenesis.**Metamorphosis**: Developmental changes from larval toadult formsininsects and amphibians.**Life Span and Aging**: Aging processes and life span variation among animals.**Animal Behavior and Adaptations**:Behavioral adaptations and their ecological significance:**Feeding Behaviors**: Carnivores, herbivores, omnivores, and feeding strategies.**Reproductive Behaviors**: Courtship, mating rituals, and parental care.**Social Behaviors**: Group behaviors, communication, and cooperation.**Human ImpactonAnimal Health and Physiology**:Environmental factors and human activities affecting animal health and physiology:**Pollution and Habitat Destruction**: Effectsonanimal populations and ecosystems.**Climate Change**: Impactondistribution, behavior, and physiologyofanimals.**Conservation and Wildlife Management**: Strategies forpreserving biodiversity and habitats.**Summary and Key Concepts**:

The chapter concludes withasummaryofkey concepts related totheorganizationoftheanimal body, reinforcing understandingofanimal structure, functions, organ systems, and adaptations.Chapter 22 providesacomprehensive explorationoftheorganization and physiological systemsofanimals, preparing students forfurther exploration into animal biology, physiology, behavior, and ecology coveredinsubsequent chaptersofthetextbook.If you have specific questions about anyofthese topics or would like more detailed informationona particular aspectofChapter 22, feel free toask!Chapter 23: theTransport SystemsChapter 23of"EssentialsofBiology" by Sylvia Mader and Michael Windelspecht, titled "The Transport Systems," typically covers themechanisms and systems involvedinthetransportofmaterials within organisms, especially focusingonanimals. Here’s an overviewofwhat you might findinthis chapter:**Introduction toTransport Systems**:Overviewoftheimportanceoftransport systemsinmulticellular organisms.Comparisonoftransport systemsinanimals and plants.**TransportinSingle-Celled Organisms**:Mechanismsoftransportinunicellular organisms:**Protozoans and Algae**: Movementofsubstances across cell membranes (diffusion, osmosis).**Circulatory SystemsinInvertebrates**:**Open Circulatory Systems**: Structure and functionininsects and other arthropods.**Closed Circulatory Systems**: Structure and functionincephalopods (e.g., squids) and earthworms.**Circulatory SystemsinVertebrates**:**Fish**: Single circulatory systemsinfish (e.g., bony fish).**Amphibians**: Adaptationsinamphibians (e.g., frogs) foraquatic and terrestrial life stages.**Reptiles**: Circulatory adaptationsinreptiles (e.g., crocodiles, turtles).**Birds and Mammals**: Double circulatory systemsinbirds and mammals, including pulmonary and systemic circuits.**Structure and FunctionoftheHeart**:Anatomy and physiologyofthevertebrate heart:**Chambers**: Atria and ventricles.**Valves**: Roleinpreventing backflowofblood.**Cardiac Cycle**: Phasesofheart contraction (systole) and relaxation (diastole).**Blood Vessels**:

Typesofblood vessels and their functions:**Arteries**: Structure, functionincarrying oxygenated blood away from theheart.**Veins**: Structure, functionincarrying deoxygenated blood back totheheart.**Capillaries**: Structure, functioninexchangeofgases, nutrients, and wastes between blood and tissues.**Blood Composition and Function**:Componentsofblood and their roles:**Plasma**: Fluid matrix containing water, ions, proteins, and hormones.**Red Blood Cells**: Structure and functioninoxygen transport (hemoglobin).**White Blood Cells**: Immune function and defense against pathogens.**Platelets**: Roleinblood clotting (hemostasis).**Gas Exchange Systems**:Respiratory structures and mechan

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