Cheat Sheet_v1.docx

Not Raise M

Inflation  Definition: It is the sustained rise in the general level of prices. Inflation rate is the rate at which the price level increases.  Measuring the inflation: -CPI: Measures average price of consumption. Reported monthly. -Problems with CPI: Index number problem. There is no “perfect price index”. -GDP Deflator: Nom GDP/Real GDP in yr t. The actual no. has no economic meaning. The rate of change does. Quarterly reporting. - The two may not be the same. Goods consumed could include imports. GDP could include exports. - PPI: Index of domestically produces good.  Causes of Inflation: -M (stock of money) V(Velocity)=P (Price level) Y(GDP) - assume that in the long run, Y and V are fixed/constant. -Monetarist Theory of Inflation: Inflation is caused by too much money chasing too few goods. Assuming V and Y constant, change in M causes change in P. -Seignorage: The revenues from money generation: = Money growth x real money balances. -Inflation Tax: Since it reduces the value of cash it can be considered tax. Tax rate is inflation rate (π) -Govt does not receive the inflation tax rate but only Seignorage. The two are only equal if the growth is constant. In the long run they are the same. Inf=Sei -Financing budget def: Issue bonds or print money.  Consequences: -Fully anticipated inflation reflects in wages and prices; has no effect. -Unanticipated inf hurts lenders and helps borrowers. -Unanticipated deflation hurts borrowers and helps lenders.  Exchange Rates: -Flex Ex Rates: High relative inf gets translated in ex rate depreciation. (πhπf=% change in exchange rates) -Fixed Ex Rates: Loses ind monetary policy  Asset Price Inf: Money creation causes asset price inf. Money is channeled into Asset Market (Prop and stock)

Game Theory

Raise M

Raise P

Not Raise P

Fed: 4 Firms: 2 Π=20% µ=natural rate

Fed: 10 Firms: 0 Π=0% µ
Fed: -4 Firms: -1 Π=20% µ>natural rate

Fed: 8 Firms: 3 Π=0% µ=natural rate

Graph

Foreign exchange market play  An indep central bank could devalue currency to increase the exports thus shifting IS to the right.  Automatic Stabilizer means increase in G and transferring all of the Fed’s funds to the new State to spur demand.

Money Supply  Time Inconsistency: An activity that may be rational in the short run but may be irrational in the long run.  Dominant Strategy: It is to indulge immediately.  Solution to Prisoner’s Dilemma is a binding commitment – a rule. Bank of Japan does not follow this rule.

Shocks on Fixed and Flexible rates  Exports Fall (Graph)

 R=Reserve Ratio. Amt banks must hold as reserves. No interest on this  Central Bank - Monetary Base: Money printed by central bank.  Banks: Max loan (1-R) Money Supply with Fractional Banking -M (Money Supply) =Dep (Total Bank Deposits) -R x Dep= Base (Monetary Base) -R x M = Base > M=Base/R Money Supply with Public Holdings and Fractional reserve -M= CU (currency in circulation) + Dep Money Multiplier -Monetary Base=CU+ Res -CU/Dep (currency-deposit ratio) Determined by public, Incr in CU/Dep lowers M. -Res/Dep (Reserve Deposit Ratio) Determined by Banks. Increases by not making loans. An increase would lower M -Time Deposits-Interest bearing loans that has maturity -Repurchase Agreement (Repo) Int on Repo= (Principal x repo rate x days repo is outstanding/360)

 Credit Card Invention (Graph)

-Term Repo -T-Bill -Eurodollar -Bank Acceptances

Money Markets

 Conclusion: If one anticipates that the shocks will demand then flex ex rate would result in less var in income than a fix ex rate. If shocks are monetary than fix ex rate would result in less var.

Relationships  Positive: Growth rate of Nominal Money Supply and inflation rate  Positive: Growth rate of Monetary base and inflation rate  Close to corr 1: Growth rate of M1 and inflation rate  Positive: Rate of depr of the currency and inflation rate

 Advantages of Repo-Investors keep surplus funds invested without losing liquidity or incurring price risk + Investors expose themselves to no credit risk because of top quality paper  Overnight Repo is lower than FFR as repo is secured unlike fed funds + many investors cannot participate in fed funds market.  Eurodollars are dollars held in bank/branch located outside the US. True international market -All deposits except call money have fixed maturity -Interest is paid on all deposits -No reserve requirement -No FDIC premiums

-Banks can invest every dollar of Eurodeposits. -Participant banks include govt., corporations, central banks, commercial banks  LIBOR – Rate at which at which banks in London offer Eurodollar.  Money Market Fund: Is a mutual fund that invests assets in short term money market assets – Repo, Eurodollar, CPs, TBills. MMF are a major supplier of liquidity in the Repo Market  TED spread would rise if there a demand for 3-month T bill and Euromarkets have frozen

Hight of financial crisis: The yields would go down as the demand for US treasuries increase.

-Int rates on the long term government bonds cannot be >2% greater than rates in the 3 lowest inflation countries -Budget deficit cannot be more than 3% of GDP -Govt debt cannot be >3% GDP  Convergence Play of EU: Bond yield would converge. Italian spread to German existed. Expect to converge. Buy Italian Bond and sell German Bonds.

Yield Curve  Yield Curve normally tends to slope upwards.  Segmented Markets: Different markets for each maturity of the bonds. -Independent supply and demand -Maturities are not substitutable -Yield is determined separately and independently in each market. -Shorter maturities are preferred. -But cannot explain short term and long term rate move together. -Operation theory- Want high ST rates and low LT interest rates. Cannot work.  Expectation Theory: Investors view assets of all maturities as perfect substitutes. Long bond rates equal the average of ST rates.  Preferred Habitat: Maturities are substitutable per not perfectly. Specific maturities are preferred. -Yield on an n period bonds = average of yield on one period bonds over the next n periods + a term premium  Expectation of recession: Inflation rate would fall. Market rate would be lower in the future. Demand for ST bond rises. Prices goes up. Yield goes down. Negatively sloped curve.

 Spread over Treasuries: Other govt yield curves are over the treasuries. US govt has the lowest risk.  Mortgage Rates are higher than T rates  Bond Indentures: -Sinking Funds-firms agree to establish a sinking fund to spread the payment burden over several years. -Senior Debt gets priority -For protection of bondholders over shareholders -Collateralized are considered safest variety of corporate bonds.  Credit Rating: Moody’s and S&P -Top rating is AAA or Aaa -Investment grade bond - Junk bonds BB and below  Speculative Grade or Junk Bond: -Fallen Angels  Riding the Yield Curve: -Strategy to raise return when the yield curve is positively sloped. -Buy a security -Hold that security until it can be sold at a gain. -Because current maturity and the yield has fallen -Banks are profitable when the yield curve is positive -Risk: ST rates might rise + yield curve might invert. -The steeper the yield curve's upward slope at the outset, the lower the interest rates when the position is liquidated at the horizon, and the higher the return from riding the curve.

 Flight to Quality: The market turmoil caused by the Asian financial crisis would cause a flight to quality: -Investors buy US treasuries resulting in a shift of the yield curve (in particular the 30 y bond). This causes inversion in the long end. -US capital account would rise

EMU  Requirement to join EMU: -The country’s inflation rate cannot be greater than 1.5% above the average rate for the 3 EC countries with the lowest inflation rates

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