MARKET VALUE OF ALL FINALS GOODS AND SERVICES PRODUCED IN A YEAR

RATE OF INCREASE IN PRICES OF GOODS AND SERVICES

Measured by GDP Deflator, PCE deflator, and Consumer Price Index

Phillips Curve

Currently inflation is up as a result of increase in crude oil, agricultural products, & other commodities, & a decline in US dollar

Overly expansionary monetary policy leads to high inflation.

Increase rates slows down growth in inflation

BANKS MOVE FUNDS FROM

SAVERS-LENDERS TO BORROWERS-SAVERS 

SHARP SURGE IN ASSET PRICES SUSTAINED BY IRRATIONAL EXUBERANCE through the wealth effect on spending and output.

Bernanke Rule:  If a bubble has not caused inflation, then the Feds should not respond. 

If a bubble causes inflation the Feds should move with tightening measures. 

Once a bubble burst, the Fed should respond immediately with easing in its policy

 stance.

Difficult to identify until after it bursts.  

TRADING OF LONG TERM DEBT / EQUITY

(MATURITY OF MORE THAN 1 YEAR)

BANKS MOVE FUNDS INDIRECTLY FROM

SAVERS TO BORROWERS 

Banks borrow short-term funds and loan these funds long term

Direct Finance - Issuance of debt or stock 

ACQUIRE FUNDS AT PERIODIC INTERVALS

Benefit:  CAN PREDICT HOW MUCH PAYOUT IS

Examples:  LIFE INSURANCE, PENSION FUNDS, ETC 

PAPER CURRENCY BACKED BY GOV

NOT EXCHANGE FOR GOLD 

Started in U.S. in 70's.  First time for U.S. exchange rate fluctuation.

DECISIONS BASED ON PAST VALUES. 

Changes in expectation are slow.

DECISIONS REFLECT OPTIMAL FORCASTS USING ALL DATA.

Leads to an efficient capital market.

Changes are fast.

LOANS MADE TO SUPPORT PRODUCTION OF GOODS AND SERVICES WILL NOT BE INFLATIONARY

BAD THEORY 

PEOPLE UNDERSTAND THAT BOND ISSUES FROM GOV'T MEAN THAT THEY WILL PAY HIGHER TAXES 

NAIRU

(Non-accelerating inflation rate of unemployment)

MAXIMUM LEVEL OF OUTPUT - ACTUAL OUTPUT

Wider gap, greater slack in resource.

GOVERNMENT AND FISCAL POLICY AFFECT OUTPUT

ECONOMY IS NOT INHERENTLY STABLE 

MONEY SUPPLY PRIMARY SOURCE OF PRICE LEVEL CHANGES

ECONOMY INHERENTLY STABLE 

WHEN INFLATION IS LOW BUT NOT YET TO DESIRED LEVEL

FED KEEPS ECONOMY PRODUCING AT SUSTAINABLE GROWTH UNTIL RECESSION

THEN EASE TO CORRECT SHORTFALL IN DEMAND

ACCEPTING LOST OUTPUT AND CEMENTING IN LOWER INFLATION FROM RECESSION 

BORROW IN CURRENCIES WITH LOW INTEREST RATES SUCH AS YEN INVEST IN "Commodity" CURRENCIES THAT PAY HIGH INTEREST RATES, LIKE NEW ZEALAND & CANADIAN DOLLAR

IMPACT OF CHANGE IN WEALTH ON HOUSEHOLD SPENDING

$1 INCREASE IN NET WORTH

= 4 CENT CHANGE IN SPENDING 

YIELD CURVE

UPWARD SLOPING = STRONGER ECONOMIC GROWTH =

Short term interest rates expected to rise

DOWNWARD SLOPING = SLOWER GROWTH =

Short term interest rates expected to fall

Flating yield curve - short term rate hikes lead to longer term increase but then investors become increasing convined that inflation will be contained.

BORROWED RESERVES (BANKS BORROWINGS AT DISCOUNT WINDOW)

AND

NONBORROWED RESERVES (INFLUENCED BY PURCHASES OR SALES OF GOV'T SECURITIES)

PURCHASES ADD NON-BORROWED RESERVES. SALES SUBTRACT NON-BORROWED RESERVES.

BANK CAN HOLD RESERVES AT FED OR IN VAULT.

TRADE OFF BETWEEN PRODUCTIVE CAPACITY AND INFLATION

IF UNEMPLOYMENT RATE IS PUSHED TOO LOW, WAGES AND PRICES WILL BE PUSH UP.

ECONOMIC SLACK 

FED'S 325 BASIS POINT RATE HIKE CAUSED LONG TERM RATES TO DECLINE BY 40 POINTS

NORMALLY INCREASE IN FED FUND RATE IS ACCOMPAINED BY SYMPATHETIC INCREASES IN LONG-TERM INTEREST RATES RATHER THAN DECLINES.

CAUSES:  GLOBAL SAVINGS GLUT, JAPANASE CARRY TRADE, LOW INFLATION EXPECTATIONS

CDO 

Off balance sheet conduits or Structured Investment Vehicles that buy risky longer-term securities and sell matching liabilities in the form of high and low risk tranches. 

Problem:  NO LIQUIDITY & HARD TO VALUE 

OUTPUT BELOW MAXIMUM (FULL EMP) LEVEL &  GROWTH ABOVE POTENTIAL 

FED TIGHTENS JUST ENOUGH TO SLOW OUTPUT GROWTH TO SUSTAINABLE POTENTIAL AS THE LEVEL OF OUTPUT REACHES MAXIMUM LEVEL(FULL EMPLOYMENT)

Examples:  Succeeded in 1994/95

Failed in 1988/89 and 1999/2000 leading to recession

ENGAGE IN A TRANSACTION AT A FUTURE POINT IN TIME. 

• Sale of a debt at a future date at a set price. 
• Lacks liquidity. 
• Default risk on part of counterparty.

AT EXPIRATION DATE, PRICE OF THE CONTRACT IS THE SAME AS THE PRICE OF THE UNDERLYING ASSET

• Sale on a future date.
• More liquid
• Types:  U.S. Treasury Sec., currency contracts, Euro dollar contracts, etc.

INTEREST RATES

EQUITY PRICES

DOLLAR VALUE 

HIGH INFLATION

LOW GROWTH

HIGH UNEMPLOYMENT

1970 WITH OIL SHOCK  

CENTRAL BANKS SEEKING TO BOOST OUTPUT AND EMPLOYMENT IN THE SHORT RUN BY EXPANSIONARY MONETARY POLICY.  

BUT ONLY THING THEY CAN DO IN THE LONG RUN IS CONTROL INFLATION, and to do this effectively, they must avoid overly expansionary policies in the short run.

HEDGE AGAINST CREDIT DEFAULT RISK IN BOND

TRIGGERED BY CREDIT EVENT 

Over-the-counter deriviative

TENDENCY OVER PAST 25 YEARS HAS BEEN LOW INFLATION ECONOMIC GROWTH WITH REDUCED FLUCTUATIONS & LOW VOLATILITY.  

GOOD JOB FED WITH COUNTER-CYCLICAL EFFECTS!

Bank reserves held at the Fed, loaned and borrowed between banks, usually overnight.

Since September through April, this rate has been cut from 5.25% to 2.25% - 300 basis points.

2.25 % Nominal FFR - 2% Core PCE = .25% Real FFR (room for futher rate cuts)

Cost of borrowing from the Fed

Available to deposity institutions

Usually 100 basis points above Fed funds rate

Stigma associated with discount window because of perception of financial weakness

Almost never equals intended investments.  If intended savings exceeds intended investments, interest rates decline. 

TIPS Spread

(Treasury Inflation Protection Spread)

Spread between yield on nominal 10 year Treasury Issues and yield on TIPS.

 Direct measure of long term inflation rates. 

Watch 5 & 10 years maturities.

July 25 - Countrywide reveals sub-mortgage market problems

August 3 - Bear Stearn closes 2 funds with heavy holdings of sub-prime mortgage backed securites.

August 9 - BNP Paribas halts redemption of asset backed securities because it could not determine market value

Coined by Greenspan. 

Catch phrase of the stock market boom of the 1990's. 

Heighted state of speculation.

According to NBER (Nat'l Bureau of Economic Research)

- Significant decline in economic activity

- Spread across the economy

- Lasting more than a few months

- Normally visible in Real GDP, real income, emplyment, industrial production & wholesale/retail sales

Conventional Definition - at least 2 consecutive quarters of declining Real GDP

A Financial Instrument

-Transfer of risk to those who want to take it at a profit

- Types: Option Contract, Foward Contracts, Future contracts, Swaps.

- Announced March 11

- Injections of $200 billion in lending liquid Treasury securities

- Exchange for illiquid mortgage backed sec.

- Available to Primary Dealers (20 banks)

- Weekly auctions

- 28 day periods

- Problem because they were limited

- Secured by collateral

Term Auction Facility (TAF)

- Introduced Dec 2007 injecting $40 Billion

- On March 7 increased injection to $100 billion in emergency liquidity

- through a series of auctions

- at a rate below the discount rate, closer to FFR

- with an extension from 28 days to 6 month terms

Core PCE (Personal Consumption Expenditures)

Feds favorite short-term indicator of the underlying trend in inflation.

Core PCE - less food & energy

Headline-everything/best long run inflation indicator

Currently curtailed by higher credit costs, declining home prices, rising energy prices, volatile stock , prices, soft employment conditions

1.  Rising inflation expecations

2.  Decling economic slack

3.  Increase in energy prices (oil)

4.  Decline in U.S. dollar in foreign exchange markets

Who makes up the FOMC ?

(Fed Open Market Committee)

7 Fed Governors + 5 Reserve Bank Pres. = 12

Meet 8 times a year.

Buys and sells gov't securities which effects interest rates and reserve amounts in the banking system.

1.  Investor complacency & overconfidence

2.  Decling inflation expectations

3.  Unusually low interest rates

4.  Abnormally narrow credit risk spread in debt mkt

5.  Investors seking "enhanced" returns.

6.  Housing boom 2003-2006

7.  Home price appreciation

8.  Housing credit bubble

9.  Housing bust 2006-2008

10. Recession

1.  Inject emergency liquidity to stabilize financial markets.

2.  Increase in reserve availability through Fed outright purchases of Treasury securities accompanied by cut in Fed fund rates.

• Occured March 14
• Use of Discount Window
• 28 day loan to J.P. Morgan to buy B.S.

• Infinite amount of funds
• Open to depository institutions plus investment banks
• Extended to 90 days

Right to buy or sell at an exercise/strike price within a specific time/before an expiration date.

You can never loose more than you paid for the option.

• Examples: stock options & futures options.
• Call: right to buy at set price before term date
• Put: right to sell at set price before term date
• Example:  Bears Stearns - Bearish (puts) bets
•  outnumbered bullish (call)bet by 2.5 to 1. 

Over-the-counter derivatives where buyer who wants to hedge a company's credit risk pays seller a periodic fee in exchange for a contingent payment triggered by a credit event (i.e. bankruptcy, downgrading of credit rating).

Transfer of credit risk between counterparties. 

A bet someone is going to default on credit.

1.  Corporate Credit Risk Spreads-widening spread of interest rate on bonds of diff. credit risk

2.  TED Spreads- cost of short term borrowings relative to costs of US Treasury (I.e. 3 month US Treasury Bills vs 3 month euro dollars rate)

3.  LIBOR spreads - rate on interbank lending relative to dollar(Fed fund rate vs. euro vs. sterling)

4.  Credit Default Swaps -protection on credit event. Crisis causes higher premium.

5.  VIX Index - volatility measure for S&P 500. Seen mostly in demand for options due to fear.

6.  30 year Fannie Mae mortgage backed securities vs. 5 or 10-year U.S. Treasury Securities Spread

1.  Stable Prices

2.  Maximum Employment

57 months

Our recent expansion was 72 months

 Triggered by a sudden collapse in the housing market and the rapid increase in defaults on subprime mortgages.  An abrupt shift from abundant liquidity to scarce liquidity, and sudden investor risk aversion as reflected in a flight to US Treasury Securities. Crisis has seen a dramatic shift favoring deleveraging of risk and the re-pricing of risk especially in the mortgage market.  A large portion of the credit bubble was extended indirectly through a shadow banking system consisting of highly leverage nonbank financial interemediaries as well as off-balance sheet conduits such as CDO.  Problem created:

1.  The underlying assets could not be valued accurately because real estate values were declining and foreclosures were increasing and

2.  There are no secondary markets for these assets.

3.  Some of these funds were closed due to an impossibility to determine their values.

4.  Some banks and other financial instituiton wrote huge write-downs of mortgage-related asset holdings.

5.  Banks hoarding liquidity, increased costs for credit.

70%   PCE (Personal Consumption Expenditures)

4%     FRI (Residential Fixed Investments)

10.8% BFI (Business Fixed Investments)

19.6% Government Spending

-5.1%  Net Exports (12.3% Exports-17.4 Imports)

Effected 6 months after transmission channels are put into place.

When dollar goes down, exports go up, deficit goes down

GDP -Total production of all final goods & services.

Sustainable Growth potential = productivity growth plus labor force growth

Natural output - max output at full employment

Output Gap = Diff between max level & actual level

Shifts in SRAS

(Short run aggregate supply)

When output exceed natural level, demand for labor exceed supply, higher labor costs, reduced profits - shift to left.

When output falls below natural level, demand for labor falls short of supply, lower labor costs, increased profits  - shift to the right

Exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries.  Assume all goods are identical & transportation & trade costs are low.  However, all goods are not identical.  Also, many goods are not traded across national borders. 

Factors affecting exhange rates in the long and short run.

3 Factors Affecting Exchange Rates

in the Short Run

1.  Price levels - when prices go up, demand goes down, and currency value goes down.

2.  Trade Barriers - cause a country's currency to appreciate.

3.  Productivitity - higher productivity reduces unit labor costs & prices leading to currency to appreciate.

Factor Affecting Exchange Rates

in the Long Run

Demand for domestic assets

• Increase in interest rates increase demand for domestic assets, currency appreciates.
• Increase in foreign interest rates decreases demand for domestic assets, currency depreciates.
• Increase in expected future exchange rate increases deman for domestic assets, currency appreciates.
• When interest rates rise due to inflation, the demand for domestic assets decrease, currency depreciates.  Fisher Equation.

in=ir+pie(e)

Nominal interest rate =real interest rate +expected inflation

Real =adjusted by subtracting expected changes in the price level to reflect true cost of borrowing

Advantage: 

1.  Keeps inflation under control.

2.  Automatic rule for monetary policy

• Tightening when currency depreciates
• Easing when currency appreciates

Disadvantage:

1. Inability to pursue independent monetary policy

2.  Open to attacks against currency

1.  Foreign Exchange Rates

2.  Purchase Power Parity

3.  International Reserves

4.  Balance of Payments -

• current account,
• capital aacount,
• sum of current and capital = net change in gov't int'l reserves,
• Sovereign wealth fund

5.  Outlook of US dollar -

• trade deficits,
• domestic demand,
• locomotive role,
• US-Euro interest rate diff

6.  Outlook of China -

• Rapid growth,
• export led,
• mercantilist style build up in int'l reserves (sell, sell, not buy)
• expansion seeking sources for oil & indust mat

Nominal GDP (current prices)/Real GDP (fixed prices)

1.  Simple Loans - business loans

2.  Fixed Payment - car/home

3.  Coupon Bond - Treasury/Corp Bonds

4.  Discount Bond/Zero Coupon-Treasury Bills/Bonds

Interest rate that equates the present value of cash flow payments on a debt with its value today.

PV = CF/(1 + i)n

PV = CF/(1+i)n

A dollar paid to you today is worth more than a dollar paid a year from now.

1.  Wealth

2.  Expected return

3.  Risk

4.  Liquidity

1.  Expected Profitability of investments

2.  Expected inflation

3.  Gov't budget

All have a direct relations to supply. 

The interest rate on a long-term bond will equal an average of short-term interest rates expected over the life of the long-term bond plus a liquidity premium which increases as the term to maturity increases.

Key assumption:  Bonds of different maturities are close though not perfect substitutes.  Expected return on one bond influences the return on another.  Nevertheless, investers prefer shorter-term bonds.

Shifts in the Demand for Money

1.  Income Effect

Income up, demand for money up, interest rates up

2.  Price Level Effect

Prices up, demand for money up, interest rate up

1.  Changes in Income

Income up, supply up, int. rates up

2.  Changes in prices

Prices up, supply up, int. rates up

3.  Changes in money supply

Money supply up, supply up, int. rates down

Stock prices follow a random walk.  Future prices are unpredictable. Past stock prices cannot predict future prices.

Extreme version of Efficient Market Hypothesis

Amount of interest sacrificed by not holding an alternative asset. 

Ex:  Holding money and not putting it into a money market account.

Trading financial instruments and generating income from fees (servicing mortgages) and loan sales (at higher rates).

If issuer of security defaluts, the bank is responsible. 

Non-bank Financial Entities

Shadow Banking System

1.  Finance companies

2.  Insurance Companies

3.  Mutual Funds

4.  Hedge Funds

5.  Private Equity Industries

6.  Pension Funds

7.  GSE

Financial Stimulus

Tobin's "q" ratio

Ratio of stock prices to replacement cost of capital.

1.  Amount of Labor Force

2. Capital Invested in the Economy

3.  Available Technology

1. Output is above or below natural level

2. Expected Price

3.  Wage Push

4.  Change in Production Cost unrelated to wage costs

5. (Productitivity)

1.  Relative Price Levels compared to other countries

2. Trade Barriers - on incoming goods

3.  Productivity - more goods at less cost

1.  Domestic Intestest Rates - increase in rates causes demand, dollar appreciates.

2. Foreign Interest Rates -increase in rates causes decrease in demand for domestic assets and causes domestic currency to depreciate.

3. Expected increase in future exchange - rate increases demand for domestic assets and cuase the domestic currency to appreciate.

4.  When domestic real interest rates rise, the demand for domestic assets increases and the domestic currency appreciates.

5.  Domestic interest rates rise due to an increase in expected inflation the demand for domestic assets decrease ad the domestic currency depreciates. 

Gov't run investment fund.  

Ex:  China's investment in Morgan Stanley, Abu Dhabi investment in City Group, Singaport investment in UBS.

Book keeping system for recording all receipts and payments that have a direct bearing on movement of funds between a nation and foreign currencies.

Key items in the balance of payment:

1. Current Accounts

2.  Capital accounts

3.  Sum of 1 and 2 = Net change in gov't international reserves

4. Sovereign wealth funds - up to 3.5 trillion

Factors that affect the US Dollars

1.  Trade deficits

2.  Domestic demand

3.  Locomotive role - our consumer pulls the world along but it is unstatainable

4.  U.S.  vs European interest rate differential - Feds need to stop cutting

1. Strike Price

2.  Stock Price

3.  Volitilaty

4.  Interest Rates

5.  Duration

T - Accounts

Fed Reserves

Assets         Liabilities

Securities      Reserves

              Discount Loans     Currency in circulation

                         Banking System

Assets          Liabilities

         Reserves        Checkable Deposit

       Securities                               

Nonbank Public

Assets             Liabilities

Securities                        

               Checkable Deposits                          

Fed's Monetary Policy Tools

Management of Short-term interest rates

1.  Discount Rate

2.  Fed Fund Rate target through open market operations

3.  Required Reserves

1.  Housing buble burst in U.K. & Spain

2.  Decrease exports by Germany because of soaring euro.

3.  U.K.'s largest mortgage lender had to be rescued by gov't

4.  Two German Banks same fate

5.  China suppressing unsustainable double digit growth

How can you pump emergency liquidity into the system?

1.  Fed supply of reserves

2.  Cutting Rates

3.  TAF, TSLF & PDCF

4.  Capital infusion by foreign sovereign wealth funds

5.  Fiscal Policy packages

1.  Fixed spending allowance - $600 per adult

2. Tax Rebates

3.  Increase in FHA insurance to mortgage companies

4.  Increase in ceiling for comforming mortgages purchased by Fannie Mae & Freddie Mac up to $729,750 from $417,000

Must be:1.  Timely 2.  Targeted 3.  Temporary

Automatic stabilization Feature

It's better than monetary policy, felt by families bearing the brunt of recession. 

Bernanke favors.  Greenspan did not because it reduces flex. in achieving major objective of sustainable growth

1.  Too much weight on stable prices

2.  Tendency to fight inflation at expense of all else

3.  Loss of credibility when target is missed

4.  Congress will want an unemployment target

Push interest rates up

Used when excess in output growth but produces strains on labor market

Stock prices will fall

Dollar will appreciate

Push interest rates down

Use when output falls short of growth potential but produces a slack in resources

Stock prices go up

Dollar depreciates

Inside Lag

Direct Effect on banking system and capital markets

Indirect impact on aggregate demand and output growth

Longer to take effect (6 to 12 months) than fiscal policy

Feds say it is critical in knowing what banks are doing to come up with innovative ideas. 

Although it may help smooth the curve, it will not eliminate peaks and trenches because human nature never changes.

1.  Wealth - increase causes increase in demand.

2.  Expected interest rates - increase cause decrease in demand.

3.  Expected inflation - increase cause decrease in demand.

4.  Riskiness - increase cause decrease in demand.

5.  Liquidity - increase cause increase in demand.

6.  Expect return - increase cause increase in demand.

1.  Profitabliity of investments - increase cause increase in supply in bonds

2.  Expect inflation - increase cause increase in supply in bonds

3.  Gov't deficit - increase cause increases supply in bonds

Unemployment rate above NAIRU

Aggregate output below maximum potential output at full employment

Output gap

Greater ecomonic slack, lower inflation

Declining ecomomic slack, higher inflation

1.  Interest Rates

2.  Asset prices, through wealth effect

3.  Foreign exchange value of dollar, which influences net exports.

Extremely depression impact on growth in a string of mostly Asian economies, while U.S. growth remained strong.

Asian market not effected today by our credit crisis.

Financial asset that can be converted into cash cheaply and quickly.

1.Capital infusion by foreign sovereign wealth funds 2.  Central banks creation of new money

3.  Global carry trades

4.  Global saving glut

5.  Home equity appreciate

6.  Feds supply of reserves

1.  Declining short term interest rates

2.  Sharp steepening in yield curve.

3.  Stock market rally

4.  Asset price bubbles

5.  Booming housing market

6.  Speculation in commodity markets

7. Decline in US dollar

1. Decline in asset prices

2.  Reduction in value of collateral

3.  Banks become more restrictive in leaning

4.  Increasing severity of economic downturn

5.   Increasing credit losses

6.  Cycle starts all over again