TUTORIAL 1 (7-7)

1. What does money do for an economy? Do we really need a monetary payment system? What would
be so bad about simply having a barter payment system (goods for goods)?
● Money is defined as anything that is generally accepted in payment for goods or services or in the
repayment of debts. Money links to changes in economic variables that affect all of us and is important to
the health of the economy. Money and monetary policy appear to be major influences on inflation,
business cycles, interest rates. Money has 3 primary functions in an economy: as a medium of exchange,
as a unit of account, and as a store of value.
● We really need a monetary payment system because the use of money as a medium of exchange
promotes economic efficiency by minimizing the time spent in exchange for goods and service.
● In a barter payment system (goods for goods), the time spent in exchange for goods and service
(transaction costs) are high because people have to satisfy a double coincidence of wants - they have to
find someone who has a good or service they want and who also want the G&S they have to offer.
2. Find some commodities that were used as money in history.
Precious metals: gold or silver; shells, alcohol, cigarettes, silk, etc.
3. Describe at least three ways you could pay for your morning cup of coffee. What are the advantages
and disadvantages of each?
Fiat money: (+) much lighter than coins or precious metals. (-) depends on trust in authorities, counterfeit, easily
stolen and expensive to transport in large quantities because of their bulk.
Checks: (+) allow transactions without the need to carry around large amounts of currency; reduce transaction
costs and improve economic efficiency. (-) it takes time to get checks from one place to another and it often takes
several business days before the bank will allow you to make use of the funds from a check you have deposited;
the paper shuffling process checks are costly, in the US: 10$ billion per year.
E-money: Debit card or Credit card. (+) faster to use than cash, convenient, and efficient.
(-) Possible security breaches/hacks
4. You are the owner of a small sandwich shop. A buyer may offer one of several payment methods:
cash, a check drawn on a bank, a credit card, or a debit card. Which of these is the least costly for
you? Explain why the others are more expensive.
Cash is the cheapest option for the merchant; no information is required about the buyer and no additional costs
are imposed (though the merchant may need to guard against counterfeiting). Most merchants will ask for a
government-issued photo ID in order to accept payment by check, requiring more time per transaction. Even with
appropriate identification, the merchant does not know if funds are actually available in the check writer's
account. If not, the merchant will likely undergo a costly process of contacting the buyer and trying to coax the
funds from the individual. A payment by credit card provides the merchant with more protection than a check
because the payment is made by the financial institution issuing the card. However, the merchant pays the card
issuer a fee (usually a percentage of the transaction value) for the certainty of the payment. Finally, while a debit
card electronically transfers funds from the buyer's account to the merchant's, this transfer is not instantaneous
and the buyer is likely already gone when the merchant may discover that the buyer did not have the funds
available.
5. Explain how money encourages specialization, and how specialization improves everyone’s standard
of living.
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.
6. Could the dollar still function as the unit of account in a totally cashless society?
Yes. The dollar can still serve as the unit of account even if it is not used as a means of payment. Using dollars to
quote prices and record debts does not depend on cash being used as a means of payment. Dollars may still serve
as the standard measurement of value even if they are not themselves exchanged.
7. Is the VND backed by gold? If not, why do you accept them as payment?
No. “Backed by gold” means that money is guaranteed by the Government by gold. We are willing to accept
VND as payment because the VND is backed by a legalized institution such as the state bank and the government
and we have trust in them.
8. What are traveler’s cheques? Are they different from normal cheques?
What Is a Traveler’s Check?
● Traveler’s checks are a form of payment issued by financial institutions. These paper cheques are
generally used by people when traveling to foreign countries.
How Traveler’s Checks Work
● They are purchased for set amounts and can be used to buy goods or services or be exchanged for cash. A
traveler’s check is similar to a regular check because it has a unique check number or serial number. When
a customer reports a check stolen or lost, the issuing company cancels that check and provides a new one.
● Key Difference: Travelers checks are pre-paid pieces of paper that come printed with all the information
that is required by the issuer. Personal checks are pieces of paper that are issued by banks that allow the
money to be deducted directly from one account.
9. Under what circumstances might you expect barter to re-emerge in an economy that has fiat money
as a means of payment? Can you think of an example of a country where this has happened
recently?
If there are periods of high inflation and the public loses confidence or trust in fiat money, barter may reemerge.
(Other circumstances under which barter economy would reemerge and dominate fiat money as the means of
payment are: Fiat money is money that is backed by government notes. One possible circumstance for
re-emergence of a barter economy would be if the country’s economy and central bank collapses. Along with this
if the government no longer has the ability to back its currency with hard assets. In that case, the citizens would
use their own assets that they have earned and trade it for other assets to make purchases. If the government
cannot back its currency with value, then citizens have no use for it since they cannot use it as a store of value or
unit of account).
For example, in the case of Venezuela, it has the world’s largest oil reserves, and was once one of the wealthiest
countries in Latin America, but its economy has been ravaged by years of runaway inflation since 2016. In the
country where bank notes are as difficult to find as chronically scarce food and medicine, Venezuelans are
increasingly relying on bartering for basic transactions.
10. Rank the following assets from most liquid to least liquid:
a. Checking account deposit
b. House
c. Currency
d. Common stock
e. Car
Rank: Currency → Checking account deposit → Common stock → Car → House
11. Why have some economists described money during a hyperinflation as a “hot potato” that is
quickly passed from one person to another?
Money is seen as a hot potato during hyperinflation because the rate at which money loses its value is very
high, with a 5-10% daily increase in prices of goods. Therefore, an individual would only want to hold money for
the shortest time possible and exchange it with the commodities they require because the prices are continuously
increasing. Because of this, it is quickly passed from an individual to another like a hot potato.
12. In Brazil, a country that was undergoing rapid inflation before 1994, many transactions were
conducted in dollars rather than in real, the domestic currency. Why?
Money has three essential functions: unit of account, medium of exchange, and store of value. With high
inflation, the domestic currency loses its value at a fast pace, prices change all the time and the domestic
currency cannot act as a store of value. Therefore, people in Brazil reject their currency and look for something
which can perform the three tasks above. Thus many people would rather hold dollars, which are a better store of
value, and serve the three functions.
13. As of September 2015, 19 of the 28 countries of the European Union have adopted the euro. The
remaining 9 countries, including Great Britain, Denmark, and Sweden, have retained their own currencies.
What are the advantages of a common currency for someone who is traveling through Europe?
The major benefit of a common currency that has been emphasized is that it facilitates trade (in both goods and
services) and investment among the countries of the union (and hence increases income growth within the region)
by reducing transaction costs in cross-border business, and removing volatility in exchange rates across the union.
14. “Market liquidity and funding liquidity are both needed to make financial markets function
smoothly”. Comment on this. Illustrate using examples from the Global Financial Crisis since 2007.
a. Market liquidity & funding liquidity
William C Dudley: Market and funding liquidity – an overview
● Market liquidity: the ability to convert an asset to cash.
● Funding liquidity: the ability of a financial entity to raise cash by borrowing on either an unsecured or a
secured basis.
● Although market and funding liquidity are often treated as distinct, they can be closely related. This is
especially the case during a financial crisis. If funding liquidity declines because of market stress, for
example, this may cause intermediaries to become less willing to provide market liquidity. Declines in
market liquidity, in turn, may further impair funding liquidity, creating a negative feedback dynamic.
→ In summary, funding problems lead to market illiquidity, and market illiquidity worsens funding problems,
creating an adverse feedback loop that makes the markets spiral into crisis.
⇒ Market liquidity and funding liquidity are both needed to make financial markets function smoothly.
b. Illustration of the Global Financial Crisis
Financial institutions couldn’t sell assets → could not get market liquidity. MMMF also got into trouble because
banks collapsed.
Banks also could not borrow money anywhere to finance their activities → got funding liquidity problems →
Turning to the Central Bank.
TUTORIAL 2 (8-8)
 1. Would $175, to be received in exactly one year, be worth more to you today when the interest rate is
15% or when it is 20%?
Today, it would be worth 175/(1+0.15) = $152 (rounded to the nearest whole number) when the interest rate is
15%, rather than 175/(1+0.20) = $146 when the interest rate is 20%. Thus, $175 received in one year would be
worth less to you today if the interest rate rose to 20%.
2. Write down the formula that is used to calculate the yield to maturity on a twenty-year 12% coupon
bond with a $1,000 face value that sells for $2,500.
coupon = 1,000*12% = $120/year
Equation:
$2,500 = $120/(1 + i) + 120/(1 + i)^2 + . . . + 120/(1 + i)^20 + $1,000/(1 + i)^20.
= (120/i)*[1-1/(1+i)^20] + 1,000/(1+i)^20
Solving for i gives the yield to maturity.
⇒ YTM = i = 2.44%
3. To help pay for college, you have just taken out a $1,000 government loan that makes you pay $126
per year for 25 years. However, you don’t have to start making these payments until you graduate
from college two years from now. Why is the yield to maturity necessarily less than 12%? (This is
the yield to maturity on a normal $1,000 fixed-payment loan on which you pay $126 per year for 25
years.)
If the interest rate were 12%, the present discounted value of the payments on the government loan are
necessarily less than the $1,000 loan amount because they do not start for two years. Thus the yield to maturity
must be lower than 12% in order for the present discounted value of these payments to add up to $1,000.
4. You are offered two bonds, a one-year U.S. Treasury bond with a YTM of 9% and a one-year US
T-bill with a yield on a discount basis of 8.9%. Which would you rather own?
T-bill cannot be compared with other money market instruments which pay coupon, as a result, a one-year U.S.
Treasury bond with a YTM of 9% and a one-year US T-bill with a yield on a discount basis of 8.9% are not
comparable. To compare the two, we should have information about the bond par value and its price, as well as
that of the T-bill to calculate the bond’s discount yield and the bill’s investment yield.
5. Do bondholders fare better when the yield to maturity increases or when it decreases? Why?
When the yield to maturity increases, this represents a decrease in the price of the bond. If the bondholder were to
sell the bond at a lower price, the capital gains would be smaller (capital losses larger) and therefore the
bondholder would be worse off.
6. A financial adviser has just given you the following advice: “Long-term bonds are a great
investment because their interest rate is over 20%”. Is the financial adviser necessarily right?
No, because if interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price that
their return might be quite low, possibly even negative.
7. If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices rises from
2% to 9%, are people more or less likely to buy houses?
Simply compute real interest rates (r = i - π) in both periods:
Before: r = 5% - 2% = 3%
After: r = 10% - 9% = 1%
People are more likely to buy houses now because the real interest rate they have to pay has fallen from 3% to
1%. People are paying back more in terms of dollars, but the values of their houses have risen at such a rate that
the real cost of financing their homes has actually fallen.
8. When is the current yield a good approximation of the yield to maturity?
The current yield will be a good approximation to the yield to maturity whenever the bond price is very close to
par or when the maturity of the bond is over about ten years. This is because cash flows farther in the future
have such small present discounted values that the value of a long-term coupon bond is close to a perpetuity with
the same coupon rate.
9. Why would a government choose to issue a perpetuity, which requires payments forever, instead of a
terminal loan, such as a fixed-payment loan, discount bond, or coupon bond?
A government would choose to issue perpetuity, a debt instrument with endless payments, rather than a terminal
loan because the cash flows in the distant future have extremely low present discounted values.
10. Under what conditions will a discount bond have a negative nominal interest rate? Is it possible for
a coupon bond or a perpetuity to have a negative nominal interest rate?
It is possible for a coupon bond to have a negative nominal interest rate, as long as the coupon payment and face
value are low relative to the current price. It is impossible for a perpetuity to have a negative nominal interest
rate, since this would require either the coupon payment or the price to be negative.
11. True or False: With a discount bond, the return on the bond is equal to the rate of capital gain.
True.
The return on a bond is the current yield iC plus the rate of capital gain.
A discount bond, by definition, has no coupon payments, thus the current yield is always zero (the coupon
payment of zero divided by current price) for a discount bond
⇒ Return = rate of capital gain with a discount bond.
12. If interest rates decline, which would you rather be holding, long-term bonds or short-term bonds?
Why? Which type of bond has the greater interest-rate risk?
If interest rates decline, I would rather be holding long-term bonds because their price would increase more than
the price of the short-term bonds, giving them a higher return.
However, long-term bonds are more susceptible to higher price fluctuations than shorter-term bonds and have a
greater interest-rate risk. So, this answer really depends on the duration of the bonds, not just their term to
maturity.
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.
PV = FV/(1+i)^n
As interest rates increase, 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.
Further explanation: 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. Retired persons often have much of their wealth placed in savings accounts and other
interest-bearing investments, and complain whenever interest rates are low. Do they have a valid
complaint?
(inominal = inflation + ireal)
While it would appear to them that their wealth is declining as nominal interest rates fall, as long as expected
inflation falls at the same rate as nominal interest rates, their real return on savings accounts will be unaffected.
However, in practice, expected inflation as reflected by the cost of living for seniors and retired persons often is
much higher than standard measures of inflation, thus low nominal rates can adversely affect the wealth of senior
citizens and retired persons.
15. 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
the inflation rate for the year turns out to be 2 percent, who gains and who loses?
Case 1: inflation (π) = 3% ⇒ real i = 4%
Case 2: π = 2% ⇒ real i = 5%
If the inflation rate for the year turns out to be 2 percent, the cost of borrowing will increase, so the borrower will
lose and the lender will gain more money.
16. Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists have
commented that real interest rates were actually much higher in the mid-1980s than in the late
1970s. Does this make sense? Do you think that these economists are right?
This does make sense. The real interest rate is the nominal rate minus inflation. Nominal interest rates were
higher in the 1970s than in the 1980s, but inflation was higher too, and the growth in nominal interest rates is
lower than the growth in the inflation rate. Therefore, real interest rates were much higher in the mid-1980s than
in the late 1970s.
EC1008
TUTORIAL 3 (12-13)

1. Explain why you would be more or less willing to buy a share of Microsoft stock in the following
situations:
a. Your wealth falls.
→ demand of stock decrease ⇒ less willing to buy stock
b. You expect the stock to appreciate in value.
Expected return ↑ ⇒ more willing to buy MS stock
c. The bond market becomes more liquid.
→ BD ↑ → relatively, stock demand declines ⇒ less willing to buy stock
d. You expect gold to appreciate in value.
Expected return for gold c → Gold demand ↑ → stock demand ↓ ⇒ less willing to buy stock
e. Prices in the bond market become more volatile.
→ Bond is more riskier → Bond demand decreases → Stock demand increases ⇒ More willing to
buy stock
2. Explain why you would be more or less willing to buy a house under the following circumstances:
a. You just inherited $100,000.
→ wealth increase → Demand for houses increases ⇒ more willing to buy a house
b. Real estate commissions fall from 6% of the sales price to 5% of the sales price.
→ Demand for houses increases ⇒ more willing to buy a house
c. You expect Microsoft stock to double in value next year.
→ expected return of Microsoft stock is higher → demand for stock↑ ⇒ less willing to buy a house
d. Prices in the stock market become more volatile.
→ demand of stock will fall ⇒ more willing to buy house because it less risky relative to stock
e. You expect housing prices to fall.
→ expected return of house value is lower ⇒ less willing to buy house.
3. Explain why you would be more or less willing to buy gold under the following circumstances:
a. Gold again becomes acceptable as a medium of exchange.
→ gold become more liquid ⇒ more willing to buy gold
b. Prices in the gold market become more volatile.
→ gold becomes more risky → the demand for gold decreases ⇒ less willingness to buy gold
c. You expect inflation to rise, and gold prices tend to move with the aggregate price level.
The expected inflation to rise → reduce real cost of borrowing → the value of gold will offset the rising prices to
keep your real value the same ⇒ more willing to buy gold.
d. You expect interest rates to rise
→ because its expected return has risen relative to the expected return on long-term bonds, which has declined ⇒
more willing to buy gold
4. Explain why you would be more or less willing to buy long-term Microsoft bonds under the
following circumstances:
a. Trading in these bonds increases, making them easier to sell.
→ more liquidity ⇒ more willing to buy
b. You expect a bear market in stocks (stock prices are expected to decline).
→ their expected return of bond has risen relative to stocks ⇒ more willing to buy
c. Brokerage commissions on stocks fall.
→ stock demand increases because they have become more liquid → relatively, bond demand decreases ⇒ less
willing to buy
d. You expect interest rates to rise.
→ Price of bond expected to fall ⇒ less willing to buy
e. Brokerage commissions on bonds fall.
→ bond demand increases because they have become more liquid ⇒ more willing to buy
5. What would happen to the demand for Picaso paintings if the stock market undergoes a boom?
Why?
If the stock market undergoes a boom, people become more wealthy. ⇒ The demand for Picasso paintings would
increase
 6. Predict the supply and/or demand change in the market for long term Treasury bonds after the
following events occur. Draw supply and demand curves in the bond market before and after the
change, describe impact on quantity and prices of bonds.
a. The economy comes out of recession and resumes strong growth.
→ (1) wealth increases → Bd increases and shift right; (2) pp need more money to finance their business → Bs
increases and shifts right
However, Bd ↑ < Bs ↑ ⇒ price decreases, i increases.
b. Corporate bonds and stocks become more risky.
→ demand of Corporate bonds and stocks decrease → relatively, demand of T bond increases → Bd increases &
shift right ⇒ price of T bond increases.
c. Government borrows more to finance its rising deficits
higher government deficits → the quantity of T bonds increases → Bs increases & shifts to the right ⇒ Price of T
bond decreases.
7. Draw a supply and demand graph in the market for money, with interest rate on the vertical axis
and the quantity of money on the horizontal axis. Describe how each of the following will affect
demand or supply of money and the resulting interest rates:
a. Incomes decrease in recession
→ Md decrease & shift left ⇒ Interest rate decreases
b. Price level rises (higher inflation)
The value of money in terms of what it can purchase is lower → people want to hold a greater nominal quantity
of money → Md shift right ⇒ interest rate will rise
c. The Federal reserve increases money supply
→ Ms shift to the right ⇒ interest rate will decline
8. “The more risk-averse people are, the more likely they are to diversify.” Is this statement true, false,
or uncertain? Explain your answer.
True, because the benefits to diversification are greater for a person who cares more about reducing risk.
9. “No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and
less liquidity than another security.” Is this statement true, false, or uncertain? Explain your
answer.
True because for a risk-averse person, those characteristics make a security less desirable.
10. An important way in which the central bank decreases the money supply is by selling bonds to the
public. Using a supply and demand analysis for bonds, show what effect this action has on interest
rates. Is your answer consistent with what you would expect to find with the liquidity preference
framework?
When the Fed sells bonds to the public, it increases the supply of bonds, shifting the supply curve to the right.
This decreases the price of bonds and increases the interest rate.
In the liquidity preference framework, the decrease in the money supply shifts the money supply curve to the left
and the equilibrium interest rate rises. The answer from bond supply and demand analysis is consistent with the
answer from the liquidity preference framework.
11. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your
answer.
Yes, interest rates will rise.
The lower commission on stocks makes them more liquid relative to bonds, and the demand for bonds will fall.
The demand curve Bd will therefore shift to the left, and the equilibrium interest rate will rise.
12. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when
the nominal money supply is fixed?
When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money
constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater
nominal quantity of money. Thus the money demand curve Md shifts to the right, and the interest rate rises.
13. What effect will a sudden increase in the volatility of gold prices have on interest rates?
Higher risk of gold prices increases the demand for bonds, raises the bond prices, and reduces the interest rate.
14. How might a sudden increase in people’s expectations of future real estate prices affect interest
rates?
Interest rates would rise.
A sudden increase in people's expectations of future real estate prices raises the expected return on real estate
relative to bonds, so the demand for bonds falls.
15. Explain what effect a large federal deficit should have on interest rates.
Budget deficit ↑ → BS↑ → P↓ i↑
In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government
budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and
stayed low for quite some time. Does this make sense? Why or why not?
i↓ → signal of economy recession
Central bank wants to offset the increase in interest rates & stimulate the economy → MS↑ → i↓ more than i↑
(liquidity effect dominated other effects)
⇒ i↓ (teacher’s answer)
(Expand fiscal policy, increase AD to stimulate the economy → P level ↑, output ↑ ⇒ Recover the economy,
stabilize interest rates)
16. Using both the supply and demand for bonds and liquidity preference frameworks, show what the
effect is on interest rates when the riskiness of bonds rises. Are the results the same in the two frameworks?
The liquidity preference framework: An increase in the riskiness of bonds raises the demand for money,
resulting in an increase in the interest rate.
The bond supply and demand framework: An increase in the riskiness of bonds reduces the demand for bonds.
As a result, the bond prices go down and the interest rate goes up.
⇒ Same results.
17. The prime minister announces in a press conference that he will fight the higher inflation rate with a
new anti-inflation program. Predict what will happen to interest rates if the public believes him.
If the public believes the president's program will be successful, interest rates will fall.
The president's announcement will lower expected inflation so that the expected return on goods decreases
relative to bonds. The demand for bonds increases and the demand curve, Bd, shifts to the right. For a given
nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of
borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the
rightward shift of the demand curve, Bd, causes the equilibrium interest rate to fall.
18. The chairman of the Fed announces that interest rates will rise sharply next year, and the market
believes him. What will happen to today’s interest rate on AT&T bonds, such as the 8s of 2022?
The interest rate on the AT&T bonds will rise.
Because people now expect interest rates to rise, the expected return on long-term bonds will fall, and the
demand for these bonds will decline. The demand curve BD will therefore shift to the left, and the equilibrium
bond price falls and the interest rate will rise.
19. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.
Interest rates will rise because the expected increase in stock prices raises the expected return on stocks relative to
bonds and so the demand for bonds decreases, P decreases, i increases.
20. Predict what will happen to interest rates if prices in the bond market become more volatile.
Bonds become riskier and the demand for bonds will fall, price falls which causes interest rates to rise.
21. If the next governor of the central bank has a reputation for advocating an even slower rate of money
growth than the current governor, what will happen to interest rates? Discuss the possible resulting
situations.
A slower rate of money growth will lead to a liquidity effect, which raises interest rates, while the lower price
level, income, and inflation rates in the future will tend to lower interest rates. There are three possible scenarios
for what will happen: (a) if the liquidity effect is larger than the other effects, then interest rates will rise; (b) if the
liquidity effect is smaller than the other effects and expected inflation adjusts slowly, then interest rates will rise at
first but will eventually fall below their initial level; and (c) if the liquidity effect is smaller than the expected
inflation effect and there is rapid adjustment of expected inflation, then interest rates will immediately fall.
22. Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or
why not?
Yes.
If people expect higher inflation, the yield on government debt will increase, meaning that the interest rates paid
to debt holders increase. In other words, higher inflation leads to a higher debt service burden and increases the
costs of financing deficit spending.
23. Why should a rise in the price level (but not in expected inflation) cause interest rates to rise when the
nominal money supply is fixed?
When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money
constant); to restore their holdings of money in real terms to their former level, people will want to hold a
greater nominal quantity of money. Thus the money demand curve Md shifts to the right, and the interest rate
rises.
24. If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of
money growth than the current chair, what will happen to interest rates? Discuss the possible resulting
situations.
Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income,
price level, and inflation will tend to lower interest rates.
25. M1 money growth in the U.S. was about 15% in 2011 and 2012, and 10% in 2013. Over the same time
period, the yield on 3-month Treasury bills was close to 0%. Given these high rates of money growth, why
did interest rates stay so low, rather than increase? What does this say about the income, price-level, and
expected-inflation effects?
2010-2020: money growth ↓ → MS↓ (i should ↑ normally) but i stayed so low rather than increase
Keep expected inflation & P level effect: Central banks commit to keep i and inflation at low level ⇒ People
don’t expect inflation → i↓ → offset increase in i
(liquidity effect is dominated by wealth, price-level and expected inflation effect).
26. Study the graph below and explain the movement of the lending rates in Vietnam.

Lending rates ảnh hưởng bởi lạm phát, so sánh với lạm phát/real interest rate là đc
TUTORIAL 4 (15-14)

1. What is a “junk bond”? If junk bonds are “junk,” then why do investors buy them?
Junk bonds represent bonds issued by companies that are financially struggling and have a high risk of defaulting
or not paying their interest payments or repaying the principal to investors. Junk bonds are also called high-yield
bonds since the higher yield is needed to help offset any risk of default.
Junk bonds offer the potential to earn more money than investment-grade corporate bonds and bonds issued by
the federal government and other government agencies. Junk bonds are referred to as "junk" in that they are
very risky investments, but provide high yields to investors who buy them at very low prices and are
therefore compensated with a high risk premium.
2. Which should have the higher risk premium on its interest rates, a corporate bond with a Moody’s
Baa rating or a corporate bond with a C rating? Why?
The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its
demand and raises its interest rate relative to that of the Baa bond.
3. Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?
U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for
Treasury bills is higher, and they have a lower interest rate.
 4. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of
defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped
in to support AIG with large capital injections and an ownership stake. How would this affect, if at
all, the yield and risk premium on AIG corporate debt?
The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher
yield. After the announcement that the government would provide extraordinary assistance to support AIG and
keep it from failing, demand for its corporate debt would rise, and yields would fall.
5. Risk premiums on corporate bonds are usually anti cyclical; that is, they decrease during business
cycle expansions and increase during recessions. Why is this so?
As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt.
During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds,
which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their
risk premium increases. The risk premium on corporate bonds is thus anti cyclical, rising during recessions and
falling during booms.
Risk premiums will fall in an economic expansion as business revenue and profits improve, making it easier for
borrowers to make scheduled interest payments on their debt and increasing the likelihood that the business will
repay the principle of that debt.
6. What is “flight to quality”? Give an example.
Flight to quality refers to the herd-like behavior of investors to shift out of risky assets during financial
downturns or bear markets. This often occurs with a shift out of stocks and into bonds, where bonds are seen as
relatively more safe and thus higher "quality" during rough economic patches. In extreme cases, the flight to
quality may involve a shift to even lower-risk assets such as Treasuries, money markets, or cash.
The increase in perceived default risk for Baa bonds in October 2008 made default-free U.S. Treasury bonds
relatively more attractive and shifted the demand curve for these securities to the right—an outcome described by
some analysts as a “flight to quality.”
7. “If bonds of different maturities are close substitutes, their interest rates are more likely to move
together.” Is this statement true, false, or uncertain? Explain your answer.
True. This statement is true due to the liquidity premium theory as well as the risk structure. If bonds of different
maturities are close substitutes, that means that the shorter term bond interest rates will affect the longer term
bond's interest rates as well. Based on the expectations theory, the longer term bond's interest rate will be the
average of the interest rates paid by the short-term bonds during this period.
8. The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in
which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds
are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What
can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds?
The liquidity premium for TIPS bonds is usually smaller than inflation compensations in nominal U.S. bond
yields of equal maturity.
9. Predict what will happen to interest rates on a corporation’s bonds if the federal government
guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will
happen to the interest rates on Treasury securities?
Interest rates on corporate bonds will decrease.
If the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future,
demand for the corporation's bonds will increase because the corporation's bonds are less risky. As a result, the
demand curve of corporation’s bonds will shift to the right, which increases their price and lower interest rates.
Demand curve for T-securities will shift left, which causes the price of T securities to decrease and Interest rates
of T securities increase.
10. Predict what will happen to the risk premiums on corporate bonds if brokerage commissions are
lowered in the corporate bond market.
Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand,
which would lower the risk premium.
11. During 2008, the difference in yield (the yield spread) between three-month AA-rated financial
commercial paper and three-month AA-rated nonfinancial commercial paper steadily increased
from its usual level of close to zero, spiking to over a full percentage point at its peak in October
2008. What explains this sudden increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to
the uncertainty of financial companies and banks.
The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about
the soundness of the financial system, and doubt about the soundness of even the most healthy banks and
financial companies. As a result, there was a sharp decline in demand for commercial paper from financial firms
relative to the seemingly safer commercial paper from nonfinancial firms. This resulted in a spike in the yield
spread between the two, reflecting the greater risk of investing in financial companies or their bonds.
12. If the income tax exemption on municipal bonds were abolished, what would happen to the interest
rates on these bonds? What effect would the change have on interest rates on U.S. Treasury
securities?
If the income tax exemptions on municipal bonds were abolished, the tax benefits of municipal bonds relative
to Treasury bonds would disappear.
The expected returns on municipal bonds thus declines relative to Treasury bonds, which leads to a decline
in the demand for municipal bonds. The downward shift of the demand curve for municipal bonds implies
lower municipal bond prices and higher interest rates. The expected return on Treasury increases relative to that
of municipal bonds, which leads to an increase in the demand for Treasury bonds. The upward shift of the
demand curve for Treasury bonds implies higher Treasury bond prices and lower interest rates.
13. Prior to 2008, mortgage lenders required a house inspection to assess a home’s value, and often used
the same one or two inspection companies in the same geographical market. Following the collapse
of the housing market in 2008, mortgage lenders required a house inspection, but this inspection
was arranged through a third party. How does the pre-2008 scenario illustrate a conflict of interest
similar to the role that credit-rating agencies played in the global financial crisis?
Credit rating agencies had a conflict of interest that was said to contribute to the crisis in that the rating agencies
had an incentive to provide overly optimistic ratings to clients whom they also advised. Similarly, the way in
which lenders and the house inspection process occurred provided incentives for the house inspectors to provide
overly optimistic assessments of the value of housing to ensure continued work in the future, and at the same time
mortgage lenders benefited because it continued the cycle of creating and selling mortgages as long as housing
value was maintained.
14. “According to the expectations theory of the term structure, it is better to invest in one-year bonds,
reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are
expected to be the same in both years.” Is this statement true, false, or uncertain?
The given statement is said to be false because the two-year term bond would have the same interest rate as the
average of the one-year bonds. Since the interest rates on one-year bonds are expected to be the same in both
years.
 15. If bond investors decide that 30-year bonds are no longer as desirable an investment as they were
previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the
term structure holds; and (b) the segmented markets theory of the term structure holds.
(a) Under the expectations theory of the term structure, if 30-year bonds become less desirable, this will increase
the demand for bonds of other maturities, since they are viewed as perfect substitutes. The result is a higher
price and a lower yield at all other maturities, and an increase in yield at the end of the yield curve. In other
words, the yield curve would steepen at the end, and flatten somewhat along the rest of the curve.
(b) Under the segmented markets theory, the assumption is that each type of bond maturity is an independent
market, and therefore not linked in any particular way. Thus changes in long rates won't affect shorter- and
medium-term bond yields. Thus, the yield curve under the segmented markets theory will result in a jump in the
30-year rate, with the remainder of the yield curve unchanged.
16. Suppose the interest rates on one-, five-, and ten-year U.S. Treasury bonds are currently 3%, 6%,
and 6%, respectively. Investor A chooses to hold only one-year bonds, and Investor B is indifferent
with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors A
and B?
Investor​ A's preferences are best explained by the segmented markets​theory, while Investor​B's preferences are
more consistent with the expectations theory.
Investor A, even though she receives a lower expected return, clearly prefers to hold short- term debt, perhaps
because it is more liquid. Investor A's preferences are consistent with the segmented markets theory. Investor B is
apparently maximizing expected return, but since he is indifferent between the five- and ten-year bonds, Investor
B doesn't appear to favor any particular maturity, and so views the five- and ten-year bonds as essentially perfect
substitutes, an assumption consistent with the expectations theory of the term structure.
17. If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the
term structure? Would you be more or less willing to accept the expectations theory?
This suggests that short term rates are expected to slightly decline. Liquidity premiums are zero if the curve is
flat, so you're more willing to accept the pure expectation theory.
18. Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it
would purchase up to $300 billion of longer-term Treasury securities over the following six months.
What effect might this policy have on the yield curve?
Purchases of long term maturities reduce supply, make the price rise and the yield fall. The yield curve would
shift​down, but mostly on​medium- and​long-term maturities.
19. If the yield curve suddenly became steeper, how would you revise your predictions of interest rates
in the future?
You would raise your predictions of future interest rates, because the higher long-term rates imply that the
average of the expected future short-term rates is higher.
20. If expectations of future short-term interest rates suddenly fell, what would happen to the slope of
the yield curve?
The slope of the yield curve would fall because the drop in expected future short rates means that the average of
expected future short rates falls so that the long rate falls.
21. If the income tax exemption on municipal bonds were abolished, what would happen to the interest
rates on these bonds and why?
Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to
Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for
 Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury
bonds would fall.
22. Assuming that the expectations theory is the correct theory of the term structure, calculate the
interest rates in the term structure for maturities of one to five years, and plot the resulting yield
curves for the following path of one-year interest rates over the next five years:
(a) 5%, 6%, 7%, 6%, 5%

(b) 5%, 4%, 3%, 4%, 5%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?
If people preferred short-term bonds to long-term bonds then individuals would be willing to accept a
slightly lower interest rate on short term bonds and require a slightly higher interest rate on long term
ones. This has the effect of steepening the yield curve.
23. Suppose that you are forecasting one-year T-bill rates as follows:
Year 1-year rate (%)
1 4.25
2 5.15
3 5.50
4 6.25
5 7.10
You have a liquidity premium of 0.25% for the next year and 0.50% thereafter. Would you be
willing to purchase a four-year T-bond at a 5.75% interest rate?
i4t = (4.25+5.15+5.50+6.25)/4 + 0.5 = 5.79% ⇒ not willing to buy a T-bond.
24. 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.
a. What are the expected one-year interest rates next year and the following year?
Long maturity yield = average of expected future short rates (plus risk premium)
Year 2 = (3+x)/2 + 1 = 4 ⇒ x = 3 (%)
Year 3 = (3+3+x)/3 + 2 = 5 ⇒ x = 3 (%)
b. If the risk premiums were all zero, as in the expectations hypothesis, what would the slope of the yield
curve be?
The slope of the yield curve would be flat
25. If inflation and interest rates become more volatile, what would you expect to see happen to the
slope of the yield curve?
The yield curve becomes steeper.
26. As economic conditions improve in countries with emerging markets, the cost of borrowing funds
there tends to fall. Explain why.
As economic conditions improve, the chance that businesses will default on their loans decreases. The decline in
default risk reduces the return demanded by lenders. As a result, the cost of borrowing funds there tends to fall.
27. 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?
If institutional investors were willing to hold speculative grade bonds in the absence of a legal restriction, the
spread between investment and speculative 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, the 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.
28. In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget
crisis. Using bond market graphs, compare the effects on the risk premium between the U.S.
Treasury debt and comparable-maturity Greek debt.
The risk premium would increase, which corresponds to demand for US Treasury debt rising relative to that of
Greek debt.
 29. Suppose a country with a struggling economy suddenly discovers vast quantities of valuable
minerals under government-owned 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 bond
yields of that country’s government bonds?
The bonds of that government would likely be upgraded, as the economic outlook for the economy would
improve and the reduction in the perceived riskiness of the bonds would shift the demand curve right. Bond
prices would increase and bond yields fall.
30. 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.

The information in both the term structure and the risk structure point to a healthy economy.
The term spread (the gap between the 3 month Treasury-bill yield and the 10 year Treasury bond yield) 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 10 year 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.
TUTORIAL 5 (14-15)

1. What kind of moral hazard problems do banks worry about?

Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are
undesirable (immoral) from the lender’s point of view, because they make it less likely that the loan will be paid
back. Moral hazard problems that banks need to worry about include: the borrowers may not use the loans they
receive efficiently or they may invest in dangerous projects and be unable to repay the loans to banks.
2. Describe two ways in which financial intermediaries help lower transaction costs in an economy.
Financial intermediaries develop expertise in such areas as computer technology so that they can inexpensively
provide liquidity services such as checking accounts that lower transaction costs for depositors. Financial
intermediaries can also take advantage of economies of scale and engage in large transactions that have a lower
cost per dollar of transaction.
3. Why are financial intermediaries willing to engage in information collection activities when
investors in financial instruments may be unwilling to do so?
Investors in financial instruments who engage in information collection face a free-rider problem, which means
other investors may be able to benefit from their information without paying for it. Individual investors therefore
have inadequate incentives to devote resources to gather information about borrowers who issue securities.
Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather
than buy the securities borrowers have issued. Since they will reap all the benefits from the information they
collect, their information collection activities will be more profitable. They thus have greater incentive to invest in
information collection.
4. Suppose you go to your local bank, intending to buy a certificate of deposit with your savings.
Explain why you would not offer a loan, at an interest rate that is higher than the rate the bank
pays on certificates of deposit (but lower than the rate the bank charges for car loans), to the next
individual who enters the bank and applies for a car loan.
During your visit at the bank you will probably realize that you will receive an annual interest rate of 1% or 2% if
you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest
rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make
both of you better off. However, you would probably like to know that individual better, in particular his net
worth (to assess his ability to pay you back), or his credit history. This process will probably be time consuming
and costly for you.
Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to
recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is
much more efficient in dealing with the adverse selection and moral hazard problems created by
asymmetric information, so much so that you are better off by buying a certificate of deposit and avoiding
all the transaction costs associated with making a loan.
5. Wealthy people often worry that others will seek to marry them only for their money. Is this a
problem of adverse selection?
Yes. Because if a person is rich, people who are most likely to want to marry him or her are gold diggers. Rich
people thus may want to be extra careful to screen out those who are just interested in their money from those
who want to marry for love.
6. Do you think the lemons problem would be more severe for stocks traded on the New York Stock
Exchange or for those traded over-the-counter? Explain.
The lemon problem would be less severe for firms listed on the NYSE because they are typically larger
corporations which are better known in the marketplace. Therefore it is easier for investors to get information
about them and figure out whether the firm is of good quality or is a lemon.
7. Would you be more willing to lend to a friend if she had put all of her life savings into her business
than you would be if she had not done so? Why?
Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or
engages in personally beneficial activities that don't lead to higher profits. Putting her life savings into her
business provides you protection against the problem of moral hazard. She will act more in the interest of the
lender, making it more likely that the loan will be paid off.
8. What specific procedures do financial intermediaries use to reduce asymmetric information
problems in lending?
- Banks screen potential borrowers before making loans.
- Monitor borrowers' financial conditions and how they are using borrowed funds after making loans.
- Insert restrictive clauses into debt contracts to limit borrowers' behavior.
- Require collateral against the loans they make.
 9. What steps can the government take to reduce asymmetric information problems and help the
financial system function more smoothly and efficiently?
The government can produce information about borrowers and provide it to investors free of charge, it can require
borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern
the behavior of financial institutions so they do not take on too much risk. These prudential regulations for banks
include banning certain activities and asset categories considered too risky, establishing minimum capital
requirements, and requiring disclosure of financial information to regulators and investors.
10. How can asymmetric information problems lead to a bank panic?
Bank depositors face an asymmetric information problem: They do not know as much as bank managers do about
how much risk banks are taking and are uncertain about the safety of their deposits and their banks' ability to pay
them back in full.
If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures
increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks
(and their deposits) are safe or not.
This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are
scrambling to withdraw their deposits before their banks run out of cash, and in extreme cases can lead to a
contagion in which a large number of banks fail within a short period of time.
11. In December 2001, Argentina announced it would not honor its sovereign (government-issued) debt.
Many investors were left holding Argentine bonds priced at a fraction of their previous value. A few
years later, Argentina announced it would pay back 25% of the face value of its debt. Comment on
the effects of information asymmetries on government bond markets. //Do you think investors are
currently willing to buy bonds issued by the government of Argentina?
Usually investors resort to many information sources about the characteristics of particular governments to assess
their ability or willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack of
information results in huge losses for bondholders. In this respect, the problem is not significantly different from
an investor who decides which corporate bond to buy, although it may be fair to say that information about
corporate bonds is more standardized (making it easier to compare firms).
After the Argentinean default, investors would only be willing to buy bonds issued by its government only at a
significant risk premium, making it very costly for Argentina to raise funds in bond markets.
12. How does the free-rider problem aggravate adverse selection and moral hazard problems in
financial markets?
The free-rider problem means that private producers of information will not obtain the full benefit of their
information-producing activities, and so less information will be produced. This means that there will be less
information collected to screen out good from bad risks, making adverse selection problems worse, and that there
will be less monitoring of borrowers, increasing the moral hazard problem.
13. Would moral hazard and adverse selection still arise in financial markets if information were not
asymmetric? Explain.
No. If the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the
good from the bad credit risks and so adverse selection will not be a problem. Similarly, if the lender knows what
the borrower is up to after the transaction, then moral hazard will not be a problem because the lender can prevent
the borrower from engaging in that behavior.
14. How do standardized accounting principles help financial markets work more efficiently?
Standardized accounting principles make profit verification easier and make it easier for investors to screen out
good firms from bad firms, thereby reducing adverse selection and moral hazard problems in financial markets. In
addition, they make it harder for managers to over- or understate profits, thereby reducing the principal-agent
(moral hazard) problem. Hence, standardized accounting principles make financial markets operate more
effeciently.
15. Which firms are most likely to use bank financing rather than issue bonds or stocks to finance their
activities? Why?
Smaller firms that are not well known are the most likely to use bank financing. Because it is harder for investors
to acquire information about these firms, it will be hard for the firms to sell securities in financial markets. Banks
that specialize in collecting information about smaller firms will then be the only outlet these firms have for
financing their activities.
16. How can the existence of asymmetric information provide a rationale for government regulation of
financial markets?
Because there is asymmetric information and the free-rider problem, not enough information is available in
financial markets. Thus there is a rationale for the government to encourage information production through
regulation so that it is easier to screen out good from bad borrowers, thereby reducing the adverse selection
problem.
The government can also help reduce moral hazard and improve the performance of financial markets by
enforcing standard accounting principles and prosecuting fraud.
17. “The more collateral there is backing a loan, the less the lender has to worry about adverse
selection.” Is this statement true, false, or uncertain? Explain your answer.
True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less, because the collateral
can be sold to make up any losses on the loan. Thus adverse selection is not as severe a problem.
18. Explain how the separation of ownership and control in American corporations might lead to poor
management.
The separation of ownership and control forms a Principal-Agent Problem. The principal-agent problem is a
conflict in priorities between a person or group and the representative authorized to act on their behalf.
The separation of ownership and control refers to the phenomenon associated with publicly held business
corporations in which the shareholders (the residual claimants) possess little or no direct control over
management decisions. Therefore, the separation of ownership and control in American corporations might lead
to poor management, as an agent may act in a way that is contrary to the best interests of the principal.
19. Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial
system. When Gustavo applied for a mortgage, he found that banks usually required collateral for
up to 300% of the amount of the loan. Explain why banks might require that much collateral in
such a financial system. Comment on the consequences of such a system for economic growth.
An inefficient legal system implies weak property​rights, and collateral helps banks recoup some of their loan if
the borrower defaults.
Consequences: Less investment and slower economic growth.
20. Why does the government find it necessary to heavily regulate the financial system? Give one
example of such government involvement into financial markets.
Governments regulate financial markets primarily to promote the provision of information and to ensure the
soundness (stability) of the financial system.
Regulations That Affect the Stock Market
The Securities and Exchange Commission (SEC) regulates the securities markets and is tasked with protecting
investors against mismanagement and fraud. Ideally, these types of regulations also encourage more investment
and help protect the stability of financial services companies.
 21. 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?
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.
22. List three types of financial intermediaries, give examples.
● Pension funds invest individual and company contributions in stocks, bonds,and real estate in order to
provide payments to retired workers.
● Insurance companies: Insurance companies accept premiums, which they invest, in return for promising
compensation to policyholders under certain events.
● Finance companies raise funds directly in the financial markets in order to make loans to individuals and
firms. Finance companies tend to specialize in particular types of loans, such as mortgage, automobile, or
business equipment.
23. Joe and Mike purchase identical houses for $200,000. Joe makes a down payment of $40,000, while
Mike only puts down $10,000; for each individual, the down payment (trả trước) is the total of his
net worth. Assuming everything else is 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 Joe’s and Mike’s net worth?
Mike is more highly leveraged because he has financed a larger part of his asset with borrowing (95 percent
compared to Joe's 80 percent).
If house prices in the neighborhood immediately fall by 10 percent (before any mortgage payments are made),
their net worth will reduce by 200,000*10% = $20,000. Joe's net worth would fall but remain positive ($20,000)
while Mike's net worth would become negative (-$10,000). He would owe $190,000 on his mortgage for a house
worth $180,000.
24. 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?
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.
25. Why do large corporations find it easier to raise funds in securities markets while small businesses
rely mostly on bank loans?
It is one of eight basic facts that only large, well-established corporations have access to direct finance, which
means large corporations often raise funds by issuing securities while small businesses often take out bank loans.
This is because lenders lack the information needed to verify the quality of small newly-established businesses. In
contrast, large well-established firms make lenders more confident about their quality.
26. Will finance companies be replaced by commercial banks?
Finance companies tend to provide credit to borrowers that exhibit higher risk. They can charge the borrowers a
higher interest rate and therefore have the potential to earn a higher return on the loans (if the borrowers repay the
loans). Commercial banks are also exposed to default risk, but not to the same degree. Their loan portfolios are
monitored by regulators. Thus, they are unlikely to replace finance companies.
27. Discuss the following: Money market funds attract money from investors who do not know what
else to do with their money. Thus money market funds are merely a last resort when there are no
better alternatives for investment. Since they invest only in short term securities, they do not play a
role in financing economic growth.
Money market funds provide liquidity to investors, which is necessary even when investors have alternative
investments that pay higher returns. In addition, money market funds play a major role in financing the budget
deficit because they invest heavily in Treasury securities. They also channel funds to corporations in the form of
commercial paper. Since the Treasury and corporations frequently reissue short-term securities, they are
sometimes using the short-term securities to finance long-term investment.
28. Why can a money market mutual fund allow its shareholders to redeem shares at a fixed price but
other mutual funds cannot?
For other mutual funds, shareholders can sell (redeem) shares at any time, but the value of these shares will be
determined by the value of the mutual fund’s holdings of securities because these fluctuate greatly. On the other
hand, money market mutual funds buy money market instruments that are both safe and very liquid. MM
instruments are often short-term instruments, so their value won’t fluctuate greatly. Therefore, a money market
mutual fund can allow its shareholders to redeem shares at a fixed price but other mutual funds cannot.
29. Should financial institutions be regulated in order to reduce their risk? Offer at least one argument
for regulation and one argument against regulation.
Regulations may be able to reduce failures of financial institutions, which may stabilize the financial system. The
flow of funds into financial institutions will be larger if the people who provide the funds can trust that the
financial institutions will not fail. However, regulation can also restrict competition. In some cases, it results in
subsidies to financial institutions that are performing poorly. Thus regulation can prevent firms from operating
efficiently.
TUTORIAL 6 (12-11)

1. Suppose Annie’s Bank starts with the balance sheet as shown here. Show how the balance sheet works
in each of the following scenarios.
● The bank issues $20 of new stock and uses the
proceeds to make loans.

Assets Liabilities and Equities

Reserves 10 Checking deposits 50

Securities 30 Nontransaction deposits 50

Loans 100 (+20) Net worth 40 (+20)

Total 140 Total 140

● Britt moves $25 from his savings account to his checking account.
 Assets Liabilities and Equities

Reserves 10 Checking deposits 75 (+25)

Securities 30 Nontransaction deposits 25 (-25)

Loans 80 Net worth 20

Total 140 Total 140

● The bank lends $5 of reserves to another bank in the federal funds market.

Assets Liabilities and Equities

Reserves 5 (-5) Checking deposits 50

Securities 30 Nontransaction deposits 50

Loans 80 Net worth 20

Federal fund loans 5 (+5)

Total 140 Total 140

2. Suppose again that Annie’s Bank starts with the balance sheet as above. Then the bank sells $10 of
loans for $10 of cash.
● What is the immediate effect on the balance sheet?
The loans shown under the asset side will decrease by $10. Another effect is that the reserves will increase by
$10. Total assets remain constant. It is because each received from loan sale becomes reserve. The change will be,
reserves become $20 and loans becomes $70
● After the loan sale, what additional transactions is the bank likely to make? What will the balance sheet
look like after these transactions?
Banks can purchase securities with the money received from the sale of the loan. This is because holding a higher
percentage of assets in cash can reduce a bank's profitability. It may be quite possible that banks have sold loans
in order to meet withdrawals.
10 added to securities = 40. Reserve will decrease by 10 = 10
3. Suppose the central bank raises short term interest rates, an action that is likely to reduce aggregate
output temporarily. Describe the various effects on the profits of commercial banks.
Overall increased short-term rates would increase the rates that banks have to pay on liabilities and this also
impacts the rate received on assets. Interest expenses as a result are more than interest income which reduces
profit of commercial banks
The situation may also lead to increased bank withdrawals, so banks would have fewer funds to make profit or
may even suffer from the decrease in net worth if their reserves are not enough to meet the obligations after
paying back to depositors.
4. Why has the development of overnight loan markets made it more likely that banks will hold fewer
excess reserves?
Because when a deposit outflow occurs, a bank is able to borrow reserves in these overnight loan markets
quickly; thus, it does not need to acquire reserves at a high cost by calling in or selling off loans. The presence of
overnight loan markets thus reduces the costs associated with deposit outflows, so banks will hold fewer excess
reserves.
5. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should
you automatically turn the customer down, explaining that you don’t have any excess reserves to lend
out? Why or why not? What options are available for you to provide the funds your customer needs?
No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly.
Instead, you might go out and borrow from other banks or the Fed to obtain funds so that you can make the
customer's loan. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary
funds.
6. If a bank finds that its ROE is too low because it has too much bank capital, what can it do to raise its
ROE?
To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its
shares. Alternatively, it can keep its capital constant but increase the amount of its assets by acquiring new funds
and then seeking out new loan business or purchasing more securities with these new funds.
7. If a bank is falling short of meeting its capital requirements by $1 million, what three things can it do
to rectify the situation?
It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby
increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its
capital relative to its assets increases, thereby meeting the capital requirements.
8. Why do equity holders care more about ROE than about ROA?
Because ROE, the return on equity, tells stockholders how much they are earning on their equity investment,
while ROA, the return on assets, only provides an indication how well the bank's assets are being managed.
9. If a bank doubles the amount of its capital and ROA stays constant, what will happen to ROE?
ROE will fall in half.
10. What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?
The benefits are that the bank now has a larger cushion of bank capital and a lower chance of insolvency if there
are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower return on equity to
shareholders.
11. A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?
Compensating balances can act as collateral. They also help establish long-term customer relationships, which
make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection
problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent
the firm from taking on too much risk, thereby not acting in the interest of the bank.
12. ‘Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to
specialize in making specific types of loans.’ Is this statement true, false, or uncertain? Explain your
answer.
False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize
in certain types of lending. For example, a bank may have developed expertise in screening and monitoring
borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and
moral hazard. Also if the bank lends to firms in a few specific industries they will become more knowledgeable
about those industries and a better judge of creditworthiness in those industries.
13. Suppose that you are the manager of a bank whose €100 billion of assets have an average duration of
four years and whose €90 billion of liabilities have an average duration of six years. Conduct a
duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates
rise by 2 percentage points. What actions could you take to reduce the bank’s interest-rate risk?
The assets fall by $8 billion ($100×4×0.02) and the value of the liabilities fall by $10.8 billion ($90×0.02×6) so
the bank’s net worth (capital) is expected to increase by $2.8 billion (-8-(-10.8)=2.8). The interest rate risk can be
reduced by shortening the maturity of the assets or by lengthening the maturity of the liabilities. Alternatively,
you could engage in an interest-rate swap, in which you swap the interest earned on your assets with the interest
on another bank’s assets that have a shorter term to maturity.
14. Suppose that you are the manager of a bank that has €15 million of fixed-rate assets, €30 million of
rate-sensitive assets, €25 million of fixed-rate liabilities and €20 million of rate-sensitive liabilities.
Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by
5 percentage points. What actions could you take to reduce the bank’s interest-rate risk?
This bank’s gap is $10 million ($30 rate sensitive assets - $20 rate sensitive liabilities). An increase in interest
rates by 5% will raise profits by $500,000 (5% of the gap). While banks enjoy the higher profits, a decrease in
interest rates would have reversed the profits into losses of equal amounts.
To avoid this profit variability, this bank could have tried to increase the amount of interest rate sensitive
liabilities it holds, decrease the rate sensitive assets it holds, or engage in an interest rate swap with another
company.
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?
If owners of lines of credit or other off-balance sheet activities go to the bank and ask to withdraw money out, the
bank will face the risk of not having enough money to pay out (which means they face liquidity problems).
16. A bank with a two-year investment horizon has issued a one-year certificate of deposit for $50 million
at an interest rate of 2 percent. With the proceeds, the bank has purchased a two-year Treasury note
that pays 4 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?
The bank may not produce enough revenue by the Treasury note to make payment for the CDs and must draw
down bank capital to do so. The risk the bank faces in this case is interest rate risk; higher rates reduce bank
profitability and lower rates increase it.
One can see this approximately with duration analysis.
● The % change in the value of the CD = -the % in i*duration (1 year). Since the CD’s face value is $50m,
each percentage point increase in interest rates reduces the value of the CD by $0.5m.
● The duration of the T-note is 2 years so each one percentage point increase in interest rates reduces the
value of the t-note by 2%, or $1m.
● Thus, for every one percentage point increase in interest rates, the net worth of the bank falls by $0.5m
(-1-(-0.5)=-0.5).
Banks hold more liquid assets than do most businesses. Explain why?
Banks hold more liquid assets than do most businesses because they need to have the reserves available to
meet the demands of their customers. Depositors demand cash and banks need to have enough liquid assets to
provide that cash right away. Businesses don't need to have access to as much cash as quickly.
17. The required reserve ratio is 10%. Bank One has the following balance sheet:
Assets Liabilities
Reserves $75 m Deposits $500 m
 Loans $525 m Bank capital $100 m
a. How much excess reserves is the bank currently holding?
Required reserves = $500*10% = $50m; Excess reserves = 75-50 = $25m
b. Give one reason why this bank may choose to hold excess reserves?
Liquidity risk is the risk of a sudden demand for liquid fun. Because of liquidity risk, bank may choose to hold
excess reserves. If a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts
of its balance sheet. Excess reserves are insurance against the costs associated with deposit outflow.
c. Suppose the bank suffers a deposit outflow of $50 m. Show how the balance sheet changes.

Assets Liabilities & Equity

Reserves (-50) $25m Deposits (-50) $450m

Loans $525m
Bank capital $100m

d. What actions must the bank take to stay afloat?

- Borrow money from another bank to keep the required reserves obligation
- Increase bank capital
e. If the return on assets is 2%, find the return on equity for this bank using the initial balance
sheet.
ROE = ROA x equity multiplier = ROA * Assets/Equity Capital = 2% * 600/100 = 12%
18. Give examples of off-balance sheet activities of a bank.
● Lines of credit - similar to limits on credit cards: The firm pays a bank a fee in return for the ability to
borrow whenever necessary.
● Letters of credit: These guarantee that a customer of the bank will be able to make a promised payment,
for example to an exporter in another country guaranteeing payment for the goods on receipt. In return for
taking this risk, the bank receives a fee.
● Trading activities and risk management techniques: Financial futures, options for debt instruments,
interest rate swaps, transactions in the foreign exchange market and speculation.
19. Give one or more examples of financial innovations used by banks and savings institutions over the
last 20 years.
● Mortgage-Backed Security (MBS)
A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans
bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon
payments.
● Asset-backed securities (ABS)
An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of
assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or
receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until
maturity. ABS are one type of collateralized debt obligations (CDOs)
 20. If the president of a bank told you that the bank was so well run that it has never had to call in
loans, sell securities, or borrow as a result of a deposit outflow, would you be willing to buy stock in
that bank? Why or why not?
No, because the bank president is not managing the bank well. The fact that the bank has never incurred costs as a
result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. Thus
the bank's profits are low, and stock in the bank is not a good investment.
Another approach:
You should care more about Return on Equity or ROE than Return on Assets (ROA).
ROE = ROA×EM (equity multiplier) = ROA x Assets/Equity capital
ROA indicates the well-being of the bank because it shows much profit is generated by every dollar. However, if
ROA is high but EM is low investors would not favor such a case. For investors it is important to consult both
with ROA and EM ratios.
21. “Bank managers should always seek the highest return possible on their assets.” Is this statement
true, false, or uncertain? Explain your answer.
False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than
other assets. Thus a bank manager has to consider risk as well as the expected return when deciding to hold an
asset.
22. Why has noninterest income been growing as a source of bank operating income?
Because the off-balance sheet activities that generate fees have become a more important part of a bank's
business.
23. Suppose you are the manager of a bank whose $100 billion of assets have an average duration of
four years and whose $90 billion of liabilities have an average duration of six years. Conduct a
duration analysis for the bank, and show what will happen to the net worth of the bank if interest
rates rise by 2 percentage points. What actions could you take to reduce the bank’s interest-rate
risk?
Duration analysis:
∆𝐴 =− 100 * 4 * 2% =− 8
∆𝐿 =− 90 * 6 * 2% =− 10. 8
⇒ ∆𝐸 = ∆𝐴 − ∆𝐿 =− 8 − (− 10. 8) = 2. 8
Equity will increase by $2.8 billion if interest rates rise by 2 percentage points.
Actions to reduce the bank’s interest-rate risk:
● By matching the maturity and re-pricing terms of its assets and liabilities
● By engaging in derivatives transactions.
24. Suppose you are the manager of a bank that has $15 million of fixed-rate assets, $30 million of
rate-sensitive assets, $25 million of fixed-rate liabilities, and $20 million of rate-sensitive liabilities.
Conduct a gap analysis for the bank, and show what will happen to bank profits if interest rates rise by
5 percentage points. What actions could you take to reduce the bank’s interest-rate risk?
Gap analysis:
∆𝑏𝑎𝑛𝑘 𝑝𝑟𝑜𝑓𝑖𝑡 = (𝑟𝑎𝑡𝑒 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑟𝑎𝑡𝑒 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑒 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠) 𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠
= (30-20)*5% = $50 million
To avoid this profit variability, this bank could have tried to increase the amount of interest rate sensitive
liabilities it holds, decrease the rate sensitive assets it holds, or engage in an interest rate swap with another
company.
TUTORIAL 7 (17-18)

1. How can the bursting of an asset-price bubble in the stock market help trigger a financial crisis?
A reduction in asset prices causes:
● borrowing firms to have less to lose so they are willing to take on additional risk.
● lenders to become more cautious and reduce the amount of loans they make.
● a serious deterioration in borrowing​firms' balance sheets.
2. What impact do declining price levels have on lending by financial institutions?
Due to steep decline in economic activities, prices decline. Decline in price levels have an adverse effect on the
net worth of firms, increasing the debt burden of the firm. Typically, a decline in price levels raises the value of
the borrowing firms and household liabilities because of an increase in the burden of indebtedness even though
the real value of their assets do not increase. The increasing gap between the assets and liabilities leads the
financial institution to reduce or stop lending to firms that have investment opportunities.
3. How can a decline in real estate prices cause deleveraging and a decline in lending?
A decline in real estate prices lowers the net worth of households or firms that are holding real estate assets. The
resulting decline in net worth means that businesses have less at risk and so have more incentives to take on
risk at the lender's expense. In addition, lower net worth means there is less collateral and so adverse selection
increases. The decline in real estate prices can thus make borrowers less credit-worthy and cause a contraction in
lending and spending. The real estate decline can also lead to a deterioration in financial institutions' balance
sheets, which causes them to deleverage, further contributing to the decline in lending and economic activity.
4. How does a deterioration in balance sheets of financial institutions and the simultaneous failures of
these institutions cause a decline in economic activity?
If financial institutions suffer a deterioration in their balance sheets and they have a substantial contraction in their
capital, they will have fewer resources to lend, and lending will decline. The contraction in lending then leads to
a decline in investment spending, which slows economic activity.
When there are simultaneous failures of financial institutions, there is a loss of information production in
financial markets and a direct loss of banks' financial intermediation. In addition, a decrease in bank lending
during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest
rates, which increases asymmetric information problems and leads to a further contraction in lending and
economic activity.
5. How does a general increase in uncertainty as a result of a failure of a major financial institution
lead to an increase in adverse selection and moral hazard problems?
The failure of a major financial institution, which leads to a dramatic increase in uncertainty in financial
markets, makes it hard for lenders to screen good from bad credit risks. The resulting inability of lenders to
solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending,
investment, and aggregate economic activity.
 6. How does a general increase in uncertainty as a result of the failure of a major financial institution
lead to an increase in adverse selection and moral hazard problems?
7. What is a credit spread? Why do credit spreads rise significantly during a financial crisis?
Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar
maturity that have no default risk. The rise of credit spreads during a financial crisis reflects the escalation of
asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken
the ability of financial markets to channel funds to borrowers with productive investment opportunities.
8. What causes bank panics to occur?
Bank panics occur because deteriorating balance sheets and tougher business conditions lead some banks
into insolvency. Depositors then fear for the safety of their deposits and not knowing the quality of bank's loan
portfolios, they run to banks and withdraw their deposits to the point that banks fail. The contagion can spread
further if the runs lead to fire sales of banks' assets, causing the assets to decline in value. The resulting fall in
banks' net worth can then lead to further bank failures and a full-fledged bank panic, in which many banks fail
together.
9. Why do bank panics worsen asymmetric information problems in credit markets?
Because banks are special in that they solve asymmetric information problems and make loans to firms and
households that cannot get loans from other sources. When bank panics happen, fewer banks are operating and
information about creditworthiness of borrower-spenders disappears, so that there will be more severe moral
hazard and adverse selection problems. These asymmetric information problems increase in credit markets,
causing a contraction in lending and a collapse of spending.
10. How does the concept of asymmetric information help to define a financial crisis?
Asymmetric information problems (adverse selection and moral hazard) are always present in financial
transactions but normally do not prevent the financial system from efficiently channeling funds from
lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to
such a degree that the resulting financial frictions lead to flows of funds being halted or severely disrupted,
with harmful consequences for economic activity
11. How can financial innovation lead to financial crises?
With restrictions lifted or the introduction of new financial products, financial institutions often go on a lending
spree and expand their lending at a rapid pace. Unfortunately, the managers of these financial institutions may
not have the expertise to manage risk appropriately in these new lines of business, leading to overly risky lending.
In addition, regulation and government supervision may not keep up with the new activities, further leading to
excessive risk taking. When loans eventually go sour, this causes a deterioration in financial institutions' balance
sheets, a decrease in lending, and therefore a decrease in economic activity.
12. What role does weak financial regulation and supervision play in causing financial crises?
Weak regulation and supervision mean that financial institutions will take on excessive risk, especially if market
discipline is weakened by the existence of a government safety net. When the risky loans eventually go sour, this
causes a deterioration in financial institution balance sheets, which then means that these institutions cut back
lending and economic activity declines.
13. The Great Depression of 1930 and the financial crisis of 2007–2009 have some similarities and some
differences. Compare and contrast the two economic crises.
Both are financial crises: decline in asset prices & firm failures.
In the Great Depression, if big financial institutions collapsed, they just collapsed. In the financial crisis
2007-2009, the government didn’t let any big financial institutions collapse. The government has undertaken a lot
of actions to deal with the crises.
.
In both cases, one common denominator was the uncertainty and weak appetite of investors. According to
many, in 1930 one of the main causes of the Great Depression was the bank run faced by the Bank of the United
States, and in 2007-09 it was again due to irresponsible activities on the part of investment banks like Bear
Stearns, Lehman Brothers, and American International Group, Inc. (AIG.) The information flow during both time
periods wasn't smooth and transparent enough. In 1930 the crisis was caused due to a default in farm mortgage
and in 2007-09 it was due to a default in house mortgage. Adverse selection and moral hazard problems were
common in both crises.
Stock markets tumbled, and investment spending reduced in 1930 by 90% from its 1929 level. In contrast, during
2007 - 2009 the problem was accentuated due to the greed of investment bankers and the prevalent cut-throat
competition among the banks to lend to subprime borrowers. It was also due to conflict of interest of rating
agencies, which was not the case in the Great Depression of 1930.
14. What do you think prevented the financial crisis of 2007–2009 from becoming a depression?
Depression: severe recession
→ The responses from the government and the central bank. Those tools somehow get the economy out of
recession (+ provide examples).
In general, it is believed that the country as a whole probably learned from the experience of the Great
Depression, and have put in place more sophisticated policy frameworks to help deal with severe economic
downturns more effectively. For instance, bank panics, which were widespread during the Great Depression, were
virtually nonexistent during the 2007-2009 crisis; this is probably due to bank accounts now being insured by the
FDIC (Federal Deposit Insurance Corporation), when they were not during the Great Depression. Another factor
seems to be the resolve by policymakers not to make the same mistakes made during the Great Depression by
instituting more aggressive, swiffer policies to avoid any contagion effects that would unnecessarily deepen or
lengthen the crisis.
15. What technological innovations led to the development of the subprime mortgage market?
The use of data mining to give households numerical credit scores that can be used to predict defaults and the use
of computer technology to bundle together many small mortgage loans and cheaply package them into securities.
Together both enable the origination of subprime mortgages, which then can be sold off as securities.
16. Why is the originate-to-distribute business model subject to the principal–agent problem?
Because the agent for the investor, the mortgage originator, has little incentive to make sure that the mortgage is a
good credit risk.
17. “Financial engineering always leads to a more efficient financial system.” Is this statement true,
false, or uncertain?
False. Financial engineering may create financial products that are so complex that it can be hard to value the
cash flows of the underlying assets for security or to determine who actually owns these assets. In other words,
the increased complexity of structured products can actually destroy information, thereby making asymmetric
information worse in the financial system and increasing the severity of adverse selection and moral hazard
problems.
18. How did a decline in housing prices help trigger the subprime financial crisis that began in 2007?
The decline in housing prices led to many subprime borrowers finding that their mortgages were "underwater"
because they owed more on them than their houses were worth. When this happened, struggling homeowners had
tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on
mortgages shot up sharply, causing losses to financial institutions, which then deleverage, causing a collapse in
lending.
 19. What role did the shadow banking system play in the 2007–2009 financial crisis?
The shadow banking system is composed of hedge funds, investment banks, and other nondepository financial
firms that are not subject to the tight regulatory frameworks of traditional banks. Due to the light regulation, they
had lower capital requirements (if any at all) and were able to take on significantly more risk than other financial
firms.
In the 2007-2009 financial crisis, they played a significant role because a large amount of funds flowed through
the shadow banking system to support low interest rates, which fueled some of the housing bubble. Because
of their large presence in financial markets, when credit markets began tightening, funding from the shadow
banking system decreased significantly, which further reduced access to needed credit and finally a decline in
economic activity.
20. When can a decline in the value of a country’s currency exacerbate adverse selection and moral
hazard problems? Why?
When a country is using foreign currencies rather than their own cash, a decline in the value of a country’s
currency exacerbates adverse selection and moral hazard problems.
If domestic currency drops, then it affects the firm’s assets (money) and results in deterioration in the firms'
balance sheets, which declines net worth. The real net worth of corporations plays a similar role to collateral in
helping to ease lenders' fears regarding both adverse selection and moral hazard and in helping to encourage more
responsible behavior on the part of corporate borrowers. Consequently, negative shocks to the real net worth of
corporations exacerbate adverse selection and moral hazard problems in financial markets and make lenders less
willing to lend, hence, causes decline in investment and economic activity.
21. How has the European sovereign debt crisis led to higher borrowing costs for governments?
A currency’s valuation significantly affects exchange rates and exports. In times of financial crises, countries
often resort to a devaluation of their currency to boost exports. However, devaluing a currency also increases the
dollar value of existing sovereign debt that is borrowed from foreign countries – as was the case for EU countries
like Greece. Therefore, the European sovereign debt crisis led to higher borrowing costs for governments.
High default risk → high cost of borrowing
22. What are the two basic causes of financial crises in emerging market economies?
Crises in advanced economies can be triggered by a number of factors. But in emerging market countries,
financial crises develop along two basic paths—either the mismanagement of financial
liberalization/globalization or severe fiscal imbalances.
23. Why might financial liberalization and globalization lead to financial crises in emerging market
economies?
The seeds of a financial crisis in emerging market economies are often sown when countries liberalize their
domestic financial systems by eliminating restrictions on financial institutions and markets, a process known as
financial liberalization, and opening up their economies to flows of capital and financial firms from other
nations, a process called financial globalization.
● Weak supervision and lack of expertise leads to a lending boom. Credit booms that accompany financial
liberalization in emerging market nations are typically marked by especially risky lending practices,
sowing the seeds for enormous loan losses down the road.
● The financial globalization process adds fuel to the fire because it allows domestic banks to borrow
abroad.
● Fixed exchange rates give a sense of lower risk.
● Banks play a more important role in emerging market economies, since securities markets are not well
developed yet. So as banks stop lending, there are really no other players to solve adverse selection and
moral hazard problems.
 24. Why might severe fiscal imbalances lead to financial crises in emerging market economies?
When governments face large fiscal imbalances and cannot finance their debt, they often cajole (cố chấp) or force
domestic banks to purchase government debt. Investors who lose confidence in the ability of the government to
repay this debt unload the bonds, which causes their prices to plummet. Banks that hold this debt then face a big
hole on the asset side of their balance sheets, with a huge decline in their net worth. With less capital, these
institutions must cut back on their lending and lending will decline. The situation can even be worse if the decline
in bank capital leads to a bank panic in which many banks fail at the same time. The result of severe fiscal
imbalances is therefore a weakening of the banking system, which leads to a worsening of adverse selection and
moral hazard problems.
In short:
● Governments in need of funds sometimes force banks to buy government debt.
● When government debt loses value, banks lose and their net worth decreases
25. What other factors can initiate financial crises in emerging market economies?
● Increase in interest rates (from abroad), such as a tightening of U.S. monetary policy. When interest
rates rise, high-risk firms are most willing to pay the high interest rates, so the adverse selection problem
is more severe. In addition, the high interest rates reduce firms’ cash flows, forcing them to seek funds in
external capital markets in which asymmetric problems are greater. Increases in interest rates abroad that
raise domestic interest rates can then increase adverse selection and moral hazard problems.
● Asset price decrease: Because asset markets are not as large in emerging market countries as they are in
advanced countries, they play a less prominent role in financial crises. Asset price declines in the stock
market do, nevertheless, decrease the net worth of firms and so increase adverse selection problems. There
is less collateral for lenders to seize and increased moral hazard problems because, given their decreased
net worth, the owners of the firm have less to lose if they engage in riskier activities than they did before
the crisis. Asset price declines can therefore worsen adverse selection and moral hazard problems directly
and also indirectly by causing a deterioration in banks’ balance sheets from asset write-downs.
● Uncertainty linked to unstable political systems: As in advanced countries, when an emerging market
economy is in a recession or a prominent firm fails, people become more uncertain about the returns on
investment projects. In emerging market countries, notoriously unstable political systems are another
source of uncertainty. When uncertainty increases, it becomes hard for lenders to screen out good credit
risks from bad and to monitor the activities of firms to whom they have loaned money, again worsening
adverse selection and moral hazard problems
26. What events can ignite a currency crisis?
- Deterioration of bank balance sheets triggers currency crises:
● Government cannot raise interest rates (doing so forces banks into insolvency): Defending their
currencies by raising interest rates should encourage capital inflows, but if the government raises interest
rates, banks must pay more to obtain funds. This increase in costs decreases bank profitability, which may
lead to insolvency.
● … and speculators expect a devaluation.
- How severe fiscal imbalances triggers currency crises:
● Foreign and domestic investors sell the domestic currency: When government budget deficits spin out
of control, foreign and domestic investors begin to suspect that the country may not be able to pay back its
government debt and so will start pulling money out of the country and selling the domestic currency.
27. Why do currency crises make financial crises in emerging market economies even more severe?
In contrast to most advanced economies that typically denominate debt in domestic currency, emerging market
economies denominate many debt contracts in foreign currency (usually U.S. dollars). An unanticipated
depreciation or devaluation of the domestic currency in an emerging market country increases the debt burden
of domestic firms in terms of the domestic currency. That is, it takes more pesos to pay back the dollarized debt.
Since most firms price the goods and services they produce in the domestic currency, the firms’ assets do not rise
in value in terms of domestic currency, but their debt does. The depreciation of the domestic currency increases
the value of debt relative to assets, and the firms’ net worth declines. The decline in net worth then increases the
adverse selection and moral hazard problems and decreases lending, which finally leads to a decline in investment
and economic activity.
The collapse of a currency also can lead to higher inflation. The central banks in most emerging market
countries, in contrast to those in advanced countries, have little credibility as inflation fighters. Thus, a sharp
depreciation of the currency after a currency crisis leads to immediate upward pressure on import prices. A
dramatic rise in both actual and expected inflation is likely to follow, which will cause domestic interest rates to
increase. The resulting increase in interest payments causes reductions in firms’ cash flows, which leads to
increased asymmetric information problems, since firms are now more dependent on external funds to finance
their investments. The increase in adverse selection and moral hazard problems then leads to a reduction in
investment and economic activity.
28. How did the financial crises in South Korea and Argentina affect aggregate demand, short-run
aggregate supply, and output and inflation in these countries?
Financial liberalization and globalization mismanaged → lending boom → stock market decline and failure of
firms increase uncertainty → adverse selection and moral hazard problems worsen, and the economy contracts →
currency crisis ensues → full-fledged financial crisis. In 1997, The Korean economy started to encounter a
financial crisis. Korea's present record balance began to disintegrate as a result of rising inflation, enthusiasm for
the Korean won, and the downturn of the world economy. On the demand side, aggregate demand diminished
impressively by less endowments and assessment increments followed by monetary stagnation.
In contrast to Mexico and the East Asian countries, Argentina had a well-supervised banking system, and a
lending boom did not occur before Argentina’s crisis. Argentina’s financial crisis was triggered by severe fiscal
imbalances. In Argentina the economy contracted in 2002 followed by the fall in GDP, the joblessness rate
extended. Both the aggregate demand and supply was lessened. On account of the declining financial crisis, the
piece of people living underneath the desperation line extended.
29. Why might emerging market economies want to implement financial liberalization and
globalization gradually rather than all at once?
The reason for emerging market economies want to implement financial liberalization and globalization gradually
rather than all at once is:
● Enforcing financial liberalization and globalization needs plenty of adjustments in the emerging demands.
● Financial liberalization induces instabilities in the economic markets of the emerging markets.
● Emerging markets require organizations, regulatory bodies, market spectators, etc.
30. What role does weak financial regulation and supervision play in causing financial crises?
Weak regulation and supervision create a better opportunity to engage in excessive​ risk-taking behavior for
financial institutions. It means that financial institutions will take on excessive risk, especially if market discipline
is weakened by the existence of a government safety net. When the risky loans eventually go sour, this causes a
deterioration in financial institution balance sheets, which then means that these institutions cut back lending and
economic activity declines.
31. Why do debt deflations occur in advanced countries but not in emerging-market countries?
Debt deflation occurs in developed economies because inflation is an integral part of such economies. In
economies with moderate inflation, which characterizes most advanced countries, many debt contracts with
fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are
contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing
firms’ and households’ liabilities in real terms (increases the burden of the debt) but does not raise the real value
of their assets. The borrowers’ net worth in real terms (the difference between assets and liabilities in real terms)
thus declines, and debt deflation occurs.
(Since the repeated experiences with cyclical financial panics that go back to the 1800's and culminated in the
Great Depression of the 1930's, many central banks inflated their economies. (In the US, the target is 2%
annually). There are many advantages to this. Industrialized economies require credit and credit needs to expand
as an economy grows. Microsoft would not exist without credit; neither would Google, hedge funds, the internet,
or Quora. Another advantage to inflation is the one the US enjoys Rass Bariaw's answer to In what ways does the
dollar being the world's reserve currency benefit the USA? . Those on the right side of credit get something for
nothing.)
On the other hand, underdeveloped economies are in a continuously deflated state. Because their
economies are depressed, very little credit is used or available. Therefore, very little inflates and without
inflation there would be no debt deflation. The collapse of a currency also can lead to higher inflation. The central
banks in most emerging market countries, in contrast to those in advanced countries, have little credibility as
inflation fighters. Thus, a sharp depreciation of the currency after a currency crisis leads to immediate upward
pressure on import prices. A dramatic rise in both actual and expected inflation is likely to follow, which will
cause domestic interest rates to increase. The resulting increase in interest payments causes reductions in firms’
cash flows, which leads to increased asymmetric information problems, since firms are now more dependent on
external funds to finance their investments. The increase in adverse selection and moral hazard problems then
leads to a reduction in investment and economic activity.
32. How can opening up to capital flows from abroad lead to a financial crisis?
Banks pay high interest rates to attract foreign capital, which leads the banks to rapidly increase their lending. The
increased lending causes banks to make riskier loans. Then as loan losses increase, banks' balance sheets
deteriorate, which reduces their lending activity and causes a financial crisis.
33. Why does the twin crisis phenomenon of currency and banking crises occur in emerging-market
countries?
In contrast to most advanced economies that typically denominate debt in domestic currency, emerging market
economies denominate many debt contracts in foreign currency (usually U.S. dollars). The depreciation of the
domestic currency increases the value of debt relative to assets, and the firms’ net worth declines. Therefore,
emerging economies suffer from currency crises.
The collapse of a currency also can lead to higher inflation. The central banks in most emerging market countries,
in contrast to those in advanced countries, have little credibility as inflation fighters. Thus, a sharp depreciation
of the currency after a currency crisis leads to immediate upward pressure on import prices. A dramatic rise in
both actual and expected inflation is likely to follow, which will cause domestic interest rates to increase. The
resulting increase in interest payments causes further deterioration in the economy.
The collapse in economic activity and the deterioration of cash flow and firm and household balance sheets
means that many debtors are no longer able to pay off their debts, resulting in substantial losses for banks.
Sharp rises in interest rates also have a negative effect on banks’ profitability and balance sheets. Even
more problematic for the banks is the sharp increase in the value of their foreign-currency-denominated liabilities
after the devaluation. Thus, bank balance sheets are squeezed from both sides—the value of their assets falls as
the value of their liabilities rises. Under these circumstances, the banking system often suffers a banking crisis in
which many banks fail.
34. How can a currency crisis lead to higher interest rates?
The collapse of a currency also can lead to higher inflation. The central banks in most emerging market countries,
in contrast to those in advanced countries, have little credibility as inflation fighters. Thus, a sharp depreciation of
the currency after a currency crisis leads to immediate upward pressure on import prices. A dramatic rise in both
actual and expected inflation is likely to follow, which will cause domestic interest rates to increase.
35. What key factors trigger speculative attacks leading to currency crises in emerging market
countries?
● Deterioration in bank balance sheets
● Severe fiscal imbalances.
TUTORIAL 8

1. Why would eliminating the central bank’s independence lead to a more pronounced political
business cycle?
Eliminating the Fed's independence might make it more shortsighted and subject to political influence. Thus,
when political gains could be achieved by expansionary policy before an election, the Fed might be more likely to
engage in this activity. As a result, more pronounced political business cycles might result.
2. “The independence of the Fed leaves it completely unaccountable for its actions.” Is this statement
true, false, or uncertain? Explain your answer.
False. The Fed is still subject to political pressure because Congress can pass legislation limiting the Fed's power.
If the Fed is performing badly, Congress can therefore make the Fed accountable by passing legislation that the
Fed does not like.
3. “The independence of the central bank has meant that it takes the long view and not the short
view.” Is this statement true, false, or uncertain? Explain your answer.
It is uncertain. Although independence may help the Fed take the long view, because its personnel are not directly
affected by the outcome of the next election, the Fed can still be influenced by political pressure. In addition, the
lack of Fed accountability because of its independence may make the Fed more irresponsible. Thus it is not
absolutely clear that the Fed is more farsighted as a result of its independence.
4. While the Fed promotes secrecy by not releasing the minutes of the FOMC meetings to Congress or
the public immediately, the ECB holds a press conference after each of its meetings. Discuss the pros
and cons of each of these policies.
The argument for not releasing the FOMC directives immediately is that it keeps congress off the Fed's back, thus
enabling the Fed to pursue independent monetary policy that is less subject to inflation and political business
cycles. The argument for releasing the directive immediately is that it would make the Fed more accountable.
The FED simply releases a statement about the setting of the monetary policy instruments. The ECB goes further
by having a press conference in which the president and vice president of the ECB take questions from the news
media. The theory of bureaucratic behavior suggests that one factor driving central banks' behavior may attempt
to increase their power and prestige. Holding such a press conference as soon as the meeting is over can be tricky
because it requires the president and vice president to be quick on their feet in dealing with the press. If they
cannot manage, it might be understood as the loss of power and the weakness of the decisions. On the other hand,
the central bank should act in the public interest, having a press conference may show transparency and
accountability.
TUTORIAL 9 (13-12)
 1. Compute the impact on the money multiplier of an increase in the currency-to-deposit ratio from 10
percent to 15 percent when the reserve requirement is 10 percent of deposits, and banks’ desired
excess reserves are 3 percent of deposits.
c = C/D↑ from 10 to 15%; r = RR/D = 10%; e = ER/D = 3%
m = (c+1)/(c+r+e)
When c = 10%, m = (0.1+1)/(0.1 + 0.1 + 0.03) = 4.78
When c = 15%, m = (0.15+1)/(0.15 + 0.1 + 0.03) = 4.11
⇒ When the currency-to-deposit ratio increases from 10 percent to 15 percent, the money multiplier decreases
from 4.78 to 4.11.
2. Does the Federal Reserve frequently purchase or sell gold or foreign exchange as part of its efforts
to change the money supply?
No. Fed transactions in foreign exchange and gold are infrequent, and are not used to alter the money supply.
Instead, the Fed manages the growth of money supply by setting bank reserve requirements, by setting the
discount rate or via open market operations.
3. Consider an open market purchase by the Fed of $3 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 M1
assuming that: (1) the required reserve ratio is 10 percent, (2) the bank does not wish to hold extra
reserves, and (3) the public does not wish to hold currency.
The bank's securities fall by $3 billion and its reserves rise by $3 billion. Based on those assumptions, the simple
deposit multiplier will be: 1/r = 1/0.1 = 10.
M1 will increase by: 3*10 = $30 billion.
4. 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?
For the Fed, the change comes in the composition of the Fed’s liabilities. The reserves held by your bank at the
Fed decline, but there is an increase in volume of currency in the hands of the nonbank public of the same
amount. Therefore, the size of the Fed's balance sheet therefore remains the same.
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.
5. Why is currency circulating in the hands of the nonbank public considered a liability of the central
bank?
Currency issued by the central bank is effectively an IOU (I owe you) to the holder of the currency. The central
bank is obliged to pay back the holder of the currency, therefore, we consider currency circulating in the hands of
the nonbank public as a liability of the Central Bank.
If the currency is backed by gold, for example, the central bank is obliged to exchange gold for currency. With
currency like Federal Reserve notes, they are also liabilities, but unlike most liabilities, they promise to pay back
the bearer solely with Federal Reserve notes; that is, they pay off IOUs with other IOUs. Accordingly, if you
bring a $100 bill to the Federal Reserve and demand payment, you will receive two $50s, five $20s, or some other
combination of bills that adds to $100.
6. How did the financial crisis of 2007–2009 affect the size and composition of the balance sheet of the
Federal Reserve?
The Fed broadened the range of assets held to include riskier instruments. The assets on the Federal Reserve's
balance sheet increased by 2.5 times, mostly in the form of securities. Purchases of mortgage-backed and U.S.
agency securities more than accounted for this gain.
On the liabilities side of the balance sheet, commercial bank deposits rose nearly 100 times! This surge was
triggered by the postLehman panic, when the Fed sought to calm banks desperately seeking a liquidity cushion by
purchasing more securities and boosting discount lending. Yet, even after the liquidity crisis subsided in 2009,
banks showed a clear desire to hold massive excess reserves. Lending their reserves at low interest rates to risky
borrowers was unattractive for banks that faced a much higher cost of capital than before the crisis. Beginning in
October 2008, banks also received interest on their reserves held at the Fed (the policy tool of paying interest on
reserves is discussed
in Chapter 18), further diminishing the opportunity cost of holding reserves.

7. 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?
Initially, the money multiplier is m = (c+1)/(c + r + m) = (0.25 + 1)/(0.25 + 0.10 + 0.05) = 3.13.
If c rises to 0.30, the multiplier falls to m = (0.30 + 1)/(0.30 + 0.10 + 0.05) = 2.89.
If, instead, the e rises to 0.1, the multiplier will be m = (0.25 + 1)/(0.25 + 0.10 + 0.10) = 2.78.
So, the multiplier falls by more with the increase in the excess reserves ratio,
8. Is the money multiplier model still useful for policymakers? If not, why not?
While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks,
it is not an accurate description of how money is created in reality. The relationship between the monetary base
and the quantity of money is not something that a central bank can exploit for short-run policy purposes. Rather
than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the
price of reserves — that is, interest rates, while in a financial crisis, other balance-sheet tools help address
liquidity needs and market disruptions more directly.
Added:
Changes in reserve requirements affect the money supply by causing the money supply multiplier to change. The
Fed has had the authority to vary reserve requirements since the 1930s; this method was once a powerful way of
affecting the money supply and interest rates but is rarely used today. At the present, policymakers rarely change
the reserve requirements because it can lead to liquidity problems and uncertainty, so the money multiplier may
not be useful for policymakers anymore.
9. 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?
The balance sheet for that 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.
10. 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 illustrate that it had learned a valuable
lesson from the Great Depression?
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 a similar decline in the money multiplier (due to a surge in demand for excess reserves)
emerged during the financial crisis of 2007-2009, the Fed rapidly expanded the supply of reserves, preventing a
collapse of the money supply like that seen in the 1930s.
11. 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?
The central bank may have conducted an open market sale of $100 million with a commercial bank. The sale of
the securities would involve $100m 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 $100m in
reserves on the central bank balance sheet.
12. Do you think the central bank was aiming to increase, decrease, or maintain the size of the money
supply by carrying out the changes described to its balance sheet in Problem 11? Explain your
answer.
By conducting an open market sale, the Central Bank reduces reserves on its balance sheet and as a result reduces
the monetary base. By carrying out this activity, the central bank was aiming to decrease the size of the money
supply, assuming the money multiplier remains unchanged.
13. Looking again at the situation described in Problem 11, 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.

A. Fed Reserve’s Balance Sheet B. Banking System’s Balance Sheet

Assets Liabilities Assets Liabilities

Securities -$100m Reserves -$100m Reserves -$100m

Securities +$100m

No. The transaction does reduce the Fed’s balance sheet. However, as reserves and securities both appear on the
asset side of the balance sheet of the banking system, the open market sale would affect the composition but not
the size of the banking system’s balance sheet.
14. 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?
Yes. The system was threatened by the inability to collect checks in the absence of civilian flights. The Fed
stepped in and provided huge amounts of liquidity to enable banks to meet their commitments. The Federal
Reserve’s prompt action as a lender of last resort in the aftermath of the September 11 attacks allowed banks to
manage the acute liquidity shortage, and to prevent public panic and possible bank runs.
15. 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?
Yes. The Fed could use other assets besides Treasury securities to carry out its open market operations. These
alternative assets would have to be traded in deep, highly active markets to avoid the Fed Reserve’s actions
causing distortions.
16. In which of the following cases will the size of the central bank’s balance sheet change?
a. The Federal Reserve conducts an open market purchase of $100 million U.S. Treasury securities.

Assets Liabilities
 Securities +$100m Reserves +$100m

Reserves increase ⇒ Size of balance sheet increases.

b. A commercial bank borrows $100 million from the Federal Reserve.
Reserves increase ⇒ Size of balance sheet increases.

Assets Liabilities

Discount loans +$100m Reserves +$100m

c. The amount of cash in the vaults of commercial banks falls by $100 million due to withdrawals by
the public.

Assets Liabilities

Currency +$100m
Reserves -$100m

The size of the balance sheet does not change.

17. You pick up the morning newspaper and note a headline reporting a major scandal about the
Federal Deposit Insurance Corporation that is likely to undermine (lessen the effectiveness) 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?
The scandal is likely to increase the public's desire to hold currency and so 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.
18. The central bank buys €100 million of bonds from the public and also lowers r. What will happen to
the money supply?
If the central bank buys €100 million of bonds from the public, bank reserves increase, which increases the
monetary base and the money supply. Lower r also increases the money supply.
19. Did central banks’ response to the global financial crisis of 2007–9 prove that they learned from the
lessons of the Great Depression?
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 a similar decline in the money multiplier (due to a surge in demand for excess reserves)
emerged during the financial crisis of 2007-2009, the Fed rapidly expanded the supply of reserves, preventing a
collapse of the money supply like that seen in the 1930s.
20. “The Fed can perfectly control the amount of the monetary base, but has less control over the
composition of the monetary base.” Is this statement true, false, or uncertain? Explain.
False. Since the Fed cannot control the amount of discount lending to financial institutions, it does not have
perfect control over the amount of reserves in the banking system and hence the monetary base.
 21. The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio.
What will happen to the money supply? (19)
22. “The money multiplier is necessarily greater than 1.” Is this statement true, false, or uncertain?
Explain your answer.
(1+c)/(rr+e+c) ≤ 1
1+c ≤ rr + e + c
1 ≤ rr + e
Only if the sum of the reserve requirement plus the excess reserve ratio is bigger than 1 will the money multiplier
ever be smaller than 1. Therefore, the statement is true because, in reality, the required and excess reserves ratios
typically add up to less than one.
23. What effect might a financial panic have on the money multiplier and the money supply? Why?
A financial panic would probably decrease the money multiplier and the money supply, for a given monetary
base. In a financial panic, you would expect banks to want to make less risky loans, and have more liquidity on
hand, which would increase the excess reserve ratio and decrease the money multiplier. In addition, depositors
may get worried about the health of banks, and increase their holdings of currency, which also would decrease the
money multiplier
24. During the Great Depression years from 1930–1933, both the currency ratio c and the excess
reserves ratio e rose dramatically. What effect did these factors have on the money multiplier?
The increase in both of these factors would reduce the money multiplier. This indicates a dramatically declining
money supply, while the monetary base grew modestly, if at all.
25. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held
by banks. How, if at all, might this affect the multiplier process and the money supply?
Being paid interest on reserves gives commercial banks incentive to hold more reserves rather than lend them out,
which should raise the excess reserve ratio, reduce the money multiplier, and reduce the money supply, holding
the monetary base constant.
26. The money multiplier declined significantly during the period 1930–1933 and also during the recent
financial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the Depression period
but increased by more than 20% during the recent financial crisis. What explains the difference in
outcomes?
The difference is that the monetary base increased dramatically during the recent financial crisis, which was more
than enough to offset the fall in the multiplier. During the Great Depression, the monetary base rose modestly, if
at all.
 TUTORIAL 10 (17-17)

1. If the manager of the open market desk hears that a snowstorm is about to strike New York City,
making it difficult to present checks for payment there and so raising the float, what defensive open
market operations will the manager undertake?
A defensive open market sale. The snowstorm would cause floats to increase, which would increase the monetary
base. To counteract this effect, the manager will undertake a defensive open market sale of securities using a
reverse repo transaction.
2. During the holiday season, when the public’s holdings of currency increase, what defensive open
market operations typically occur? Why?
A defensive open market purchase of securities. When the public's holding of currency increases during holiday
periods, the currency-checkable deposits ratio increases and the money supply falls. To counteract this decline in
the money supply, the Fed will conduct a defensive open market purchase of securities.
3. If the Treasury pays a large bill to defense contractors and as a result its deposits with the Fed fall,
what defensive open market operations will the manager of the open market desk undertake?
A defensive open market sale of securities. When the Treasury's deposits at the Fed fall, the monetary base
increases. To counteract this increase, the manager would undertake an open market sale of securities.
4. Suppose, one morning, the Open Market Trading Desk drastically underestimates the demand for
reserves when deciding the quantity of reserves to supply to the market. Based on analysis of the
market for bank reserves, explain why the market federal funds rate will not exceed the discount
rate regardless of how large the gap between estimated and actual reserve demand.
If the actual demand for reserves were larger than the estimated demand, the actual reserve demand curve would
be farther to the right than the estimated demand curve. If the gap is large enough, the demand and supply curves
for reserves would intersect on the horizontal portion of the reserve supply curve. As banks can get whatever
quantity of reserves they need through discount loans, they will not be willing to borrow in the federal funds
market at a rate above the discount rate. Therefore, no matter how great the underestimate of reserve demand, the
market the federal funds rate will not rise more than above the target.
 5. Consider a situation where reserve requirements are binding and the central bank decides to reduce
the requirements. How would the Open Market Trading Desk act to maintain the interest rate
target, assuming the demand for excess reserves remains unchanged.
If required reserves fell with no change in desired excess reserves, then demand for reserves would fall. To hit the
target federal funds rate, the Open Market Trading Desk would carry out open market sales to reduce the supply
of reserves until the supply and demand curves for reserves intersected at the target rate.

6. In a graph of the market for bank reserves, show how the Federal Reserve limits deviations of the
market federal funds rate from its interest rate target under the channel system. Next, show how the
Open Market Trading Desk would implement a decision by the FOMC to raise the target federal
funds rate. Assume that the Fed alters the discount and deposit rates to maintain fixed spreads
between them and the target federal funds rate.

In the graph, the initial target interest rate, discount rate, and deposit rate are indicated. If the reserve demand
curve shifts sufficiently rightward to intersect the horizontal portion of the reserve supply curve, banks would
borrow from the Fed rather than pay a higher interest rate in the open market. Similarly, the deposit rate (the
interest rate that the Fed pays on reserves) sets a floor under the market federal funds rate, as banks will not be
willing to lend funds to each other at a rate below what they can earn from depositing those funds at the Fed. In
this way, the discount and deposit rates establish a channel within which the market fed funds rate can fluctuate.
The width of the channel depends on the importance of interest rate stability as a goal of the central bank.

How Open Market Trading Desk would implement a decision by the FOMC to raise the target federal funds rate,
assumed that the Fed alters the discount and deposit rates to maintain fixed spreads between them and the target
federal funds rate:
● To achieve a higher target for the federal funds rate, the Open Market Trading Desk would carry out open
market sales, shifting the supply of reserves to the left until demand and supply of reserves intersect at
the new higher target federal funds rate. The corresponding rise in the discount and deposit rates to
maintain the spreads means that the supply and demand curves for reserves become perfectly elastic at
higher rates.
7. “Discount loans are no longer needed because the presence of the FDIC eliminates the possibility of
bank panics.” Is this statement true, false, or uncertain?
This statement is false. The FDIC alone would likely be ineffective in eliminating bank panics without the Fed's
ability to provide discount loans to troubled banks to keep bank failures from spreading. Additionally, the FDIC's
insurance covers only about 1% of total bank deposits. Since the Fed has unlimited ability to provide loans to the
banking system, it can be much more effective in stabilizing the banking system in a panic.
8. What are the disadvantages of using loans to financial institutions to prevent bank panics?
Providing loans to financial institutions creates a moral hazard problem. If firms know that they will have
access to Fed loans, they are more likely to take on risk, knowing that the Fed will bail them out if a panic should
occur. As a result, banks that deserve to go out of business because of poor management may survive because of
Fed liquidity provision to prevent panics. This might lead to an inefficient banking system with many poorly run
banks.
9. “Considering that raising reserve requirements to 100% makes complete control of the money
supply possible, Congress should authorize the Fed to raise reserve requirements to this level.”
Discuss.
If the rr were to increase to 100% then the Fed would have complete control on the money supply. However, this
would make banks unable to make loans to the public because there will be no excess reserves. Ultimately, this
would lower the money supply. Decrease in MS will cause the economic growth to seize.
One problem with this proposal is that it provides perfect control over the official measure of the money supply,
but it may weaken control over the money supply that is economically relevant. Congress should not do this
because it will make it more difficult for individuals and businesses to get loans for investments and as a result
reduce the amount of investment that takes place in the​economy, which will slow economic growth. Moreover, it
will be very costly to restructure the way the economy works.
10. Compare the methods of controlling the money supply—open market operations, loans to financial
institutions, and changes in reserve requirements—--on the basis of the following criteria: flexibility,
reversibility, effectiveness, and speed of implementation.
Open market operations are more flexible, reversible, and faster to implement than the other two tools. Discount
policy is more flexible, reversible, and faster to implement than changing reserve requirements, but it is less
effective than either of the other two tools.

11. What are the advantages and disadvantages of quantitative easing as an alternative to conventional
monetary policy when short-term interest rates are at the zero lower bound?

Advantages Disadvantages
● Short term loans cannot be lowered be lowered ● It may not actually have the effect of increasing
below the zero bound so monetary policy economic activity through greater loans
would be ineffective monetary expansion
● Purchase of intermediate and longer term ● If credit and financial markets are significantly
securities could reduce longer term interest damaged, banks may hold the extra liquidity as
rates, increase the money supply further and excess which may not lead to greater loans and
lead to expansion monetary expansion
● It provides immediate results. It can be easily ● It leads to business cycles. Many critics believe
applied as a quick fix that quantitative easing creates easy money in
● Raises bank reserves the economy. The money reaches the lender
who wants to lend out any cost.... in the process
loans might be made to people with high credit
risks
● First the process of quantitative easing create a
boom i.e. the expansionary phase and then after
businesses begin to contract

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional
monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of
intermediate and long-term securities could reduce longer-term interest rates, increase the money supply
further, and lead to expansion.
One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic
activity through greater loans and monetary expansion. If credit and financial markets are significantly
damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and
monetary expansion
 12. Why is the composition of the Fed’s balance sheet a potentially important aspect of monetary policy
during an economic crisis?
The Fed can influence interest rates and provide more targeted liquidity. For keeping control of the crises, it
changes its balance sheet by changing the assets and liabilities. This impacts the money supply of the economy
and hence recuperates an economy.
13. What is the main advantage and the main disadvantage of an unconditional policy commitment?
The main advantage to an unconditional policy commitment is that it provides a significant amount of
transparency and certainty, which makes it easier for markets and households to make decisions about the future.
The main disadvantage is that it represents an implicit commitment by the central bank; if conditions suddenly
change where a change in policy stand may be assured, then holding to the commitment could be destabilizing.
On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and
the central bank could lose significant credibility.
14. “The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount
rate.” Is this statement true, false, or uncertain? Explain your answer.
False. The Fed could affect the level of borrowed reserves in two ways. First, they could directly limit the
amount of discount loans an individual bank can take out. Second, they could reduce non-borrowed reserves to
such a point that even with a fixed discount rate, borrowed reserves will rise.

15. “The federal funds rate can never be above the discount rate.” Is this statement true, false, or
uncertain? Explain your answer.
In theory, this is true. The discount rate should act as an upper bound in the federal funds market because if the
fed funds rate ever went above the discount rate, banks would not borrow in the fed funds market, but only
borrow from the discount window (which would eventually drive the fed funds rate down).
However, in practice, it is uncertain because the Fed funds rate does rise above the discount rate due to the
stigma which is associated with the banks borrowing directly from the Federal Reserve. In addition, nonbank
financial institutions, which do not have access to the discount window, can and do participate in the federal funds
market. The extent to which nonbank financial companies participate in the Fed Funds market may mean that the
gap when the Fed funds rate is above the discount rate may not be arbitraged away.
 16. “The federal funds rate can never be below the interest rate paid on reserves.” Is this statement
true, false, or uncertain? Explain your answer.
Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate
on reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly
from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower
rate; this should prevent the fed funds rate from ever falling below the interest rate paid on reserves.
However, in practice, the fed funds rate can be (and has been) below the interest rate paid on reserves. This is
because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds
market and provide a significant amount of funding to the market. The extent to which nonbank financial
companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest
rate on reserves may not be arbitraged away.
17. Why is paying interest on reserves an important tool for the Federal Reserve in managing crises?
It allows the Fed to increase its lending as much as it wants without reducing the federal funds rate.
18. Why are repurchase agreements used to conduct most short-term monetary policy operations,
rather than the simple, outright purchase and sale of securities?
Repurchase agreements are temporary open market purchases that can be reversed. Repurchase agreements allow
the Fed to easily adjust open market operations in response to daily conditions.
19. Open market operations are typically repurchase agreements. What does this tell you about the
likely volume of defensive open market operations relative to the volume of dynamic open.
It suggests that defensive open market operations are far more common than dynamic operations because
repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the
monetary base.
20. From 1979 to 1982, the FOMC used money growth as an intermediate target. To do so, the
committee instructed the Open Market Trading Desk to target the level of reserves in the banking
system. What was the justification for doing so? Explain why the result was unstable interest rates.
Would you advocate a return to reserve targeting? Why or why not?
In 1979, the Fed had to reduce inflation. It would not have been politically acceptable for the Fed to explicitly
raise interest rates to the level required to bring down inflation, so instead the Fed targeted reserves. When the
Fed attempts to keep the supply of reserves constant, changes in the demand for reserves change the interest rate,
resulting in increased volatility. Because changes in the interest rate affect the real economy, targeting the federal
funds rate is a much more effective monetary policy than targeting reserves.
21. Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase.
Explain how the Fed’s actions are intended to work.
By purchasing mortgage-backed securities (MBS), the Fed sought to lower mortgage rates in order to increase
home sales, raise house prices, and promote housing construction.
22. 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 of “constrained discretion.” What does this
mean?
Inflation targeting, which involves the public announcement of a medium-term numerical target for inflation and
a commitment to achieving it. A major advantage of inflation targeting is that it combines elements of both
“rules” and “discretion” in monetary policy. This “constrained discretion” framework combines two distinct
elements: a precise numerical target for inflation in the medium term and a response to economic shocks in the
short term.
Rather than focusing on achieving the target at all times, the approach has emphasized achieving the target over
the medium term—typically over a two- to three-year horizon. This allows policy to address other
objectives—such as smoothing output—over the short term. Thus, inflation targeting provides a rule-like
framework within which the central bank has the discretion to react to shocks. Because of inflation targeting’s
medium-term focus, policymakers need not feel compelled to do whatever it takes to meet targets on a
period-by-period basis.
Constrained discretion is an approach that allows monetary policymakers considerable space in responding to
economic shocks, financial disturbances, and other unforeseen developments but constrained by a strong
commitment to keep inflation low and stable.
Because the components of inflation targeting are: (1) Public announcement of numerical target, (2)
Commitment to price stability as primary objective, (3) Frequent public communication. It means
that the strategy of inflation targeting increases policymakers accountability and helps to establish their
credibility but they are also constrained by a strong commitment to keeping inflation low and stable to
reach the objectives that they have announced to the public. Thus, the results would not only be the
simplicity and clarity of a numerical target for the inflation rate but also usually higher and more stable growth as
well.
23. Go to the website of the Federal Reserve Board at www.federalreserve.gov and find the section
describing monetary policy tools. Which unconventional tools employed during the financial crisis
of 2007–2009 has the Fed stopped using? What do you think determined the order in which various
facilities were shut down? Which, if any, of the tools still remain in operation?
https://www.federalreserve.gov/monetarypolicy/mpr_default.htm
During the global financial crisis and Great Recession of 2007–2009, central banks around the world pushed
short-term interest rates to near zero. Unfortunately, given the severity of the economic downturn, even these
ultralow interest rates were not enough to revive output and employment growth sufficiently. Therefore, central
banks turned to unconventional policy tools to achieve their objectives. For the Federal Reserve, these
unconventional monetary policy tools included forward guidance through communication about future
short-term interest rates as well as the purchase of government bonds or quantitative easing.
Unconventional tool employed during 2007-2009 that the Fed stopped using is targeted assistance to ailing
nonbank financial institutions because in the period after, financial institutions are in good health so it does not
need to use this measure.
https://www.frbsf.org/economic-research/publications/economic-letter/2018/december/review-of-unconventional-
monetary-policy/

24. The ECB pays a market-based interest rate on required reserves and a lower rate on excess
reserves. Explain why the system is structured this way.
Paying a market-based interest rate on required reserves reduces the costs to banks of holding reserves. Paying
interest on excess reserves helps set a floor under the overnight lending rate: banks would not lend to each other
at a rate below the rate paid on excess reserves. Unlike the interest rate paid on required reserves, the interest rate
paid on excess reserves affects banks' willingness to hold reserves at the margin, and thereby influences the
interbank lending rate.
 25. 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?
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 expected future interest rates and 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.
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 go back on the policy
commitment to keep rates low and steady in the future.
26. With the policy interest rate at zero, how might a central bank counter unwanted deflation?
They could use forward guidance, quantitative easing, and/or targeted asset purchases. The bank could commit to
keeping the policy interest rate at zero until inflation starts to increase. They could engage in large scale
quantitative easing to signal that they are committed to these low rates.
27. Outline and compare the ways in which the Federal Reserve and the ECB added to or adjusted their
monetary policy tools in response to the financial crisis of 2007–2009 and the subsequent financial
crisis in the euro area.
During the financial crisis of 2007-2009, the ECB encountered difficulty conducting a common monetary policy
for countries experiencing significantly different economic conditions. During the subsequent sovereign debt
crisis, the ECB faced the dilemma of whether to buy the sovereign debt of struggling governments so that the
governments would still be able to raise funds by selling bonds. The ECB bond purchases would also serve to
protect the solvency of European banks with large holdings of government bonds. But the ECB bond purchases
risk raising expectations of higher future inflation and more moral hazard in government budgetary policies.

FEDERAL RESERVE ECB

● Lower interest rate by pumping liquidity into ● Do not change its interest rates at first but then
the system + quantitative easing. lower.
● Purchase toxic assets from the market (open ● May 2009, ECB proceeded with the
market operations). acquisition of cover bonds (60 billion euros) to
encourage the liquidity of the partially
paralyzed market segment responsible for
providing funds to banks. Secondly, it
implemented some temporary configuration
changes in the long-term refinancing operation
(LTRO).
 28. How might the Federal Reserve exit from the unconventional policies it employed during the
financial crisis of 2007–2009 without causing inflationary problems?
The Fed could tighten monetary policy without selling assets by raising the deposit rate it pays on reserves. As the
deposit rate sets a floor to the market funds rate, the fed funds rate would rise to this level even if reserve supply
is unchanged.
29. The central bank of a country facing economic and financial market difficulties asks for your
advice. The bank hit the zero bound with its policy interest rate, but it wasn’t enough to stabilize the
economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of
2007–2009, what might you advise this central bank to do?
You should advise the central bank to use unconventional monetary policy tools such as quantitative easing,
where aggregate reserves are provided beyond the level needed to lower the policy rate to zero, or credit easing, a
policy in which the central bank alters the composition of its balance sheet. The central bank could also inform
markets of its commitment to keep interest rates low (forward guidance).
30. 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 make to its system in the future?
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. You might also suggest that the ECB narrow the
relatively long list of institutions that qualify as counterparties to open market operations and reduce the range of
assets it accepts as collateral for these operations.
31. Why might inflation targeting increase support for the independence of the central bank to conduct
monetary policy?
Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined
inflation target can be instrumental in building public support for a central bank's independence and for its
policies. Also inflation targeting is consistent with democratic principles because the central bank is more
accountable.
32. ‘Because the public can see whether a central bank hits its monetary targets almost immediately,
whereas it takes time before the public can see whether an inflation target is achieved, monetary
targeting makes central banks more accountable than inflation targeting does.’ Is this statement
true, false, or uncertain? Explain your answer.
Uncertain. If the relationship between monetary aggregates and the goal variable—say, inflation—is unstable,
then the signal provided by the monetary aggregates is not very useful and is not a good indicator of whether the
stance of monetary policy is correct and does not make the Fed more accountable.
33. ‘Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output
fluctuations.’ Is this statement true, false, or uncertain? Explain your answer.
False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targets do worry about
output fluctuations, and inflation targeting may even be able to reduce output fluctuations because it allows
monetary policymakers to respond more aggressively to declines in demand, as they don't have to worry that the
resulting expansionary monetary policy will lead to a sharp rise in inflation expectations.
 34. ‘A central bank with a dual mandate will achieve lower unemployment in the long run than a
central bank with a hierarchical mandate in which price stability takes precedence.’ Is this
statement true, false, or uncertain?
False. There is no long-run trade-off between inflation and unemployment, so in the long run a central bank with
a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no
more success at reducing unemployment than one whose primary goal is price stability.