Chapter 1 An Introduction to Money and the Financial System Problems List the financial transactions you have engaged in over the past week. How might each one have been carried out 50 years ago? Answer: Commercial purchases that you made likely used credit cards and debit cards. Fifty years ago they would have all used cash. Payment of utilities (if you do it) might have been done by electronic transfer, rather than a check (which would have been the method 50 years ago). How were you, or your family or your friends affected by the recent failure of the financial system to function normally during the financial crisis of 2007-2009? Answer: It is likely that you or someone you know had an account with one of the many financial institutions that folded during the crisis, or that someone you know was refused a business loan or a mortgage or had a bank foreclose on their house. List three items you used to buy with cash but you now purchase with a debit card. Answer: Among the possibilities: purchases of cappuccino at the local coffee shop, gasoline for your car, and groceries for the week. Various financial instruments usually serve one of two distinct purposes: to store value or to transfer risk. Name a financial instrument used for each purpose. Answer: Financial instruments used to store value include bank accounts, stocks and bonds. Instruments used to transfer risk include car insurance and life insurance. Financial innovation has reduced individuals’ need to carry cash. Explain how. Answer: Everyone has a number of alternative methods of payment. Electronic forms, like credit and debit cards, are the primary ones that have reduced need to carry cash. Many people believe that, despite ongoing financial innovations, cash will always be with us to some degree as a form of money. What core principle could justify this view? Answer: Core Principle 3 – information is the basis for decisions. When cash is used to settle a transaction, it is a final payment, not some form of a promise to pay. No information is needed about the payer once cash has been handed over to settle a transaction. This has obvious advantages to the recipient, as the information costs are negligible. In some circumstances, one or both parties to a transaction may wish to preserve their anonymity, and cash allows this. When you apply for a loan, you are required to answer lots of questions. Why? Why is the set of questions you must answer standardized? Answer: The questions are aimed at figuring out how likely you are to repay the loan. They are standardized to reduce the cost of making the loan. Name two distinct financial markets and describe the kind of asset traded in each. Answer: Among the best-known financial markets are those for stocks and for bonds. In the stock markets, equities or ownership shares in companies are bought and sold. In the bond market, debt issues of government units or companies are traded. Why do you think the financial system has become more globally integrated over time? Can you think of any downside to this increased integration? Answer: Technological progress is one obvious reason. According to Core Principle 3, information is the basis for decisions. Improvements in technology have allowed for huge volumes of information to be collected and disseminated quickly and cheaply on a global basis, facilitating long distance financial transactions. Increased integration allows for problems that arise in the financial system of one country to spread more quickly and easily to other countries, as we saw during the financial crisis of 2007-2009. The government is heavily involved in the financial system. Explain why. Answer: For markets to work there have to be rules. And the rules need to be enforced. The government both makes the rules and enforces them so that we all trust the markets to work as they should. Without the government to monitor the financial system, ensuring that people behave themselves, the system would collapse. If offered the choice of receiving $1,000 today or $1,000 in one year’s time, which option would you choose, and why? Answer: Core Principle 1 states that time has value, so you should choose option 1. By receiving the $1,000 today, you can immediately put the money to use. Perhaps you buy a new computer or put the money in the bank to earn interest. Regardless of what you do with the money, waiting a year to receive the money involves an opportunity cost. If time has value, why are financial institutions often willing to extend you a 30-year mortgage at a lower annual interest rate than they would charge for a one-year loan? Answer: With a mortgage, the house you purchase acts as collateral for the loan. In the event you default, the bank can sell the house and recoup its funds. The existence of collateral reduces the risk associated with the loan and so reduces the compensation the bank requires. Using Core Principle 2, under what circumstances would you expect a job applicant to accept an offer of a low base salary and an opportunity to earn commission over one with a higher base salary and no commission potential? Answer: The applicant would have to expect to earn a higher total salary working for a low base and commission, as they require compensation for the risk they assume due to the uncertainty about the level of commission earnings. Suppose medical research confirms earlier speculation that red wine is good for you. Why would banks be willing to lend to vineyards that produce red wine at a lower interest rate than before? Answer: The future prospects for the vineyards have improved, reducing the risk involved in lending to them. The banks require less compensation than before. If the U.S. Securities and Exchange Commission eliminated its requirement for public companies to disclose information about their finances, what would you expect to happen to the stock prices for these companies? Answer: You should expect the stock prices to fall. Gathering sufficient information upon which to make an informed investment decision would become much more costly for investors, reducing the demand for the stock at a given price. If 2 percent growth is your break-even point for an investment project, under which outlook for the economy would you be more inclined to go ahead with the investment: (1) A forecast for economic growth that ranges from 0 to 4 percent, or (2) a forecast of 2 percent growth for sure, assuming the forecasts are equally reliable? What core principle does this illustrate? Answer: You would be more inclined to invest in the project if you knew for sure that growth would be 2%. Uncertainty about the future makes investment less attractive, as you run the risk of losing out if the lower end of the forecast is realized. This illustrates core principle 5 – stability improves welfare. Why are large, publicly listed companies much more likely than small businesses to sell financial instruments such as bonds directly to the market, while small businesses get their financing from financial institutions such as banks? Answer: Information costs associated with small businesses are higher than those for large, publicly listed companies—costs that bond market investors are unlikely to be willing to incur. Banks are skilled at gathering information about borrowers and evaluating the risks associated with loans. Therefore, they are more likely to be willing to lend to smaller businesses. During the financial crisis of 2007-2009, some financial instruments that received high ratings in terms of their safety turned out to be much riskier than those ratings indicated. Explain why markets for other financial instruments might have been adversely affected by that development. Answer: Core Principle 3 states that information is the basis for decisions. Ratings are an important source of information for investors in assessing many financial instruments, and so when confidence in that information is undermined, they are more reluctant to lend. Suppose financial institutions didn’t exist but you urgently needed a loan. Where would you most likely get this loan? Using Core Principles, identify an advantage and a disadvantage this arrangement might have over borrowing from a financial institution. Answer: In the absence of financial institutions, you are most likely to borrow from a family member or a friend. An advantage of this arrangement, under Core Principle 3, would be that your family and friends naturally have more information about you than a bank and know, without having you fill in copious forms, that you can be relied upon to pay them back. A disadvantage would be the necessity of finding a family member or friend who happened to have funds available to lend to you at that particular point in time. Financial institutions help bring potential borrowers and lenders in the financial market together to allocate available resources (Core principle 4). In broad terms, explain how a central bank tries to maintain economic and financial stability and encourage economic growth. Answer: Central banks can moderate business cycle fluctuations by adjusting interest rates. They also have powerful tools to steady fragile financial systems and to support dysfunctional markets. By helping to reduce the volatility associated with business cycles and financial instability, they reduce the risks that individuals can’t eliminate on their own, allowing to invest in the future. That promotes economic growth. The Dodd-Frank Act, enacted in the United States in the aftermath of the 2007-2009 financial crisis, includes provisions aimed at enhancing the coordination of various regulatory agencies. Which two core principles might best explain these reforms? Answer: Core Principle 3 - Information is the basis for decisions. Coordination should improve the flow of information among regulatory agencies, enabling better decision making. Core Principle 5 - Stability improves welfare. Improved regulation as a result of greater coordination should bring greater stability to the financial system and so improve welfare. In December 2015, the Federal Reserve increased its policy interest rate target. This was the first increase since cutting the target to close to zero in December 2008 to combat the economy weakness associated with the financial crisis. If central banks use interest rates to moderate business cycle swings in the economy, what might you infer from this decision about the Fed’s view of the economy? Answer: The Federal Reserve’s decision to begin raising the target for the policy interest rate from its historic low level reflected its view at that time that the economic recovery was on a solid footing. Data Exploration Go to the FRED database at the Federal Reserve Bank of St. Louis website (http://fred.stlouisfed.org). Register to set up your own account. Doing so will allow you to save and update graphs, alter them for submitting assignments and making presentations, and receive a notice whenever the data is updated. Answer: Sign up as indicated. To begin using FRED, plot the consumer price index (FRED code: CPIAUCSL) and find the date and level of the latest monthly observation. Then plot the inflation rate as measured by the percent change from a year ago of this index. Answer: As of June, 2016, the value of the index was 239.927; note that tis value is subject to revision. The plot for CPI (adjusting for any data revisions) is: Recessions are depicted by vertical shaded bars. Plot the level of real GDP (FRED code: GDPC1). Then plot the rate of economic growth as the percent change from a year ago of this index. Describe how real GDP behaves in recessions, which are denoted in the FRED graph by vertical shaded bars. If you registered on FRED (as in Data Exploration Problem 1), save the graph so that you can recall and update the graph easily when new observations become available. Answer: The graph for the level of real GDP is: The plot of the rate of economic growth, expressed as the percentage change from a year ago, is: Real GDP usually declines in recessions and rebounds afterwards. In the 2007-2009 episode, the percentage declines of nominal and real GDP were the largest since Great Depression. In that episode, nominal GDP fell below year-ago levels for the first time in nearly five decades. Examine nominal GDP (FRED code: GDP) based on a figure showing percent change from a year ago. What was special about the behavior of nominal GDP during the financial crisis of 2007-2009 compared to previous decades? Answer: The plot appears below. Unlike other recessions since 1960, nominal GDP fell noticeably during the 2007-2009 financial crisis. Plot on one figure the percent change from a year ago of both the GDP deflator (FRED code: GDPDEF) and real GDP (FRED code: GDPC1). How does the GDP deflator link nominal and real GDP? Since the mid-1980s, does it fluctuate more or less than real GDP? Answer: The data plots with real GDP and the GDP deflator is given below: Nominal GDP is the product of real GDP and the GDP deflator. Alternatively, real GDP is nominal GDP divided by the deflator. In simple terms, if Y is nominal GDP, P is the deflator, and Q is real GDP, then Y = PQ or equivalently Q = Y / P. Compared with earlier periods, the GDP deflator appears to have become less variable since the mid-1980s. Furthermore, it appears less volatile than real GDP indicates more difficult problems. Chapter 2 Money and the Payments System Conceptual and Analytical Problems Describe at least three ways you could pay for your morning cup of coffee. What are the advantages and disadvantages of each? Answer: You could use money, a check, or a debit card. Money: This is the most likely to be accepted, but it means you have to replenish your supply periodically. Check: The least likely to be accepted, and it means you have to walk around with your checkbook. But the funds remain in your bank account for the time it takes the check to make its way through the clearing system. Debit Card: This is very convenient, and likely to be accepted. But when the electronic signal arrives at your bank later in the day, the funds are withdrawn immediately from your account. (This is probably the cheapest option for the merchant). 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. Answer: 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 does 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. Explain how money encourages specialization, and how specialization improves everyone’s standard of living. Answer: Without money, people have to barter to exchange goods and services. This requires a “double coincidence of wants,” which makes it difficult to specialize. In the example in the text, a plumber is buying groceries; if the grocer doesn’t need a plumbing repair, but does need the outside of his store painted, the plumber may decide to paint the store in order to pay for his groceries even though it is not what he does best. When money is used, people are free to specialize in areas in which they have a comparative advantage, increasing the production of society as a whole, and improving everyone’s standard of living. Could the dollar still function as the unit of account in a totally cashless society? Answer: Yes. Using dollars and cents to quote prices and record debts does not depend on cash being used as a means of payment. Dollars and cents may still serve as the standard measurement of value even if they are not themselves exchanged. Give four examples of ACH transactions you might make. Answer: You receive your paycheck as an electronic transfer from your employer’s account into your account, which may be at a bank different from your employer’s. You schedule your monthly electric bill payment to be made automatically. You make your payments on your credit card to your bank by scheduling the payment each month for the outstanding balance. You make your monthly car payment by arranging for the amount to be deducted from your checking account on the fourth day of each month. As of July 2016, 19 European Union countries have adopted the euro, while the remaining member countries have retained their own currencies. What are the advantages of a common currency for someone who is traveling through Europe? Answer: Each country has the same unit of account, making it easier for a traveler to compare prices in different countries. The traveler also saves the costs of exchanging currencies. Why might each of the following commodities not serve well as money? Tomatoes Bricks Cattle Answer: Tomatoes are perishable and thus would not serve as a store of value. Bricks are heavy and bulky and will break easily. In addition, even though bricks break easily, they are not easily divisible into usable units. Cattle are not standardized in terms of weight and other potentially important characteristics. Despite the efforts of the United States Treasury and the Secret Service, someone discovers a cheap way to counterfeit $100 bills. What will be the impact of this discovery on the economy? Answer: People will be unwilling to accept $100 bills as payment and will require payment via check, credit card, debit card, or electronic transfer instead, all of which are more costly. Theoretically, inflation could result if the supply of money was increased by a large enough amount. You receive a check drawn on another bank and deposit it into your checking account. Even though this is a “demand deposit” the funds are not immediately available for your use. Why? Would your answer change if the check is drawn on the account of another customer of your own bank? Answer: Funds drawn on another bank are not immediately available (i.e., “on demand”) until the funds are transferred through the check-clearing process. So, when you deposit a check drawn on another bank, you must wait until your bank obtains the funds from the other bank. However, if the check is drawn on an account at your own bank, then the funds are internally transferred from the check writer’s account into your account, so the funds may be available almost immediately. Over a nine-year period in the 16th century, King Henry VIII reduced the silver content of the British pound to one-sixth its initial value. Why do you think he did so? What do you think happened to the use of pounds as a means of payment? If you held both the old and new pounds, which would you use first, and why? Answer: King Henry needed to silver to pay for wars. The use of pounds as a means of payment declined because people could not be sure how much silver each coin contained. People spent the new coins first since the old coins had a higher intrinsic value. Under what circumstances might you expect barter to reemerge in an economy that has fiat money as a means of payment? Answer: You might expect an economy to revert to barter when the public loses confidence in the fiat money issued by the government, perhaps because of over-use of the printing presses. You visit a tropical island that has only four goods in its economy – oranges, pineapples, coconuts and bananas. There is no money in this economy. Draw a grid showing all the prices for this economy. (You should check your answer using the n(n - 1)/2 formula where n is the number of goods.) An islander suggests designating oranges as the means of payment and unit of account for the economy. How many prices would there be if her suggestion were followed? Do you think the change suggested in part b is worth implementing? Why or why not? Answer: There would be six prices in total.
Oranges Pineapples Coconuts Bananas
Oranges
Pineapples Pineapples/Oranges
Coconuts Coconuts/Oranges Coconuts/Pineapples
Bananas Bananas/Oranges Bananas/Pineapples Bananas/Coconuts
There would be three prices—pineapples/oranges, coconuts/oranges and banana/oranges. In the case of this four-good economy, there is only a small gain by using oranges as a unit of account. The gains would be significantly bigger in an economy with more goods. If the islanders think the range of goods in their economy is likely to expand, then it is probably worth implementing the change. One of the drawbacks to consider would be the danger that more people would grow oranges, due to their special status, thus pushing up the prices of the other fruits in terms of oranges. Consider again the tropical island described in Problem 12. Under what circumstances would you recommend the issue of a paper currency by the government of the island? What advantages might this strategy have over the use of oranges as money? Answer: The islanders must have enough confidence in their government to accept notes backed only by a government decree that have no intrinsic value themselves. The have to believe that these notes will be widely accepted by other islanders as final payment for goods and services and in settlement of debts. They must trust that the government will not print too much of the money and undermine its value. Some advantages of the paper money over commodity money in the form of oranges include: being easier to carry, longer lasting and more divisible. Most importantly, it would be the government that would control the supply of money on the island as only the government could print new notes, while any of the islanders might decide to grow more oranges. What factors should you take into account when considering using the following assets as stores of value? Gold Real estate Stocks Government bonds Answer: The potential for the price of gold to rise, the ability to buy and sell gold easily and any costs associated with storage and security. The rate at which real estate is appreciating and is likely to appreciate in the future; how easy or difficult it is to sell real estate; the housing services you could receive from holding the real estate. The potential appreciation in nominal value of the stock; the historical volatility of the stock price; the volume of the stock being traded on the secondary market to gauge its liquidity. The rate of return on the bonds – including any potential capital gain as well as interest payments. When assessing an asset as a store of value, the primary things to consider are the risk and return of the asset and its liquidity. Under what circumstances might money in the form of currency be the best option as a store of value? Answer: If there were deflation in the economy, then paper currency would increase in value. When deflation occurs, overall prices in the economy are falling and so the currency you hold has more purchasing power. During periods of falling prices of goods and services, prices of assets often fall too and so currency might be an attractive option as a store of value. Suppose a significant fall the price of certain stocks caused the market makers in those stocks to experience difficulties with their funding liquidity. Under what circumstances might that development lead to liquidity problems in markets for other assets? Answer: Faced with difficulties in borrowing money, the market makers in the stocks may decide to hold more cash to ensure their ability to meet clients’ demands. This, in turn, reduces loans available for other market participants potentially causing them to alter their behavior and could lead to funding liquidity problems throughout the financial system. Moreover, to fund itself, the market maker might try to sell other assets, depressing their prices and spreading the disruption. Consider an economy that only produces and consumes two goods - food and apparel. Suppose the inflation rate based on the consumer price index is higher during the year than that based on the GDP deflator. Assuming underlying tastes and preferences in the economy stay the same, what can you say about food and apparel price movements during the year? Answer: Since the two price indices yield different inflation rates with preferences remaining constant, the relative price of the two goods must have changed. In other words, the price of one of the goods must have gone up by a greater percentage than the other. For example, suppose the price of food went up by 10% while the price of apparel went up by 20%. This would induce consumers to substitute away from apparel to food. As a fixed weight index, the CPI would not take this substitution into account while the GDP deflator would, as it is calculated on the basis of what is actually purchased. Therefore, the CPI inflation rate would be higher than the rate calculated from the GDP deflator. Assuming no interest is paid on checking accounts, what would you expect to see happen to the relative growth rates of M1 and M2 if interest rates rose significantly? Answer: When interest rates rise, you would expect that people would shift funds from checking accounts into savings accounts, as the opportunity cost of holding funds in a non-interest bearing account has risen. Checking accounts are a component of M1 while both checking and some savings accounts are included in M2. Therefore, any shift from checking to savings accounts would depress growth in M1 to a greater degree than growth in M2, leading to a relative increase in the M2 growth rate. If money growth is related to inflation, what would you expect to happen to the inflation rates of countries that join a monetary union and adopt a common currency such as the euro? Answer: Once countries join a monetary union, they effectively share a common money supply. Given the link between money growth and inflation, you would expect the inflation rates of these countries to converge. Why might one doubt that current new forms of digital money, such as Bitcoin, will replace more traditional fiat currencies? Answer: These private digital currencies currently do not fulfill the three key functions of money—means of payment, unit of account, and store of value Is the challenge of making “time consistent” policy unique to fiat-based paper money? Answer: No. Even if the value of money is linked to a commodity such as gold, the government could abolish this current commitment at a point in the future such as in a time of crisis. For example, the United States exited the Gold Standard in 1933, allowing the price of gold to vary in dollar terms for the first time in a century. Data Exploration Find the most recent level of M2 (FRED code: M2SL) and of the U.S. population (FRED code: POP). Compute the quantity of money divided by the population. (Note that M2 is measured in billions of dollars and population is in thousands of individuals.) Do you think your answer is large? Why? Answer: In June 2016, the value of M2 was $12,811 billion. The total population was 323.9 million, resulting in M2 per capita of $39,551. This seems like a lot, but M2 includes money market mutual fund shares, money market deposit accounts, small-denomination time deposits, checking accounts, and traveler’s checks in addition to currency in the hands of the public. It also includes holdings by businesses, in addition to households. Reproduce Figure 2.3 from 1960 to the present, showing the percent change from a year ago of M1 (FRED code: M1SL) and M2 (FRED code: M2SL). Comment on the pattern over the last five years. Would it matter which of the two monetary aggregates you looked at? Answer: The data plot of Figure 2.3 is: M1 is relatively volatile so it may be less reliable for indicating important underlying trends. Which usually grows faster: M1 or M2? Produce a graph showing M2 (FRED code: M2SL) divided by M1 (FRED code: M1SL). When this ratio rises, M2 outpaces M1, and vice versa. What is the long-run pattern? Is the pattern stable? Answer: The plot of the ratio M2/M1 appears below. Over the long run, M2 has usually grown faster than M1, but this pattern is not stable. In particular, M2 growth fell relative to M1 growth after the recession of the early 1990s and after the financial crisis of 2007-09. Later in the book, we will see that both periods were characterized by heightened caution on the part of banks. Traveler’s checks are a component of M1 and M2. Using FRED, produce a graph of this component of the monetary aggregates (FRED code: TVCKSSL). Explain the pattern you see. Answer: The indicated data plot is: The use of traveler’s checks has declined since the mid-1990s. Traveler’s checks were essentially prepaid checks drawn on the account of a widely-recognized issuer. As such, they were convenient for making payments when voyaging away from the geographical area covered by your bank. Merchants in other areas who lacked familiarity with banks outside their own locations might be unwilling to accept your personal check. The rise of nationwide banking and the proliferation of credit and debit cards have reduced the demand for traveler’s checks. Plot the annual inflation rate based on the percent change from a year ago of the consumer price index (FRED code: CPIAUCSL). Comment on the average and variability of inflation in the 1960s, the 1970s, and the most recent decade. Answer: The indicated data plot is: The variability of inflation in the 1960s was reasonably low in the first part of the decade, then rising with the trend of inflation toward the end. In the 1970s, inflation was highly variable and averaged well above the 1960s norm. Over the decade to 2016, inflation was variable mostly during the financial crisis of 2007 - 2009. In general, periods with low average inflation – such as the first half of the 1960s and the long interval from the mid-1980s to the financial crisis – also were periods of relatively low inflation variability indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
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