Asymmetric Information and Banking Regulation

In earlier chapters, we have seen how asymmetric information, the fact that different parties in a financial contract do not have the same information, leads to adverse selection and moral hazard problems that have an important impact on our financial system. The concepts of asymmetric information, adverse selection, and moral hazard are especially useful in understanding why government has chosen the form of banking regulation we see in the United States and in other countries. There are eight...

The Lemons Problem How Adverse Selection Influences Financial Structure

Www.nobel.se economics laureates 2001 public.html A complete discussion of the lemons problem on a site dedicated to Nobel prize Lemons in the Stock and Bond Markets A particular characterization of the adverse selection problem and how it interferes with the efficient functioning of a market was outlined in a famous article by Nobel prize winner George Akerlof. It is referred to as the lemons problem, because it resembles the problem created by lemons in the used-car market.3 Potential buyers...

Tradeoff Between Safety and Returns to Equity Holders We now see that bank capital

Bank capital benefits the owners of a bank in that it makes their investment safer by reducing the likelihood of bankruptcy. But bank capital is costly because the higher it is, the lower will be the return on equity for a given return on assets. In determining the amount of bank capital, managers must decide how much of the increased safety that comes with higher capital (the benefit) they are willing to trade off against the lower return on equity that comes with...

Info

Source Wall Street Journal, January 3, 2003, p. C4. Source Wall Street Journal, January 3, 2003, p. C4. The following information is included in each column. International Business Machines (IBM) common stock is used as an example. YTD Chg The stock price percentage change for the calendar year to date, adjusted for stock splits and dividends over 10 52 Weeks Hi Highest price of a share in the past 52 weeks 126.39 for IBM stock 52 Weeks Lo Lowest price of a share in the past 52 weeks 54.01 for...

Managing Credit Risk

As seen in the earlier discussion of general principles of asset management, banks and also other financial institutions must make successful loans that are paid back in full (and so subject the institution to little credit risk) in order to earn high profits. The economic concepts of adverse selection and moral hazard (introduced in Chapters 2 and 8) provide a framework for understanding the principles that financial institutions have to follow to reduce credit risk and make successful loans.3...

The Enron Scandal and the Stock Market

In 2001, two big shocks hit the stock market the September 11 terrorist attacks and the Enron scandal. Our analysis of stock price evaluation, again using the Gordon growth model, can help us understand how these events affected stock prices. The September 11 terrorist attacks raised the possibility that terrorism against the United States would paralyze the country. These fears led to a downward revision of the growth prospects for U.S. companies, thus lowering the dividend growth rate (g) in...

Why Study Banking and Financial institutions

Part III of this book focuses on financial institutions and the business of banking. Banks and other financial institutions are what make financial markets work. Without them, financial markets would not be able to move funds from people who save to people who have productive investment opportunities. They thus also have important effects on the performance of the economy as a whole. Structure of The financial system is complex, comprising many different types of private sector the Financial...

ISLM Model in the Long

So far in our ISLM analysis, we have been assuming that the price level is fixed so that nominal values and real values are the same. This is a reasonable assumption for the short run, but in the long run the price level does change. To see what happens in the ISLM model in the long run, we make use of the concept of the natural rate level of output denoted by Yn , which is the rate of output at which the price level has no tendency to rise or fall. When output is above the natural rate level,...

The Market for Reserves and the Federal Funds Rate

Fed Funds Rate Supply And Demand

In Chapter 15, we saw how open market operations and discount lending affect the balance sheet of the Fed and the amount of reserves. The market for reserves is where the federal funds rate is determined, and this is why we turn to a supply-and-demand analysis of this market to analyze how all three tools of monetary policy affect the federal funds rate. Supply and The analysis of the market for reserves proceeds in a similar fashion to the analysis of Demand in the the bond market we conducted...

Questions and Problems

Questions marked with an asterisk are answered at the end of the book in an appendix, Answers to Selected Questions and Problems. 1. The money multiplier is necessarily greater than 1. Is this statement true, false, or uncertain Explain your answer. 2. If reserve requirements on checkable deposits were set at zero, the amount of multiple deposit expansion would go on indefinitely. Is this statement true, false, or uncertain Explain. 3. During the Great Depression years 1930-1933, the currency...

Whats New in the Seventh Edition

In addition to the expected updating of all data through the end of 2002 whenever possible, there is major new material in every part of the text. Indeed, this revision is one of the most substantial that I have ever done. Expanded Coverage of the Stock Market With the wide swings in the stock prices in recent years, students of money and banking have become increasingly interested in what drives the stock market. As a result, I have expanded the discussion of this market by describing simple...

Jq Determinants of the Money Supply

In Chapter 15, we developed a simple model of multiple deposit creation that showed how the Fed can control the level of checkable deposits by setting the required reserve ratio and the level of reserves. Unfortunately for the Fed, life isn't that simple control of the money supply is far more complicated. Our critique of this model indicated that decisions by depositors about their holdings of currency and by banks about their holdings of excess reserves also affect the money supply. To deal...

Credits

Following the Financial News Foreign Stock Market Indexes. International Stock Market Indexes from The Wall Street Journal, January 21, 2003, p. C6. Republished by permission of Dow Jones, Inc. via Copyright Clearance Center, Inc. 2003 Dow Jones amp Co., Inc. All Rights Reserved Worldwide. Page 54. Following the Financial News The Monetary Aggregates. Monetary Aggregates from The Wall Street Journal, January 3, 2003, p. C10. Republished by permission of Dow Jones, Inc. via Copyright...

Why Are Exchange Rates So Volatile

The high volatility of foreign exchange rates surprises many people. Thirty or so years ago, economists generally believed that allowing exchange rates to be determined in the free market would not lead to large fluctuations in their values. Recent experience has proved them wrong. If we return to Figure 1, we see that exchange rates over the 1980-2002 period have been very volatile. The asset market approach to exchange rate determination that we have outlined in this chapter gives a...

Financial Crises and Aggregate Economic Activity

Agency theory, our economic analysis of the effects of adverse selection and moral hazard, can help us understand financial crises, major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms. Financial crises have been common in most countries throughout modern history. The United States experienced major financial crises in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930-1933 but has not had a...

Supply and Demand in the Market for Money The Liquidity Preference Framework

Fixed Supply Demand Curve

Whereas the loanable funds framework determines the equilibrium interest rate using the supply of and demand for bonds, an alternative model developed by John Maynard Keynes, known as the liquidity preference framework, determines the equilibrium interest rate in terms of the supply of and demand for money. Although the two frameworks look different, the liquidity preference analysis of the market for money is closely related to the loanable funds framework of the bond market.4 The starting...

Monetary Targeting

In many countries, exchange-rate targeting is not an option, because either the country or bloc of countries is too large or because there is no country whose currency is an obvious choice to serve as the nominal anchor. Exchange-rate targeting is therefore clearly not an option for the United States, Japan, or the European Monetary Union. These countries must look to other strategies for the conduct of monetary policy, one of which is monetary targeting. Monetary In the 1970s, monetary...

Io Banking Industry Structure and Competition

The operations of individual banks how they acquire, use, and manage funds to make a profit are roughly similar throughout the world. In all countries, banks are financial intermediaries in the business of earning profits. When you consider the structure and operation of the banking industry as a whole, however, the United States is in a class by itself. In most countries, four or five large banks typically dominate the banking industry, but in the United States there are on the order of 8,000...

ISLM Model and the Aggregate Demand Curve

Model And Aggregate Demand

We now examine further what happens in the ISLM model when the price level changes. When we conduct the ISLM analysis with a changing price level, we find that as the price level falls, the level of aggregate output rises. Thus we obtain a relationship between the price level and quantity of aggregate output for which the goods market and the market for money are in equilibrium, called the aggregate demand curve. This aggregate demand curve is a central element in the aggregate supply and...

Using Economic Analysis to Predict the Future

Answer the remaining questions by drawing the appropriate exchange market diagrams. 7. The president of the United States announces that he will reduce inflation with a new anti-inflation program. If the public believes him, predict what will happen to the U.S. exchange rate. 8. If the British central bank prints money to reduce unemployment, what will happen to the value of the pound in the short run and the long run 9. If the Canadian government unexpectedly announces that it will be imposing...

Tell Us About Rational Expectations and Efficient Markets

On October 19, 1987, dubbed Black Monday, the Dow Jones Industrial Average declined more than 20 , the largest one-day decline in U.S. history. The collapse of the high-tech companies' share prices from their peaks in March 2000 caused the heavily tech-laden NASDAQ index to fall from around 5,000 in March 2000 to around 1,500 in 2001 and 2002, for a decline of well over 60 . These two crashes have caused many economists to question the validity of efficient markets and rational expectations....

New Keynesian Model

In the new classical model, all wages and prices are completely flexible with respect to expected changes in the price level that is, a rise in the expected price level results in an immediate and equal rise in wages and prices. Many economists who accept rational expectations as a working hypothesis do not accept the characterization of wage and price flexibility in the new classical model. These critics of the new classical model, called new Keynesians, object to complete wage and price...

Bank Panics of 19301933 Why Did the Fed Let Them Happen

The Federal Reserve System was totally passive during the bank panics of the Great Depression period and did not perform its intended role of lender of last resort to prevent them. In retrospect, the Fed's behavior seems quite extraordinary, but hindsight is always clearer than foresight. The primary reason for the Fed's inaction was that Federal Reserve officials did not understand the negative impact that bank failures could have on the money supply and economic activity. Friedman and...

Early Monetarist Evidence on the Importance of Money

In the early 1960s, Milton Friedman and his followers published a series of studies based on reduced-form evidence that promoted the case for a strong effect of money on economic activity. In general, reduced-form evidence can be broken down into three categories timing evidence, which looks at whether the movements in one variable typically occur before another statistical evidence, which performs formal statistical tests on the correlation of the movements of one variable with another and...

How Moral Hazard Affects the Choice Between Debt and Equity Contracts

Moral hazard is the asymmetric information problem that occurs after the financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the secu rity. Moral hazard has important consequences for whether a firm finds it easier to raise funds with debt than with equity contracts. Moral Hazard in Equity contracts, such as common stock, are claims to a share in the profits and assets Equity...

Early Keynesiansmall

Nominal Versus Real Interest Rates

Group of economists at the University of Chicago, led by Milton Friedman, Evidence adopted what was then the unfashionable view that money does matter to aggregate demand. Friedman and his disciples, who later became known as monetarists, objected to the early Keynesian interpretation of the evidence on the grounds that the structural model used by the early Keynesians was severely flawed. Because structural model evidence is only as good as the model it is based on, the monetarist critique of...

6. A The Yield To Maturity Would Be 5 For A One Year Bond 6 For A Two-year Bond. 6.33 For A Three-year Bond 6.5 For A

Then a better store of value, and you would have been willing to hold more of it. 9. Money loses its value at an extremely rapid rate in hyperinflation, so you want to hold it for as short a time as possible. Thus money is like a hot potato that is quickly passed from one person to another. 11. Not necessarily Although the total amount of debt has predicted inflation and the business cycle better than M1, M2, or M3, it may not be a better predictor in the future. Without some theoretical reason...

If A Bank Decides That It Wants To Hold 1 Million Of Excess Reserves What Effect Will This Have On Checkable Deposits

Questions marked with an asterisk are answered at the end of the book in an appendix, Answers to Selected Questions and Problems. 1. If the Fed sells 2 million of bonds to the First National Bank, what happens to reserves and the monetary base Use T-accounts to explain your answer. 2. If the Fed sells 2 million of bonds to Irving the Investor, who pays for the bonds with a briefcase filled with currency, what happens to reserves and the monetary base Use T-accounts to explain your answer. 3. If...

Tools to Help Production of Information Monitoring You have seen that the principalagent problem

Solve the arises because managers have more information about their activities and actual profits Principal-Agent than stockholders do. One way for stockholders to reduce this moral hazard problem is Problem for them to engage in a particular type of information production, the monitoring of the firm's activities auditing the firm frequently and checking on what the management is doing. The problem is that the monitoring process can be expensive in terms of time and money, as reflected in the...

Application The Enron Bankruptcy and the Baa Aaa Spread

In December 2001, the Enron Corporation, a firm specializing in trading in the energy market, and once the seventh-largest corporation in the United States, was forced to declare bankruptcy after it became clear that it had used shady accounting to hide its financial problems. The Enron bankruptcy, the largest ever in the United States, will be discussed further in Chapter 8. Because of the scale of the bankruptcy and the questions it raised about the quality of the information in accounting...

The M2 Money Multiplier

The derivation of a money multiplier for the M2 definition of money requires only slight modifications to the analysis in the chapter. The definition of M2 is where C currency in circulation D checkable deposits T time and savings deposits MMF primarily money market mutual fund shares and money market deposit accounts, plus overnight repurchase agreements and overnight Eurodollars We again assume that all desired quantities of these variables rise proportionally with checkable deposits so that...

Monitoring and Enforcement of Restrictive Covenants Once a loan has been made the

Borrower has an incentive to engage in risky activities that make it less likely that the loan will be paid off. To reduce this moral hazard, financial institutions must adhere to the principle for managing credit risk that a lender should write provisions restrictive covenants into loan contracts that restrict borrowers from engaging in risky activities. By monitoring borrowers' activities to see whether they are complying with the restrictive covenants and by enforcing the covenants if they...

Monitoring and Enforcement of Restrictive Covenants As the example of Steve and his

Ice-cream store shows, if you could make sure that Steve doesn't invest in anything riskier than the ice-cream store, it would be worth your while to make him the loan. You can ensure that Steve uses your money for the purpose you want it to be used for by writing provisions restrictive covenants into the debt contract that restrict his firm's activities. By monitoring Steve's activities to see whether he is complying with the restrictive covenants and enforcing the covenants if he is not, you...

The Distinction Between Real and Nominal Interest Rates

Go to charts of real versus nominal rates to view 30 years of nominal interest rates compared to real rates for the 30-year T-bond and 90-day T-bill. So far in our discussion of interest rates, we have ignored the effects of inflation on the cost of borrowing. What we have up to now been calling the interest rate makes no allowance for inflation, and it is more precisely referred to as the nominal interest rate, which is distinguished from the real interest rate, the interest rate that is...

Why Study Money and Monetary Policy

Money Supply

Money, also referred to as the money supply, is defined as anything that is generally accepted in payment for goods or services or in the repayment of debts. Money is linked policy, banking system, research, and economic data of the Federal Reserve. to changes in economic variables that affect all of us and are important to the health of the economy. The final two parts of the book examine the role of money in the economy. In 1981-1982, total production of goods and services called aggregate...

Supply and Demand in the Gold Market

The analysis of a commodity market, such as the gold market, proceeds in a similar fashion to the analysis of the bond market by examining the supply of and demand for the commodity. We again use our analysis of the determinants of asset demand to obtain a demand curve for gold, which shows the relationship between the quantity of gold demanded and the price when all other economic variables are held constant. Demand Curve To derive the relationship between the quantity of gold demanded and its...

Application Should Foreign Exchange Rates Follow a Random Walk

Although the efficient market hypothesis is usually applied to the stock market, it can also be used to show that foreign exchange rates, like stock prices, should generally follow a random walk. To see why this is the case, consider what would happen if people could predict that a currency would appreciate 9The first type of test, using only stock market data, is referred to as a test of weak-form efficiency, because the information that can be used to predict stock prices is restricted to...

Function of Financial Intermediaries

As shown in Figure 1 p. 24 , funds can move from lenders to borrowers by a second route, called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders. For example, a bank might acquire funds by issuing a liability to the public an asset for...

The Importance of Financial Intermediaries to Securities Markets An International Comparison

Patterns of financing corporations differ across countries, but one key fact emerges. Studies of the major developed countries, including the United States, Canada, Great Britain, Japan, Italy, Germany, and France, show that when businesses go looking for funds to finance their activities, they usually obtain them indirectly through financial intermediaries and not directly from securities markets. Even in the United States and Canada, which have the most developed securities markets in the...