1. 20 in Loans Go Uncollectable
Solvent Bank
Assets Liabilities
Reserves
Loans
Invests
Premises
Deposits 200
Capital
Insolvent Bank
Assets Liabilities
Reserves
Loans
Invests
Premises
Deposits 200
Capital
FDIC closes bank

2. Number US Bank Failures
Total GA
Failures
Portion
2007 3 1
2008 25 5
2009
140
2010
151 21
2011
123 23
2012 51 10
2013 24 2
2014 18
2015 8
2016
2017
FDIC usually closes banks on Fridays. Why?

3. Six Goals of Monetary Policy
Set by the Humphrey-Hawkins Act of 1978
Price stability
Full employment
Economic growth
Interest rate stability
Stability of the financial system
Stability of foreign exchange markets
with first two being primary goals.
Monetary policy first impacts the financial sector. Then financial sector affects the real sector. Two schools of thought on how this works.

4. Money Supply Measures
Monetary Base = Federal Reserve notes outstanding + depository institution balances at the Fed
Money supply is total amount of money in economy.
Two money supply measures are
(CDs)
money aggregates
Monetary base and money supply are not same thing
(definitions are different).

5. Monetary Base Graph

6. Money Supply Comments
M1 focuses on money as a medium of exchange such as for settling a debt.
M2 includes money as a “store of value.” There are also other money supply measures M3, MZM, etc.
Different money supply measures are studied because they have different abilities to help understand employment, inflation, interest rates, . .
Money supply is what is believed to be important, but Fed can only control it imprecisely through monetary base, because Fed can’t force banks to lend and most money supply aggregates are determined by private decisions.

7. M1 Graph

8. Repos & Reverse Repos on Fed Bal Sheet
Used by Fed for temporary adjustments to monetary base.
Repurchase agreements. Securities sold by dealers under agreement to repurchase on a certain date at a certain price. (adds reserve balances to the banking system)
Reverse repurchase agreements. Securities purchased by dealers under agreement to resell back on a certain date at a certain price. (drains reserve balances from the banking system)
repo -- economic equivalent of a collateralized loan
reverse repo -- economic equivalent of collateralized borrowing

9. Repos & Reverse Repos on Fed Bal Sheet
Repurchase agreement (dealer borrows from Fed)
Fed buys securities from dealer for X
Dealer repurchases securities from Fed for X+interest
Reverse repurchase agreement (dealer loan to Fed)
Fed sells securities to dealer for X
Fed repurchases securities from dealer for X+interest
Repos are used all over the financial world. Need to study repos hard.
It is called a repo or reverse repo depending upon how it looks to a dealer.

10. Monetarist Economists
Monetarists believe
key explanatory variable is the money supply
people will buy more if feel they have “more money,” and spend less if feel they have “less money.”
idea is to use monetary policy to influence the money supply.
in this way, adding reserves should promote economic growth, reducing reserves should slow the economy.

11. Keynesian Economists Keynesians believe
key explanatory variable is the interest rate
John Maynard Keynes was influential British economist of 1930s.
money supply does not make that much difference
believe economic growth is stimulated by falling interest rates, and slowed by rising rates

12. Market Rate of Interest Rate
Market rate of interest performs an allocative function by assuring
SSUs rate will be low enough so someone will borrow from them
DSUs rate will be high enough so someone will lend to them.

13. Production Opportunities
In addition to Fed affecting the Fed Fund rate, interest rates are affected by business opportunities (production opportunities, in book).
The lower the rate of interest, the greater the number of business ventures that should be profitable.

14. Nominal vs. Real Rate of Interest
Nominal interest rate is the observed rate (the market rate).
Real rate of interest is nominal rate minus inflation.
Prior to 10 years ago, real rate of interest had historically been between about 2% and 4%, getting back to that now.

15. Fisher Effect
Inflation is built into interest rates.

16. Fisher Equation i nominal rate of interest
r real rate of interest (i.e., rental rate)
expected rate of inflation.
Regular Fisher equation
Exact Fisher equation
The three terms see to it that lender gets compensated for:
rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest

17. Example 1
Willing to lend $3 billion to a company going through a difficult time for rental rate of 10% plus full protection against inflation which is forecast at 4%. Boss says figure out interest rate to charge. What is difference between regular and exact?
10/8

18. Ex ante vs. Ex post
ex ante means based upon anticipated effects (i.e., what lies ahead)
here, we assume r and forecast (e is expected)
ex post means based upon analysis of past performance (i.e., what lies behind)
here, we know both i and (a is actual)

19. Other Forms of Fisher Equations
regular for ex ante use: exact for ex ante use:
regular for ex post use: exact for ex post use:

20. Example 2
Suppose a loan were set up with a nominal interest rate of 12%. What would be exact real rate of return if inflation turned out to be 4%?

21. When Inflation Deviates From Anticipated
Inflation greater than anticipated: benefits borrowers, Results in an unintended transfer of PP from lender to borrower.
Inflation less than anticipated: benefits lenders. Results in an unintended transfer of PP from borrower to lender.
So what is Fisher Effect? …that embedded in nominal interest rates are inflation expectations.