Economics of Social Issues Study Set 2

Business

Quiz 12 :

Inflation: How to Gain and Lose at the Same Time

Quiz 12 :

Inflation: How to Gain and Lose at the Same Time

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Explain why commercial banks are financial intermediaries.
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At any given time, there are some individuals who have more money than they immediately require for purchases, leaving them with a certain amount that they would save. At the same time, there are other individuals who need money for various purposes, meaning that there is an amount that they would borrow. Commercial banks are called financial intermediaries because they act as a mediator between savers and borrowers to meet the needs of both groups. Savers make deposits in a bank with the expectation of receiving an interest payment in exchange for allowing the bank to hold on to the money. At the same time, the bank lends a portion of that deposit to borrowers, who repay the loan with interest. The bank earns a profit by bringing in more interest from borrowers than it pays to savers.

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What measures did the Federal Reserve undertake to restore credit in response to the financial crisis? Discuss.
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During and after the 2008 financial crisis, the Federal Reserve took several steps in order to increase the availability of credit.
• The financial crisis began with the collapse of the housing market, with many subprime mortgages that had been created as the result of former policies going into default after rates increased and home owners could no longer afford their payments. Two large mortgage institutions, Fannie Mae and Freddie Mac (formerly governmental entities but privatized in the 1960s), represented a major supply of liquidity and were unable to perform that role as they became saddled with a huge number of defaulted mortgages. The Federal Reserve effectively took control of these institutions and extended credit to them in order to prevent further collapse of the real estate market.
• Investment banks faced collapse in the financial crisis, in part because much of the debt that they had come to own consisted of subprime mortgages that were now going into default. The Federal Reserve intervened by facilitating a merger between two large investment banking firms, and providing a loan for another in order to prevent its collapse. Another bank, however, was allowed to collapse. However, by "saving" at least some of the investment banks, the policy objective was to avoid a potential "domino effect" with other financial institutions collapsing because of the loss of assets they had entrusted to failed investment banks, with those collapses creating still others.
• In the past, the Federal Reserve has controlled the money supply in part by setting the Federal Funds Rate. Increasing the rate reduces the money supply and lowering the rate increases the money supply. During the financial crisis, in order to combat the tightening of credit, the Federal Reserve dropped the rate to 0.25%, the lowest rate of all time.
• A further action taken by the Federal Reserve was quantitative easing. Rather than buying and selling securities in the marketplace in normal open-market operations, the Federal Reserve would purchase assets directly from financial institutions. The intention was to ease the pressure caused by the debt that consisted of defaulted mortgages and other "toxic" assets.
In addition to actions by the Federal Reserve, another major undertaking during the financial crisis was the creation of the Troubled Assets Relief Program (TARP) by an act of Congress. TARP was carried out by the Treasury Department. This enabled the Treasury Department to purchase assets from institutions that were in danger of collapsing, essentially transferring ownership of those assets to the government. The intent of TARP was to further eliminate "toxic" assets owned by financial institutions.

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How did the financial crisis of 2008 begin in the home real estate market?
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The 2008 financial crisis is thought to have begun in the home real estate market in the US. The stage was set for this crisis several years earlier with the adoption of governmental policies that encouraged home ownership in groups of consumers who historically had not been able to purchase homes because they were unable to obtain mortgages. The new policies enabled these individuals to obtain what were called subprime mortgages, intended for customers without good credit ratings. Most of these were adjustable rate mortgages , meaning that the interest rate on the loan was set to the market interest rates. In effect, many new home buyers entered the market with initial mortgage payments that they could afford at the current interest rates.
These policies increased the demand for home real estate properties, which had the consequence of driving up prices. Home prices increased by very high percentages in many cases. The rising price of homes encouraged speculative buyers to enter the market, further increasing the demand. Also, with property values increasing, many other homeowners were now able to take out equity loans against the new higher value of their homes.
Starting in 2005 and continuing in 2006 and 2007, interest rates were increased by the Federal Reserve from 1% to 5%. This caused the mortgage payments of many subprime, adjustable rate mortgages to increase. The increase was more than what many of these home buyers could afford. Consequently, many of these mortgages went into default, loading the market with a huge amount of foreclosed properties. As a result, home prices began a sharp decline between 2006 and 2008. Many mortgages on homes purchased prior to this time were now worth more than the value of the home they had originally purchased. This caused even more properties to default. The crisis from the collapse of the housing market cascaded into the larger financial system, because the mortgages had been sold to and traded among financial companies (in order to earn from the interest on the loans). This was one of the factors that led to the 2007-2009 recession.

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Explain the quantity theory of money. What is the starting point for the theory? Is this theory supported by empirical data? Discuss.
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Explain why excess reserves held by U.S. banks have increased dramatically since 2009. Why do some fear that this phenomenon will lead to inflation? Discuss.
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What are the functions of money? Discuss the different definitions of money.
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In your opinion, what should the Federal Reserve do to prevent a future financial crisis? Explain.
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How do investment banks differ from commercial banks? How did the financial crisis change investment banks?
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What is the current Federal Funds rate? Has it changed over the course of the past 12 months? If so, how has this affected the growth in M2? Explain.
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What is the difference between stocks and bonds?
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Distinguish between primary and secondary financial markets. What type of market is the New York Stock Exchange?
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Discuss how financial innovations affected the financial crisis of 2008.
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How is the rate of interest determined in the money market? Illustrate your answer with a graph.
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How do insurance companies earn their profits?
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What does the U.S. constitution say about banking? Discuss the early history of banks in the United States.
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How do people profit from owning shares of corporate stock?
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Assume the Fed sells government securities on the open market. What will happen to consumer spending and why?
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Discuss the major policy controls of the Federal Reserve. Include in your discussion the relative effectiveness of open-market operations, the discount rate, and the legal reserve requirement.
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Assume a new demand deposit of $1,000 and a legal reserve requirement of 10 percent. Explain in detail how money is created, and show the final balance sheet of the banking system, assuming the maximum increase in the money supply.
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Compare and contrast quantitative easing and traditional monetary policy. Has quantitative easing been an effective tool for the Fed since 2009? Defend your answer.
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