Whitman College Econ 407 Exam 2 November 22, 2013 Write all answers in your blue book. Show all of your work. The exam ends at 12:30. Use the following information on Treasury yield curve rates to answer Questions 1 and 2.
Treasury Yield Curve Rates
Date 1 Mo 11/21/13 0.02% 1 Yr 2 Yr 0.12% 0.29% 3 Yr 0.55% 5 Yr 1.38% 7 Yr 10 Yr 20 Yr 2.12% 2.79% 3.59% 30 Yr 3.89% 1. Suppose that the assumptions of the Pure Expectations (PE) theory of the term structure of interest rates hold. (a) (2pts) List the assumptions of the PE theory. (b) (3pts) Use the PE theory to forecast the interest rate on a two-­‐year Treasury security offered for sale three years from now. 2. Suppose that the assumptions of the Liquidity Premium (LP) theory of the term structure of interest rates hold. (a) (2pts) List the assumptions of the LP theory. (b) (8pts) Suppose savers require the liquidity premium schedule given in the table below. Use the LP theory to forecast the interest rate on a two-­‐year Treasury security offered for sale three years from now. Term to
Liquidity premium
maturity
(in percent per year)
1 month
0%
1 year
0.05%
2 years
0.15%
3 years
0.20%
5 years
0.25%
10 years
0.60%
20 years
1.00%
30 years
1.50%
1 3. (5pts) Define bank capital. For Questions 4 and 5 consider the following excerpts from the Wall Street Journal. Fed’s Rosengren Calls for Larger Capital Cushions By MICHAEL S. DERBY
November 19, 2013
Federal Reserve Bank of Boston President
Eric Rosengren has been a frequent advocate
for additional reforms to the financial
regulatory environment in the wake of the
financial crisis. He has focused on the
unfinished business of the landmark DoddFrank Act, and has targeted money-market
funds, among others, for serving as potential
source of new financial instability….
Mr. Rosengren is interested in the risk posed
by…[financial intermediaries] that rely
heavily on short term financing to keep their
operations running… “For these
organizations, the primary risk issue is the
riskiness of their funding model …”
Because of the way these banks fund
themselves he said there may need to be a
change in how they are evaluated by
regulators. “Certainly one way to [reduce the
risk these firms pose to the broader financial
system] would be to impose capital charges
for bank holding companies highly reliant on
wholesale [i.e. very short term] funding,” Mr.
Rosengren said. “Larger capital positions for
firms with a business model reliant on
wholesale funding will help to further reduce
the likelihood of a liability run.”
4. Consider the article “Liquidity Crises: Understanding sources and limiting consequences: A
theoretical framework” by Robert Lucas and Nancy Stokey, Federal Reserve Bank of Minneapolis The
Region, June 2011, pp. 6-15.
(20pts) Use Lucas and Stokey’s analysis to help explain the riskiness of a financial intermediary with a
funding model that relies heavily on short term financing. Your explanation should include the following:
(a) Describe how the Lucas and Stokey model creates a role for a bank to borrow short term. You need to thoroughly describe the model. (b) Describe the conditions under which a bank can fulfill its promise that everyone can withdraw their funding on demand. (c) Why is the bank’s ability to make good on its withdrawal promise fragile? 2 5. Consider the interview with Darrell Duffie on post-crisis financial reforms in Federal Reserve Bank of
Minneapolis The Region June 2012, pp. 12-27.
(a) (5pts) Mr. Duffie describes how the potential for fire sales creates interconnectedness in the financial system. Use Duffie’s description to help explain Mr. Rosengren’s reasoning that when “the primary risk issue is the riskiness of their funding model” we get “risk to the broader financial system” posed by intermediaries with very short term financing. (b) (5pts) According to Mr. Duffie, why should bank capital requirements be set via international coordination, such as through Basel III? 6. (10pts) Consider Brad DeLong’s March 29, 2010 blog postings. Mr. DeLong writes “it is no
accident that the modern market-driven financial crisis and the industrial business cycle start in 1825, as
the British Industrial Revolution enters its heyday.” Explain his reasoning. 7. (5pts) In 1873 Walter Bagehot writes “I know it will be said…that I have pointed out a deep malady, and only suggested a superficial remedy.” The malady is the susceptibility to financial panics of a fractional-­‐reserve maturity-­‐transforming banking system. His remedy has come to be known as the Bagehot Rule. What is the Bagehot Rule? 8. (10pts) Why didn’t the Federal Reserve serve as a lender of last resort during the bank panics of 1930-­‐1933? 9. (a) (10pts) In the FRB of St Louis Monetary Trends article “The Monetary Base and Bank Lending: You Can Lead a Horse to Water…” (2010) David Wheelock asks “Why was the increase in the money supply [after September 2008] so small when the increase in the monetary base was so large? How does he answer his question? In the FRB of St Louis Monetary Trends article “How Not to Reduce Excess Reserves” (2009) David Wheelock notes “many observers contend that the large increase in excess reserves [since September 2008] poses a significant inflation risk.” (b) (5pts) Why could the increase to the current $2.3 trillion of excess reserves in the commercial banking system, from nearly zero in 2008, potentially cause inflation? Mr. Wheelock notes the similarity of the current situation to that of 1936, when the Federal Reserve was deciding what to do about the fact that excess reserves had risen to a very high level from nearly zero before the Great Depression. (c) (10pts) In 1936, what did the Fed decide to do about the high level of excess reserves, and what were the results of these Fed actions? 3