Business Economics Name: _________________
Exam II
CHOOSE 6 OUT OF THE 10 QUESTIONS
1. On January 22, 2015, the European Central Bank (ECB) put out the following Press Release:
ECB announces expanded asset purchase programme:
• ECB expands purchases to include bonds issued by euro area central governments, agencies and European institutions
• Combined monthly asset purchases to amount to €60 billion
• Purchases intended to be carried out until at least September 2016
• Programme designed to fulfil price stability mandate
The Governing Council of the European Central Bank (ECB) today announced an expanded asset purchase programme. Aimed at fulfilling the ECB's price stability mandate, this programme will see the ECB add the purchase of sovereign bonds to its existing private sector asset purchase programmes in order to address the risks of a too prolonged period of low inflation.
The Governing Council took this decision in a situation in which most indicators of actual and expected inflation in the euro area had drifted towards their historical lows. As potential second-round effects on wage and price-setting threatened to adversely affect medium-term price developments, this situation required a forceful monetary policy response.
Asset purchases provide monetary stimulus to the economy in a context where key ECB interest rates are at their lower bound. They further ease monetary and financial conditions, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately contributes to a return of inflation rates towards 2%.
The programme will encompass the asset-backed securities purchase programme (ABSPP) and the covered bond purchase programme (CBPP3), which were both launched late last year. Combined monthly purchases will amount to €60 billion. They are intended to be carried out until at least September 2016 and in any case until the Governing Council sees a sustained adjustment in the path of inflation that is consistent with its aim of achieving inflation rates below, but close to, 2% over the medium term.
The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money, which the institutions that sold the securities can use to buy other assets and extend credit to the real economy. In both cases, this contributes to an easing of financial conditions.
Based on the ECB Press Release, please explain the following:
1a) What is the purpose of expanding the asset purchase programme, which was established last year in October 2014?
1a) The Press Release mentions that the "purchase programme" (note: this is a British spelling) will include "sovereign bonds", "asset-backed securities" and "covered bonds". Can you explain what are these bonds and securities? For example, what are "sovereign bonds", etc....
1b) The Press Release also mentions that the "expanded purchase programme" will last until September 2016 or until the inflation rate reaches the target of 2%. Do you know the reasons why the ECB announces the end date of the programme and the inflation rate target? (Hint: When you answer this question you should think as a long term investor)
2. This question pertains to the financial collapse that hit Wall Street in 2008 and the subsequent world financial markets.
In March 2008, Mr. Bernanke, Chairman of the Board of Governors, Federal Reserve Bank (Fed), asked J P Morgan Chase, a regulated commercial bank, to bail out Bear and Stearns, an investment bank. J P Morgan (JPM) bought Bear and Stearns (BS) for $2 a share (it was raised to $10 per share a few weeks later) and it took over all of BS financial assets and liabilities. In the bailout deal, the Fed guarantees whatever junk assets BS has accumulated on its balance sheet. Specifically, the Fed has agreed to provide financing of up to $30 billion of less liquid and risky assets held by BS. Roughly $20 billion of that funding will back collateralized mortgage obligations (CMO) held by BS.
However, in November 2008, Mr. Bernanke and Mr. Geithner, the Secretary of the US Treasury, let Lehman Brothers, another large investment bank, filed for bankruptcy. There was no bailout. As a result, the credit markets froze. The US economy took a nosedive. The US Congress passed an $800 billion stimulus package and President Obama signed it quickly. The goal is to revive the economy and to increase employment.
The Fed action creates a significant precedent.
a) Please explain why the Fed action is a historical precedent?
(Hints: 1) What types of banks does the Fed regulate? 2) Prior to March 2008, what kind of collateral does the Fed require when a commercial bank comes to the Discount Window to borrow funds?)
b) The Fed knew before the bailout that CMOs have been losing their value at an alarming rate, in other words they are quite toxic, but why then did the Fed decide to back these CMOs?
(Hint: Who are holding these CMOs? Please note that CMOs are also categorized as Collateralized Debt Obligations or CDOs)
The US Congress and the President actions to approve the $800 billion stimulus are a first since the Great Depression of the 1930s.
c) Please explain how the US Treasury is paying for the huge stimulus package? In other words, how does the US Treasury get the funds to bail out the failed companies, the bankrupted states, and create jobs?
NOTE: In addition to the well-known banks noted above, there are about 942 other banks, credit unions, government sponsored enterprises (e.g. Fannie and Freddie), mortgage services companies, state housing agencies, etc...and 2 auto companies that have received bailouts. For those who are curious, see the whole list and amount of bailout at:
https://projects.propublica.org/bailout/list
3. Please refer to the February 27, 2016, Food for Thought I emailed to you on that date. The Food for Thought is about an August 11, 2015, Wall Street Journal article with the heading "China Yuan Fall Won't Ease Pressure on Economy". Please answer the following questions, which are based on several paragraphs of the article:
a) 3rd Paragraph: "This will take pressure off Chinese exporters. The yuan has been basically fixed against the US dollar since March, but it has appreciated against other global currencies, eroding competitiveness"
Please explain:
i. Why is the yuan fixed against the dollar?
ii. Why the appreciation of the dollar erodes Chinese exporters' competitiveness?
b) 5th Paragraph: "Rather a more flexible exchange rate seems intended to solve...This has lowered the return on yuan assets relative to other currencies, pushing investment money out of China"
Please explain why investment money or capital is flowing out of China?
c) 6th Paragraph: "In the first half of the year.....Defending the currency also means spending foreign-exchange reserves. With the Federal Reserve to start raiding interest rate this year, this situation is only set to intensify."
Please explain:
i. What are "foreign-exchange reserves"?
ii. Why does China (or any country) need foreign-exchange reserves to defend its currency?
d) 7th Paragraph: "In theory, the dilemma can be resolved by letting the yuan depreciate....Rapid depreciation would also risk a wave of defaults on Chinese companies' dollar-denominated debts, which Daiwa economist Kevin Lai estimates could be as high as $3 trillion."
Please explain why Chinese companies with dollar-denominated debts would default if the yuan devalues further?
4. In reading/listening to the news you must have heard of the word "QE 2". Like some folks note, "QE 2" sounds like a luxury ocean liner. Aah! I wish it is, but to the contrary QE 2 is more like the Titanic.
Here are the facts: In November 2010, Mr. Bernanke announced that the Fed would implement a second round of "quantitative easing", also known as QE 2 among the financial folks. In QE 2 the Fed would purchase $600 billion in long term US Treasury Bonds, ostensibly to push down long term interest rates. Of course, the Fed will not buy the $800 billion worth of US bonds in one purchase but it plans to stretch it over many months.
Then in July 2012, there are reports that the Fed is contemplating a QE 3 because the economies of European countries are slowing down fast. China admits that its economy is slowing down too because of the situation in Europe. So the Fed strongly hints that the Fed might act soon regarding a QE 3. On September 13, 2012, the Fed acted on QE 3. But then in July 2013, the Fed showed signs that it may slow down its purchase of US securities since the economy shows sign of continuing growth. Stock prices decrease upon hearing that the Fed may reduce its economic stimulus.
a) In QE 2, the Fed is the buyer, but who is the seller?
b) Why would the Fed want to push down long term interest rates?
c) Foreign currency traders are carefully watching the magnitude of the potential QE 3, i.e. how much billions of dollars would the Fed spend to purchase US Treasury Bonds. Why do these traders worry so much about QE 3?
c) What would be the ultimate consequence of QE 2 and QE 3?
d) Why would the stock market decrease when the Fed wants to decrease its purchase of US securities?
e) On February 1, 2014, Ms. Yellen, became the new Fed Chairman. At her February 11, 2014 testimony before Congress, Ms. Yellen pledged that she will continue to maintain Mr. Bernanke policies by scaling back stimulus by "measured steps" and only a notable change in the economic outlook will prompt her to slow the pace of tapering.
Could you explain what Ms. Yellen is saying?
5. The following consists of TWO unrelated questions, 5A and 5B:
5A. In mid-February 2008, President Bush and Congress approved a $168 billion stimulus package that will provide tax rebates to all taxpayers, that is to those who file their tax returns. The tax stimulus was in addition to a tax rate cut, which was implemented earlier in 2002. The stimulus checks were mailed in May 2008. In February 2011, under President Obama administration, Congress voted to extend the Bush era tax rate cut to all levels of income.
Please analyze the stimulus package by using the income multiplier. (A tax rebate is a decrease in autonomous tax, the To in the total tax formula mentioned in class).
Using the derivation of the income multiplier, which we discussed in class, please show the effects of:
5ai - A tax rebate on the US GDP; and
5aii - A tax rate cut on the US GDP.
Which tax strategy has a stronger effect in the long term?
5B. Prior to 2007 i.e. prior to Wall Street financial problems and the subsequent recession, what factors have caused the extraordinary growth of the US economy accompanied by such low inflation rate?
Please use the Aggregate Supply and Aggregate Demand curves to buttress your answer.
6. This question pertains to the tools of monetary policy/
a) Why does the Fed use open-market operations as its principal tool of monetary management, rather than changes in the required reserve ratios, or changes in the discount rate? (Hint: Think about the matter of "announcement effects")
b) What are the differences in the effects that each technique would have on individual banks, on the commercial banking system as a whole, and on the money supply?
7. In addition to the mortgage and credits markets problems, there are two other issues that have kept the Fed Chairwoman sleepless at night. They are
i) The US budget deficit; and
ii) The huge foreign reserves surplus held by China, Japan, United Arab Emirates, Kuwait and other countries national banks that for months have mentioned that they will change their "investment strategies" (i.e. dumping US dollars for other currencies). Note: foreign reserves are foreign currencies held by a country national bank. Since the US dollar is the international currency, it is the biggest component of foreign reserves.
a) Please explain how each(budget deficit and foreign reserves) of the above noted economic issues affects long term interest rates and the inflation rate in the US.
(Hints: i) How does the US Treasury finance the deficit? And ii) What happens if other countries national banks decide to dump the dollar. One way of "dumping" the dollar is to sell US Securities and then use proceeds from the sale to purchase European sovereign debts?)
8. For 2,000 years on the far away island of Yap in Micronesia, located in the Pacific Ocean, the inhabitants have been using giant stones as money (Note: this is a true story)
a) What are the functions of money? Can these stones fulfill all or partially the functions of money?
b) Because the stones are worthless when broken, the islanders leave the larger ones where they are and simply take note of the fact that ownership has changed. How is this similar to paying by checks?
Historical Note: The history of the island of Yap in the 20th century is as follows: Seized by Japan in 1915, Yap became a U.S. protectorate after World War II and gained independence in 1986, as part of the Federated States of Micronesia. Since then, the U.S. has provided subsidies that account for 70% of public spending on Yap. In 2011, the U.S. contribution came to $15.5 million. A treaty also gives U.S. military dominion over the area. In the March 9, 2013, issue of the Wall Street Journal, "Is Yap Ready for the World?", Alex Frangos reports: "The people of Yap, a flyspeck of an island in the western Pacific, learned long ago how to make money the hard way: They carved giant stone currency and ferried it across open ocean in canoes. These days, islanders are split over how to make money in a global economy-and in particular what to do with a tide of Chinese money now washing up on these remote shores.Deng Hong, a Chinese real-estate developer, envisions a billion-dollar, 4,000-room casino-and-golf resort that he promises would quadruple the island's annual economic output to $200 million"
9. At 8:30 AM, Washington DC time, on Friday February 5, 2016, the Bureau of Labor Statistics (BLS) made the following announcement:
THE EMPLOYMENT SITUATION -- January 2016
Total nonfarm payroll employment increased by 151,000 in January, and the unemployment rate was little change at 4.9 percent, the U.S. Bureau of Labor Statistics reported today. Job gains occurred in several industries led by retail trade,food services and drinking places, health care, and manufacturing. Employment declined in private educational services, transportation and warehousing, and mining.
9a) How does the BLS determine the unemployment rate for January 2016?
9b) How does the BLS determine the employment rate?
Right after the BLS announced the employment level and the unemployment rate for January 2016, a bunch of Wall Street analysts offered their opinions about what Ms. Janet Yellen, the Chairman of the Federal Reserve Bank, next steps would be. The majority of the analysts stated that Ms. Yellen will keep current interest rates as they are in March 2016 and will raise rates in the third quarter of 2016. Their opinions are based on the following:
Unemployment
Rate Employment
Increase
October 2015 5.0% 295,000
November 2015 5.0% 280,000
December 2015 5.0% 262,000
January 2016 4.9% 151,000
However, other analysts believe that Ms. Yellen will not change the current level of interest rates until the end of 2016 due to the economic slowdown and uncertainties in Europe, China and other Asian countries.
9c) Please provide your opinions on which direction Ms. Yellen should take and why?
10. You are the president of a commercial bank that is also a member of the Federal Reserve System, and you want to increase your bank's reserves. But you currently have negative excess reserves, in which case your bank is borrowing from the Fed and the Fed may be putting pressure on you to remove that debt.
a) How would you raise your bank's reserves?
b) What effects would your attempt to raise reserves have on the banking and monetary system?