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UW-Madison ECON 102 - Econ 102 Review

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Securitization: bringing together a whole bunch of diversified loans.Mortgage backed securities: Made up of a thousand mortgage loans. A security. (Now not considered as risky)Derivative: Credit Default Swap- an insurance contract on a security. Does not have its own value because it is comprised of other assets.What the FED did during the Great Recession: 1) Direct lending to housing markets. They did so (bypassed the banks) to avoid pushing on a string, or bunching up of reserves. The federal funds rate was 0 at the time, so the banks only lent to each other. Our interest rate stayed high. The FED lent to houses to lower that interest rate so investment/GDP could increase. 2) They paid interest on reserves. They did so to avoid pushing on a string. Kept the banks solvent and did not hurt tax payers. 3) They purchased long term debt, to invest in the capital stock. They also purchased mortgage backed securities and lowered the discount rate***Ways the FED could increase the money supply: - Open market purchases- Decrease the federal funds rate- Decrease the discount rate- Decrease the required reserve ratioMust watch out for a liquidity trap; interest rates too low they can’t go anylower. We may be in one now. Seen by the excess reserves, a federal funds rate of 0, and the cost of borrowing barely covering inflation. PRO”S AND CON”S TO MONETARY AND FISCAL POLICYMonetary PolicyLong Run: leads to inflation, no change in output, gdp, labor. Only higher P’s. Short Run: effective in changing interest and investment ratesFiscal Policy: Long Run: Crowding out of investment (due to increase in interest rates)Crowding out of NX and C; as the government spends, our dollar appreciates and C and NX fall. Short Run: No room for it. Doesn’t work because of lags. M1: m2: Currency (46%) Savings Deposits (64%)Checking Deposits M1Travelers Checks Small Time DepositsDemand Deposits Money Market FundsTwo things the FED does for the Banks: Holds Reserves Oversee’s check clearingList two factors that were major contributors to the onset of the Great Recession.Bank DeregulationFormation of securities that linked housing markets globallyPolicy that encouraged homeownershipBurst of the Housing BubbleEquation for reserve ration: (Required Reserves + Any Excess Reserves)/ Deposits. EX; (15,000+10,000)/ (50,000) = 50% Reserve Ratio Notes from office hours: Investment banks were the ones who securitized. Idea is that they’re diverse, so if one looses, the others win, all will be okay. Enormous amount of wealth. They used to be restricted regionally, now they were deregulated so they could be riskier. Securitization: pooling and repackaging loans that were unrelated. Now that’s not true, because the securities were all linked. Investment banks didn’t really care about the riskiness. They encouraged people to buy even though they knew it was crappy. Cheated the customer. Credit Default Swaps- loans on the security- AIG gave them out and never thought they’d have to pay for them. AIG believed markets were regional. Didn’t think there would be a national downfall. Thought they were diversified enough. AIG wasn’t required to hold reserves so they couldn’t back it up when they failed. Increase in defense spending, crowding out, interest rates increase. Increase in transactions demand for money. Interest rates go up, investment fall, output falls, wages fall. AS will shift because there’s no capital deepening. Our assets look less attractive to foreigners, don’t demand as many dollars, dollar gets cheaper, helps our exporters. Our currency is cheaper so C and NX go up. Why are banks part of economic infrastructure 1) allocates savings to firms, affects capital deepening. 2) Banks affect inflation through the money multiplier. FED buys bonds, somebody somewhere has more money. Money Multiplier. Increases the ability to spend. If banks do make the loans, the money supply can multiply. Turns a bond into something more liquid, helps economy.Banking Bailout- Great Recession:Banks rescued by the government because they made all these risky loans. That rescue gave us HUGE government debt. If we hadn’t rescued the banks, Deposit Insurance would’ve forced us to pay people who deposited back. So even if they did nothing, they’d have to pay ppl back because of Fed Deposit Insurance…. Expensive Either way.Moral Hazard- if something really bad ever happens again, they’ll be bailed out again. Bad incentive. Stabilization- If we were to use, classical think fiscal policy distorts economy, possibility of long run affecting capital deepening. No short run benefit. Classical don’t worry about monetary policy because it can’t harm.Keynes like monetary policy because its neutral and doesn’t distort, but they DO like fiscalBOTH AGREE1) Had to have bailed out the banks in a recession2) Agree on necessary education funding. 3) Both like monetary policy better. Disagree on amounts/how much. Temporary cyclical stuff. Still affected by great recession: Debt still enormous. Tax increases back to normal seem HUGE because they’ve been low for so long. Willingness to pay taxes has been affected. Strengths and Weaknesses: Monetary Policy- No inside lags, very quick. Decide quick- Strength- Neutral in long run, doesn’t distort economy (besides a little inflation)… inflation is fine if all nominal wages adjust with it. - Disadvantage: pushing on a stringFiscal Policy- Keynes think we can just hire people to affect AD. Works in short run.- Weakness: Long inside lags. - Long run distorting affect on investment and possibly capital stock (crowding out). QE- like an open market purchase (only those are short term), QE is long term- 10 year, 30 year. Do so to affect capital stock. They try to avoid doing so. Pushing on a string caused by1) banks sitting on reserves2) a liquidity trapNone of these matter if we’re trying to REDUCE AD. That’s easy. Money market: If price falls, transaction demand for money falls, Md shifts down, Lower REAL interest rate. We don’t know whats happening to NOMINAL interest rate. Interest Rate Effect! Say’s Law: summarizes classical model. Supply creates demand. People refer to all rates of return as interest rates. Its hard to see expectations when buying bonds/stocks. Easy to look at interest rate. Graphs: Know increase and decrease in money supply. Know the three graphs…. Monetary


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UW-Madison ECON 102 - Econ 102 Review

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