CHATGPT Quiz - Finance Concepts PDF

The increased money supply in modern economies compared to the past is largely due to the \*\*enhanced ability of banks to create money.\*\* This ability has been \*SUPPORTED\* by advances in central banking, deregulation, financial innovation, globalization, technological advancements, and economic...

The increased money supply in modern economies compared to the past is largely due to the \*\*enhanced ability of banks to create money.\*\* This ability has been \*SUPPORTED\* by advances in central banking, deregulation, financial innovation, globalization, technological advancements, and economic growth. \-- ALL CREATED MONEY COMES FROM A COMMERCIAL BANK, NOT THE TREASURY OR THE FED! BUT THEY CONTRIBUTE TO THE COMMERCIAL BANK\'S ABILITY TO CREATE THIS MONEY , THAT IS THEM, ALONG WITH MANY OTHER FACTORS, ARE THE \"MASTERMINDS\" WHO CAN AFFECT HOW MUCH MONEY THE BANKS CAN MAKE AND HOW MUCH MONEY THEY CANT MAKE = \*They CONTROL THE POTENTIAL of the banks\' money creation, the banks are the ones who then FULFILL this potential by themselves\* \-- The creation of money, primarily through commercial banks\' lending activities, has significantly contributed to economic growth and improved living standards. This process, supported by central bank policies, facilitates economic transactions, provides essential credit for business expansion and infrastructure development, and drives investment in innovation. The increased money supply has enabled higher productivity, greater access to goods and services, and improved quality of life, including better health and education. However, while this credit expansion has accelerated growth, it requires careful management by central banks and regulators to maintain financial stability and prevent inflation. Overall, the financial system\'s ability to create money has been a crucial factor in advancing economic development and enhancing human well-being. = Before the 1980s, the US financial markets were much larger than those outside the US, but in recent years, the dominance of US markets have been weakening Recent trends have shown that not only has the US lost its international dominance in manufacturing industries over the past few decades, that its financial market is also losing its dominance. The US stock and bond markets have recently seen their share of sales of newly issued corporate securities slip The London and Hong Kong Stock Exchanges now handle a larger share of \[\[Initial Public Offering ( IPO )\]\] of stock as compared to the NYSE which had been the most dominant exchange in terms of IPO value before the 2000s. On top of this, the number of stocks listed on the US exchange has been decreasing whilst the converse is true for other countries why is this the case? why would corporations issue their securities in financial markets in Asia and Europe? This is due to these countries being able to adopt technological innovation quicker than that of the US markets, alongside the tighter immigration controls in the US following \[\[9/11 Terrorist Attacks\]\] and perceptions that listing on American Exchanges would expose foreign securities issuers to greater risks of lawsuits Many others see the Financial Regulation as burdensome and thus the main cause of the US markets losing their edge, this follows after a number of accounting scandals in the US , which caused the \[\[Sarbanes-Oxley Act\]\] to be created. The costs of complying with these new rules thus prove to be greater in the US than in foreign countries The improvements in the foreign financial markets are a result of the increased savings in these countries ( Japan ) and the deregulation of their financial markets. Summary: \- The American financial markets, alongside their industrial markets are weakening, and this is because the regulatory environment is too strict, whilst they are not adopting the latest technologies fast enough, this is in comparison to other parts of the world such as Asia and London. International Bond Markets \-- Instruments in foreign markets are known as \[\[Foreign Bonds\]\], which are bonds issued in a domestic market, by a \*foreign entity\* in the market\'s currency as a means of raising capital. ( e.g. German company issuing a Foreign Bond in the US, denominated in \$USD ) A large percentage of US railroads built in the 19th century were financed by the sales of foreign bonds in Britain ( US sold their bonds in Britain, denominated in Pounds 💷) A more recent innovation in the international bond market is the \[\[Eurobond\]\], a bond denominated in a currency other than that of the country in which it is sold (e.g. A bond issued in Britain, but denominated in USD) The Eurobond Market is now LARGER than that of the US corporate bond market, currently over 80% of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly A variant of the Eurobond are \[\[Eurocurrencies\]\], which are foreign currencies deposited in banks outside of the home country, the most important being the Eurodollar, which is the depositing of USD in foreign banks outside the US. \*Do not confuse the Euro with Eurobond as they do not have any correlation, the only exception that is made is when the bond denominated in Euros, is sold outside the countries in which the Euro is the domestic currency, but besides this, eurocurrency, Eurodollars etc do not mean the euro is involved.\* Eurobond market vs The eurobond Summary: \- \*\*Foreign Bond - a bond issued BY a foreign party\*\* When discussing Euro\~ such as an Eurobond or Eurocurrency, just know that it would always involve a currency mismatch. \- \*\*Eurobond - Bond which is denominated in a foreign currency\*\* \- \*\*Eurocurrency - A currency deposited in foreign banks outside of the jurisdiction of the home country\*\* \^\^ These are the only distinct traits you would need to know, all else is flexible \-\-- How well a person does financially by holding a bond or any other security over a particular time period is accurately measured by the security\'s return, or in more precise terminology, the rate of return. We do not purely look at the interest rate because interest rates fluctuate. We need to fully understand the concept of what \*Return\* entails before diving deeper into the various topics in finance. \*\*Rate of Return\*\*: The rate of return is defined as the (amount of each payment to the owner + the change in the value of the security) , divided by the purchase price. in this case it is clear that the return is defined not only as the interest payments we receive from taking on the risk of lending money out, but is inclusive of the fluctuations of the actual price of the bond itself! = Capital Gains + Interest Gains / Purchase Price This shows us that since the return of the bond includes the component of the fluctuation of the actual price itself, the yield to maturity which only considers the payments we receive, is not an accurate measure of the \*net\* returns we receive from a bond. Remember that YTM is the Annualised return % that is applied on the FACE VALUE of the bond, not the price of the bond When the interest rates change from 10% -\> 20% we see that for a 1 year maturity bond, the face value is going to be paid back at the end of that one year, thus it does not matter what happens to the \*Price\* of the bond as the face value will be paid back on that year regardless of the change in price. for a 3 year maturity bond, the face value will only be paid back on the 3rd year, meaning to say that the fluctuations in the price which occur from the moment the bond is issued to the time it matures, are able to affect the \*Returns\* received yearly. and are able to Using the Equation we have when calculating the Value of a bond !\[\[Pasted image 20231009211042.png\]\] We see that an increase in the interest rates which is equivalent to the increase in the Yield to Maturity, would have a different effect on the final price of the bond depending on the number of payments This essentially means that the differing maturities of bonds ( directly correlated to number of payments ) would result in differing bond values, one singular change in the interest rates produces multiple possibilities of Bond prices resulting from that change, This is only true if the coupon rates, and the face value is the same for all of the bonds, only the maturity is different and kept as a variable If coupon is the same, then its like saying the fixed payments are the same, the difference in prices of bonds of differing maturities comes, not from the individual coupon payments , but come from the Face value which would be repaid, at that interest rate, being much lower when N is much higher. Face value and Coupons are constant! only interest is changing in this case. The risk level associated with an asset\'s return that results from interest rate changes is so important that it has its own term, \*Interest rate risk\*. Dealing with interest rate risk is a major concern of managers of financial institutions. Short term debt instruments have substantially less interest rate risk than long term debt instruments, bonds with maturity terms as short as the holding period, would have no interest rate risk. If you have trouble understanding why this is the case, it is because the face value is already being repaid on that year, and that changes in the interest rates have no effect on the price at the end of the holding period for these bonds and thus the price is already fixed at face value. The statement \"has no interest rate risk\" only applies for a discount bond, that is a bond which does not make any payments before the maturity of the bond. If there are intermediate payments, they have to be reinvested, at the new interest rate, which would introduce an element of risk. However, this risk is usually small even if we were to take it into account. Another thing to note is that when we claim that short term bonds have little to no interest rate risk, we are making one important assumption that term to maturity of the bonds are not shorter than the holding period of the investor. if the Holding period is longer than the maturity of the bond, then the investor would be exposed to Reinvestment Risk, which arises as the investor would need to reinvest the proceeds from the short term bond Scenario 1: 2 year holding , 2 year maturity, at 10%. The returns on 2 years of holding the bond would be 20% Scenario 2: 2 year holding, 1 year maturity bond at 10%, interest rates then rose, so the 1 year maturity bond is now offering 20% The returns: 10% on the first year 20% on ( Initial + 10% ) on the second year = 32% We can see that the annualised returns in case 1 was only 10% whilst it was 16% in case 2 due to the fluctuation of interest rates. The Converse is true: If interest rates were to, however fall, then they would earn less than the would have on the 2 year maturity bond. Summary: Interest payments received on bonds are not equal to the return on the bond, the return is actually the net result of the differential in prices along with the interest rate payments. The price of the bond changes with the differing periods to maturity, economic climate etc. thus unless you are keeping a bond till its maturity period, you would also always face a price risk Needless to say, should you reinvest your money into new bonds after your bond expires, you would also obviously be paying a different price. Banks make profits by selling liabilities with 1 set of characteristics, and using the proceeds to buy assets with a different set of characteristics, this process is known as \*\*asset transformation\*\*, For example: A savings deposits held by one person can provide the funds that enable a bank to make a mortgage loan to another person, The bank has essentially transformed the savings deposit into a mortgage loan Banks usually Borrow Short, and Lend Long, this is where they make long term loans and funds these loans by issuing short term deposits. To make our analysis f the operation of a bank more concrete we make use of a tool called a T account, which is a simplified balance sheet, with lines in the form of a T. When analysing the T account, it is important to know how to classify items, whether they are under Assets or Liabilities. We can figure this out by revising \[\[Balance Sheets\]\] If 2 banks are in separate states, and funds are transferred from one bank to another, then it would be too time consuming for the banks to ask for the money from one another, they simply use their \[\[Fed Account\]\] to transfer the funds. When a bank gains a certain sum of deposits, it gains an equal sum of reserves, vice versa The gains from the sum of deposits are subject to the reserve requirement %, if \$100 is deposited in the bank and the RRR is 10% then the reserve requirement for that bank would increase by \$10 and the excess reserves woulld increase by \$90 There are approximately 6000 banks in the US, far more than in any other country in the world, US has an extraordinary number of small banks, and the industry is \*\*not dominated by a few large\*\* banks. The 10 largest commercial banks in the US together hold under 70% of the assets in their industry This is in contrast to other industries in the country, where large firms tend to dominate the industries to a great extent. Restrictions \-\-- The presence of so many commercial banks reflects past regulations which restricted the ability of these financial institutions to open branches, each state had its own regulations on the number and type of branches which could be open. The \[\[McFadden Act of 1927\]\] ( repealed by the \[\[Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994\]\]) which was designed to put national banks and state banks on equal footing, alongside the \[\[Douglas Amendment of 1956\]\], which closed a loophole in the McFadden Act, effectively prohibited banks from branching across state lines and forced all national banks to conform to the branching regulations. The McFadden Act and state branching regulations constituted strong anticompetitive forces in the commercial banking industry, allowing many small banks to \*stay in existence as larger banks were unable to open branches nearby\* American public has been historically more hostile to large banks, states with the most restrictive branching regulations were typically ones in which the populist antibank sentiment was strongest in the 19th century. Summary: \- America has many banks, ranging from small to large due to their laws which set restrictions on bank\'s and their ability to expand - Anti-Competition \*\*Responses to the Branching Restrictions\*\* Competition can be repressed but not completely quashed, this is due to the restrictive regulations stimulating financial innovations that get around the regulations \- Bank Holding Companies A holding company is a corporation which owns several different companies, it has important advantages for banks, allowing them to \*circumvent restrictive branching regulations, as the holding company can own a controlling interest in several banks\* even if branching is not permitted. The bank holding company can also engage in other activities related to banking, such as the provision of investment advice, data processing, and transmission services, leasing , credit card services and servicing of loans Today, the growth of bank holding companies has been dramatic over the past 3 decades, today bank holding companies own almost all large banks and more than 90% of all commercial bank deposits are held in banks owned by holding companies \- Automated Teller Machines Another financial innovation was the ATM, banks realised that if the ATM was owned by someone else and the bank merely paid a fee for each transaction, the ATM would not be considered a branch of the bank. A number of such facilities such as Cirrus, NYCE have been established nationwide, even if the ATM is owned by a bank, \*states typically have special provisions that allow wider establishment of ATMs\* than is permissible for traditional brick and mortar branches ISSUANCE OF BONDS - COVER GOVERNMENT\'S ASS BY RAISING FUNDS VIA DEBT ( has got nothing to do with stimulus but only to fund the govt. ) = INCREASES BURDEN FOR FUTURE GENERATIONS ( DEBT HAS TO BE REPAID SOME DAY ) THIS DEBT TO THE BONDHOLDERS IS USUALLY PAID USING THE MONEY FROM THE ECONOMY AT THAT TIME, THE TREASURY CANNOT CREATE MONEY. CREATION OF MONEY - TO REPLACE IDLE RESOURCES LIKE BONDS WITH LIQUID RESERVES WHICH CAN BE LENT OUT VIA BANKS = THIS CREATION OF MONEY IS SIMPLY TO \*\*REPLACE\*\* BONDS, WHICH DO NOT STIMULATE THE ECONOMY MUCH, WITH LIQUID RESERVES CAPABLE OF DOING SO. THE AMOUNT OF BONDS BOUGHT WHICH IS PROPORTIONATE WITH THE AMOUNT OF RESERVES INTRODUCED INTO THE ECONOMY ( BASICALLY THE EXTENT TO WHICH THEY PROVIDE STIMULUS ) IS DEPENDENT ON THE FED AND ITS ANALYSIS OF HOW MUCH STIMULUS THE ECONOMY NEEDS THERE IS NOTHING BAD ABOUT CREATION OF MONEY, SO LONG AS THE AFTER EFFECTS ARE WELL MANAGED ( LIKE INFLATION ) IN FACT THE FED IS DOING A VERY ESSENTIAL ROLE HERE\... THEY AREN\'T INTRODUCING ANYTHING ! THE ONLY CHANGE WOULD BE INCREASED MONEY SUPPLY DUE TO THE COMMERCIAL BANKS\' MONEY MULTIPLIER!! The debt which the government sold to the central bank can essentially be seen as the government borrowing money from the fed, but instead of using the current fed reserves, the fed just \"Prints\" this money and gives it to the government to spend in the economy, introducing that same money into the economy \*\*The main goal of printing money is to replace the idle resources ( bonds ), in the hands of the primary dealers, with money so that this money can be used to stimulate the economy, the total bonds held by the banks fall, but in return the total level of banking reserves increases, allowing for stimulus in the economy. The concept of printing money is only useful because the Fed creates the money to pay for the bonds rather than taking it from the economy ( as that would defeat the purpose of doing so ) = A major misconception you had was thinking that the Creation / Printing of money by the Fed was what leads to inflation, it ISN\'T. In fact that action itself doesn\'t lead to inflation. Rather, it indirectly results in it as creation of money allows for the replacement of illiquid bonds with liquid reserves which can be lent out, \*\*When this happens, the banks begin THEIR version of money creation, creating deposits due to the money multiplier effect, when this happens this directly results in increased money supply being able to be lent out (under normal economic conditions ). This would mean that interest rates fall, and thus its more attractive for consumers and firms to borrow money. In this case, total loans increase, and spending increases thereafter, the economic activity is boosted,\*\* should the demand in the economy outstrip the supply, this would lead to demand-pull inflation which would cause inflation to rise. = of course, take note that this is highly theoretical and several assumptions are being made when you concluded this paragraph, its more for understanding the basic mechanism. For example, when the reserves are introduced by the Fed and deposits increase, it also depends on the reserve requirements, the banks\' sentiment & thus willingness to lend out the money, interest rate environment and the regulatory environment, these affect HOW MUCH of those reserves ( if any ) would be lent out and would undergo the money multiplier effect Then you can also say that it doesn\'t mean that lower interest rates would result in a proportional increase in loans as that then depends on many other factors affecting the willingness of the consumers, firms taking on the loans. Both commercial banks and the fed create money, the commercial banks loan money into existence whilst the central banks create the money out of thin air. Each year, the government would need to get funds for their spending from somewhere, when they do not have enough to spend, they may either raise taxes, or they can issue bonds which essentially is taking loans from others in order to finance debt, the second option is usually chosen due to taxes being unpopular amongst the general population. Thus, the government would seek the help of the \[\[US Treasury ( Institution )\]\] which is responsible for the issuing of the bonds, ( creating its own loan ), just like \[\[Commercial Banks\]\], the US Treasury is able to store central bank reserves \*\*\*The main problem here is the government , should they spend unwisely, they implicate everyone! The key takeaway is that printing money doesn\'t have any effects on the economy so long as it is used to REPLACE, that means the Fed TAKES AWAY \$X of illiquid reserves and GIVES \$X of liquid reserves. NET CHANGE = 0 , but what it will do is allow for greater economic activity which unavoidably would lead to banks creating more money just because that\'s how they operate, and unavoidably lead to inflation if left unmanaged. \-- When the stimulus gets too much, then the Fed needs to cut back on the stimulus by reversing their actions, they do so by selling the bonds they bought, back to the economy and taking the created reserves back, again, net change = 0 ! THOSE RESERVES ARE THEN REMOVED FROM EXISTENCE = You thus notice that CREATING MONEY DOESN\'T MEAN THAT ITS EXTRA MONEY ADDED INTO THE ECONOMY, SO LONG AS IT IS EXCHANGED FOR SOMETHING ELSE, ALL THAT CHANGES IS THAT THERE ARE MORE LIQUID RESERVES AND LESS ILLIQUID RESERVES!!! \-- \[\[\"Rolling Over\" Debt\]\] \[\[Cost Of Servicing Debt\]\] \[\[inflationary policy not only reduces the purchasing power of money but it also leads to clusters of malinvestments\]\] An interest rate swap is an agreement between 2 parties to exchange 1 stream of interest payments for another, over a set period of time. \[\[Swaps ( Derivative )\]\] are derivative contracts and they trade OTC The most commonly traded and most liquid interest rate swaps are known as \"vanilla\" swaps, which \*\*exchange fixed-rate payments for floating-rate payments based on\*\* \[\[Libor Rate\]\], which is the interest rate high-credit quality banks charge one another for short-term financing. LIBOR is the benchmark for floating short-term interest rates and is set daily, although there are other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of the market Investment and commercial banks with strong credit ratings are \*\*Swap Market Makers\*\*, whom offer both fixed and floating-rate cash flows to their clients The counterparties in a typical swap transaction are a \*corporation, a bank or an investor\* on one side and an \*\*investment or commercial bank\*\* on the other side If the swap transaction is large, the inter-dealer broker may arrange to sell it to a number of counterparties and the risk of the swap becomes more widely dispersed. IR swaps were initially used to help corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates and receive floating rate payments, they could thus lock into paying the prevailing fixed rate and receive payments which matched their floating rate debt. However, because swaps reflect the market\'s expectations for interest rates in the future, swaps also became an attractive tool for other fixed income market participants, including speculators, investors and banks. !\[\[Pasted image 20231126171154.png\]\] \*\*They are just paying for each other\'s loan, partially or fully.\*\* = A now pays (LIBOR+2% ) AND 7% to B At the same time, it would receive ( LIBOR + 1%) It can USE WHAT B HAS PAID IT FOR THE LOAN PAYMENT , effectively paying 8% ( 7% that it has paid to B and the remaining 1% it has to pay Lender 1) The \*\*SWAP RATE\*\* is the \*fixed\* interest rate that B would demand from A for paying LIBOR+1% \-- \- When the \*Swap Rate increases\*, then it is indicative of the fact that LIBOR is expected to rise Essentially reflecting the \*\*market\'s expectations of rising interest rates in the broader market\*\*, factors such as central bank policies, inflation expectations or economic growth \- It may also indicate a higher credit risk, if the market participants perceive higher risk in the creditworthiness of either or both parties, the swap rate could rise to compensate for that risk Since it is merely a swap of risk preferences, where \*both companies feel that they would gain\* from the transaction, both would also demand for a fair deal Each speculates the opposite of the other, one expects the variable rate ( LIBOR ) to decrease whilst the other expects it to increase, whoever\'s right makes money. This means that the total value of the swap\'s fixed rate flows should be equal to the value of the total value of all the floating rate payments ( using the Forward LIBOR Curve ) The LIBOR forward curve allows for the person who initially has a fixed IR payment, to estimate how much they would pay all the way until maturity, if they were to pay the LIBOR Rate, this is going to be compared to the total they will pay on their fixed interest rate, They will be willing to accept an equal exchange, because the main point of the deal is they are more ballsy, willing to gamble and potentially pay a lower ( or higher if they are wrong ), interest rate If i took the loan with the LIBOR rate, i would have been comfortable with the total interest rate im paying up till maturity, which i would estimate with the LIBOR forward curve, however that is the ideal If the IR deviate from the LIBOR forward curve, then i would be paying something i was not comfortable with paying! So i engage in a swap with someone more ballsy The main point is \*\*\*not to profit off of each other, but really just to have a swap due to differing risk appetites\*\*\*, both parties would not short-change themselves in the initial deal, it just does not make sense, If im collecting fixed IR from Jim, that means im holding onto a fixed interest rate payment scheme initially. Thus after the swap, Jim pays this for me. I would then be paying Jim a Variable interest rate, which he is now holding onto BEFORE THE SWAP If i am demanding a higher fixed IR from Jim, it is because i see that the forward LIBOR curve is showing that IR would rise and i would need to pay more, and thus to prevent a loss for myself, i ask Jim to pay for the expected rise Jim would agree, and we would both have an equal deal \*AT THAT TIME\* On the other hand,\*if Jim sees that the LIBOR rate he has now, is expected to fall in future, he would definitely not short-change himself, he would want me to pay him a higher interest rate\* / he would want to pay a lower fixed interest rate, which allows him , rather than me, to profit off of the expected drop This i would be ok with, because at the end of the day, i am not trying gain from Jim, but i would gain if the market does not go as forecasted, i have a greater risk appetite than Jim who would simply not be able to enjoy any benefits from the deviation, or loss from the deviation. if LIBOR is forecasted to fall, why would Jim swap with my fixed payments? Because, Jim is not willing to deal with consequence of the LIBOR not moving as planned! it could go up instead of down! But if i am willing to take that risk, then it makes sense for both to swap! The \*vast liquidity\* of treasuries makes the securities important for a range of market-related trading and analytical activities, For example, because market participants can buy and sell the issues quickly and with low transaction costs, they use treasuries to hedge positions in other fixed-income securities and to speculate on interest rates. The high volume of trading and narrow bid-ask spreads also make treasury rates a reliable reference for pricing and analysing other securities, Despite the importance of Treasury Market Liquidity, in-depth studies on the topic have been hampered by the absence of high-frequency, or highly detailed market data. In a liquid market, trades can be executed at no costs, it is difficult to measure these costs when markets are illiquid as it depends on the factors such as 1\) Size of the trade 2\) Timing of trade 3\) The trading venue 4\) The counterparties information needed to calculate these transaction costs are also often unavailable, as a result there are a wide range of measures used to evaluate liquidity, these measures are not completely effective, each has its own advantages and disadvantages. Summary: \- When trading in a liquid market, it would mean that transaction costs are minimal and that it won\'t be affected ( at least not to a very large extent ) by specific elements of the trade such as the size of the trade, the time at which the trade was placed etc. \*\*Measuring Liquidity:\*\* Trading Volume \-\-- Trading volume is an indirect but widely cited measure, its popularity stemmed from its \*simplicity and availability\* as well as the fact that more active markets tend to be more liquid. Studies however, have linked market trading volume to volatility which can impede market liquidity Trading Frequency \-\-- Trading frequency reflects the number of trades executed within a specified interval, without regard to trade size. This may indicate a more liquid market But it too can be associated with volatility and hence lower liquidity. Bid-Ask Spread \-\-- The Bid-ask spread, is commonly used as an indicator of liquidity too, it measures the cost of executing a single trade of a certain size, the \*\*\*Quote Size\*\*\* is an estimate of the quantity of the securities tradable at the bid and offer prices. It helps to account for market depth and complements the bid-ask spread Market makers however, do not reveal the full quantity they will transact at a given price, so the measuresd depth underestimates the true depth Thus, an alternative to measure this depth is \*\*\*Trade Size\*\*\* which measures the quantity of securities tradable at the bid and offer prices, reflecting any negotiation over quantity. however this also underestimates market depth, because the quantity traded is often less than the quantity that could have been traded at a given price. Price Impact Coefficient \-\-- The price impact coefficient considers the rise in price that typically occurs with a buyer-initiated trade. The measure is useful to those executing large trades or a series of trades and together with bid-ask spread and the other depth measurement methods, would provide a fairly complete measure of liquidity This method however lacks as there is a difficulty in obtaining the data required for estimation, particularly on a real-time basis calculated from \[\[Regressions\]\] of 5 minute price changes on net order flow for the same 5 minute interval \[Net order flow= ( Buyer initiated volume )-( Seller initiated volume )\] Usually plotting the impact coefficients: 32nds of a point per \$1 billion of net order flow AGAINST: Time so we would get a graph where we see how the Price impact of the trades vary as time goes by. On-The-Run / Off-The-Run Yield Spread \-\-- The final measure examined is the \*Spread between more and less liquid securities\* often computed as the difference in yields of an on the run and an off the run security with similar cash flow characteristics This spread can be calculated without high-frequency data, and it provides insight into the value of liquidity not provided by other measures On-the-run securities tend to trade at a premium, confounding interpretation of the spread Findings by Fleming \-\-- Fleming finds that the bid-ask spread and the price impact coefficient are sound liquidity measures, both directly quantifying the cost of transacting. Both also correlate with episodes of reported poor market liquidity in the expected manner Summary: \- Flaws : 1\. Contradictory Information Some of the data would also reflect the volatility in the market, if volume is high, we can draw 2 assumptions - that liquidity is high, and that liquidity is low, as volume tends to reduce liquidity 2\. Accuracy of Data Some of the data simply isn\'t accurate enough, this could be due to transparency in providing such information / the cost of obtaining such information 3\. Availability of Data Some figures which are necessary for drawing the right conclusion is just not available. 4\. Lack of Accuracy in Conclusions Some methods simply don\'t have a holistic enough approach for us to conclude certain things confidently. The idea behind short selling is to borrow something you do not own from someone else and then sell it, you will collect the money now, but you are still \*short\* on what you just sold, you would need to return the item or entity you sold on the market which means that \*\*you would need to buy it later on and return it\*\* IF you buy it for a cheaper price, you will make a profit, if it is more expensive in future, you will make a loss. Summary: \*\*Essentially you are selling for example a commodity that isn\'t even yours and collecting the money from that, at some point you would need to return the commodity ( assuming its indistinguishable from each other ) to the original owner, you would thus need to buy the commodity back. Should the price at which you buy it at be lower, you make the differential.\*\* This of course, assumes that the market is very liquid and you would be able to buy the commodity back at the prevailing market price whenever and whereever you like the Futures market is designed to provide liquidity for professional traders for managing their portfolio risk in equities and commodities, The big benefit to institutional investors and traders is that they can hedge their positions or increase their exposure without having to buy 500 stocks individually, as they can invest in the index as a whole This frees up both transaction costs and execution time In a futures contract, since they are \[\[Derivatives\]\], which are contractual obligations between 2 counterparties, you would not own something belonging to someone but are exposed to the entire market index. if you wanted to short, just pick the level to sell the quantity you want. For example: If you are a big investor currently long in a huge portfolio of assets, in a few days there would be a major market moving event which you would not like the risk of, Thus instead of selling all the stocks now and holding onto the money just to buy them back in a few days You would short the futures market to hedge your long portfolios and offset losses for a temporary period of time A surprising burst of inflation immediately reduces the real value of a borrower\'s debt burden, \*transferring wealth from lenders to borrowers\* The \"real\" amount of money they have to pay back decreases It is also likely to raise future borrowing costs because investors ( those funding the lending ) would expect the higher inflation and thus demand higher nominal yields on debt to compensate them for the expected loss of purchasing power and the associated uncertainty !\[\[Pasted image 20231205054316.png\]\] A government\'s nominal debt is the cumulated sum of past deficit spending, and the real value is in terms of a basket of goods and services, \*calculated by dividing the nominal debt value by the price level\* Summary: Inflation - \> Relieving of debt burden regardless of the stakeholder. Devaluing of the currency - \> Increased debt burden for stakeholder Inflation - \> Inflation Expectations ( positively related.) The \[ability of a government to service debt is closely related to its tax base\], which depends on the size of the national economy, we \*\*thus consider the ratio of government debt to GDP\*\* which allows for the comparison of debt levels \*over-time and across countries\* \- Gross debt- Only counts the debt that governments issue \- Net debt- deducts the value of assets that governments hold from the Gross Debt The \*increase in price level directly reduces the real value of government debt\*, as well as the ratio of debt to GDP ceteris paribus, as higher prices increases the nominal GDP thus this this \*\*\*transfers wealth from holders of US government debt, to US taxpayers\*\*\* Government has to pay less \$ in real terms, back to its lenders (Treasury Investors) They however have spent this money prior to the inflation which allows for the direct increasing in incomes ( Nominal GDP ) which is the transferrence of wealth Unexpected inflation will however, tend to raise the cost of servicing future US debt ( making the necessary payments in future ) \*With an unexpected rise in inflation, the total interest rates would also increase, when inflation rises, it would erode profits as what was earned before is now of lesser real value.\* This is the same for the yields on bonds, when the inflation rises, the real return on bond payments fall and thus when new bonds are issued, higher nominal yields are demanded (\*\*Nominal Yields - Inflation = Real Yields\*\*) In the event the nominal yields rise to a larger extent than inflation does, this would be to the benefit of the bond holders i.e. the lenders of the money as they would recieve higher levels of real yields and thus would be earning more money. Summary: Inflation not only eases burdens, but erodes profits ! Works both ways\... \-\-- The US has previously experienced unexpectedly high inflation rates that reduced the real value of the national debt, the US ran very high inflation rates of 12.9% and 11% in 1946 and 1947 respectively. This was a time when the country was recovering from WWII and the government had removed wartime price controls ( yellow oval in the figure above ) and this inflationary burst helped reduce the US debt-to-GDP ratio In the subsequent years, inflation rose more gradually and market expectations only gradually adjusted to this rising inflation, however. This was shown by the yield on the 10-year Treasury just keeping up with the GDP deflator inflation rate Consequently the time when the ex-post real 10-year yield was negative meant that the government was borrowing long term at negative real rates however this was only for a period of time. After the yield on the 10-year Treasury peaked in 1981, it declined only slowly until the mid-2000s remaining well above the inflation rate, The ex-post real yield for the 10-year Treasury, the difference between the 10-year yield an inflation over the life of the bond, rose dramatically and peaked in 1981, slowly declining after These high real interest rates meant that the government was borrowing at high real interest rates for many years because the inflation in the 1960s-1970s had raised inflation expectations and uncertainty about inflation, both of which increased the yields that investors would demand \-\-- Thus the sudden burst of inflation would raise 2 effects \-\-- 1\) Immediately reduces the real value of existing debts 2\) Raise expected inflation and thus yields, which increases the cost of borrowing in the future \*The Federal Reserve\'s credibility with the market would determine the extent to which the the cost of borrowing increases and stays high, if the markets believe that the Fed can control inflation, long term rates would not rise too much and would return to levels consistent with the Fed\'s inflation rate target\* The most simple form of money making which we had went through previously consisted of commercial banks having the responsibility of creating loans and settling interbank payments using central bank reserves \- Creation of loans Ensuring they have enough capital to cushion any bank runs, their balance sheet is well maintained etc. \- Settling Interbank Payments Easiest is to have an account at the Fed, for easy wiring of money to other banks \-\-- What is a foreign bank?? Foreign banks refer to a bank, whose \*\*headquarter is in a different nation as their bank branch.\*\* For example, in US\'context, a foreign bank refers to a bank who is operating in the US but is headquartered outside of the US. If a foreign bank has an account at the Fed, then they would operate in the same way. Big foreign banks generally have Fed accounts, although smaller ones may not A smaller foreign bank can build a dollar loan business too, but it would instead \*use dollar deposits at a US bank to settle interbank payments\* Smaller banks essentially \*build a fractional banking system on a fractional banking system\* Foreign bank would accept deposits from US residents and would create loans just as a US commercial bank would, but if they do not have a Fed account, when \*Sally, their client\* transfers money to \*Peg, who banks in normal US commercial banks,\* As with all commercial banks, so long as Peg does not bank with the same bank as Sally, Sally\'s bank would LOSE that deposit and thus the bank would have lesser funds They go around this issue by taking Sally\'s money and putting it into a US Commercial bank They take Sally\'s money and transfers it to Peg, At this moment, the problem is settled as the Bank\'s Bank would xfer the funds over to Peg\'s bank via Central Bank Reserves. The foreign bank itself engages in a fractional banking system, taking a fraction of sally\'s money to create assets When they go to the local commercial bank to create an account, then the local commercial bank would take their money, which is actually Sally\'s money, and the local commercial bank would take a fraction of Sally\'s money to create assets. In effect, the foreign bank would use a fraction of Sally\'s full deposits to create assets whilst the local bank would use a \*fraction of a small part ( if sally xfers a small part ) of Sally\'s money\* to create assets \*\*\*Why can\'t the foreign bank just carry out a direct transfer to Peg\'s bank?\*\*\* \- Regulatory Compliance Without intermediaries, regulatory hurdles are faced as financial systems are heavily regulated to prevent fraud, money laundering and to ensure security \- Technical Integration Different Banking systems may not be technically integrated and thus this makes direct transfers more difficult \*Banks across the world use various software platforms and hardware configurations to manage their operations, these systems need to be compatible for direct communication and transaction processing\* Without common platform or protocol these systems cannot easily communicate or process transactions directly \- Settlement Risk Using an intermediary such as a central bank would reduce the risk associated with the settlement of funds. This could include counterparty risks or time zone differences etc. Thus the use of the third party allows for both sides to fulfil their ends of the bargain before the transaction goes through. 1\) \*\*Central Bank reserve ratios together with the quantity\*\* of central bank reserves, DO NOT limit the size of the banking sector This is because of the presence of the Eurodollar system which does not use Central Bank Reserves ( if they are a bank with no Fed account ). Without the Eurodollar system, we would be able to estimate based on the Central Bank reserves and the ratio, how much money is created etc. If the total reserves in US is \$1 and the reserve ratio was 10, we can estimate that the size of the banking sector is around \$10 BUT, since we have the eurodollar system, we cannot measure this accurately, even if we tried using their level of deposits in local banks\... They may deposit \$100 in a local bank but this may not act purely as their \"reserves\" and can actually use this money still for creation of assets. Foreign banks are not constrained by reserve requirements as they are not bound by Regulation D, they are thus free to decide the level of reserves which they deem fit, depending on their risk tolerance Bear in mind when we are talking about their \"Level Of Reserves\" this comes in the form of bank deposits in another local bank\... Foreign banks can thus Create more liabilities ( by accepting more deposits ) as they do not have a reserve requirement which corresponds to the amt of liabilities they can have and can also create more assets ( by issuing more loans ). as they can utilise more of the liabilities they have to generate more 2\) The Growth Of Money Is Driven By Bank Profitability: \[\[Commercial Banks\]\] Summary: \- Foreign commercial banks usually would have to bank with the local banks as they have their own forms of \"Fed Accounts\" These foreign commercial banks would be able to lend out the money they receive ( but park with a local bank) , hence creating a fractional banking system whereby they create money On the other hand, the money which they do park with the local bank would also undergo the money creation process as the local bank utilises fractional banking practices on the received funds. Though \*this would not be equal to the total deposits received by the foreign bank , only what is chooses to keep at the local banks as its \"Fed account balance\"\* These foreign banks are usually operating under the regulations of both the home and host countries. Foreign Bank\'s Regulations: Usually a mix of both the home and host regulations 1\. License In order to operate inside of the host country they would need to meet specific regulatory requirements set by the host country\'s banking authorities They would also be subject to supervision by the host country\'s regulatory authorities 2\. Capital and Reserve Requirements They must adhere to the host country\'s capital adequacy requirements which dictate the minimum amount of capital a bank must hold relative to its assets, alongside reserve requirements 3\. Consumer Protection and Compliance They must comply with consumer protection laws including those related to transparency, fair lending practices, and data protections, whilst adhering to anti-money laundering and counter-terrorism financing regulations Home Country Regulations 1\. Parent Company Oversight The home country\'s regulatory authorities would oversee the parent company of the foreign bank and ensures the overall stability and soundness of the bank\'s operations They may also impose capital and liquidity requirements \*\*They usually collaborate with the host country.\*\* \*\*\*Movements in the money supply will affect the interest rates and inflation and thus affect everyone in the economy.\*\*\* The Money Supply Process \-\-- The 3 Players in the Money Supply Process: 1\) \[\[Central Banks\]\] 2\) \[\[Commercial Banks\]\] 3\) Depositors At The Banks The central bank is the most important player of the 3 as the conducting of monetary policy involves actions which affect its balance sheet. I.e. the operation of the Fed and its monetary policy involve actions that \*affect its balance sheet or holdings of assets and liabilities\* What constitutes an \[Asset\] in the Fed\'s balance sheet? \- Securities \- Loans to financial institutions What constitutes a \[Liability\] in the Fed\'s balance sheet? \- Currency in circulation \- Reserves \*\*\*LIABILITIES\*\*\* The 2 liabilities on the balance sheet, currency in circulation and reserves are often referred to as \*\*monetary liabilities\*\* of the Fed They are an important part of the monetary supply as \*increases in either both will lead to an increase in the money supply ceteris paribus\* The \*sum\* of the \*Fed\'s liabilities/monetary liabilities\* ( Currency in circulation, Reserves ) and the \*Treasury\'s monetary liabilities\* ( Treasury currency in circulation, primarily coins ) is called the \*\*Monetary Base\*\* Fed\'s Liabilities + Treasury\'s Liabilities = Monetary Base ( \"High powered Money\" ) The liabilities of the US Treasury accounts for less than 10% of the monetary base and therefore is not our main focus 1\. Currency In Circulation The Fed issues currency, and currency in circulation is the amount of currency \*\*in the hands of the public\*\* Currency which is held by depository institutions is also a liability of the Fed, but is counted as being part of the \"Reserves\" Fed Reserve notes are IOUs from the Fed to the bearer of the notes and are also liabilities, but unlike most liabilities they promise to pay the bearer back solely with Fed Reserve notes They pay off their IOUs with IOUS\... People are willing to accept these IOUS from the Fed as the Fed Reserve notes are \*a recognised medium of exchange\* ( it is accepted as a means of payment and thus function as money ), but if we really think about it, the \*Dollar notes which the Federal Reserve issues is really not worth anything more than the paper it is written on!\* yes, dollar notes or any fiat money is a form of an IOU from the Fed IOUs will only become a liability for the Fed if it lands in the hands of the public, even if they make \$1 Trillion in IOUS but only issue \$1 in IOUs, then the non-issued IOUs would neither make you richer or pooorer and does not affect your indebtedness The only thing which matters would be the \$1 in IOUs which you gain from and you must return the rest is simply \"unactivated\" Any created currency which is not yet in the hands of the public, that is it is not in circulation in the public and thus not anyone\'s asset or liability is simply \*\*\*as good as being non-existent\*\*\* and thus the currency component of the monetary supply includes only the currency in circulation Summary: \- Currency is issued by the FED, and it is essentially an IOU from the Fed to the Person who holds their notes, its not worth anything but the paper its printed on \- The reason why people use it either ways is because its recognised as a medium of exchange. \- Currency which is made but not circulated is as good as not being existent as it doesn\'t increase or decrease the money supply as its not in the economy\'s system. 1\. Reserves All banks have an account at the Fed where they hold deposits \*Deposits at Fed\* ( i.e. Money stored in the Banks\' Fed account) + \*Currency Physically Held by Banks\* (Vault Cash) = \*\*\*Reserves\*\*\* Reserves are assets for the banks but are liabilities for the Fed because the banks can demand payment on them at any time, and the Fed must satisfy its obligation by paying Federal Reserve notes The Reserves can be divided into 2 categories, \- Required Reserves \- Excess Reserves The fed also implements the Required Reserve Ratio \*\*Deposits owned by the average person at the bank ( Bank deposits ), do not come up as liabilities for the Fed, rather it is the Bank\'s liability!\*\* Though they are not directly under the Fed\'s liabilities, the fed still has the power to influence this via their various policies. This is mainly using their tools such as the FFR. \*\*\*ASSETS\*\*\* The 2 assets on the Fed balance sheets are important for 2 reasons, the first being \*changes in the asset items leads to changes in the reserves and monetary base\*, secondly, these \*assets earn higher interest rates than the liabilities\* The Fed\'s assets earn income and the liabilities practically cost nothing Although the Fed returns most of its earnings to the government, it does spend some if it on worthy causes such as the supporting of economic research 1\. Securities This category of assets covers the \*\*Fed\'s holdings of securities issued by the US Treasury\*\* and in \*unusual circumstances\* , other securities The \*primary\* way in which the Fed provides reserves to the banking system is by \*\*purchasing securities and thus increasing its holdings of these assets\*\*, an increase in either government, or other securities held by the Fed leads to an increase in the money supply. 2\. Loans to Financial Institutions The Fed can also make loans to banks and other financial institutions, the loans are referred to as \*Discount Loans\* or \*Borrowings\* from the Fed or \*Borrowed Reserves.\* These loans appear as a liability on the financial institutions\' balance sheet and thus appear as a form of liability for the institution. The Fed can make loans to other financial institutions but these are during times of economic distress Increments in the number of loans \*\*\*can also be a source of an increase in the money supply\*\*\*, \*during normal times, the Fed makes loans only to banking institutions\* and the interest rates charged to banks for these loans is called the discount rate. Summary: The \*Fed is the one controlling how many assets it holds\*, it mainly purchases securities such as bonds from the secondary market, they do not take part in the primary market. Rather they would purchase the bonds from the dealers who had took part in the primary market ( Treasury Auction\... ), in the secondary market. For Loans, it is also the one deciding how much money it decides to lend out to financial institutions such as banks, and it does so through its policy tools such as the discount window etc. Controlling The Monetary Base \-\-- The Fed exercises control over the monetary base through its purchases or sales of securities in the open market, called \[\[Open Market Operations ( OMO )\]\] \*\*and\*\* through the extension of \*Discount Loans to Banks\* The Primary way in which the Fed causes changes in the monetary base is through its \*\*Open Market Purchases - This is the act of purchasing a bond\*\* , the opposite is an \*\*Open Market Sale - The act of selling bonds\*\* All Federal Reserve purchases or sales of bonds are always done through Primary \[\[Dealers\]\], who operate out of private banking institutions Primary dealers would participate in the primary market, and would later on sell the bonds they had bought directly from the Treasury to the Fed IN THE SECONDARY MARKET! \*\*Open Market Purchases\*\* If the Fed purchases \$100 Million of bonds from a dealer, it adds \$100 Million to the dealer\'s deposit account at the Fed Reserves in the Banking System go up by \$100 Million The Fed\'s Assets go up by \$100 M in Securities ( Bonds ) but its Liabilities also go up by \$100 M in Reserves \*\*The Fed\'s purchase of bonds injects new money into the banking system, in effect, it transforms idle assets (bonds) which were previously doing nothing in the accounts of the primary dealers, into liquid reserves which can be used to finance new loans and investments which allows for increased stimulus in the economy\*\* = Thus , it is important to note that the CREATION of money is merely a \"stepping stone\", a necessary, for the EXCHANGE of idle assets for liquid reserves, this is the MAIN GOAL and the MAIN SOURCE of stimulus. = We don\'t print money to stimulate the economy, we exchange idle resources , held by the primary dealers, for liquid reserves so as to allow for those liquid reserves to be lent out into the economy, that is our main goal. But those liquid reserves have to come from somewhere, and it would defeat the purpose if we were to take it FROM the economy, so the Fed just creates it. = \*\*\*Fed\'s Liabilities + Treasury\'s Liabilities = Monetary Base\*\*\* ( \"High powered Money\" ) Since the Fed\'s liabilities is then = Currency in Circulation + Reserves, The Monetary base thus increases by an amount equal to the value of the bonds bought \*\*Open Market Sales\*\* Similarly, if the Fed makes a sale of \$100 M of bonds to a primary dealer, the Fed would Deduct \$100M from the Dealer\'s deposit account and thus the Fed\'s liabilities fall by \$100M and the monetary base also falls by the same amount \*Don\'t be confused with this : The Treasury issues the amount of bonds which corresponds to fiscal financing needs, they do not control the money supply indirectly, the FED is the one which decides how many bonds it will buy and for how much\...\* !\[\[Pasted image 20240626072049.png\]\] in essence the feds role is only to restore the funds that the primary dealers had spent on buying the bonds but the stereotype of the Fed \"Creating money out of thin air\" is referring to the money they used to buy the bonds from the primary dealers as it essentially didn\'t come from the economy and was just created by the Fed. \-\-- PRIMARY DEALERS ARE OBLIGATED ( BUT NOT FORCED TO BUY) TO PARTAKE IN THE BOND AUCTIONS, THIS IS TO RAISE GOVERNMENT FUNDS TO FUND THE SPENDING OF THE GOVERNMENT PRIMARY DEALERS ARE ALSO IN THE BUSINESS OF BUYING AND SELLING AND WOULD NATURALLY ACCUMULATE A POOL OF BONDS THEMSELVES THROUGH DAY TO DAY OPERATIONS The Treasury initiates the process by issuing bonds and using the proceeds for government spending, which directly increases the money supply by injecting funds into the economy. The Fed enhances this effect by buying those bonds from financial institutions in the secondary market, thereby increasing bank reserves ( in exchange , they take away those bonds and park it under their Assets in their balance sheets ) enabling further lending, which amplifies the overall increase in the money supply. = Shifts From Deposits into Currency: Even when the Fed does not conduct open market operations, a \*shift from deposits to currency will affect the reserves in the banking system\* This however, \*\*WILL NOT AFFECT THE MONETARY BASE\*\* Thus the \*Fed has more control over the monetary base than it does for reserves\* , these same factors ( outside the Fed\'s control ) which can affect the level of reserves in the banking system, cannot affect the monetary base Since Currency in circulation + Reserves = Liabilities A conversion of reserves to currency would simply cancel itself out and thus leave the monetary base unaffected Thus random fluctuations may occur for reserves but not for the monetary base Loans to Financial Institutions: The monetary base is affected when the Fed makes a loan to a financial institution, when the Fed makes a \$100M loan to a bank, the bank is credited with \$100M in reserves from the loan \- Fed\'s Balance Sheet - Experiences a \$100M increase in Loans ( Assets ) Experiences \$100M increase in Reserves too ( Liabilities) \- Banking System - Experiences a \$100M increase in Reserves ( Assets ) Experiences \$100M increase in Loans ( Liabilities) The monetary liabilities of the Fed have now increased as the level of reserves has increased in the banking system. Therefore, the monetary base would essentially increase by \$100M too. When the bank pays off a loan however, the process is reversed and thus the total reserves in the banking system falls whilst the Fed\'s liability disappears - The Monetary Base thus falls by \$100M \-\-- Other Factors Which Affect the Monetary Base: \-- Besides the Fed, 2 more items affect the monetary base and are \*not controlled by the Fed\*. 1\. Float When the Fed clears checks for banks, it often credits the amount of the check to the receiving bank \*\*\*before\*\*\* it debits the amount from the bank that sent the check, there would thus be a short period, before the amount it debited, where there is a temporary net increase in the total amount of reserves in the banking system This is Float \*Float is affected by RANDOM events such as the weather which influences how quickly the checks are presented for payment\* 2\. Treasury Deposits When the US Treasury moves the deposits from commercial banks to its account at the Fed, it causes a deposit outflow at these banks, this causes the reserves in the banking system and thus the monetary base to decrease \*\*As we can see, none of these are affected by the Fed\*\* Furthermore, the decisions by the US Treasury to have the Fed intervene in the Forex market also affects the monetary base \-\-- Thus there are 2 primary methods which determine the monetary base: \- Open Market Operations \- Lending to Financial Institutions The amount of OMO is completely controlled by the Fed who places orders with dealers in bond markets, the central bank cannot unilaterally determine and therefore cannot predict the amount of borrowings from the Fed The central bank \*can only set the discount rate, it is the banks who make the decisions about whether or not they would like to borrow from them or not.\* It is thus not entirely controllable by the Fed We can thus split the monetary base into 2, \- Controllable by the Fed Amount of the base which results from open market operations \- Less Controllable by the Fed Amount of the base which is created by loans from the Fed Factors not controlled at all by the Fed like Float or Treasury Deposits undergo substantial short-run variations and can be important sources of fluctuations in the monetary base over time periods as short as a week These fluctuations are usually predictable and can be offset through more \[\[Open Market Operations ( OMO )\]\] \*Although the Float and Treasury Deposits undergo substantial short-run fluctuations, they do not prevent the Fed from accurately controlling the monetary base, it just complicated the control of it\* \-\-- \*\*\*Factors which determine the Money Supply\*\*\* \- Changes in non-borrowed monetary base The Fed\'s open market purchases increase the nonborrowed monetary base and its OMO decrease it holding all other variables constant Open market purchase would increase the monetary base and the reserves such that multiple deposit creation occurs and the money supply increases Open market sales that reduce the monetary base would shrink the monetary base and the reserves and thus cause a \*multiple contraction of deposits and a decrease in the money supply\* \*\*The money supply is positively related to the nonborrowed monetary base\*\* \- Changes in the borrowed reserves from the Fed Increase in loans from the Fed would provide additional reserves, increasing the amount of the monetary base and the reserves which would lead to multiple deposit creation and the expansion of the money supply. The money supply is positively related to the level of the borrowed reserves \- Changes in the Required Ratio If the required ratio on checkable deposits increases whilst all other variables are constant such as the monetary base, then the multiple deposit expansion is reduced and hence the money supply falls. The money supply is negatively related to the required reserve ratio In recent years, the reserve requirements have become less important in the determination of the money multiplier and the money supply \- Changes in the Excess Reserves When banks increase holdings of excess reserves those are no longer used to make loans causing a multiple deposit creation to stop dead in its tracks The money supply is negatively related to the amount of excess reserves \- Changes in Currency Holdings Checkable deposits undergo multiple expansion whereas currency does not. When checkable deposits are converted into currency as long as the amount of excess reserves are constant, a switch is made from a component of the money supply that undergoes multiple expansions to one which does not. Holding excess reserves constant, the money supply is negatively related to currency holdings The Money Multiplier = The relationship between the money supply, the money multiplier and the monetary base is described as: \[Money Supply\] = Money Multiplier X Monetary Base The money multiplier tells us the multiple of the monetary base which is transformed into the money supply, as the money multiplier is usually larger than 1, it is also described as \*\*High-Powered Money\*\* Reserves ( R ) = Required Reserves ( RR ) + Excess Reserves ( ER ) RR = reserve ratio ( rr ) X Amount of Checkable Deposits (D) R = ( rr X D ) + ER Since the monetary base is: MB = R + Currency ( C ) = \*( rr X D ) + ER + C\*... !\[\[Pasted image 20240215061728.png\]\] e: excess reserves ratio set by banks c: currency ratio set by depositors rr: required ratio set by Fed The increase in the money supply has to be smaller when there is an increase in the monetary base as compared to what was propose earlier by the deposit multiple So long as c is positive, the money supply would not increase as much as we had hoped for in our simpler model of the money multiplier Furthermore since e is positive, any increase in the monetary base and deposits would lead to higher excess reserves, thus the amount of reserves which supports checkable deposits and thus deposit creation is not as much as we had predicted again, hence the smaller money multiplier \*It will also seem as though the shift from deposits to currency should lower the overall amount of multiple expansion and hence the money supply, this is correct however it would assume that the value of the excess reserves ratio is small. However in the case where the excess reserves ratio is abnormally high, when a dollar moves from deposits into currency, the amount of excess reserves falls by a large amount which releases reserves to support more deposits causing the money multiplier to rise\* e= ER / D c= C / D This reveals the amount of monetary base needed to support the existing amounts of checkable deposits, currency and excess reserves \-\-- QE and \[\[The Money Supply\]\] During the Financial Crisis and Coronavirus Crisis \-\-- When the global financial crisis became virulent the Fed initiated lending programmes an large scale asset purchase programmes in an attempt to bolster the economy By end 2014, these led to a 350% increase in the Fed\'s balance sheet and the monetary base because the lending and purchase programmes resulted in a huge expansion in the monetary base Such a massive expansion should have led to a large expansion of the money supply, however in this case the M1 money supply only increased by 100%! Despite the huge increase in the monetary base, the money supply rose by much less as the money multiplier fell by over 50%, the currency ratio had a slight downward trend from 2007-2020, which would raise the money multiplier However, this was matched by an extraordinary rise in the excess reserves ratio which climbed 30-Fold from September 2008 - December 2014 When the Fed began to pay interest on the excess reserves in October 2008, the interest rate was equal to or slightly more than the rate at which the Fed could lend them in the funds market IE. the opportunity cost of these excess reserves was now close to zero, banks were willing to hold any amount of excess reserves The same effect happened in the Coronavirus crisis, with the excess reserves ratio climbing 33% which led to a decline in the money multiplier thus the increase in the monetary base did not lead to a large increase in the money supply. Before the \[\[The Financial Crisis\]\] and the \[\[Eurozone\'s Debt Crisis 2009-2012\]\], the most prominent examples of severe financial crises came from the developing countries as well as the emerging market economies, this was because they were especially \*\*vulnerable\*\* to financial turmoil as they \*\*opened their markets to the outside world\*\*, and in particular, \*international capital flows in the 1990s with high hope of economic growth and reduced poverty\* The most dramatic crises were as follows: \- \[\[The Mexican Crisis (1994)\]\] \- \[\[The East Asian Crisis (1997)\]\] \- \[\[The Argentine Crisis (2001)\]\] Emerging market economies - Economies in the \*early stage of market development\* and have \*recently opened up the flow of goods and services, and capital from the rest of the world\*. Summary: EMEs tend to open up their economies to international capital flows in hopes of growth and reduction of poverty Stage 1 : Initial Phase \-\-- Crises in advanced economies can be triggered by a number of different factors, but with emerging market economies, financial crises develop along \*\*\*2 basic paths\*\*\*: 1\. Mismanagement of Financial \*\*\*Liberalisation & Globalisation\*\*\* 2\. Severe \*\*\*Fiscal Imbalances\*\*\* \-\-- \*\*\*MISMANAGEMENT OF FINANCIAL LIBERALISATION & GLOBALISATION\*\*\*: The most common path, and the one that precipitated the first 2 crises mentioned earlier, that of Mexico and East Asia, is the mismanagement of financial liberalisation and globalisation! When the country liberalises the domestic financial systems by \*eliminating restrictions on financial institutions and markets\* - \*\*Financial Liberalisation\*\*, and opens up its economy to flows of capital and financial firms from other nations - \*\*Financial Globalisation\*\* Liberalisation and Globalisation is thought to be less problematic for advanced economies due to their more mature financial system The emerging economies usually begin the period of the crisis with a solid fiscal policy\... \*Mexico ran a budget deficit of only 0.7% GDP\*, a number which most advanced economies are unable to reach \*Countries of East Asia\* \*ran budget surpluses\* before their crises struck It is often said that these economies often have a \*weak \"Credit Culture\"\* characterised by both \*\*ineffective screening and monitoring\*\* of borrowers and \*\*lax government supervision\*\* of banks. Financial Liberalisation would \*usually lead to both a credit boom\* as well as \*\*\*risky lending practices\*\*\* which sows the seeds for an enormous loan loss down the road. Financial Globalisation would \*add fuel to the fire\* as it allows the domestic banks to \*borrow from abroad\*. This is usually done by \*\*\*offering high interest rates\*\*\* in order to attract foreign capital and thus allows for the banks to rapidly increase their lending. The \*\*\*capital inflow is further stimulated by government policies\*\*\* that fix the value of the domestic currency to the USD which would provide foreign investors a sense of comfort Just as the \[\[Dynamics of A Financial Crisis in an Advanced Economy\]\], lending booms end in lending crashes, \*significant loan losses\* emerge from long periods of \*risky lending\*. Weakening bank balance sheets would thus prompt banks to deleverage, cutting back on lending and this has an even greater impact in an emerging economy compared to if it was in an advanced economy. Advanced countries have sophisticated securities markets and large nonbank financial sectors who can pick up the slack when banks falter Therefore, when banks stop lending, then there are no other players to solve the adverse selection and moral hazard problems Summary: \- Just like the financial crisis we see in the advanced economies, the main issue or the main factor which results in the financial crisis in the first place are the banks taking on lower quality loans and excessively taking on risks for the emerging economy, the main theme is \"biting off more than it can chew\", via financial liberalisation and innovation, they usually do not have adequate infrastructure, laws, or practices to deal with the huge increment of inflows when they do liberalise their financial systems. This would subsequently lead to a credit boom, but the boom is made up of shitty loans which at the end of the day, would lead to future default rates rising etc. and thus significant losses for the bank - bank runs - bank failures - financial crises.\\ \- Furthermore, the EMEs also do not have sufficient \"backup\" such as other sectors or markets to help cushion the financial crisis. \-\-- It is however, important to note that \*financial liberalisation and globalisation do not necessarily result\* in lending booms and crashes. These only happen if there is an institutional weakness that prevents the nation form successfully navigating the liberalisation/globalisation process \- Prudential Regulation \- Prudential Supervision With these 2, there is a limiting of excessive risk taking, which would avoid a lending boom and thus lending bust. So what usually results in a lack of prudential regulation and supervision? The \[\[Principal-Agent Problem\]\]! Powerful domestic business interests are \*\*encouraged by the prospect of high payoffs\*\* to pervert the financial liberalisation process \*Politicians and Prudential Supervisors are ultimately agents for the voters-taxpayers\*, their goals are supposed to be to protect the taxpayer\'s interest, as they are always almost the ones bearing the cost of bailing out the banking sector if losses were to occur Once the financial markets have been liberalised, the \*powerful business interests which own the banks may benefit\* from prudential supervisors who do not do their jobs properly, they thus encourage the supervisors to act in ways which do are not in the public\'s best interest. These are the same people who will contribute heavily to politician\'s campaigns and are often able to persuade them to weaken regulations which restrict the banks\' from engaging in high-risk/high-reward strategies Afterall, \*even if their high risk strategies fail, the government would be there to bail it out\* and thus the taxpayers would be left holding the bill. These business interests \*\*can also make sure\*\* that the supervisory agencies, even in the presence of tough regulations, \*\*lack the resources they need to effectively monitor\*\* banking institutions or to close them down \*\*\*Weak institutional environments\*\*\* of emerging market economies add to the perversion of the financial liberalisation process, as \*business interests are far more influential and powerful in emerging market economies\* than they are in advanced economies, where a \*\*better-educated public and a free press\*\*, monitor politicians and bureaucrats who are not acting in the public interest. Summary: \- The problem would be avoided should the country be able to supervise and regulate even after they have liberalised the financial system. However this is usually not the case There is a conflict of interest as the politicians and regulators, in certain periods are reliant on large businesses who benefit from ineffective regulations and supervisions. these large businesses provide the funds to their campaigns etc. and this thus results in the politicians being prone to bribes or blackmail \*\*\*SEVERE FISCAL IMBALANCES\*\*\* The inappropriate financing of government spending can also place emerging market economies on a path toward financial crisis, this was the case in Argentina, other crises include \[\[Russian Crisis (1998)\]\] and the \[\[Ecuador Crisis (1999)\]\] and \[\[Turkey Crisis (2001)\]\]. Governments sometimes have the same attitude when they face large fiscal imbalances and cannot finance their debt, they \*often force domestic banks into purchasing government debt\* \*Investors who lose confidence\* in the ability of the government to repay this debt thus \*\*unloads the bonds and causes bond prices to plummet\*\*, banks which hold this debt then face a large fall in the value of their assets on their balance sheets which leads to a \*\*decline in their net worth\*\* With \*less capital, they have less to lend\*, in some cases this may lead to a bank panic which would then cause many banks to fail at the same time. Severe fiscal imbalances thus leads to the weakening of the banking system which leads to the \*worsening of adverse selection and moral hazard problems\* \*\*\*ADDITIONAL FACTORS\*\*\* Other factors often play a role in the first stage of the financial crisis \- Rising Interest Rates ( Due to events abroad ( Mexico )) High interest rates, \*only high-risk firms are most willing to pay\* and thus adverse selection becomes severe, high interest rates also reduce firms\' cash flow and thus \*forces them to seek external funds in which asymmetric information poses as a greater threat\* \- Asset Markets are Smaller in Emerging Market Economies \*Decrease in net worth of firms due to decreased asset prices\* lead to adverse selection problems, there is less collateral for lenders to seize and thus a greater moral hazard as owners of the firm have less to lose \- Unstable Political Systems This is a source of \*great uncertainty\*, which when uncertainty increases, it is \*harder for lenders to screen good credit risks from bad ones\* to \*monitor\* the activities of the firms to which they have loaned money, this again increases moral hazard and adverse selection Summary: \- Thus far, there are 2 factors which mainly affect the economy: A credit boom and bust Asset price decreases (whether or not there is an asset price boom prior is not relevant to whether or not it could precipitate a financial crisis) \*the main idea you must take away is that any decrease in asset prices such as bonds, equities etc. would have an impact on the net worth of the individual or firm who holds such assets. Should this be the banks, this would result in LOSSES, when the general public notice this quickly, they would pull funds out due to a lack of trust. This would thus result in bank runs - lesser loans - slowing economic activity etc.\* STAGE 2 : Currency Crisis \-\-- Participants in the foreign exchange market \*sense an opportunity, they can make huge profits if they bet on a depreciation\* of the currency of an emerging market country When the emerging market\'s currency is fixed against another currency, it can be subject to a \[\[Speculative Attack\]\] where speculators engage in large scale sales of the currency. As the currency sales flood the market, the supply far outstrips the demand for it, the value of the currency thus collapses and a \[\[Currency Crisis\]\] ensues \- High interest rates abroad increases the uncertainty \- Falling asset prices play a role too The \*\*\*deterioration of bank balance sheets\*\*\* and \*\*\*severe fiscal imbalances\*\*\* are the 2 key factors which trigger the speculative attacks. 1\. Deterioration of Bank Balance Sheets When banks and other financial institutions are in trouble, governments have a \*limited number of options,\* The government can raise interest rates which \*should encourage capital inflows\* but if the government raises the interest rates, then banks must now pay more to obtain funds, this would mean that their \*costs are increased and thus profitability is decreased which may lead to insolvency.\* Thus there is a dilemma as raising rates weakens the already weak banks and not raising rates would mean that they are unable to defend their currency The speculators would thus be \*\*\*able to know\*\*\* when the government is \*unable to raise rates due to it being too costly\* and thus \*giving up\* and allowing its currency to depreciate This is an almost guaranteed bet which they would seize and they would begin to sell the currency, when this happens on a large scale, the currency\'s value will begin to plummet and the central bank would not have any choice but to keep using up its reserves of foreign currency to buy its own domestic currency to prevent it from falling Once they have depleted their holdings of foreign currency, the cycle ends and the government would not have a choice but to allow for the devaluation of the currency We would come to realise that developed countries with stable macroeconomic conditions would be sheltered from such speculative attacks, although they are not absolutely immune from it. Currencies of US and Eurozone were not affected by speculative attacks during the financial crisis and the eurozone debt crisis respectively Currencies of UK and Italy were however subjects of speculative attacks showing that advanced economies are not immune to such attacks 2\. Severe Fiscal Imbalances Severe fiscal imbalances can lead to a \*deterioration of bank balance sheets\* and thus can indirectly help to produce a currency crisis, or even do so directly. When a government\'s budget deficit spins out of control, foreign and domestic \*investors begin to suspect that the country may not be able to pay its debt and would start to pull money out\* of the country and \*sell its domestic currency\* This would thus result in a speculative attack which eventually results in a collapse On top of this, consider all of the other stakeholders and how they are affected when the government spends irresponsibly \*\*The main result is essentially the loss of confidence which has far reaching impacts.\*\* When there is a loss of confidence, investors may just pull out of everything that has got to do with the country, including stocks, bonds etc. When this happens then the net worth of firms, banks, individuals who hold these assets would decline and this could be detrimental to a bank\'s health. With a loss of confidence in the government, the government, in order to raise the same funds it had raised before, would need to offer higher premiums which increases the costs of capital. This would simultaneously crowd out the funding that the firms would be able to receive \*\*Remember that firms and the government would be competing for the same funds, and when the government offers higher premiums, naturally \"more business\" or more funds would go to the government.\*\* - harder for the firms to raise funds. Summary: \- The government has limited options should the country start to face troubles, one option would be to increase the interest rates in order to encourage inflows of foreign funds. This would however, raise local costs and could worsen the situation at home \- The government\'s spending along with its funding is closely monitored by EVERYONE, including foreign investors. Should the spending be unhealthy or unbalanced, then the foreign investors would begin to pull their money out. This can cause huge outflows from the local banks/ \*\*\*LIMITED RESOURCES - WHO COMPETES FOR THEM? IN THE EVENT THAT ONE RECEIVES MORE, KEEP IN MIND WHO LOSES AS A RESULT. FINITE RESOURCES - SOMEONE WILL ALWAYS LOSE IF SOMEONE ELSE WINS \*\*\*LIMITED RESOURCES - WHEN COSTS ARE RISING, WHAT IS THE RESULT? LIMITED FUNDS ARE SHARED AMONGST VARIOUS COSTS, WHAT IS COMPROMISED / NEGLECTED SHOULD COSTS RISE?\*\*\* Stage 3 : Full-Fledged Financial Crisis \-\-- Emerging market economies \*\*denominate many of their debt contracts in foreign currency\*\* leading to what is referred to as \[\[Currency Mismatch\]\]. An unanticipated \*depreciation or devaluation of the domestic\* currency in an emerging market country \*increases the debt burden\* of the domestic firms in terms of the domestic currency When this happens, the debt becomes more expensive to pay back, however what the debt is funding, in the case of firms are the goods which the firms produce, and thus the goods are priced in the domestic currency. The firm\'s collective asset value does not rise as it is priced in the domestic currency, but the value of its debt rises in terms of its domestic currency. When this happens, the net worth of the firm declines and the decline in net worth would lead to: \- Moral Hazard \- Adverse Selection As the firm has \"less skin in the game\" and thus would be more likely to display riskier behaviours \*at this point, the economy would be experiencing both a currency crisis (depreciation of its currency, and the decline in net worth of firms which result in sharply higher moral hazard and adverse selection)\* This is also known as a \[\[Twin Crises\]\] The \*collapse of a currency can also lead to higher inflation rates\* and because the \*\*\*emerging economies\' central banks have less credibility in fighting inflation\*\*\* The economy would experience an immediate \*\*upward pressure on import prices\*\* and thus a \*\*dramatic rise in the actual and expected inflation\*\* would likely follow, causing a \*\*rise in the domestic interest rates\*\* Firms would then have to increase interest payments which would lead to \*reductions in their cash flows\* which leads to increased \*\*asymmetric information problems\*\* as they are now more dependent on external funds to finance their investments The adverse selection and moral hazard problem would thus lead to a reduction in investment and economic activity Then, the collapse in economic activity coupled with the deterioration of firms\' cash flow and household balance sheets would result in \*\*many debtors no longer being able to pay off their debts\*\* When this happens, banks get it the worst. 1\. Banks face an \[increasing number of defaults\] which results in a fall in the value of their assets 2\. Increased interest rates ( which affects the households and firms cash flow) \[also affect the banks\' profitability\] and balance sheets 3\. When there is a simultaneous devaluation of the domestic currency, \[foreign-currency-denominated liabilities also become more expensive for the banks to pay back\] \*\*Banks thus stand to lose the most, experiencing both a decline in asset values and a rise in the values of their liabilities\*\* Under these circumstances, the banking system \*often suffers from a banking crisis\* where many banks begin to fail, this would thus \*\*\*further worsen the adverse selection and moral hazard problems and further collapse the lending and economic activity\*\*\* in the country!!! Summary: \- When there is a currency crisis, the local currency would fall and the foreign currency would rise. Should the country\'s debt ( usually the case for emerging economies ) be denominated in the foreign currency, this would lead to higher debt burdens Who takes on these debts? local firms , consumers, who\'s assets are denominated in the weaker, local currency. This would finally result in a double whammy Not only are they facing falling net-worth\'s, they are also having to pay more in order to settle their debts. \- \*\*\*As with any discussion regarding the exchange rate, its normal to think of the result is has on the exchanges between the countries, i.e. the imports and exports. In this case, when the currency weakens locally, all imports are immediately more expensive, and when we talk about expenses, we always go back to the idea of inflation. \*\*Exchange Rate - Exchange - Imports and Exports ( Cheaper? More Expensive?)\*\* \*\*Value Of Currency ( Exchange Rate / Inflation ) - Debt Burden \*\*Price of Goods - Inflation\*\* \*\*Whenever we talk about the net worth, of individuals or firms, always remember that if the net worth declines, that they would always have LESS TO LOSE. Thus should they have any obligations or responsibilities, they would treat it less seriously - Moral Hazard. These are the relationships to keep in mind, when you talk about one thing, the other should intuitively pop up\... \-\-- Crisis In South Korea 1997-1998 \-\-- Prior to it\'s financial crisis, it was known as one of the great economic success stories. After the Korean War had ended, the country was still extremely poor and it was on par with Somalia During the post-war period, South Korea pursued an \*export-oriented strategy\* which helped it become one of the world\'s major economies and was one of the leaders in the \"Asian Miracle\". Like other East Asian Economies, its \*macroeconomic fundamentals were strong before the crisis and the government budget was enjoying a slight surplus\*, something most advanced economies could not achieve Perversion of the financial liberalisation and globalisation process The powerful business interests play an active role in the mismanagement of financial liberalisation. When the \*\*family-owned conglomerates known as the Chaebols dominated the economy\*\*, with \*sales amounting to nearly 50%\* of the country\'s GDP They were \*politically very powerful and were deemed \"Too Big To Fail\"\* by the government With this \*implicit guarantee\*, the chaebols knew that they would receive direct government assistance or directed credit if they were to get into trouble but if their bets paid off they would keep all of the profits instead They thus became \*\*highly leveraged and borrowed large amounts\*\* In the \*\*1990s they began to stagnate\*\*, they were not making any money, and the return on assets for the top 30 chaebols was not more than 3% between 1993-1996 and right before the crisis hit, the average rate of return on assets had fallen to 0.2%. Only the top 5 Chaebols had a profit whilst the 6th to 30th chaebols did not With the \*poor profitability record and the high leverage, bankers would have, under normal circumstances, pulled back\* on lending to these conglomerates, however \*\*\*due to the presence of the government safety net, the banks knew that their loans were also indirectly guaranteed\*\*\* by the government The chaebols decided that the way out of their troubles was to \*pursue growth\* which would require an even more substantial amount of funds to do so, there was however, \*\*just not enough loanable funds available to finance their planned expansion\*\* despite South Korea\'s high savings rate Thus they turned to the \*\*\*international markets\*\*\* They thus encouraged the South Korean government to accelerate the process of opening up South Korean financial markets to foreign capital as part of the liberalisation process, in 1993, the \*government expanded the ability of domestic banks to make loans denominated in foreign currency\* and at the same time, they \*\*effectively allowed unlimited short-term borrowing by financial institutions\*\* but maintained quantity restrictions on long-term borrowing as a means of managing the capital inflows into the country This made no sense, short-term capital can fly out of the country extremely rapidly and was the one making the economy much more fragile Opening up to short-term capital however, made \*political sense\* as the chaebols needed money and it was \*much easier and cheaper for them to borrow short-term at lower interest rates\* in the international markets rather than borrowing long-term as foreign creditors would demand higher interest rates for the higher risks due to the longer period of the loan South Korean banks thus opened 28 branches in foreign countries that gave them access to foreign funds As the Chaebols did not have Access to all the loans they needed as they were not allowed to own commercial banks, they \*turned to the Merchant Bank\* These were \*wholesale financial institutions who engaged in underwriting securities, leasing and short-term lending\* to the corporate sector, they \*\*obtained funds for these loans by\*\* issuing bonds and commercial paper and by borrowing from interbank and foreign markets At that time, the merchant banks \*\*could borrow abroad and were virtually unregulated\*\*, the chaebols saw the opportunity and convinced the government to convert many finance companies into merchant banks The merchant banks then channeled massive amounts of funds to their chaebol owners where they flowed into undproductive investments like steel, automobile production and chemicals Summary: \- Up till this point, we see that the government had been politically pressured by the Chaebols, who made up a huge portion of the S Korea economy. \[Moral Hazard\] As a result, the government allowed for unlimited short term loans ( cheaper than long term) for the Chaebols. Resulting in huge short term inflows which put the country at risk due to their volatility \- Allowing them to gain a large sum of their funding from abroad, and furthermore with lax supervision which came along due to the unregulated nature of merchant banks led to a decrease in quality of loans alongside a huge reliance on foreign investors When the loans went sour, the financial crisis ensued: The \*economy then experienced a negative shock to export prices\*, hurting the chaebol\'s \*already-thin profit margins\* and the small and medium sized firms that were tied to them, on January 23 1997 a second major shock occurred creating great uncertainty for the financial system Hanbo, the 14th largest chaebol \*declared bankruptcy and subsequently 5 more chaebols\* declared bankruptcy before the year was over This caused the \*\*stock market to decline substantially\*\* by more than 50% from its peak An \*\*increase in uncertainty and a decrease in net worth form the stock market decline will exacerbate asymmetric informational\*\* problems, it is now harder to screen good borrowers from bad ones Firms\' collateral decrease and their incentives to make risky investments increase as they have less equity to lose Summary: \- When the export prices fell, the chaebols experienced losses due to thin profit margins - bankruptcy resulted in a weakened stock market \*\*Large firms are deemed \"too big to fail\" because if they do fail, the economy and the country as a whole tanks! \- Firms experienced falling net-worths - less to lose - moral hazard \- Banks reduced lending due to the uncertainty in the economy increasing, along with falling asset prices negatively affecting the banks\' balance sheets. Thus, \*lending declined and the economy weakened\*, the deterioration of bank balance sheets ripened the South Korea economy for the next stage. Due to the weakness of the balance sheets of the financial sector, and the economy\'s \*increased exposure to the sudden stops in capital inflows\*, a large amount of \*short-term external borrowing stopped suddenly\*, With the collapse of the Baht in July 1997 and the closing of 42 finance companies in Thailand in early August 1997, \*\*contagion began to spread\*\* as participants wondered if such problems existed in other East Asian countries Once they realised that the South Korean \*\*central bank could no longer defend the currency by raising rates\*\*, as the banks were already in dire conditions, speculators \*\*pulled out\*\* of the South Korean currency, leading to a speculative attack. The speculative attack led to a \*sharp drop in the value of the won, by nearly 50%\* and both nonfinancial and financial firms \*\*had so much foreign currency debt that the depreciation of the currency doubled the value of the foreign denominated debt\*\* leading to a \*\*\*severe erosion of their net worth\*\*\* This led to a \*further increase in the asymmetrical informational\* problem in South Korea Summary: \- At this time, foreign investors lost confidence and began to pull funds out of the country, the large pool of short-term foreign funding was stopped \- When there are huge capital outflows, the probability of devaluation increases \- With the already strained economy and strained balance sheets of businesses and banks , further increases in the interest rates, in hopes of attracting foreign funds , would have destroyed the economy even more. \*Speculators at that time understood that even if the central bank were to increase rates, there is only so much room left before it does more harm than it does good.\* \*\*\*LARGE OUTFLOWS FROM A COUNTRY - DEPLETION OF CURRENCY RESERVES AS THE CENTRAL BANK WOULD ATTEMPT TO INTERVENE AND TO MAINTAIN THE VALUE OF ITS CURRENCY ( BUY ITS OWN CURRENCY, SELL ITS FOREIGN CURRENCIES ) THERE IS ONLY SO MUCH THEY CAN DO BEFORE DEPLETING RESERVES AND HAVING NO CHOICE BUT TO ALLOW THE CURRENCY TO DEPRECIATE\\ When there is a stoppage to the short-term funding , businesses who needed that funding ( in the form of foreign currency to pay foreign debts, imports etc. ) would bid higher ( in local currency ) for foreign currency, leading to a depreciation of the local currency Furthermore when the sentiment is weak in that country, foreign investors may sell off assets, exchanging the money back into their local currency, further exacerbating the problem For banks, they would find outflows in their balance sheets and reduced liquidity \-\-- The deterioration in the firms\' cash flows and balance sheets worsened the banking crisis, \*banks paid off foreign currency by borrowing with more Korean won\* and yet \*\*could not collect on the dollar-denominated loans\*\* they had to made to domestic firms The fact that they had previously borrowed that much money in terms of short-term loans, made it worse as they now needed much more liqudiity ads they had to pay the loan back in such as short time The government stepped in to guarantee all bank deposits and to prevent a bank panic, however the loss of capital meant that banks had to curtail their lending \*Real\* \*GDP fell\* at over a 6% rate and \*unemployment rose sharply\*, we might thus expect the inflation to fall as well, however \*it did not , it rose\* and this is because of the \*\*\*currency crisis\*\*\* The speculative attack \*\*raised import prices and this fed directly into inflation and weakened the credibility of the Bank of Korea\*\* as an inflation fighter, the rise in import prices led to a price shock while the weakened credibility of the Bank of Korea led to a rise in expected inflation \*Market interest rates soared\* to compensate for high inflation, along side the Bank of Korea pursuing a tight monetary policy in line with recommendations from the IMF This led to a \*fall in cash flows which forced firms to obtain external funds\* and \*\*increased the adverse selection and moral hazard\*\* problems in the credit market Keep in mind that \*external funds here means funding outside of the firm i.e. banks\* in the domestic economy is one source, when all firms experience falls in cash flows, both the good and bad firms \*\*\*exhibit similar financial stress indicators\*\*\* and thus lenders cannot differentiate them, thus lenders may increase their interest rates or have stricter lending criteria which would deter low risk firms and leave them with a pool of high risk firms- \[Adverse Selection ( Pre-Loan )\] Firms also know that the financial burden of failure partially falls on the lenders - \[Moral Hazard ( Post-Loan )\] This, along with the higher interest rates led to a \*\*further contraction of investment spending\*\* providing another reason for the falling economic activity In 1998, the South Korean Government responded very aggressively to the crisis by implementing a series of financial reforms that helped to restore the confidence in the financial system The Argentine Crisis 2001-2002 \-\-- The Argentine crisis was triggered by severe fiscal imbalances, it had a well supervised banking system, a lending boom did not occur before the crisis itself. The banks were in a surprisingly good shape though a severe recession had begun in 1998. In Argentina, the \*provinces control a large percentage of public spending but the responsibility for raising revenue is left primarily to the federal government,\* \*\*\*provinces\*\*\* thus have the \*incentives to spend beyond their means\* and then call on the federal government to assume the responsibility of their debt. The recession in 1998 made matters worse as it led to \*\*declining tax revenues and a widening gap between government expenditures and taxes\*\*, subsequent severe fiscal imbalances were so large that the government had \*\*trouble\*\* getting domestic residents and foreigners to \*\*buy its bonds\*\* The government thus had to coerce the banks into buying large amounts of government debt \[\[How The Government Makes Banks Buy Government Debt\]\] By 2001, the investors were losing confidence in the ability of the Argentine government to pay back its debt and the value of the debt thus plummeted, this left \*\*big holes in the banks\' balance sheets\*\* The deterioration of the balance sheets, along with the loss of deposits led the banks to cut back on their spending, thus adverse selections and moral hazard problems worsened and lending began to decline In October 2001, \*negotiations\* between the central government and the provinces to improve th