ECO 350: Money and Banking

Professor Griffy

UAlbany
Announcements
I I know online courses can be a bit of a mess, but I hope this
course was fairly constistent and predicatable.
I I’ve actually covered all the material I wanted to cover, so I
will be having a review session on Thursday at 9am rather
than having an additional course at the office hours Zoom link.
I Note: Please fill out online evals!
I Final format:
1. Cumulative.
2. Roughly 20-25 multiple choice questions.
3. 2 Short answer questions.
4. Open note, open book, but you probably want to review
because there won’t be as much time on this exam.
I Probably:
I You will have 1.5 hours to do the multiple choice once you
start.
I You will have 3 hours to do the short answers once you start.
I Don’t start them at the same time! Otherwise you will have
to complete them both.
Grading Update

I Because this has been a messy semester, I’m going to change

my grading scheme a bit.
I I will drop your midterm score if it will help your grade.
I ie, I will calculate your overall grade with and without your
midterm score and give you the better grade.
I So if you did poorly on the midterm, you can still do well in
the class.
I Note: this only applies to the midterm, you still need to take
and do well on the final.
I And this only applies to students who did not use Chegg on
the first midterm.
Introduction

I Today: remind you of the topics from the first two parts of
the semester.
I Go through a few key concepts.
I Since there’s a lot of material, I will highlight (in red) most
likely short answer topics in red from midterm.
I i.e., the short answer will be from one of these topics, but
specific parts might involve knowledge from other topics.
I Chapters: 1-15, 19-20, 22.
Topics Covered prior to midterm

I Key topics:
1. Calculating present values.
2. Yield to maturity vs. coupon rate.
3. Bond types, and calculating their values.
4. Definitions and need for money.
5. Determining prices with equilibrium.
6. The market for bonds and the market for money.
7. Default risk, and other sources of risk.
8. The yield curve.
9. Transaction costs, adverse selection, and moral hazard.
10. Regulation and asymmetric information.
11. Pricing stocks, rational expectations, and the efficient market
hypothesis.
12. Assets, liabilities, and Bank’s Balance Sheet.
13. Interest rate sensitivity.
14. Bank Regulation.
Topics after midterm
I All topics are fair game.
I Key topics:
1. Moral Hazard and Too Big to Fail.
2. Structure of the banking industry; definitions of bank types.
3. Securitization, financial derivatives, & other financial
innovations.
4. Financial crises & balance sheet deteriorations.
5. Structure of the Federal Reserve.
6. Tools of Monetary Policy.
7. Theories of Money Demand
8. Investment-Savings Curve
9. Aggregate Demand and Aggregate Supply
I The primary topic of the short answer questions will come
from one of these or the highlighted topics on the previous
slide.
I Some parts of the short answer might involve knowledge from
other parts of the course.
I One will come from this material the midterm.
The Market for Bonds
I How is the price of a bond determined?
I In a market with supply and demand.
Comparative Statics

I What happens when a substitute investment increases its rate

of return?
I How do municipal bonds affect federal and corporate bonds?
I What happens to bonds during a recession?
Asymmetric Information

I Transactions subject to potential information problems.

I Types of asymmetric Information:
1. Adverse Selection: inability to assess quality prior to
transaction.
2. Moral Hazard: inability to dictate risk taking behavior after
transaction.
I Both can lead to the breakdown of markets.
Lemon Problem

I Adverse selection is otherwise known as the “lemon problem.”

I i.e., why would someone sell a good unless it’s a “lemon.”
I Example:
1. Buyer and seller value a car equally (at the price of the car).
2. A car can range from perfect quality (W = 1) to very bad
quality (W = 0).
3. The price of a perfect quality car is $10000, and the price of a
bad quality car is $5000
4. i.e., price = 5000 × W + 5000
Lemon Problem

I People with bad quality cars will try to pass their’s off as good.
I At a price of $7500, nobody with a car with a higher value
willing to sell (i.e., with quality greater than 0.75)
I Ultimately, only low quality cars show up in market.
Iter. Max W Min W Ave W Market price
1 1 0 0.5 $7500
2 0.5 0 0.25 $6250
3 0.25 0 0.125 $5625
4 0.125 0 0.0625 $5312.50
∞ 0 0 0 $5000
Too Big to Fail

I Lots of examples of moral hazard.

I Main problem: insurance causes people to take more risk than
they would otherwise.
I “Too Big to Fail”: Banks have incentive to take on so much
risk that they would devastate the economy if they collapsed.
Too Big to Fail Example

I A bank currently has the following balance sheet:

Assets Liabilities
Reserves: $50M Deposits: $500M
MBS: $500M Repos: $300M
Securities: $250M Bank Capital: $100M
Cash: $100M
I The bank knows that at any point there is a 50/50 chance
that their MBS fall in value by half.
I They also know that if they increase their assets to more than
$1B, the government will only allow them to fall to a net
worth of zero.
I What do they do?
The Investment-Saving Relationship

I How does output vary with the real interest rate?

I Lower real interest rate → more investment, and vice versa.
I IS relationship mathematically:

1 d +X
Y = [C̄ +Ī−d ×f¯+Ḡ +NX
¯ −mpc×T̄ ]× −r ×
1 − mpc 1 − mpc
(1)
IS Example
I Suppose the following:
1. C̄ = 10, Ī = 5, Ḡ = 5, NX
¯ =5
2. f = 2, T̄ = 4
¯
3. mpc = 0.7
4. d = 0.02, X = 0.01
I If government spending increased from 5 to 10, what would
happen to the curve?
I Since we have numbers, we can calculate how much it would
shift by: (pick r = 0):

1
(10 + 5 + 0.02 × 2 + 5 + 5 − 0.7 × 4) × = 73.67
1 − 0.07
(2)
1
(10 + 5 + 0.02 × 2 + 10 + 5 − 0.7 × 4) × = 90.53
1 − 0.07
(3)

I Curve shifts out by 16.66.

Aggregate Supply and Aggregate Demand

I Relationship between inflation and output.

I Note the difference between this and the IS curve.
I Three key components:
1. Long run aggregate supply: determined by the productivity of
the country.
2. Short run aggregate supply: determined by the cost of
production to the firm, and how wages change in response to
output.
3. Aggregate demand: Determined by consumption of goods and
service, investment decisions of firms, and government policies.
I What happens to the economy during
1. a demand driven recession?
2. a short run supply driven recession?
Conclusion
I Thanks again, it was a good semester despite the continued
uncertainty.
I No class Thursday. Extra review session instead.
I Note: Please fill out online evals!
I Final format:
1. Cumulative.
2. Roughly 20-25 multiple choice questions.
3. 2 Short answer questions.
4. Open note, open book, but you probably want to review
because there won’t be as much time on this exam.
I Probably:
I You will have 1.5 hours to do the multiple choice once you
start.
I You will have 3 hours to do the short answers once you start.
I Don’t start them at the same time! Otherwise you will have
to complete them both.