Not Raise Fed: -4 Fed: 8
Inflation M Firms: -1
 Definition: It is the sustained rise in the
general level of prices. Inflation rate is the
rate at which the price level increases.
 Measuring the inflation:
-CPI: Measures average price of
consumption. Reported monthly.
-Problems with CPI: Index number
problem. There is no “perfect price
index”.
-GDP Deflator: Nom GDP/Real GDP in yr t.
The actual no. has no economic meaning.
The rate of change does. Quarterly
reporting.
- The two may not be the same. Goods
consumed could include imports. GDP
could include exports.
- PPI: Index of domestically produces
good.
 Causes of Inflation:
-M (stock of money) V(Velocity)=P (Price
level) Y(GDP)
- assume that in the long run, Y and V are
fixed/constant.
-Monetarist Theory of Inflation: Inflation
is caused by too much money chasing too
few goods. Assuming V and Y constant,
change in M causes change in P.
-Seignorage: The revenues from money
generation: = Money growth x real money
balances.
-Inflation Tax: Since it reduces the value of
cash it can be considered tax. Tax rate is
inflation rate (π)
-Govt does not receive the inflation tax
rate but only Seignorage. The two are only
equal if the growth is constant. In the long
run they are the same. Inf=Sei
-Financing budget def: Issue bonds or
print money.
 Consequences:
-Fully anticipated inflation reflects in
wages and prices; has no effect.
-Unanticipated inf hurts lenders and helps
borrowers.
-Unanticipated deflation hurts borrowers
and helps lenders.
 Exchange Rates:
-Flex Ex Rates: High relative inf gets
translated in ex rate depreciation. (πh-
πf=% change in exchange rates)
-Fixed Ex Rates: Loses ind monetary policy
 Asset Price Inf: Money creation causes
asset price inf. Money is channeled into
Asset Market (Prop and stock)
Game Theory
Raise P Not Raise P
Raise M Fed: 4 Fed: 10
Firms: 2 Firms: 0
Π=20% Π=0%
µ=natural rate µ<natural rate
Firms: 3
Π=20% Π=0%
µ>natural rate µ=natural rate
Graph
 Time Inconsistency: An activity that may
be rational in the short run but may be
irrational in the long run.
 Dominant Strategy: It is to indulge
immediately.
 Solution to Prisoner’s Dilemma is a
binding commitment – a rule. Bank of
Japan does not follow this rule.
Shocks on Fixed and Flexible rates
 Exports Fall (Graph)
 Credit Card Invention (Graph)
 Conclusion: If one anticipates that the
shocks will demand then flex ex rate
would result in less var in income than a
fix ex rate. If shocks are monetary than fix
ex rate would result in less var.
Relationships
 Positive: Growth rate of Nominal Money
Supply and inflation rate
 Positive: Growth rate of Monetary base
and inflation rate
 Close to corr 1: Growth rate of M1 and
inflation rate
 Positive: Rate of depr of the currency and
inflation rate
Foreign exchange market play
 An indep central bank could devalue
currency to increase the exports thus
shifting IS to the right.
 Automatic Stabilizer means increase in G
and transferring all of the Fed’s funds to
the new State to spur demand.
Money Supply
 R=Reserve Ratio. Amt banks must hold as
reserves. No interest on this
 Central Bank
- Monetary Base: Money printed by
central bank.
 Banks: Max loan (1-R)
Money Supply with Fractional Banking
-M (Money Supply) =Dep (Total Bank
Deposits)
-R x Dep= Base (Monetary Base)
-R x M = Base > M=Base/R
Money Supply with Public Holdings and
Fractional reserve
-M= CU (currency in circulation) + Dep
Money Multiplier
-Monetary Base=CU+ Res
-CU/Dep (currency-deposit ratio)
Determined by public, Incr in CU/Dep
lowers M.
-Res/Dep (Reserve Deposit Ratio)
Determined by Banks. Increases by not
making loans. An increase would lower M
-Time Deposits-Interest bearing loans that
has maturity
-Repurchase Agreement (Repo)
Int on Repo= (Principal x repo rate x days
repo is outstanding/360)
-Term Repo
-T-Bill
-Eurodollar
-Bank Acceptances
Money Markets
 Advantages of Repo-Investors keep
surplus funds invested without losing
liquidity or incurring price risk + Investors
expose themselves to no credit risk
because of top quality paper
 Overnight Repo is lower than FFR as repo
is secured unlike fed funds + many
investors cannot participate in fed funds
market.
 Eurodollars are dollars held in
bank/branch located outside the US. True
international market
-All deposits except call money have fixed
maturity
-Interest is paid on all deposits
-No reserve requirement
-No FDIC premiums
 -Banks can invest every dollar of
Eurodeposits.
-Participant banks include govt.,
corporations, central banks, commercial
banks
 LIBOR – Rate at which at which banks in
London offer Eurodollar.
 Money Market Fund: Is a mutual fund that
invests assets in short term money market
assets – Repo, Eurodollar, CPs, TBills.
MMF are a major supplier of liquidity in
the Repo Market
 TED spread would rise if there a demand
for 3-month T bill and Euromarkets have
frozen
Hight of financial crisis: The yields would
go down as the demand for US treasuries
increase.
-Int rates on the long term government
bonds cannot be >2% greater than rates in
the 3 lowest inflation countries
-Budget deficit cannot be more than 3% of
GDP
-Govt debt cannot be >3% GDP
 Convergence Play of EU: Bond yield would
converge. Italian spread to German
existed. Expect to converge. Buy Italian
Bond and sell German Bonds.

Yield Curve

 Yield Curve normally tends to slope
upwards.
 Segmented Markets: Different markets
for each maturity of the bonds.
-Independent supply and demand
-Maturities are not substitutable
-Yield is determined separately and
independently in each market.
-Shorter maturities are preferred.
-But cannot explain short term and long
term rate move together.
-Operation theory- Want high ST rates and
low LT interest rates. Cannot work.
 Expectation Theory: Investors view assets
of all maturities as perfect substitutes.
Long bond rates equal the average of ST
rates.
 Preferred Habitat: Maturities are
substitutable per not perfectly. Specific
maturities are preferred.
-Yield on an n period bonds = average of
yield on one period bonds over the next n
periods + a term premium
 Expectation of recession: Inflation rate
would fall. Market rate would be lower in
the future. Demand for ST bond rises.
Prices goes up. Yield goes down.
Negatively sloped curve.
 Spread over Treasuries: Other govt yield
curves are over the treasuries. US govt has
the lowest risk.
`
 Mortgage Rates are higher than T rates
 Bond Indentures:
-Sinking Funds-firms agree to establish a
sinking fund to spread the payment
burden over several years.
-Senior Debt gets priority
-For protection of bondholders over
shareholders
-Collateralized are considered safest
variety of corporate bonds.
 Credit Rating: Moody’s and S&P
-Top rating is AAA or Aaa
-Investment grade bond
- Junk bonds BB and below
 Speculative Grade or Junk Bond:
-Fallen Angels
 Riding the Yield Curve:
-Strategy to raise return when the yield
curve is positively sloped.
-Buy a security
-Hold that security until it can be sold at a
gain.
-Because current maturity and the yield
has fallen
-Banks are profitable when the yield curve
is positive
-Risk: ST rates might rise + yield curve
might invert.
-The steeper the yield curve's upward
slope at the outset, the lower the interest
rates when the position is liquidated at
the horizon, and the higher the return
from riding the curve.

 Flight to Quality: The market turmoil EMU

caused by the Asian financial crisis would
 Requirement to join EMU:
cause a flight to quality:
-The country’s inflation rate cannot be
-Investors buy US treasuries resulting in a
greater than 1.5% above the average rate
shift of the yield curve (in particular the 30
for the 3 EC countries with the lowest
y bond). This causes inversion in the long
inflation rates
end.
-US capital account would rise