Money, Finance,and the Crisis of 2008-2012

1. Money, Finance,and the Crisis of 2008-2012

2. Outline of money section • Essence of financial markets • Balance sheets • Introduction to the supply and demand for funds • Central banking and the Fed • The term structure of interest rates • The demand for money • Panics!

3. Evolution of Financing System • From autarchy, to barter, to simple banks, to complex banks, to securitization, and to today’s globalized system • Specialization in human history

4. The essence of saving and investment Households and non-financial institutions $ Loans, bonds, stocks Businesses (investment )

5. But in a modern economy, this takes place through the financial system Households and non-financial institutions $ Financial system Deposits $ Businesses (investment ) Loans, bonds, stocks

6. An even more realistic system Lenders: - Households - Rest of World (China) Securities and paper - Mortgages • - Conventional stuff • (stocks, bonds, • asset based ) - Commercial paper Banks Commercial Savings Other • Borrowers: • - Households • Firms • Governments Non-banks Money market funds Mutual funds Pension funds Other

7. An even more realistic system Lenders: - Households - Rest of World (China) And you have the central bank and other regulatory agencies looking over the entire system Securities and paper - Mortgages • - Conventional stuff • (stocks, bonds, • asset based ) - Commercial paper Banks Commercial Savings Other • Borrowers: • - Households • Firms • Governments Non-banks Money market funds Mutual funds Pension funds Other

8. The Essence of Finance • At its very basics, the financial system: • Consists of financial intermediaries between borrowers and lenders • Moves claims around the world over people, time, space, and uncertain states of nature. • Turns illiquid assets into liquid assets… • but the mismatch of assets and liabilities causes the fundamental instability of the financial system.

9. How the Fed influences financial markets • Begin with short-run interest rate (federal funds rate) • Supply of money and reserves determined by central bank (Fed, ECB, …) • Demand for transactions money (M1) from medium of exchange; • Equilibrium of supply and demand for money/reserves → short-term nominal risk-free interest rate. • Then to other assets and rates: • Short risk-free rate + expectations → long risk-free rates • Risky rates = risk-free rate + risk premiums • Real rate = nominal rate – inflation (Fisher effect)

10. How the Fed influences financial markets (cont) • Central thing to understand is how the Fed (and other central banks) determines short run, nominal interest rates. • They do this by determining the level of bank reserves; then short rates are determined by supply and demand in the bank-reserve market. • We emphasize policy in normal times. Today is not a normal times because in liquidity trap and Fed balance sheet greatly expanded.

11. iff Supply and demand diagram for federal funds on daily basis SR DR Federal funds interest rate iff* DR SR R* Bank reserves

12. Balance sheet of typical Yale student

13. Financial Balance Sheets

14. Actual Financial Balance Sheets (pre-crisis 2008:Q1) Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet. 14

15. Actual Financial Balance Sheets (pre-crisis 2008:Q1) Banks are required to hold reserves against transactions balances. Reserves are cash plus deposits at the Fed. Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet. 15

16. Mechanics of OMO: The Fed buys a security… Fed Commercial banks and primary dealers Assets Liabilities Assets Liabilities Bonds 1000 Cu 900 Checkable deposits 1000 Reserves (bank deposits) 100 Reserves (bank deposits) 100 Bank borrowings 0 Equity 100 Investments 1000

17. … and this increases reserves … Fed Commercial banks and primary dealers Assets Liabilities Assets Liabilities Bonds 1000 +10 Cu 900 Checkable deposits 1000 Reserves (bank deposits) 100 +10 Reserves (bank deposits) 100 +10 Bank borrowings 0 Equity 100 Investments 1000 -10 Fed buys bond. Dealer deposits funds in bank. This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red)

18. … and normally this increases investments and M Fed Commercial banks and primary dealers Assets Liabilities Assets Liabilities Bonds 1000 +10 Cu 900 Checkable deposits 1000 +100 Reserves (bank deposits) 100 +10 Reserves (bank deposits) 100 +10 Bank borrowings 0 Equity 100 Investments 1000 +100 -10 Fed buys bond. Dealer deposits funds in bank. This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red) In normal times, the bank lends out the excess, and this leads to money creation (blue). Today, this just increases reserves.

19. iff Increase in reserves lowers federal funds interest rate SR DR S’R Federal funds interest rate iff* iff** DR SR R* Bank reserves

20. Theory of Central Bank Interest Rate Determination • Definition of transactions money is M1= Cu + D. Assume currency is exogenous. Then analysis the supply and demand for bank reserves, which yields the equilibrium “federal funds rate.” Bold = Fed instruments. • Demand for R: • Bank regulation: reserve requirement on checking deposits (D). • (1) R >h D • (1’) R = hD In normal times (not now!) • The demand for checking deposits is determined by output and interest rate: • Dd = M(i, Y) • This leads to the demand for reserves by banks in normal times: • Rd = h M(i, Y) • Supply of R: • Fed supplies non-borrowed reserves (NBR) by open-market operations (OMO). Additionally, banks can borrow at discount rate d. This leads to supply of reserves function: • Rs = NBR + BR(d) • Which yields equilibrium of the market for reserves • (5) h M(i, Y) = NBR + BR(d)

21. So this shows the way the Fed determines i:h M(i, Y) = NBR + BR(d) • Note the three instruments of (normal) Fed policy, h, NBR, and d. • Essence of modern central banking: • Banks required to hold reserves against demand deposits • Fed intervenes through open market operations to set NBR • The interaction of supply and demand determines short interest rates. • This affects the entire term structure of interest rates; other asset prices; and the economy. • However, in times of stress (financial crises), the central bank can use non-conventional tools – this is the central issue of US monetary policy today.

22. iff Supply and demand diagram for federal funds on daily basis SR DR Federal funds interest rate iff* DR SR R* Bank reserves

23. iff Supply and demand diagram for federal with interest rate target DR Federal funds interest rate Federal funds rate target iff* DR Bank reserves

24. Today’s zero interest and excess reserves

25. iff SR DR S’R Federal funds interest rate iff* iff** DR SR R* Bank reserves

26. When Fed buys reserves today, it just increases excess reserves Fed Commercial banks and primary dealers Assets Liabilities Assets Liabilities Bonds 1000 +10 Cu 900 Checkable deposits 1000 Reserves (bank deposits) 100 +10 Reserves (bank deposits) 100 +10 Bank borrowings 0 Equity 100 Investments 1000 -10 Fed buys assess backed mortgage (from bank for simplicity) Bank is glad to unload it, and just holds excess reserves. No impact on the money supply or on federal funds rate. A (very small) impact on mortgage interest rates.

27. Recent history of Fed Funds rate: 2007-2011

28. Actual and required reserves

29. Federal funds rate Federal funds rate = interest rate at which depository institutions lend balances to each other overnight. 1955-date 2007-date Policy has hit the “zero lower bound” last year.

30. The key monetary-policy instrument: The federal funds rate* Hits the zero nominal bound on interest rates. *Overnight rate on bank reserves at the fed. I.e., BofA lends its reserves to Citibank.