Money, Finance,and the Crisis of 2008 1 Course logistics Problem sets: • • • • Pset 1 due at start of class Wednesday It is “ungraded,” meaning we only check that you did it Rules on working together: See course web site Utility of problem sets for exams and macro Sections and office hours • TF open office hours in Tobin Common Room 28 HH • Sections this week: If unassigned, go to any one • I will have office hours generally Thurs and Fri. Sign up on classes.v2 2 Outline of money section 1. 2. 3. 4. 5. 6. 7. 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 Households and non-financial institutions Deposits But in a modern economy, this takes place through the financial system $ Financial system $ Loans, bonds, stocks Businesses (investment ) 6 An even more realistic system Lenders: - Households - Rest of World (China) Securities and paper - Mortgages - Conventional stuff (stocks, bonds, asset based ) - Commercial paper - Repos Banks Commercial Savings Other Borrowers: Shadow banks Money market funds Investment banks Hedge funds Other - Households - Firms - Governments 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 Securities and paper - Mortgages system - Conventional stuff (stocks, bonds, asset based ) - Commercial paper Banks Commercial Savings Other Borrowers: Non-banks Money market funds Mutual funds Pension funds Other - Households - Firms - Governments 8 What is the Essence of Finance? - 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 Different interest rates Fixed income (bond like) - Money (means of exchange , zero interest rate) - Short v. long (overnight, 3 month, 10 year, …) - Risk-free v. risky (Treasuries v. Baa) - Many other (asset based, mortgages, repos, …) Equities (stock like) - Residual claimant on incomes (Apple, BP,…) Tangible capital - Ownership of durable assets (my house, Toyota plant, …) 10 Some important interest rates, 1990 - today 12 Federal funds 3 month T bill 10 year T bond BAA (risky) bond 10 8 6 4 2 0 1990 1995 2000 2005 2010 11 The evolution of risk 7 The Lehman bankruptcy 6 5 4 3 2 1 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Risk spread = Baa minus Treasury rate 12 Overview of Interest Rates Begin with Fed actions: 1. Fed determines short-term nominal risk-free dollar interest rate Then to other assets and rates: 2. Short rates + expectations → long risk-free rate (term structure theory) 3. Risky rates = risk-free rate + risk premiums 4. Real rates = nominal rates – inflation (Fisher effect) 13 Flow chart of rates (in class) 14 The key monetary-policy instrument: The federalFYFF funds rate* 20 Interest rate (% per year) 16 12 8 4 0 1980 1985 1990 1995 2000 2005 2010 Shaded areas are NBER recessions *Overnight rate on bank reserves at the fed. For example, BofA lends its reserves to Citibank. 15 Balance sheet of typical Yale student Assets Liabilities 16 Construct a Yale student balance sheet and pass it in. 17 Nordhaus comments on Student balance sheets Comments: - Generally well done. - Some net worth math lost the sign: • 30 assets, 50 liabilities, implies -20 net worth. - Generally do not include future income or payments on balance sheets (Enron did before going bankrupt) - Make sure you know the difference between income and wealth (flow and stock). No income on balance sheet! - Should subtract depreciation from value of capital assets (purchase price = 1000 less depreciation 800 gives 200) 18 Normal Financial Balance Sheets Balance Sheet of Central Bank Assets Bcb Loans to banks Balance Sheet of Private Banks Liabilities Cu R Assets R Loans Securities Liabilities D Savings accts Credit market stuff Equity Bcb = bonds held by the central banks Cu = currency R = Reserves held with the central bank D = checkable deposits 19 Actual Financial Balance Sheets (pre-crisis 2008:Q1) Central Bank Assets Securities Loans from banks Other Total Commercial banks Liabilities 631 151 150 932 Cu 770 Bank Reserves Vault Cash Deposits Other Total 66.9 46 21 Assets Liabilities Reserves Checkable deposits 66.9 568 Govt sec. 1111 Savings accounts Mortgages 3683 Other 4442 Other 6613 Equity 920 5544 95.1 932 Total 11,474 Total Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet. 11,474 20 Now let’s see how the Fed determines short rates 21 How the Fed influences financial markets • 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 → shortterm nominal risk-free interest rate. 22 iff DR SR -Supply and demand diagram for federal funds on daily basis Federal funds interest rate - Fed supplies funds through its open market operations (OMOs) iff* DR SR R* Bank reserves 23 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. 24 Actual Financial Balance Sheets (pre-crisis 2008:Q1) Central Bank Assets Securities Loans from banks Other Commercial banks Liabilities 631 151 150 Cu 770 Bank Reserves Vault Cash Deposits Other 66.9 46 21 Assets Liabilities Reserves Checkable deposits 66.9 Govt sec. 1111 Savings accounts Mortgages 3683 Other 4442 Other 6613 Equity 920 Banks are required to hold reserves against 95.1 transactions balances. Total 932 Total 932 568 Total 11,474 Total 5544 11,474 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. 25 Actual Financial Balance Sheets (pre-crisis 2008:Q1) Central Bank Assets Securities Loans from banks Other Total Commercial banks Liabilities 631 151 150 932 Cu 770 Bank Reserves Vault Cash Deposits Other Total 66.9 46 21 Assets Liabilities Reserves Checkable deposits 66.9 568 Govt sec. 1111 Savings accounts Mortgages 3683 Other 4442 Other 6613 Equity 920 5544 95.1 932 Total 11,474 Total 11,474 Note: the current Fed balance sheet is extremely different and not representative, so I have used an older balance sheet. 26 Mechanics of OMO: The Fed buys a security… Fed Commercial banks and primary dealers Assets Bonds Liabilities 1000 Bank borrowings 0 Cu Assets 900 Reserves (bank deposits) 100 Liabilities Reserves (bank deposits) 100 Investments 1000 Checkable deposits Equity 1000 100 27 … and this increases reserves … Fed Commercial banks and primary dealers Assets Bonds Liabilities 1000 +10 Bank borrowings 0 Cu Assets 900 Reserves (bank deposits) 100 +10 Liabilities Reserves (bank deposits) 100 +10 Investments Checkable deposits 1000 -10 Equity 1000 100 1. Fed buys bond. 2. Dealer deposits funds in bank. 3. This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red) 28 … and normally this increases investments and M Fed Commercial banks and primary dealers Assets Bonds Liabilities 1000 +10 Bank borrowings 0 Cu Assets 900 Reserves (bank deposits) 100 +10 Reserves (bank deposits) 100 +10 Liabilities Checkable deposits Investments 1000 +100 -10 1. Fed buys bond. 2. Dealer deposits funds in bank. 3. This creates a credit in the account of the bank at the Fed and voilà! the Fed has created reserves. (red) 4. In normal times, the bank lends out the excess, and this leads to money creation (blue). Today, this just increases reserves. Equity 1000 +100 100 29 iff DR SR S’R Increase in reserves lowers federal funds interest rate Federal funds interest rate iff* iff** DR SR R* Bank reserves 30 iff DR Supply and demand diagram for federal with interest rate target Federal funds interest rate Federal funds rate target iff* DR Bank reserves 31 Today’s zero interest and excess reserves 32 iff DR SR S’R Federal funds interest rate iff* iff** DR SR R* Bank reserves 33 When Fed buys reserves today, it just increases excess reserves Fed Commercial banks and primary dealers Assets Bonds Liabilities 1000 +10 Bank borrowings 0 Cu Assets 900 Reserves (bank deposits) 100 +10 Liabilities Reserves (bank deposits) 100 +10 Investments 1000 -10 Checkable deposits Equity 1000 100 1. Fed buys assess backed mortgage (from bank for simplicity) 2. Bank is glad to unload it, and just holds excess reserves. 3. No impact on the money supply or on federal funds rate. A (very small) impact on mortgage interest rates. 34 The federal funds rate hits the zero lower bound 35 Excess reserves 36 Federal funds rate Federal funds rate = interest rate at which depository institutions lend balances to each other overnight. 1955-date 2007-date 24 6 Federal funds interest rate 20 5 16 4 12 3 8 2 4 1 0 55 60 65 70 Federal funds rate (% per year) 75 80 85 90 95 00 05 10 0 07M01 07M07 08M01 08M07 Policy has hit the “zero lower bound” last year. 09M01 09M07 10M01 37