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