Money, Finance,and the
Crisis of 2008-2012
1
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!
2
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
3
The essence of
saving and
investment
Households and
non-financial
institutions
$
Loans,
bonds, stocks
Businesses
(investment )
4
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 )
5
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:
Non-banks
Money market funds
Mutual funds
Pension funds
Other
- Households
- Firms
- Governments
6
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
7
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.
8
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 → shortterm 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)
9
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.
10
iff
DR
SR
Supply and demand
diagram for federal
funds on daily basis
Federal funds
interest rate
iff*
DR
SR
R*
Bank reserves
11
Balance sheet of typical Yale student
Assets
Liabilities
12
Financial Balance Sheets
Balance Sheet of Central Bank
Assets
Bcb
Loans to banks
Liabilities
Cu
R
Balance Sheet of Private Banks
Assets
R
Loans
Securities
Liabilities
D
Savings accts
Credit market stuff
Equity
13
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.
14
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.
15
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
16
… 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)
17
… 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
18
iff
DR
SR
S’R
Increase in
reserves lowers
federal funds
interest rate
Federal funds
interest rate
iff*
iff**
DR
SR
R*
Bank reserves
19
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:
(2)
Dd = M(i, Y)
This leads to the demand for reserves by banks in normal times:
(3) 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:
(4)
Rs = NBR + BR(d)
Which yields equilibrium of the market for reserves
20
(5)
h M(i, Y) = NBR + BR(d)
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.
21
iff
DR
SR
Supply and demand
diagram for federal
funds on daily basis
Federal funds
interest rate
iff*
DR
SR
R*
Bank reserves
22
iff
DR
Supply and demand
diagram for federal with
interest rate target
Federal funds
interest rate
Federal funds rate target
iff*
DR
Bank reserves
23
Today’s zero interest and excess reserves
24
iff
DR
SR
S’R
Federal funds
interest rate
iff*
iff**
DR
SR
R*
Bank reserves
25
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.
26
Recent history of Fed Funds rate: 2007-2011
27
Actual and required reserves
1,400
1,200
Reserves
Required reserves
1,000
800
600
400
200
0
90
92
94
96
98
00
02
04
06
08
10
28
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
29
The key monetary-policy instrument:
The federalFYFF
funds rate*
20
Interest rate (% per year)
16
Hits the zero
nominal bound on
interest rates.
12
8
4
0
1980
1985
1990
1995
2000
2005
2010
Shaded areas are NBER recessions
*Overnight rate on bank reserves at the fed. I.e., BofA lends its
reserves to Citibank.
30