Financial System Liquidity,
Asset Prices and Monetary Policy
Hyun Song Shin
2005 Reserve Bank of Australia conference
July 11-12, 2005
Background
• Monetary policy works through financial
markets
• Seen through lens of IS curve
– Central bank controls directly only overnight
rate
– But can influence long rates through
expectations of future path for short rates
– Affects consumption, investment...
Tinbergen-style Separation
• Price/output stabilisation
– Monetary policy
• Financial stability
– Prudential/supervisory policies
Tinbergen-style Separation
• Price/output stabilisation
– Monetary policy
• Financial stability
– Prudential/supervisory policies
Tinbergen-style Separation
• Price/output stabilisation
– Monetary policy
• Price/output stabilisation
– Prudential/supervisory policies
Unwinding Financial Excess
• Output costs of financial crises
• Fiscal costs of financial sector
restructuring
• Asymmetry of mechanisms
– “on the way up”
– “on the way down”
Asset prices
Debt
Monetary Policy
Balance sheet
strength
Spreads
Pricing claims in a system setting
• Some assets (e.g. loans) are claims on
other parties
• Value of my claim against A depends on
value of A’s claims against B, C,...
• But B or C may have claim against me
Price of Debt/Claim
price of debt
xi
face value
xi
xi  fi  xi , ai  x, v  
xi
assets
ai
System
x1  f1  x1 , a1  x, v  
x2  f 2  x2 , a2  x, v  
xn  f n  xn , an  x, v  
Or, more simply
x  F  x; x , v 
Pricing claims
• Tarski’s fixed point theorem: increasing
function on complete lattice has largest
and smallest fixed point.
• 0  dfi / dai  1 ensures uniqueness
Indebtedness and Spreads
x
x
v
• Suppose
x affects v
– Spread can fall as debt rises
– De-leveraging can lead to rise in spreads
Feedback
x
x
v
• Balance sheet strength determines
lending capacity
Feedback
Stronger
balance sheets
x
x
Increased
debt
Simplified Financial System
Young Households
Old Households
Banks
Young Households’ Balance Sheet
Assets
Liabilities
Net worth
Property
Mortgage
Banks’ Balance Sheet
Assets
Liabilities
Net Worth
Mortgage
Deposits
Old Households’ Balance Sheet
Assets
Liabilities
Deposits
Property
Equity
Net worth
Duration of Assets and Liabilities
Value
Mortgage
Value
Deposit
Value
tight monetary
policy
loose monetary
policy
Treasury
Prices
Property Price
Property
Price
Supply
of property
from old
v
v
property stock
held by young
Property Price as Function of
Mortgage Price
Property price, v
v  p
Mortgage price
p
Bank lending
Banks’
net worth
Mortgage Price as
Function of Property Price
p(v)
v
Define h(.) as inverse of v(p)
p
h(v)
p(v)
v
Step Adjustment:
Fall in Treasury Yields
p
h(v)
p(v)
p(v)
v
Another Scenario...
Households
Fannie Mae
Pension Funds
Households
Assets
Liabilities
Property
Net Worth
Other assets
Mortgage
Fannie Mae
Assets
Liabilities
Net Worth
Mortgage
Bonds
Other Assets
Pension Funds
Assets
Liabilities
Bonds
Net Worth
Cash
Pension
Liabilities
Bonds
• Bonds issued by Fannie Mae are
perpetuities
• Price p, yield r
• Duration is
dp / dr

p
p
Pension Liabilities
1  2  3 
duration
Duration of bond
Duration of pension liability
Price of bond
Pension Funds
• Pension funds mark their liabilities to
market
• Pension funds match duration of liabilities
with assets of similar duration
Pension funds’ demand for
bonds
Price of bonds
duration
of bonds
demand
for bonds
duration of
pension liabilities
Weight of Money into Property
• Fannie Mae accommodates increased
demand for bonds by new issues of bonds
• Cash proceeds lent out to households
• Money flows into property sector
• Property price rises...
Property Price as
Function of Bond Price
p increase
bond issue
v increase
v(p)
p
Credit Quality
• Credit quality of bonds depends on
household net worth
v increase
+ net worth
p increase
Bond Price as
Function of Property Price
p(v)
v
Define h(.) as inverse of v(p)
p
h(v)
p(v)
v
Step Adjustment:
Fall in Treasury Yields
p
h(v)
p(v)
p(v)
v
Nature of Property Wealth
Property
Price
Supply
of property
from old
v
v
property stock
held by young
Nature of Property Wealth
• Is housing net wealth?
• Suppose: increased debt
in spreads
reduction
• How is this possible without increase in
net wealth?
• Culprit is marking to market
Reversal
• New mechanisms “on the way down”
• Asymmetric nature of debt
– Easy to build up
– Not so easy to extinguish
– Importance of bankruptcy regime (Cf. Hong
Kong)
Scenario
• Suppose defaulting borrowers can return
the keys and walk away...
– Banks hold property directly
– Banks mark property to market
Bank Balance Sheet
Assets
Liabilities
Property
Deposits
Other
assets
Net Worth
Capital Adequacy Ratio
pei  Di
*
r
p  ei  si 
top: net worth
bottom: marked-to-market assets, after
s sale of property
Sales function s(p)
• When capital adequacy constraint binds,
bank i sells property
  1  r *  pei  Di 
si  p   min ei ,

*
r p


s  p    i si  p 
s
New equilibrium
s(v)
d(v)
v
What has changed?
Short term
incentives
Stronger
balance sheets
x
Marking
to market
x
Increased
debt
Changing Nature of Monetary Policy
• Monetary policy works by manipulating
asset prices
• Repercussions for wider financial system
• Is the “IS” view of monetary policy
sufficient?
– Financial stability is also about output/price
stabilisation
– Costs of getting it wrong are large