Money, Finance,and the Crisis of 2008

1. Money, Finance,and the Crisis of 2008

2. 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

3. 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!

4. 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

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

6. 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

7. 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: • - Households • Firms • Governments Shadow banks Money market funds Investment banks Hedge funds Other

8. 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

9. 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.

10. 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, …)

11. Some important interest rates, 1990 - today

12. The evolution of risk The Lehman bankruptcy

13. 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)

14. Flow chart of rates (in class)

15. The key monetary-policy instrument: The federal funds rate* *Overnight rate on bank reserves at the fed. For example, BofA lends its reserves to Citibank.

16. Balance sheet of typical Yale student

17. Construct a Yale student balance sheet and pass it in.

18. 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)

19. Normal Financial Balance Sheets Bcb = bonds held by the central banks Cu = currency R = Reserves held with the central bank D = checkable deposits

20. 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. 20

21. Now let’s see how the Fed determines short rates

22. 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 → short-term nominal risk-free interest rate.

23. iff -Supply and demand diagram for federal funds on daily basis- Fed supplies funds through its open market operations (OMOs) SR DR Federal funds interest rate iff* DR SR R* Bank reserves

24. 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.

25. 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. 25

26. 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. 26

27. 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

28. … 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)

29. … 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.

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

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

32. Today’s zero interest and excess reserves

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

34. 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.

35. The federal funds rate hits the zero lower bound

36. Excess reserves

37. 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.