1 Econ 122: Fall 2010 Financial macroeconomics and the Great Recession of 2007 –

2 The financial system in financial crisis

Announcements First problem set out this week; due next Wednesday in class. - Please read rules on problem sets. Sections begin this week. Consult classes for your section and location. Rules on problem sets: “The rules on collaborative work are the following: Working together to talk about problem sets is encouraged. Study groups are extremely useful. But the answers must be your own. You are not allowed to copy answers or to allow others to copy your answers. Copying answers is not only a violation of fundamental rules of academic honesty. Just as important, it will fool the copier into thinking that the problem is understood.” 3

4 Some introductory concepts of financial macro Real v. financial variables financial claims are to $ flows; real claims are ownership of goods, capital, property, … The balance sheet: Net worth = assets – liabilities Financial system as intricate transportation system moving $ claims over space, time, and risk. Major interest rate concepts: - Federal funds rate: overnight rate on bank reserves: Fed instrument - Risk free: Short-run (T bill) Long-run (T bond) by term structure theory - Risky have premiums for default risk (Baa, …)

Evolution of Financing System 5 From autarchy, to barter, to simple banks, to complex banks, to securitization, and to today’s globalized system

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

7 Households and non-financial institutions Financial system Businesses (investment ) Loans, bonds, stocks Deposits $ $ But in a modern economy, this takes place through the financial system

An even more realistic system (Gorton/Metrick) 8

The Essence of Finance At its very basics, the financial system: -Consists of financial intermediaries -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

Role of Central Bank Central bank: - Has primary role in setting interest rates and supervising banks - Along with the fiscal authority, can help stem panics through its function as “lender of last resort.” - In periods of great distress, can use wide variety of instruments to enhance liquidity, bear risks, and engage in quasi-fiscal measures. We begin by analyzing how Fed determines the short-run interest rate, which is the most important government policy instrument of financial policy. 10

The key monetary-policy instrument 11 Hits the zero nominal bound on interest rates.

The evolution of risk 12 The financial problem was first recognized. The Lehman bankruptcy

13 Balance sheet of typical Yale student

14 Financial Balance Sheets Bank regulation: 1.required reserves on deposits: R > hD 2. reserves = deposits with Fed + bank vault cash 3. capital requirements (Basle I and II): capital > assets at risk Net result or 1 + 2: D = R/h

15 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. Corrected from class.

16 Econ 122: Fall 2010 Determination of interest rates: Supply and demand for money and other assets

Information items We will have special TF Friday presentations on finance, math, and financial reform later in course. Problem 1 will be posted today. Readings on money are chapter 19 not 18. Sections this week. If you are Wed pm, go to Thurs pm or other. Sections: Wed 4-4:50 is in WLH 112 Wed 5-5:50 is in WLH 209 Thurs 4-4:50 is in WLH 203 Thurs 5-5:50 is in WLH 002 Thurs 7-7:50 is in WLH 112 Thurs 8-8:50 is in WLH 007 Notes on readings [on the board] 17

Major Objectives of Central Banks 1.Price stability (focus on core inflation in 1 to 2 % p.y. range) 2.Real activity (low unemployment, high real GDP growth) 3.Exchange rate (for fixed-exchange-rate countries) 4.Orderly financial markets in normal times 5.Maintain financial stability in times of great stress (1930s, for US, many times for other countries). 18

The main theory you need to understand is how the Fed (and other central banks) actually determine 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. 19

20 Theory of Central Bank Interest Rate Determination Definition of transactions money is M 1 = 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 In normal times (not now!), (1’) R = h D The demand for checking deposits is determined by output and interest rate: (2) D d = M(i, Y) This leads to the demand for reserves by banks: (3) R d = 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 function: (4) R s = NBR + BR( d ) Which yields equilibrium of the market for reserves (5) h M(i, Y) = NBR + BR( d )

21 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 Banks can affect by borrowing, but this is usually unimportant The interaction of supply and demand determines short interest rates. This affects the entire term structure of interest rates. This changes prices and yields on all assets; generally largest effect on short interest rates; but spills over to long rates, stocks, real estate, exchange rates. However, in times of stress (financial crises), the central bank can use non-conventional tools – more on this later.

22 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves Supply and demand diagram for federal funds on daily basis

23 DRDR DRDR i ff Federal funds interest rate i ff * Bank reserves Federal funds rate target Supply and demand diagram for federal with interest rate target

Federal funds rate date1955-date Federal funds rate = interest rate at which depository institutions lend balances to each other overnight. Policy has hit the “zero lower bound” last year.

Fed funds to short rates 25

Fed funds to long rates 26

How does the Fed actually administer monetary policy? 1.FOMC meets 8 times per year to set a target for the Federal Funds rate. 2.FF rate is the overnight rate for bank reserves. 27

Federal Reserve Structure 28

29 Federal Reserve Districts

3. FOMC Minutes August 10, 2010 The information reviewed at the August 10 meeting indicated that the pace of the economic recovery slowed in recent months …. The economy was operating farther below its potential than they had thought and the pace of recovery had slowed in recent months… Many said they expected underlying inflation to stay below levels they judged most consistent with the dual mandate to promote maximum employment and price stability. Participants viewed the risk of deflation as quite small, but a number judged that the risk of further disinflation had increased somewhat despite the stability of longer-run inflation expectations. The Committee determined it would be appropriate to maintain the target range of 0 to 1/4 percent for the federal funds rate …. [It] Reiterated the expectation that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. [Additionally and unconventionally, the Fed will] maintain the total face value of domestic securities held in the System Open Market Account at approximately $2 trillion by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. Voting: 10 to 1 in favor. 30

Administration (cont.) 4. Actual mechanism: Open market operations are arranged by the Domestic Trading Desk at the Federal Reserve Bank of New York (“the Desk”) Every morning, staff decided if an OMO is needed to keep rate near target. Fed contacts the “primary dealers” (e.g., Goldman Sachs, BNP Paribas, Morgan Stanley, etc.) and asks them to make offers Fed generally makes temporary purchases (“repos” = purchase and forward sale, or the reverse) at 10:30 each day, but generally does not enter more than once per day. Because the Fed intervenes only daily, the FF rate can deviate from the target. 5. Then supply and demand for reserves take over 31

Recent history of Fed Funds rate:

Recent history of Fed Funds rate:

General equilibrium of assets Have multiple assets of interest rates or yields General theory: - short term nominal rates determined by Fed - long term safe rates determined by expected future short rates. - risky rates = safe rates + risk premium - real interest rate = nominal interest rate - inflation 34

Note on theory of the term structure Many businesses and households borrow risky long-term (mortgages, bonds, etc.). These differ from the federal funds rate in two respects: - term structure (discuss now) - risk premium (postpone) The elementary theory of the term structure is the “expectations theory.” It says that long rates are determined by expected future short rates. Two period example (where r t,T is rate from period t to T): (*) (1+r 0,2 ) 2 = (1+r 0,1 ) [1+E(r 1,2 )] With risk neutrality and other conditions, (*) determines term structure. (Finance people find many deviations, but good first approximation.) 35

Recent term structure interest rates (Treasury) 36 Expectations theory says that short rates are expected to rise in coming years. Note that this can explain why Fed makes statement about future rates (look back at Fed statement.)

Older term structure interest rates (Treasury) 37 In period of very tight money ( ) short rates were very high, and people expected them to fall.

Example Short rates: 1 year T-bond = 0.41 % per year 2 year T-bond =1.03 % per year Implicit expected future rate from 1 to 2 is: (1+r 0,2 ) 2 = (1+r 0,1 ) [1+E(r 1,2 )] ( ) 2 = ( ) [1+E(r 1,2 )] This implies: E(r 1,2 ) = 1.65 % per year [Again, finance specialists point to deviations from this simple theory.] 38

But the major story to remember is the following: 39

Mechanics of OMO: The Fed buys a security… 40 FedCommercial banks and primary dealers Assets Liabilities Bonds 1000 Bank borrowings 0 Cu 900 Reserves (bank deposits) 100 Investments 1000 Checkable deposits 1000 Equity 100 Reserves (bank deposits) 100

… and this increases reserves … 41 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits 1000 Equity 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) Reserves (bank deposits)

… and normally this increases investments and M 42 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits Equity 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. Reserves (bank deposits)