1 Money, Finance,and the Crisis of

Outline of money section 1.Essence of financial markets 2.Balance sheets 3.Introduction to the supply and demand for funds 4.Central banking and the Fed 5.The term structure of interest rates 6.The demand for money 7.Panics! 2

Evolution of Financing System 3 -From autarchy, to barter, to simple banks, to complex banks, to securitization, and to today’s globalized system - Specialization in human history

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

5 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

6 Banks Commercial Savings Other Borrowers: - Households - Firms - Governments Lenders: - Households - Rest of World (China) Non-banks Money market funds Mutual funds Pension funds Other Securities and paper - Mortgages - Conventional stuff (stocks, bonds, asset based ) - Commercial paper An even more realistic system

7 Banks Commercial Savings Other Borrowers: - Households - Firms - Governments Lenders: - Households - Rest of World (China) Non-banks Money market funds Mutual funds Pension funds Other Securities and paper - Mortgages - Conventional stuff (stocks, bonds, asset based ) - Commercial paper An even more realistic system And you have the central bank and other regulatory agencies looking over the entire system

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

9 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 (M 1 ) from medium of exchange; Equilibrium of supply and demand for money/reserves → short- term 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)

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 How the Fed influences financial markets (cont)

11 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

12 Balance sheet of typical Yale student

13 Financial Balance Sheets

14 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.

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. Banks are required to hold reserves against transactions balances. Reserves are cash plus deposits at the Fed.

Mechanics of OMO: The Fed buys a security… 16 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 … 17 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 18 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)

19 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves Increase in reserves lowers federal funds interest rate i ff ** S’ R

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 (1’) R = h D In normal times (not now!) 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 in normal times: (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 of reserves 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 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.

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

Today’s zero interest and excess reserves 24

25 DRDR DRDR i ff Federal funds interest rate SRSR SRSR i ff * R* Bank reserves i ff ** S’ R

When Fed buys reserves today, it just increases excess reserves 26 FedCommercial banks and primary dealers Assets Liabilities Bonds Bank borrowings 0 Cu 900 Reserves (bank deposits) Investments Checkable deposits 1000 Equity 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. Reserves (bank deposits)

Recent history of Fed Funds rate:

Actual and required reserves 28

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.

The key monetary-policy instrument: The federal funds rate* 30 Hits the zero nominal bound on interest rates. *Overnight rate on bank reserves at the fed. I.e., BofA lends its reserves to Citibank.