1 Money, Finance,and the Crisis of 2008

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 2

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! 3

Evolution of Financing System 4 -From autarchy, to barter, to simple banks, to complex banks, to securitization, and to today’s globalized system - Specialization in human history

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

6 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

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

8 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

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. 9

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, …) 10

Some important interest rates, today 11

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)

Flow chart of rates (in class) 14

The key monetary-policy instrument: The federal funds rate* 15 *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.

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) 18

19 Normal Financial Balance Sheets B cb = 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.

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

22 How the Fed influences financial markets 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.

23 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 - Fed supplies funds through its open market operations (OMOs)

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. 24 How the Fed influences financial markets (cont)

25 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.

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.

Mechanics of OMO: The Fed buys a security… 27 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 … 28 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 29 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)

30 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

31 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 32

33 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 34 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)

The federal funds rate hits the zero lower bound 35

Excess reserves 36

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.