Embed Size (px)
Citation preview
1
Econ 122: Fall 2010
Financial macroeconomics and the Great Recession of 2007 –
2010
1
2
The financial system in financial crisis
AnnouncementsFirst 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 – liabilitiesFinancial 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
0
4
8
12
16
20
1980 1985 1990 1995 2000 2005 2010
Federal funds rate
Shaded regions are NBER recessions
Hits the zero nominal bound on interest rates.
The evolution of risk
12
1
2
3
4
5
6
7
90 92 94 96 98 00 02 04 06 08 10
The risk premium on investment grade bonds
Per
cent
per
yea
r
[Baa bonds minus 10-year Treasury bonds]
The financial problem was first recognized.
The Lehman bankruptcy
13
Balance sheet of typical Yale student
Assets
Liabilities
14
Financial Balance Sheets
Balance Sheet of Central Bank
Assets
Bcb
Loans to banks
Liabilities
Cu R
Balance Sheet of Private Banks
Assets
R Loans Securities
Liabilities
D Savings accts Credit market stuff Equity
Bank regulation:1.required reserves on deposits: R > hD2. reserves = deposits with Fed + bank vault cash3. capital requirements (Basle I and II): capital > assets at riskNet result or 1 + 2: D = R/h
15
Central Bank Commercial banks
Assets Liabilities Assets Liabilities
Securities 631 Cu 770 Reserves 66.9Checkable deposits 568
Loans from banks 151 Bank Reserves 66.9 Govt sec. 1111
Savings accounts 5544
Mortgages 3683 Other 4442
Other 150Vault Cash 46 Other 6613 Equity 920Deposits 21
Other 95.1
Total 932 Total 932 Total 11,474 Total 11,474
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 209Thurs 4-4:50 is in WLH 203Thurs 5-5:50 is in WLH 002Thurs 7-7:50 is in WLH 112Thurs 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 times5. Maintain financial stability in times of great stress
(1930s, 2007-2010 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 M1= 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 DIn normal times (not now!), (1’) R = hDThe demand for checking deposits is determined by output and interest rate:(2) Dd = M(i, Y)This leads to the demand for reserves by banks:(3) Rd = 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) Rs = 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
DR
DRiff
Federal funds interest rate
SR
SR
iff*
R* Bank reserves
Supply and demand diagram for federal funds on daily basis
23
DR
DRiff
Federal funds interest rate
iff*
Bank reserves
Federal funds rate target
Supply and demand diagram for federal with interest rate
target
Federal funds rate
24
2007-date1955-date
Federal funds rate = interest rate at which depository institutions lend balances to each other overnight.
0
4
8
12
16
20
24
55 60 65 70 75 80 85 90 95 00 05 10
Federal funds interest rate
0
1
2
3
4
5
6
07M01 07M07 08M01 08M07 09M01 09M07 10M01
Federal fundsrate (% per year)
Policy has hit the “zero lower bound” last year.
Fed funds to short rates
25
0
2
4
6
8
10
88 90 92 94 96 98 00 02 04 06 08 10
Federal funds3 month T bill
Fed funds to long rates
26
0
2
4
6
8
10
12
88 90 92 94 96 98 00 02 04 06 08 10
Federal funds rate3 month T bill10 year T bondBaa bond rate
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: 2007-2010
32
Recent history of Fed Funds rate: 2008
33
General equilibrium of assets
Have multiple assets of interest rates or yieldsGeneral 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 structureMany 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 rt,T is rate from period t to T):
(*) (1+r0,2)2 = (1+r0,1) [1+E(r1,2)]
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.)
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 5 10 15 20 25 30
Yiel
d to
mat
urity
(%
per
yea
r)
Term or maturity of bond
9/18/2009 9/17/2008
Older term structure interest rates (Treasury)
37
0
2
4
6
8
10
12
14
16
18
20
0 5 10 15 20 25 30
Yiel
d to
mat
urit
y (%
per
yea
r)
Term or maturity of bond
9/18/2009 9/17/2008
9/19/2006 May-81
In period of very tight money (1981-82) short rates were very high, and people expected them to fall.
Example
Short rates:1 year T-bond = 0.41 % per year2 year T-bond = 1.03 % per year
Implicit expected future rate from 1 to 2 is: (1+r0,2)2 = (1+r0,1) [1+E(r1,2)]
(1+.0103)2 = (1+ .0041) [1+E(r1,2)]
This implies:E(r1,2) = 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
0
2
4
6
8
10
12
88 90 92 94 96 98 00 02 04 06 08 10
Federal funds rate3 month T bill10 year T bondBaa bond rate
Mechanics of OMO: The Fed buys a security…
40
Fed Commercial banks and primary dealers
Assets AssetsLiabilities 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
Fed Commercial banks and primary dealers
Assets AssetsLiabilities Liabilities
Bonds 1000 +10
Bank borrowings 0
Cu 900
Reserves (bank deposits) 100 +10
Investments 1000 -10
Checkable deposits 1000
Equity 100
1. 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) 100 +10
… and normally this increases investments and M
42
Fed Commercial banks and primary dealers
Assets AssetsLiabilities Liabilities
Bonds 1000 +10
Bank borrowings 0
Cu 900
Reserves (bank deposits) 100 +10
Investments 1000 +100 -10
Checkable deposits 1000 +100
Equity 100
1. 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) 100 +10
