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Money, Finance,and the Crisis of 2008-2012

Outline of money section1. Essence of financial markets2. Balance sheets3. Introduction to the supply and demand for funds4. Central banking and the Fed5. The term structure of interest rates6. The demand for money7. Panics!

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Evolution of Financing System

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

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Households and non-financial institutions

Businesses (investment )

Loans,bonds, stocks

$

The essence of saving and investment

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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

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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

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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.

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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 (M1) 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.

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How the Fed influences financial markets (cont)

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

Supply and demand diagram for federal funds on daily basis

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Balance sheet of typical Yale student

Assets

Liabilities

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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

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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 95.1Total 932 Total 932 Total 11,474 Total 11,474

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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.

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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 95.1Total 932 Total 932 Total 11,474 Total 11,474

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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…

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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 …

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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

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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

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

Increase in reserves lowers federal funds interest rate

iff**

S’R

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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 D• (1’) R = hD In normal times (not now!)• The 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 in normal times:(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 of reserves function:

(4) Rs = NBR + BR(d)• Which yields equilibrium of the market for reserves• (5) h M(i, Y) = NBR + BR(d)

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• 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.

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

Supply and demand diagram for federal funds on daily basis

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DR

DRiff

Federal funds interest rate

iff*

Bank reserves

Federal funds rate target

Supply and demand diagram for federal with interest rate

target

Today’s zero interest and excess reserves

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DR

DRiff

Federal funds interest rate

SR

SR

iff*

R* Bank reserves

iff**

S’R

When Fed buys reserves today, it just increases excess reserves

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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 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) 100 +10

Recent history of Fed Funds rate: 2007-2011

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Actual and required reserves

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0

200

400

600

800

1,000

1,200

1,400

90 92 94 96 98 00 02 04 06 08 10

ReservesRequired reserves

Federal funds rate

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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.

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

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0

4

8

12

16

20

1980 1985 1990 1995 2000 2005 2010

FYFF

Shaded areas are NBER recessions

Inte

rest

rate

(% p

er y

ear) Hits the zero

nominal bound on interest rates.

*Overnight rate on bank reserves at the fed. I.e., BofA lends its reserves to Citibank.