Transcript Final Examination

Econ 122: Fall 2010
Financial macroeconomics
and the Great Recession of 2007 – 2010
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1
The financial system in financial crisis
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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.”
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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, …)
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Evolution of Financing System
From autarchy, to barter, to simple banks, to
complex banks, to securitization, and to today’s
globalized system
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The essence of
saving and
investment
Households and
non-financial
institutions
$
Loans,
bonds, stocks
Businesses
(investment )
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Households and
non-financial
institutions
Deposits
But in a modern
economy, this takes
place through the
financial system
$
Financial
system
$
Loans,
bonds, stocks
Businesses
(investment )
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An even more realistic system (Gorton/Metrick)
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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.
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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.
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The key monetary-policy instrument
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Federal funds rate
16
Hits the zero
nominal bound on
interest rates.
12
8
4
0
1980
1985
1990
1995
2000
2005
2010
Shaded regions are NBER recessions
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The evolution of risk
The risk premium on investment grade bonds
[Baa bonds minus 10-year Treasury bonds]
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Percent per year
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The Lehman
bankruptcy
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4
The financial
problem was
first
recognized.
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2
1
90
92
94
96
98
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02
04
06
08
10
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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
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
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Actual Financial Balance Sheets (pre-crisis 2008:Q1)
Central Bank
Assets
Securities
Loans
from
banks
Other
Total
Commercial banks
Liabilities
631
151
150
932
Cu
770
Bank Reserves
Vault
Cash
Deposits
Other
Total
66.9
46
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Assets
Liabilities
Reserves
Checkable
deposits
66.9
568
Govt sec.
1111
Savings
accounts
Mortgages
3683
Other
4442
Other
6613
Equity
920
5544
95.1
932
Total
11,474
Total
11,474
Note: the current Fed balance sheet is extremely different and not
representative, so I have used an older balance sheet. Corrected from class.
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Econ 122: Fall 2010
Determination of interest rates:
Supply and demand for money and other assets
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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]
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Major Objectives of Central Banks
1.
2.
3.
4.
5.
Price stability (focus on core inflation in 1 to 2 % p.y. range)
Real activity (low unemployment, high real GDP growth)
Exchange rate (for fixed-exchange-rate countries)
Orderly financial markets in normal times
Maintain financial stability in times of great stress (1930s,
2007-2010 for US, many times for other countries).
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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.
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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>hD
In normal times (not now!),
(1’)
R = hD
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:
(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
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(5)
h M(i, Y) = NBR + BR(d)
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.
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iff
DR
SR
Supply and demand
diagram for federal
funds on daily basis
Federal funds
interest rate
iff*
DR
SR
R*
Bank reserves
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iff
DR
Supply and demand
diagram for federal with
interest rate target
Federal funds
interest rate
Federal funds rate target
iff*
DR
Bank reserves
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Federal funds rate
Federal funds rate = interest rate at which depository
institutions lend balances to each other overnight.
1955-date
2007-date
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6
Federal funds
interest rate
20
5
16
4
12
3
8
2
4
1
0
55
60
65
70
Federal funds
rate (% per year)
75
80
85
90
95
00
05
10
0
07M01
07M07
08M01
08M07
Policy has hit the “zero
lower bound” last year.
09M01
09M07
10M01
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Fed funds to short rates
10
Federal funds
3 month T bill
8
6
4
2
0
88
90
92
94
96
98
00
02
04
06
08
10
25
Fed funds to long rates
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Federal funds rate
3 month T bill
10 year T bond
Baa bond rate
10
8
6
4
2
0
88
90
92
94
96
98
00
02
04
06
08
10
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How does the Fed actually administer monetary policy?
1.
2.
FOMC meets 8 times per year to set a target for the
Federal Funds rate.
FF rate is the overnight rate for bank reserves.
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Federal Reserve Structure
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Federal Reserve Districts
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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.
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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
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Recent history of Fed Funds rate: 2007-2010
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Recent history of Fed Funds rate: 2008
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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
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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 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.)
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Recent term structure interest rates (Treasury)
4.5
Yield to maturity (% per year)
4
Expectations theory
says that short
rates are expected
to rise in coming
years.
3.5
3
2.5
2
1.5
9/18/2009
1
9/17/2008
0.5
0
0
5
10
15
20
25
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Note that this can
explain why Fed
makes statement
about future rates
(look back at Fed
statement.)
Term or maturity of bond
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Yield to maturity (% per year)
Older term structure interest rates (Treasury)
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9/18/2009
9/17/2008
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9/19/2006
May-81
In period of very
tight money (198182) short rates
were very high, and
people expected
them to fall.
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14
12
10
8
6
4
2
0
0
5
10
15
20
25
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Term or maturity of bond
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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+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.]
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But the major story to remember is the following:
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Federal funds rate
3 month T bill
10 year T bond
Baa bond rate
10
8
6
4
2
0
88
90
92
94
96
98
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02
04
06
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Mechanics of OMO: The Fed buys a security…
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
Liabilities
Reserves (bank
deposits)
100
Investments
1000
Checkable
deposits
Equity
1000
100
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… and this increases reserves …
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
+10
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
+10
Liabilities
Reserves (bank
deposits)
100
+10
Investments
Checkable
deposits
1000
-10
Equity
1000
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)
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… and normally this increases investments and M
Fed
Commercial banks and primary dealers
Assets
Bonds
Liabilities
1000
+10
Bank borrowings
0
Cu
Assets
900
Reserves (bank
deposits)
100
+10
Reserves (bank
deposits)
100
+10
Liabilities
Checkable
deposits
Investments
1000
+100 -10
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.
Equity
1000
+100
100
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