Liquidity Preference

• Supply and Demand for Money– mirrors S&D for bonds

• Assume that people hold their wealth in money or bonds

• Bonds pay a better return than money.

• Money is more liquid than bonds.

Money S&D

• What’s the price of money?

• Who’s doing the demanding?– Anyone who wants to make a

transaction. (Buy something.)

• Slope of money demand?

• As interest rates rise– Bonds become more attractive– Liquidity (money) is more costly– Md falls– Md slopes down

Money Supply

• Controlled by the Fed– doesn’t respond to interest

rates.– Fed could shift S to change i

• Banks supply money when they make loans.

• Banks lend more higher interest rates so Ms slopes up.

• Fed controls Ms to a great degree - close to vertical.

Determinants of Money Demand

• Wealth (GDP)

• Prices

• expected inflation

How does a rise in prices affect interest rates?

Hyperinflation

Example of Fed operation

• If the Fed wants to lower interest rates, what does it do?

• Shifts Ms to the right.

How do they do it? Stay tuned.

Tax Cuts and Interest Rates

How does a tax cut affect interest rates?

We can analyze this with S&D of money or bonds.

Bond market analysis is ambiguous. Depends on relative strength of the shifts.

Quantity of Money

Quantity Theory of Money:

MV=PY

M – money supply

V – velocity

P – price level

Y – real output

Velocity

V=PY / M

V= nominal GDP / M

Velocity is the number of times and ‘typical’ dollar is used in a year.

Often assumed to be stable (constant).

Monetarism

• Milton Friedman

Assumes:

• Velocity is stable

• Changes in M have uncertain “real” effects.– “Long and variable lags”

Monetarist conclusions

• “Inflation is always and everywhere a monetary phenomenon.”

• Keep money supply growth constant.

Monetarism is not completely correct, but the connection between the money supply and prices is important.

Money Supply Growth

• Ms shifts out – lowers interest rates– “liquidity effect”

However,• prices and expected inflation also

rise– shifts money demand out– raises interest rates

• Timing – Liquidity effect operates the quickest.– Economists use “impulse response

functions” to describe changes over time

Review Problem

The Fed reduces the money supply.

• How does the liquidity effect affect equilibrium interest rates?

• If the output effect dominates the liquidity effect, show the change in interest rates using money S&D and an impulse response function.

Risk and Term Structure of Bond Yields

Risk Structure

Bonds with the same time to maturity can have different yields due to:

• Default risk – corporations are more likely to default on bonds than (most) countries

• Tax considerations – ex. Muni bonds are not taxed

• Liquidity

Default Risk

• Gov’t bonds have low default risk.

• Corporations tend to have higher default risk.

• Default risk of corporate bonds varies dramatically – “blue chip” ex. IBM– “junk” ex. Esocks.com

• Moody’s and S&P rate corporations on their reliability for investors.

Risk Premium

• RP - difference in yields between a corporate bond and a government bonds (riskless)

• Show by comparing S&D for each bond

• Higher default risk leads to higher risk premia.

Problem: Using bond S&D, show the effect of a bond losing its listing on an exchange on its risk premium.

Muni Bonds

• Municipal bonds are not taxed.– higher prices– lower yields

than corporate bonds.

• Muni bond puzzle: – Yields should be even lower than

they are. – The RP for muni bonds is

surprisingly large.

Term Structure

• Bond yields vary according to time to maturity.

• The “yield curve” describes this relationship.

• Predicting the yield curve is hard– Many factors involved

Example

What’s better?:– 1 year bond with a 5% yield– 2 year bond with a 6% yield

Depends upon your expectation about interest rates next year.

If you expect interest rates to fall in the future, then

you prefer the 2 year bond at the higher yield.

Question

The yield on a one year bond (today) is 10%. The expected yield on a one year bond a year from today is 8%.

What should the yield on a two year bond be (today)?

Expectations Hypothesis

Expected FV of a two year bond

=

Expected FV of two one year bonds

Why might this be true?

Example

it = 10% iet+1 = 8%

What should the yield for a 2 year bond be?

Invest $100,

after 1 year receive $110

after 2 years expect to receive $110(1.8) = 118.8

What yield on a 2 year bond would give the same amount?

100(1+i2)2 = 118.8

i2=8.995% which is very close to 9%, the average of 10% and 8%.

Expectations Theory of the term structure

Assume:

-Expectations Hypothesis

then

Yield on a two year bond

=

average of the yield this year and the expected yield next year

(for one year bonds)

Expectations theory

In,0 – yield on an n-year bond (today)

i0 – yield on a one year bond today

iet – expected yield on a one year bond at time t

The expectations theory assumes that an n-year bond is equivalent to a sequence of one year bonds.

Expectations Theory

The yield for an n-year bond should be the average of the present and expected future interest rates over the n-1 years.

in,0 = (1/n)(i0 + ie1 + ie2 + ……+ iet+n-1)

Expectations Theory

The yield on a one year bond is 10%.

The expected rate next year is 4 %

The expected rate the following year is 1%.

What should the yield on a 3 year bond be?

• Yield on a 2 year bond?• What does the yield curve look like?

Expectations Theory

If interest rates are expected to rise in the future, what should the yield curve to look like?

If the economy is expected to go into a recession, what should the shape of the yield curve be (probably)?

Questions

• If the current one year rate is 5% and the expected one year rate is 5% for the next 4 years, what does the yield curve look like?

• Is the expectations theory correct?

• What does it ignore?

• What’s a big concern when buying long term bonds?

Liquidity Premium

If interest rates are expected to remain unchanged in the future:

• Expectations theory:– yield curve is flat– demand for long term bonds is the

same as short term.

• However, long term bonds are riskier.

Q: How does this affect the yield on longer term bonds?

Q: How does this affect the yield curve?

Liquidity Premium

• The liquidity premium model adds a term to the expectations theory expression for long term bond yields.

• The liquidity (term) premium is higher for longer term bonds.

in,t = (1/n)(it + iet+1 + iet+2 + ……+ iet+n-1)

+ lpn

Liquidity Premium

in,t = (1/n)(it + iet+1 + iet+2 + ……+ iet+n-1)

+ lpn

Example: if it = 6%, iet+1 = 5%,

iet+2 = 6%, iet+3 = 7% and the liquidity premium is 0.5(n-1)%, draw the yield curve

Liquidity Premium

Q: What does a flat yield curve mean for expected interest rates? (Compared to expectations hypothesis?)

if i0 = 6%, ie1 = 5%, ie2 = 4%,

ie3 = 3% draw the yield curve under the expectations hypothesis (no liquidity premium).

Draw the yield curve if the liquidity premium is 0.5(n-1).

Liquidity Premium

Q: What does a flat yield curve mean for expected interest rates? (Compared to expectations hypothesis?)

Q: What does a downward sloping yield curve mean for the economy?

- interest rates expected to fall

- rates pro-cyclical

- possible recession

Yield Curve and Forecasting

• “Inverted” (downward sloping) thought to predict a recession

• “Spreads” – difference between yields on bonds with different maturity are used to report the state of the yield curve.

Practice Problem

When investors observed that Lehman brothers could no longer obtain short term loans, the price of their stock fell. Show the corresponding effect on the risk premium.

Economic Analysis of Financial Institutions

Banks & Financial institutions overcome

problems of:• Connecting Savers and

Borrowers.

• Face problems of asymmetric information– Banks don’t know who has a

good chance of paying them back.

– Banks don’t know whether a borrower will use the money wisely (or buy lottery tickets).

Banks & Financial institutions overcome

problems of:

• Transactions cost – lending has many legal and accounting costs

• Moral Hazard – borrowers have incentive to misuse the money

• Adverse Selection – firms / people most in need of loans tend to be the greatest default risk

Moral Hazard Remedies

• monitoring – audits / standard accounting principles (Enron)

• contract restrictions of the use of the money

• Collateral

• High Net Worth

• venture capital (specialized lender) – tech firms

Adverse Selection

Arises when banks lend to corporations (or consumers) or buy corporate bonds.

Remedies:

• Ratings

• Required disclosure of information

• Expertise – some banks employ industry analysts

Asymmetric Info

All remedies to asymmetric information problems have costs.

Financial intermediaries can deal with these better than individuals.

Returns to Scale for Banks

• Accounting & legal tasks

• Assessing risk, dealing with asymmetric information– Screening– Monitoring– Etc.

• Free riding on information

Why don’t rating agencies sell information on firms (or stocks)?

Moral Hazard with stocks and bonds

• Investors (principle) and managers (agents) of companies have different incentives.

• Investors want the manager to maximize firm profits, but the manager wants to maximize his/her own salary.

• Extreme example: manager turns profits into own salary and reports 0 profit.

• Options are one solution, but brings up other problems.

Banking is one of the most regulated industries. Why?

• Importance of information.– Accounting standards

necessary for good banking.– many customers don’t have

access or understanding of information

• Problems in banking impact most firms.

• Banking crises are self-reinforcing and spread to the entire economy.– Depression

Financial Crisis Example – Stock Market Crash

Why can this lead to a broader financial crisis?

1. Value of firms falls, 2. Firm net worth falls, less

collateral 3. Banks reduce lending to

corporations – MH and AS4. Firms contract, less profit5. Value of firms falls6. Etc.

Firm contraction continues….recession

Extreme Crisis

• Recession leads to reduced profits, firms can’t repay their debts and banks become insolvent.

• Debt deflation– recession leads to deflation – increases the value of firms’ debts.

Any increase in uncertainty can lead to a crisis. (Banks get scared)

High interest rates can also trigger financial crises – credit rationing.

Credit Rationing – another “remedy” to adverse selection

problems

• Bank don’t want to lend at extremely high interest rates

• People willing to borrow are probably high risk

• If borrowers are not successful, “When you ain’t got nothin’….”

• Who does lend at higher rates? How can they succeed?

Banking Industry

Features of U.S. Banking Industry

• many banks / many sizes

• Dual banking system

• Three major crises – Great Depression– S&L crisis in the 80s– Housing crisis 2008-9

• Trends: – continual financial innovation– consolidation– more fee generating services– integration of financial services

Some History

• City vs. Country battle – Gold vs. Silver– Wizard of OZ / Cross of Gold

• Fed was not established until 1913– rural states concerned about

econtrol by big city bankers.

– JP Morgan bailed out the U.S.

• McFadden Act (20s) – outlawed cross state banking – limited control of a single bank

More History

• Great Depression – bank failures– stock market crash, lost savings

• FDIC created

• Glass-Steagall Act separated commercial banking from– investment banking– securities brokers– insurance

Glass-Steagall was punishment of big banks.

Bank Consolidation

• Traditional banking in decline– Regulation Q (1970s)– Mutual Funds– Junk bonds

• Consolidation despite McFadden– Holding companies– ATMs

• Riegle-Neale, 1994 finished the job, interstate banking OK

• Pros: – less transactions cost – lower risk

• Cons: – small, local banks may not survive– new huge bank might engage in risky

behavior

Repeal of GS

• Gramm-Leach Bliley Act (1999) repeals Glass-Steagall– State Farm takes deposits– Banks can make investments– Holding companies can have

different financial firms.

• Investment banks (What?)

Financial Innovation

• Always happening - banks try to increase profits

• Old type: foreign bond funds• New type: derivatives / junk

bonds / CDO / SIV• All these fill a market void.

– derivatives allow farmers to hedge against low prices

– junk bonds allow financing for troubled companies

• Potential problems – investors don’t fully understand the

risks – regulators are a step behind (CDS)

Banking Regulation

• FDIC – deposit insurance up to $250,000

• Prevents runs– deals with failed (insolvent) banks

• insurance payoff (dissolution)• finds a new partner, purchase and

assumption method

• Creates incentives for banks to take on more risk– moral hazard– Less depositor vigilance

• More regulation is needed (!?)

Asymmetric information

• Insured banks tend to be riskier - MH

• AS - crooks become bankers

Sometimes FDIC does more:

“Too big to fail” creates similar incentives

MH and AS between regulators and bankers.

Regulations

• Capital requirements– min leverage ratio/max EM

• Disclosure regulations– Show balance sheets– standard accounting practices

• Consumer protection (CRA)– anti-discrimination– standardized contracts

Chartering

Banks chartered by the

• Comptroller of the Currency (Treasury) for national banks

• State agency

• helps w/ AS problem

• Banks also file periodic call reports

Examination

• National Banks– Comptroller

• State banks– Fed– state agency

• CAMELS ratings

• Basel accords– Uniform banking regulation– Asset quality

Dodd – Frank (2009)

• OTS eliminated

• Consumer Protection Agency

• Research & Macro oversight

• Insurance regulation

• Standardized– CDS– MBS etc.

• Many other provisions

Nothing about TBTF

S&L crisis of the 80s

Causes: • lower profits• higher risk• little oversight

Profit squeeze• Regulation Q – hard to attract

funds• Mutual funds• Interest rates rise

More causes

Risky assets

• Junk Bonds

• Derivatives (innovations)

• Real Estate

Oversight

• Depositors didn’t pay attention to risks– Higher deposit insurance– Brokered deposits

• Regulation– S&Ls deregulated (1980)– Regulators had little expertise

assessing risk of new assets

Bank and S&L failures

• Recession of early 80s

• High interest rates– affected liabilities more than

assets– Regulation Q phased out

• Overinvestment in real estate– commercial buildings– High risk typical of large

ventures

• Large number of insolvent banks and S&Ls

Role of Regulators

• Regulators (FSLIC) let S&Ls continue to operate– Effect on S&Ls?

• Huge Moral Hazard Problem – S&L engaged in extremely risky behavior (why not, they’re already dead)

“Zombie S&Ls”

Politics

• S&Ls contribute to politicians who pressure regulators (Keating 5)

• Politicians didn’t give regulators enough money

• Regulators didn’t want to admit mistake

Deal with it

1987 – Congress lends money to FSLIC, not nearly enough – more defaults

1989 – FIRREA,

• eliminates FSLIC

• creates OTS

• restricted S&L asset holdings

• created RTC to take over insolvent S&Ls and sell off assets – cost of $150 billion

Dealing with it

1989 – FDICIA• FDIC’s insurance fund was

running out of money• Congress lends them money• Mandate - FDIC must close

insolvent banks using the least costly method available – counters moral hazard problem

• Required regulators to assess capital/risk conditions of banks

• Provided for Treasury dept. lending to regulators in times of crisis.

S&L Debacle Summary

• Initial crisis due to – squeeze on profits – increase in real interest rates ’79-’80

• Crisis extended because of weakness of regulators– under-funded– tended to use assumption method, in

effect all deposits were guaranteed– politically influenced

• FDICIA helps prevent future crises– mandates dealing w/ insolvency– mandates using the cheapest method– give financial backup to regulators

Banking Crises

The rule not the exception

• Financial innovation is always occurring.

• Regulators struggle to keep up.

• Consequently– banks are regulated– regulators are regulated– enough regulation?

Monetary Policy Institutions

Federal Reserve

• check clearing• Economic research / data• Regulates Banks

– charters national banks and state banks that choose to join (about 1/3 of all banks)

– approves bank mergers

• Controls the Money Supply• Discount loans (original

purpose)

Structure of the Fed System

• Board of Governors (Washington D.C.)

– Chairman– appointed by president / confirmed by

Senate– Board Members have 14 year terms– Chairman has a 4 year term

• 12 Branch Banks • FOMC

– Makes decisions on monetary policy every 6 weeks

– 7 members of the board (including the chairman) and 5 branch presidents (always including NY)

Tools of Monetary Policy

• Reserve Requirement

• Discount Rate/lending

• OMO – decision of the FOMC– most important in practice – Chairman rules

Fed Independence

How?

• Congress/President can’t fire Board members or dictate policy

• Governors have 14 year terms and can be reappointed.

• Fed has its own source of funds and budget.

Fed Independence

Why?• Avoid continual print & spend

policy– excessive seignorage

• Gov’t revenue from inflation

– Fed can think long term– independence lowers inflation

• avoid the temptation to print money before an election

Fed Independence

Arguments against:

• too much power in too few hands

• undemocratic

• fiscal and monetary policy uncoordinated

Fed Balance Sheet

Assets:• Bonds• Discount Loans• Gold etc.• Foreign currencies

Liabilities:• Reserves deposits from banks• Legal tender (green stuff)

Very profitable business model.

Money Supply Process

Monetary Base or “High Powered Money” is

MB = C + R (liabilities of the Fed)

C – Currency in circulationR – Reserves

Changes in MB lead to large changes M=C+D

The Fed affects the MB through OMO and discount loans.