michael woodford

8102019 Michael Woodford

httpslidepdfcomreaderfullmichael-woodford 125



22 Journal of Economic Perspectives

Why a New Framework for Macroeconomic Analysis is Needed Why a New Framework for Macroeconomic Analysis is Needed

It may be useful rst to review why familiar macroeconomic models do notIt may be useful 1047297rst to review why familiar macroeconomic models do not

already incorporate the features needed to make sense of recent economic devel-already incorporate the features needed to make sense of recent economic devel-opments I shall argue that it is dif cult to understand why either the signi cantopments I shall argue that it is dif1047297cult to understand why either the signi1047297cant

decline in house prices since 2006 or the substantial losses sustained by nancialdecline in house prices since 2006 or the substantial losses sustained by 1047297nancial

rms should have so seriously affected aggregate employment and economic1047297rms should have so seriously affected aggregate employment and economic

activity except in the context of a model in which nancial intermediaries play aactivity except in the context of a model in which 1047297nancial intermediaries play a

crucial role and in which their ability to ful ll that function can at some times becrucial role and in which their ability to ful1047297ll that function can at some times be

signi cantly impairedsigni1047297cantly impaired

Housing Prices and Aggregate DemandHousing Prices and Aggregate Demand

While the severity of the recent nancial crisis has been extensively discussed While the severity of the recent 1047297nancial crisis has been extensively discussed

some have questioned whether it was really the primary cause of the Great Recessionsome have questioned whether it was really the primary cause of the Great Recession

For example Baker (2010) argues that a substantial reduction in aggregate demandFor example Baker (2010) argues that a substantial reduction in aggregate demand

can be explained as a wealth effect on consumer expenditure given the declinecan be explained as a wealth effect on consumer expenditure given the decline

in US householdsrsquo housing wealth by several trillion dollars In this analysis ldquothein US householdsrsquo housing wealth by several trillion dollars In this analysis ldquothe

problem is not rst and foremost a nancial crisisrdquo But as Buiter (2010) points outproblem is not 1047297rst and foremost a 1047297nancial crisisrdquo But as Buiter (2010) points out

there is no aggregate wealth effect of a decline in housing prices since the house-there is no aggregate wealth effect of a decline in housing prices since the house-

hold sector in aggregate is both the owner of the housing stock and the consumerhold sector in aggregate is both the owner of the housing stock and the consumer

of the services supplied by it A fall in house prices reduces the value of an assetof the services supplied by it A fall in house prices reduces the value of an asset

but also reduces the cost of buying the stream of housing services that people werebut also reduces the cost of buying the stream of housing services that people were

planning to purchase by exactly the same amountplanning to purchase by exactly the same amountIt is possible to have a nonzero effect on aggregate expenditure on other goodsIt is possible to have a nonzero effect on aggregate expenditure on other goods

(when other prices remain unchanged) even without nancial frictions owing to(when other prices remain unchanged) even without 1047297nancial frictions owing to

redistribution of wealth between households with a net ldquolongrdquo position in housingredistribution of wealth between households with a net ldquolongrdquo position in housing

and those with net ldquoshortrdquo positions if the average marginal propensities to consumeand those with net ldquoshortrdquo positions if the average marginal propensities to consume

out of wealth are different between the two types Nonetheless because the positiveout of wealth are different between the two types Nonetheless because the positive

and negative wealth effects will largely offset one another the effect on aggregateand negative wealth effects will largely offset one another the effect on aggregate

demand is likely to be fairly small relative to the size of the aggregate decrease indemand is likely to be fairly small relative to the size of the aggregate decrease in

housing wealthhousing wealth

Larger effects are instead possible if one recognizes that the losses resultingLarger effects are instead possible if one recognizes that the losses resulting

from the collapse of housing prices were disproportionately concentrated in certainfrom the collapse of housing prices were disproportionately concentrated in certainnancial institutions which play a role in the allocation of resources that cannot1047297nancial institutions which play a role in the allocation of resources that cannot

easily be replaced by those to whom wealth was redistributed A model of this kindeasily be replaced by those to whom wealth was redistributed A model of this kind

is sketched below For a quantitative analysis of the effects of the fall in US housingis sketched below For a quantitative analysis of the effects of the fall in US housing

prices that stresses such effects see Greenlaw Hatzius Kashyap and Shin (2008)prices that stresses such effects see Greenlaw Hatzius Kashyap and Shin (2008)

Banking and the Money SupplyBanking and the Money Supply

It is also dif cult to understand why large losses by nancial institutions onIt is also dif1047297cult to understand why large losses by 1047297nancial institutions on

housing-related bets should have such a signi cant effect on the real economyhousing-related bets should have such a signi1047297cant effect on the real economy

without a model that takes account of credit frictions According to the well-known without a model that takes account of credit frictions According to the well-known

monetarist view banking crises affect the economy because they reduce the totalmonetarist view banking crises affect the economy because they reduce the total

supply of money in the economy since the ldquomoney multiplierrdquomdashthe factor by whichsupply of money in the economy since the ldquomoney multiplierrdquomdashthe factor by which



Michael Woodford 23

the economyrsquos money supply exceeds the ldquomonetary baserdquo supplied by the centralthe economyrsquos money supply exceeds the ldquomonetary baserdquo supplied by the central

bankmdashfalls when funds are withdrawn from commercial banks in response tobankmdashfalls when funds are withdrawn from commercial banks in response to

concerns about their stability The lower money supply is then only consistent withconcerns about their stability The lower money supply is then only consistent with

money demand to the extent that money demand is also reduced through somemoney demand to the extent that money demand is also reduced through somecombination of lower economic activity and de1047298ation This is the classic account bycombination of lower economic activity and de1047298ation This is the classic account by

Friedman and Schwartz (1963) of how the widespread bank failures in the UnitedFriedman and Schwartz (1963) of how the widespread bank failures in the United

States deepened the Great DepressionStates deepened the Great Depression

However such a model at least as conventionally elaborated cannot explainHowever such a model at least as conventionally elaborated cannot explain

why the recent problems of the nancial sector should have caused a sharp reces- why the recent problems of the 1047297nancial sector should have caused a sharp reces-

sion for the FriedmanndashSchwartz story depends on the monetary base remainingsion for the FriedmanndashSchwartz story depends on the monetary base remaining

xed despite a collapse of the money multiplier But under contemporary insti-1047297xed despite a collapse of the money multiplier But under contemporary insti-

tutional arrangements the Fed automatically adjusts the supply of base money astutional arrangements the Fed automatically adjusts the supply of base money as

necessary to maintain its target for the federal funds interest rate thus any changenecessary to maintain its target for the federal funds interest rate thus any change

in the money multiplier due to a banking crisis should automatically be offset by ain the money multiplier due to a banking crisis should automatically be offset by a

corresponding increase in the monetary base neutralizing any effect on interestcorresponding increase in the monetary base neutralizing any effect on interest

rates in1047298ation or outputrates in1047298ation or output11

Moreover many of the institutions whose failure or near-failure appeared toMoreover many of the institutions whose failure or near-failure appeared to

do the most damage in the recent crisis such as Lehman Brothers did not issuedo the most damage in the recent crisis such as Lehman Brothers did not issue

liabilities that would count as part of Friedman and Schwartzrsquos measure of theliabilities that would count as part of Friedman and Schwartzrsquos measure of the

money supply Under a classic monetarist view the failure of such institutionsmoney supply Under a classic monetarist view the failure of such institutions

should pose no threat to the aggregate economy (Hence the proposals by someshould pose no threat to the aggregate economy (Hence the proposals by some

that nance can remain only lightly regulated as long as commercial banks arethat 1047297nance can remain only lightly regulated as long as commercial banks are

strictly excluded from the riskier activities) But the consequences of the failurestrictly excluded from the riskier activities) But the consequences of the failureof Lehman suggest otherwiseof Lehman suggest otherwise

Models of the Bank Lending ChannelModels of the Bank Lending Channel

Models that postulate an essential role for banks in nancing certain kinds ofModels that postulate an essential role for banks in 1047297nancing certain kinds of

expenditure are better able to explain how a nancial crisis could have such dire conse-expenditure are better able to explain how a 1047297nancial crisis could have such dire conse-

quences for the real economy as we have observed However the kinds of nancialquences for the real economy as we have observed However the kinds of 1047297nancial

constraints that were emphasized in many past models of this kind assumed speci cconstraints that were emphasized in many past models of this kind assumed speci1047297c

institutional forms and regulatory requirements that have become less relevant to theinstitutional forms and regulatory requirements that have become less relevant to the

US nancial system over timeUS 1047297nancial system over time

Consider for example traditional accounts of the ldquobank lending channelrdquo ofConsider for example traditional accounts of the ldquobank lending channelrdquo ofthe transmission of monetary policy This argument emphasized the indispensablethe transmission of monetary policy This argument emphasized the indispensable

role of commercial banks as sources of credit for certain kinds of borrowers inrole of commercial banks as sources of credit for certain kinds of borrowers in

particular those without direct access to capital markets Deposits were in turn heldparticular those without direct access to capital markets Deposits were in turn held

to be an indispensable source of funding for the lending of commercial banks andto be an indispensable source of funding for the lending of commercial banks and

these were subject to legal reserve requirements To the extent that reserve require-these were subject to legal reserve requirements To the extent that reserve require-

ments were typically a binding constraint a reduction in the supply of reserves byments were typically a binding constraint a reduction in the supply of reserves by

the Federal Reserve would require the volume of deposits to be reduced whichthe Federal Reserve would require the volume of deposits to be reduced which

1 For example in the model without credit frictions expounded in Figure 2 below a banking panicthat reduces the money multiplier will have no effect other than to increase the supply of base moneyrequired to implement the central bank reaction function represented by the schedule MP




would in turn require less lending by commercial banks Bernanke and Blinder would in turn require less lending by commercial banks Bernanke and Blinder

(1988) and Kashyap and Stein (1994) offer expositions of this view Smant (2002)(1988) and Kashyap and Stein (1994) offer expositions of this view Smant (2002)

provides a critical review of the literatureprovides a critical review of the literature

Clearly the importance of this channel for effects of monetary policy onClearly the importance of this channel for effects of monetary policy oneconomic activity depended on the validity of each of the links in the proposedeconomic activity depended on the validity of each of the links in the proposed

mechanism that reserve requirements were a binding constraint for many banksmechanism that reserve requirements were a binding constraint for many banks

that commercial banks lacked sources of funding other than deposits that anthat commercial banks lacked sources of funding other than deposits that an

important subset of borrowers lacked sources of credit other than commercialimportant subset of borrowers lacked sources of credit other than commercial

banks and that banks lacked opportunities to substitute between other assets andbanks and that banks lacked opportunities to substitute between other assets and

lending to bank-dependent borrowers Each of these assumptions was less obviouslylending to bank-dependent borrowers Each of these assumptions was less obviously

defensible after the nancial innovations and regulatory changes of the 1980s anddefensible after the 1047297nancial innovations and regulatory changes of the 1980s and

1990s Adrian and Shin (forthcoming a b) discuss the changing structure of the1990s Adrian and Shin (forthcoming a b) discuss the changing structure of the

US nancial system in more detailUS 1047297nancial system in more detail

Nonbank nancial intermediaries became increasingly important as sources ofNonbank 1047297nancial intermediaries became increasingly important as sources of

credit particularly as a result of the growing popularity of securitization Figure 1A credit particularly as a result of the growing popularity of securitization Figure 1A

shows the contributions of several categories of nancial institutions to total netshows the contributions of several categories of 1047297nancial institutions to total net

lending in the United States while commercial banks are clearly still importantlending in the United States while commercial banks are clearly still important

they are far from the only important source of credit More importantly both thethey are far from the only important source of credit More importantly both the

recent lending boom and the more recent nancial crisis had more to do withrecent lending boom and the more recent 1047297nancial crisis had more to do with

changes in nancial 1047298ows of several of the other types shown in the gure forchanges in 1047297nancial 1047298ows of several of the other types shown in the 1047297gure for

example lending by issuers of asset-backed securities surged in the period up untilexample lending by issuers of asset-backed securities surged in the period up until

the summer of 2007 and then crashed while lending by market-based mutual fundsthe summer of 2007 and then crashed while lending by market-based mutual funds

and other market-based nancial intermediariesand other market-based 1047297nancial intermediaries22

crashed after the fall of 2008crashed after the fall of 2008Nor are deposits the main source of funding for the nancial sector even inNor are deposits the main source of funding for the 1047297nancial sector even in

the case of commercial banks Figure 1B shows the net increase in nancial sectorthe case of commercial banks Figure 1B shows the net increase in 1047297nancial sector

liabilities each quarter from several sources Checkable deposits are only a smallliabilities each quarter from several sources Checkable deposits are only a small

part of the sectorrsquos nancing moreover deposits shrank during the years of thepart of the sectorrsquos 1047297nancing moreover deposits shrank during the years of the

lending boom but have risen again during the crisismdashso that neither the growth inlending boom but have risen again during the crisismdashso that neither the growth in

credit during the boom nor the contraction of credit in 2008ndash09 can be attributedcredit during the boom nor the contraction of credit in 2008ndash09 can be attributed

to variations in the availability of deposits as a source of nancing Even to theto variations in the availability of deposits as a source of 1047297nancing Even to the

extent that deposits do matter one may doubt the extent to which the availability ofextent that deposits do matter one may doubt the extent to which the availability of

such funding is constrained by reserve requirements as in recent years these havesuch funding is constrained by reserve requirements as in recent years these have

ceased to be a binding constraint for many banks (for example see Bennett andceased to be a binding constraint for many banks (for example see Bennett andPeristiani 2002)Peristiani 2002)

In response to skepticism about the relevance of the traditional bank lendingIn response to skepticism about the relevance of the traditional bank lending

channel Bernanke and Gertler (1995) have instead stressed the importance ofchannel Bernanke and Gertler (1995) have instead stressed the importance of

an alternative ldquobroad credit channelrdquo in which the balance sheets of ultimatean alternative ldquobroad credit channelrdquo in which the balance sheets of ultimate

borrowers constrain the amount that they are able to borrow models incorpo-borrowers constrain the amount that they are able to borrow models incorpo-

rating such effects include those of Kiyotaki and Moore (1997) and Bernankerating such effects include those of Kiyotaki and Moore (1997) and Bernanke

Gertler and Gilchrist (1999) However the recent crisis at least in its initial phaseGertler and Gilchrist (1999) However the recent crisis at least in its initial phase

2 This category includes mutual funds the government-sponsored enterprises (GSEs) GSE-backed mort-gage pools 1047297nance companies real-estate investment trusts broker-dealers and funding corporationsThe ldquomarket-based 1047297nancial intermediariesrdquo terminology derives from Adrian and Shin (forthcoming a)



Financial Intermediation and Macroeconomic Analysis 25

Figure 1

Financial Flows over the Most Recent Credit Cycle

Source Federal Reserve Board Flow of Funds Accounts

A Contributions to US Total Net Lending from Several Categories of FinancialInstitutions(quarterly in billions of dollars )

$

b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash15002 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

Commercial banking

Money market mutual funds

Asset-backed securities issuers

Other market-based 1047297nancial institutions

B Contributions from Several Sources of Funding to the Net Increase in theLiabilities of the US Financial Sector(quarterly in billions of dollars )

2 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

$ b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash1500

Checkable deposits

Money market mutual fund shares

Fed funds and repos

Commercial paper




resulted more from obstacles to credit supply resulting from developments in theresulted more from obstacles to credit supply resulting from developments in the

nancial sector itself than from a reduction in credit demand owing to the prob-1047297nancial sector itself than from a reduction in credit demand owing to the prob-

lems of ultimate borrowerslems of ultimate borrowers

Hence what is needed is a framework for macroeconomic analysis in whichHence what is needed is a framework for macroeconomic analysis in whichintermediation plays a crucial role and in which frictions that can impede anintermediation plays a crucial role and in which frictions that can impede an

ef cient supply of credit are allowed for a framework which also takes account ofef1047297cient supply of credit are allowed for a framework which also takes account of

the fact that the US nancial sector is now largely market-based Fortunately thethe fact that the US 1047297nancial sector is now largely market-based Fortunately the

development of a new generation of macroeconomic models with these featuresdevelopment of a new generation of macroeconomic models with these features

is now well underway Adrian and Shin (forthcoming b) and Gertler and Kiyotakiis now well underway Adrian and Shin (forthcoming b) and Gertler and Kiyotaki

(forthcoming) provide surveys of recent work in this area Here I sketch a basic(forthcoming) provide surveys of recent work in this area Here I sketch a basic

version of such a model show how it can be used to interpret the recent crisis version of such a model show how it can be used to interpret the recent crisis

and then discuss some implications of a model of this kind for monetary policy Aand then discuss some implications of a model of this kind for monetary policy A

complete monetary dynamic stochastic general equilibrium model based on thecomplete monetary dynamic stochastic general equilibrium model based on the

approach sketched here is developed in Cuacuterdia and Woodford (2009)approach sketched here is developed in Cuacuterdia and Woodford (2009)

Credit and Economic Activity A Market Based ApproachCredit and Economic Activity A Market-Based Approach

The theory sketched here is appropriate to a market-based nancial system inThe theory sketched here is appropriate to a market-based 1047297nancial system in

which the most important marginal suppliers of credit are no longer commercial which the most important marginal suppliers of credit are no longer commercial

banks and in which deposits subject to reserve requirements are no longer the mostbanks and in which deposits subject to reserve requirements are no longer the most

important marginal source of funding even for commercial banksimportant marginal source of funding even for commercial banks

Macroeconomics with a Single Interest RateMacroeconomics with a Single Interest Rate

It is useful to begin by recalling how interest-rate policy affects aggregateIt is useful to begin by recalling how interest-rate policy affects aggregate

activity in a conventional model that abstracts from nancial frictions In theactivity in a conventional model that abstracts from 1047297nancial frictions In the

simplest versions of such models nancial conditions can be summarized by a singlesimplest versions of such models 1047297nancial conditions can be summarized by a single

interest rate the equilibrium value of which is determined in a market for creditinterest rate the equilibrium value of which is determined in a market for credit

Figure 2A shows the key equilibrium condition The loan supply scheduleFigure 2A shows the key equilibrium condition The loan supply schedule LS showsshows

the amount of lendingthe amount of lending L that ultimate savers are willing to nance (by refrainingthat ultimate savers are willing to 1047297nance (by refraining

from expenditure themselves) for each possible value of the interest ratefrom expenditure themselves) for each possible value of the interest rate i receivedreceived

by savers while the loan demand scheduleby savers while the loan demand schedule LD shows the demand for such fundsshows the demand for such funds

for each possible value of the interest rate that must be paid by borrowers Notefor each possible value of the interest rate that must be paid by borrowers Notethat the slopes for the curvesthat the slopes for the curves LS

andand LD both re1047298ect the same principle which isboth re1047298ect the same principle which is

that a higher interest rate gives both savers and borrowers a reason to defer currentthat a higher interest rate gives both savers and borrowers a reason to defer current

spending to a greater extent Equilibrium in the credit market then determinesspending to a greater extent Equilibrium in the credit market then determines

both a market-clearing interest rate and an equilibrium volume of lending as shownboth a market-clearing interest rate and an equilibrium volume of lending as shown

byby i 11 andand L

11 in the gurein the 1047297gure

In Figure 2A the loan supply and demand curves are speci ed while holdingIn Figure 2A the loan supply and demand curves are speci1047297ed while holding

constant a great many variables other than the current interest rate In particularconstant a great many variables other than the current interest rate In particular

the curves are shown assuming a particular level of current-period aggregate outputthe curves are shown assuming a particular level of current-period aggregate output

(and hence income)(and hence income) Y A higher level of income should increase the supply of loans A higher level of income should increase the supply of loans

at any given interest rate (as not all of the additional income should be consumedat any given interest rate (as not all of the additional income should be consumed

if future income expectations are held xed) hence an increase inif future income expectations are held 1047297xed) hence an increase in Y should shiftshould shift



Michael Woodford 27

Figure 2

Interest-Rate and Output Determination in the Standard Model

Notes In panel A LS is the loan supply schedule and LD is the loan demand schedule which are speci1047297edholding constant aggregate income Y The arrows show how the curves shift with an increase in Y

Panel B shows an IS schedule derived by tracing out the equilibrium interest rate for any assumedlevel of current income Y and a monetary policy reaction function (MP) showing how the central

bankrsquos interest rate target will vary with the level of economic activity The MP curve is drawn for a givenin1047298ation rate The arrow shows the consequence of an exogenous shift in the policy reaction functionthat implies a lower interest rate for any given level of economic activity

A Effect of an Increase in Aggregate Income on Loan Supply and Demand

B Effect of a Loosening of Monetary Policy on Interest Rates and Output

i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y

I n t e r e s t r a t e


Volume of lending

Aggregate income




thethe LS curve down and to the right as shown by the arrow It should also reducecurve down and to the right as shown by the arrow It should also reduce

the demand for loans insofar as borrowers have more current income availablethe demand for loans insofar as borrowers have more current income available

out of which to nance current spending needs or opportunities in which case theout of which to 1047297nance current spending needs or opportunities in which case the

LD curve shifts down and to the left as also shown in the gure The vertical shift incurve shifts down and to the left as also shown in the 1047297gure The vertical shift in

thethe LD curve is likely to be smaller than the vertical shift of thecurve is likely to be smaller than the vertical shift of the LS curve as shown incurve as shown in

Figure 2A if the expenditure of borrowers is more interest-elastic than the expendi-Figure 2A if the expenditure of borrowers is more interest-elastic than the expendi-

ture of savers The intersection of the grey curves shows the new equilibrium valuesture of savers The intersection of the grey curves shows the new equilibrium values

i 22 andand L

22

Tracing out the equilibrium interest rate for any assumed level of currentTracing out the equilibrium interest rate for any assumed level of current

incomeincome Y one obtains the one obtains the IS

schedule plotted inFigure 2B (Alternatively forschedule plotted in Figure 2B (Alternatively for

each possible interest rateeach possible interest rate i the schedule shows the level of national income for the schedule shows the level of national income for

which investment equals savings as this is equivalent to equality between supply which investment equals savings as this is equivalent to equality between supply

of and demand for funds) The monetary policy reaction function of the centralof and demand for funds) The monetary policy reaction function of the central

bank indicating how the central bankrsquos interest-rate target will vary with the level ofbank indicating how the central bankrsquos interest-rate target will vary with the level of

economic activity is shown by the curveeconomic activity is shown by the curve MP in this gurein this 1047297gure33

If we suppose that theIf we suppose that the MP curve is drawn for a given in1047298ation rate then thecurve is drawn for a given in1047298ation rate then the

upward slope shown indicates a response of interest rates to the level of output (rela-upward slope shown indicates a response of interest rates to the level of output (rela-

tive to trend or to potential) of a kind implied for example by the ldquoTaylor rulerdquotive to trend or to potential) of a kind implied for example by the ldquoTaylor rulerdquo

(Taylor 1993)mdashthat is higher interest rates when output is high relative to trend or(Taylor 1993)mdashthat is higher interest rates when output is high relative to trend or

potential and lower interest rates when output is low relative to trend or potentialpotential and lower interest rates when output is low relative to trend or potential

In this case the equilibrium level of output determined in Figure 2B depends onIn this case the equilibrium level of output determined in Figure 2B depends on

the in1047298ation rate a graph showing how the equilibrium level of output would varythe in1047298ation rate a graph showing how the equilibrium level of output would vary

with in1047298ation yields an aggregate demand relation in in1047298ationndashoutput space Plot- with in1047298ation yields an aggregate demand relation in in1047298ationndashoutput space Plot-ting that relation along with a Phillips curve (or aggregate supply) relation betweenting that relation along with a Phillips curve (or aggregate supply) relation between

in1047298ation and output one can then nally determine equilibrium outputin1047298ation and output one can then 1047297nally determine equilibrium output44

This kind of model provides a straightforward account of the way in which aThis kind of model provides a straightforward account of the way in which a

central bankrsquos interest-rate policy affects the level of economic activity (and also thecentral bankrsquos interest-rate policy affects the level of economic activity (and also the

in1047298ation rate once one adjoins a Phillips curve to the model) However this modelin1047298ation rate once one adjoins a Phillips curve to the model) However this model

of the credit marketmdashin which ultimate savers lend directly to ultimate borrowers soof the credit marketmdashin which ultimate savers lend directly to ultimate borrowers so

that the interest rate received by savers is the same as that paid by borrowersmdashclearlythat the interest rate received by savers is the same as that paid by borrowersmdashclearly

omits some important features of actual nancial systems In actual economies weomits some important features of actual 1047297nancial systems In actual economies we

observe multiple interest rates that do not move perfectly together Changes inobserve multiple interest rates that do not move perfectly together Changes in

spreads between certain of these interest rates have been important indicators ofspreads between certain of these interest rates have been important indicators ofchanging nancial conditions both during the recent housing boom and duringchanging 1047297nancial conditions both during the recent housing boom and during

the subsequent crash as is discussed further belowthe subsequent crash as is discussed further below

3 In the case that monetary policy is assumed to correspond to some 1047297xed supply of money then theMP curve becomes simply the Hicksian LM curve However an upward-sloping relation of the kindshown in the 1047297gure will exist under many other hypotheses including ones more descriptive of actualcentral bank behavior than the Hicksian construct On the relation between IS ndashMP analysis and the olderIS ndashLM analysis see for example Romer (2000) in this journal4 Alternatively one can substitute the in1047298ation rate implied by the Phillips curve (for a given level ofoutput) into the central bank reaction function and plot the resulting relation for i as a function of Y

as the curve MP In this case MP slopes upward as shown even if the central bankrsquos reaction functionresponds only to in1047298ation and the equilibrium shown in Figure 2B already takes account of the endo-geneity of the in1047298ation rate




Introducing Multiple Interest RatesIntroducing Multiple Interest Rates

Here I illustrate one way to introduce multiple interest rates into this modelHere I illustrate one way to introduce multiple interest rates into this model

Suppose that instead of directly lending to ultimate borrowers themselves saversSuppose that instead of directly lending to ultimate borrowers themselves savers

fund intermediaries who use these funds to lend to (or acquire nancial claimsfund intermediaries who use these funds to lend to (or acquire 1047297nancial claimson) the ultimate borrowers Then it becomes necessary to distinguish between theon) the ultimate borrowers Then it becomes necessary to distinguish between the

interest rateinterest rate i ss (the rate paid to savers) at which intermediaries are able to fund(the rate paid to savers) at which intermediaries are able to fund

themselves and the interest ratethemselves and the interest rate i bb (the borrowing or loan rate) at which ultimate(the borrowing or loan rate) at which ultimate

borrowers are able to nance additional current expenditure We can still think inborrowers are able to 1047297nance additional current expenditure We can still think in

terms of the two schedules shown in Figure 2A but now theterms of the two schedules shown in Figure 2A but now the LS schedule representsschedule represents

the supply of funding for intermediaries rather than the supply of loans to ultimatethe supply of funding for intermediaries rather than the supply of loans to ultimate

borrowers and we must now recognize that the supply of funding and the demandborrowers and we must now recognize that the supply of funding and the demand

for loans are functions of two different interest rates Hence the equilibrium levelfor loans are functions of two different interest rates Hence the equilibrium level

of lendingof lending L can be at a point other than the one where the two schedules cross ascan be at a point other than the one where the two schedules cross as

shown in Figure 3Ashown in Figure 3A

What determines the equilibrium relation between the two interest rates What determines the equilibrium relation between the two interest rates i ss andand

i bb Given the funding supply and loan demand curves (which means given the Given the funding supply and loan demand curves (which means given the

values of a set of variables that include the current value of income values of a set of variables that include the current value of income Y) we can deter-) we can deter-

mine the unique volume of intermediation that is consistent with any given spreadmine the unique volume of intermediation that is consistent with any given spread

ωω betweenbetween i bb andand i ss

If the funding supply curve If the funding supply curve LS and the loan demand curveand the loan demand curve LD

have the slopes shown then a larger credit spreadhave the slopes shown then a larger credit spread ωω implies a lower equilibriumimplies a lower equilibrium

volume of intermediated credit volume of intermediated credit L This relation between the quantity of intermedi- This relation between the quantity of intermedi-

ated credit and the credit spread is graphed as the curveated credit and the credit spread is graphed as the curve XD inFigure 3B which wein Figure 3B which we

can think of as the ldquodemand for intermediationrdquocan think of as the ldquodemand for intermediationrdquoThe demand for intermediation scheduleThe demand for intermediation schedule XD

indicates the degree to whichindicates the degree to which

borrowers are willing to pay an interest rate higher than the one required in orderborrowers are willing to pay an interest rate higher than the one required in order

to induce savers to supply funds to nance someone elsersquos expenditure This repre-to induce savers to supply funds to 1047297nance someone elsersquos expenditure This repre-

sents a pro t opportunity for intermediaries to the extent that they are able tosents a pro1047297t opportunity for intermediaries to the extent that they are able to

arrange for the transfer of funds at suf ciently low cost The volume of lending thatarrange for the transfer of funds at suf1047297ciently low cost The volume of lending that

actually occurs though will also depend on the capacity of the nancial sector toactually occurs though will also depend on the capacity of the 1047297nancial sector to

supply this service at a margin low enough for the services to be demandedsupply this service at a margin low enough for the services to be demanded

The corresponding ldquosupply of intermediationrdquo schedule indicating the creditThe corresponding ldquosupply of intermediationrdquo schedule indicating the credit

spread required to induce nancial institutions to intermediate a certain volumespread required to induce 1047297nancial institutions to intermediate a certain volume

of credit between savers and ultimate borrowers is depicted by the curveof credit between savers and ultimate borrowers is depicted by the curve XS inin

Figure 3B This curve re1047298ects the consequences of pro t maximization by inter-Figure 3B This curve re1047298ects the consequences of pro1047297t maximization by inter-

mediaries where the intermediaries in question need not be understood to consistmediaries where the intermediaries in question need not be understood to consist

solely or even primarily of traditional commercial banks Both the equilibrium creditsolely or even primarily of traditional commercial banks Both the equilibrium credit

spread and the equilibrium volume of credit are then determined by the intersec-spread and the equilibrium volume of credit are then determined by the intersec-

tion between thetion between the XS andand XD schedules And given an equilibrium credit spreadschedules And given an equilibrium credit spread ωω

determined in Figure 3A one can useFigure 3A to determine the two interest ratesdetermined in Figure 3A one can use Figure 3A to determine the two interest rates

Determinants of the Supply of IntermediationDeterminants of the Supply of Intermediation

The structural relationship represented by the supply of intermediationThe structural relationship represented by the supply of intermediation

scheduleschedule XS inFigure 3B can be motivated in various ways One model assumesin Figure 3B can be motivated in various ways One model assumes

that intermediaries have costs of originating and servicing loans or of managingthat intermediaries have costs of originating and servicing loans or of managing





Michael Woodford 31

their portfolios so that in a competitive equilibrium the ratetheir portfolios so that in a competitive equilibrium the rate i bb at which they areat which they are

willing to lend (or the return that they will require on assets that they purchase) will willing to lend (or the return that they will require on assets that they purchase) will

exceed their cost of fundsexceed their cost of funds i ss by a spread that re1047298ects the marginal cost of lendingby a spread that re1047298ects the marginal cost of lending

This marginal cost may be increasing in the volume of lending by the intermediaryThis marginal cost may be increasing in the volume of lending by the intermediaryif the production function for loans involves diminishing returns to increases in theif the production function for loans involves diminishing returns to increases in the

variable factors owing to the xity of some factors (such as specialized expertise or variable factors owing to the 1047297xity of some factors (such as specialized expertise or

facilities that cannot be expanded quickly)facilities that cannot be expanded quickly)55

Probably a more important determinant of the supply of intermediation derivesProbably a more important determinant of the supply of intermediation derives

from the limited capital of intermediariesmdashor more fundamentally the limitedfrom the limited capital of intermediariesmdashor more fundamentally the limited

capital of the ldquonatural buyersrdquo of the debt of the ultimate borrowersmdashtogether withcapital of the ldquonatural buyersrdquo of the debt of the ultimate borrowersmdashtogether with

limits on the degree to which these natural buyers are able to leverage their posi-limits on the degree to which these natural buyers are able to leverage their posi-

tions The market for the debt of the ultimate borrowers may be limited to a narrowtions The market for the debt of the ultimate borrowers may be limited to a narrow

class of ldquonatural buyersrdquo for any of a variety of reasons special expertise may beclass of ldquonatural buyersrdquo for any of a variety of reasons special expertise may be

required to evaluate such assets other costs of market participation may be lowerrequired to evaluate such assets other costs of market participation may be lower

for certain investors or the natural buyers may be less risk averse or less uncertaintyfor certain investors or the natural buyers may be less risk averse or less uncertainty

averse or more optimistic about returns on the particular assetsaverse or more optimistic about returns on the particular assets

Leverage may also be constrained for any of a variety of reasons The recentLeverage may also be constrained for any of a variety of reasons The recent

literature has emphasized two broad types of constraints On one hand there mayliterature has emphasized two broad types of constraints On one hand there may

be a limit on the size of the losses that the intermediary would be subject to inbe a limit on the size of the losses that the intermediary would be subject to in

bad states of the world relative to its capital such limits may result from regula-bad states of the world relative to its capital such limits may result from regula-

tory capital requirements or (the case of greatest relevance in the recent crisis)tory capital requirements or (the case of greatest relevance in the recent crisis)

such limits may be imposed by the intermediaryrsquos creditors who are unwilling tosuch limits may be imposed by the intermediaryrsquos creditors who are unwilling to

supply additional funding if the leverage constraint is exceeded (as in Zigrandsupply additional funding if the leverage constraint is exceeded (as in ZigrandShin and Danielsson 2010 Adrian Moench and Shin 2010b Adrian and ShinShin and Danielsson 2010 Adrian Moench and Shin 2010b Adrian and Shin

forthcoming b Beaudry and Lahiri 2010)forthcoming b Beaudry and Lahiri 2010)66

Alternatively intermediaries may raise funds by pledging particular assets as Alternatively intermediaries may raise funds by pledging particular assets as

collateral for individual loans and the amount that they can borrow may be limitedcollateral for individual loans and the amount that they can borrow may be limited

by the value of available collateral Gacircrleanu and Pedersen (2010) and Ashcraftby the value of available collateral Gacircrleanu and Pedersen (2010) and Ashcraft

Gacircrleanu and Pedersen (forthcoming) consider the consequences of collateralGacircrleanu and Pedersen (forthcoming) consider the consequences of collateral

constraints in a model where the fraction of each assetrsquos value that can be borrowedconstraints in a model where the fraction of each assetrsquos value that can be borrowed

using that asset as collateral is among the de ning characteristics of the assetusing that asset as collateral is among the de1047297ning characteristics of the asset

Geanakoplos (1997 2003 2010) instead proposes a theory in which margin require-Geanakoplos (1997 2003 2010) instead proposes a theory in which margin require-

ments are endogenously determined in competitive marketsments are endogenously determined in competitive marketsUnder these types of theories the capital of intermediaries becomes a crucialUnder these types of theories the capital of intermediaries becomes a crucial

determinant of the supply of intermediation For a given quantity of capital thedeterminant of the supply of intermediation For a given quantity of capital the

5 This is one of two relatively reduced-form models of endogenous credit spreads considered in themonetary dynamic stochastic general equilibrium model we present in Cuacuterdia and Woodford (2009)The device of a ldquoloan production functionrdquo is also used in Goodfriend and McCallum (2007) and inGerali Neri Sessa and Signoretti (2010)6The ldquovalue-at-risk constraintrdquo assumed by authors such as Zigrand Shin and Danielsson (2010) AdrianMoench and Shin (2010b) and Adrian and Shin (forthcoming b) is an example of a constraint of thisform Beaudry and Lahiri (2010) impose a similar constraint by simply assuming that intermediaries can

sell only riskless debt The constraint assumed by Adrian and Shin (forthcoming b) is formally equivalentto the one assumed by Beaudry and Lahiri (2010) though the former authors prefer to interpret theconstraint as one on value at risk




supply schedulesupply schedule XS will be upward sloping as shown inFigure 3B if the accept- will be upward sloping as shown in Figure 3B if the accept-

able leverage ratio is higher when the spread between the expected return onable leverage ratio is higher when the spread between the expected return on

the assets in which intermediaries can invest and the rate they must pay on theirthe assets in which intermediaries can invest and the rate they must pay on their

liabilities is greater Consider for example a value-at-risk constraint that requiresliabilities is greater Consider for example a value-at-risk constraint that requiresthe future value of the intermediaryrsquos assets to be worth at least some fractionthe future value of the intermediaryrsquos assets to be worth at least some fraction k

of the amount owed on its debt with at least some probability 1of the amount owed on its debt with at least some probability 1 ndash p and suppose and suppose

that the risky asset in which the intermediary invests will pay at least a fractionthat the risky asset in which the intermediary invests will pay at least a fraction s ofof

its expected payoff with probability 1its expected payoff with probability 1 ndash p Then the value-at-risk constraint is satis- Then the value-at-risk constraint is satis-

ed if and only if the intermediaryrsquos leverage ratio (debt as a fraction of the total1047297ed if and only if the intermediaryrsquos leverage ratio (debt as a fraction of the total

value of its assets) is no greater than value of its assets) is no greater than sk times the factor (1times the factor (1

++ i bb )(1)(1

++ i ss ) where) where

i bb is the expected return on the risky asset andis the expected return on the risky asset and i ss

is the rate that the intermediaryis the rate that the intermediary

must pay on its debt Thus the acceptable leverage ratio and correspondingly themust pay on its debt Thus the acceptable leverage ratio and correspondingly the

maximum value of assets that the intermediary can acquire will be an increasingmaximum value of assets that the intermediary can acquire will be an increasing

function of the credit spreadfunction of the credit spread

TheThe IS ndashndash MP Model with Credit FrictionsModel with Credit Frictions

The equilibrium credit spread and volume of credit shown in Figure 3A areThe equilibrium credit spread and volume of credit shown in Figure 3A are

determined for a particular value of national incomedetermined for a particular value of national income Ybecause the schedules because the schedules LS

andand LD depend ondepend on Y

as shown in Figure 2A the location of the schedule as shown in Figure 2A the location of the schedule XD (at(at

least) in Figure 3B also depends onleast) in Figure 3B also depends on Y For reasons already discussed above a higher For reasons already discussed above a higher

level oflevel of Y should shiftshould shift LS

to the right andto the right and LD to the left and each of these effectsto the left and each of these effects

results in a lower equilibrium value of the rateresults in a lower equilibrium value of the rate i ss paid to savers for any given positionpaid to savers for any given position

of the scheduleof the schedule XS Hence we can once again derive an Hence we can once again derive an IS

schedule indicating theschedule indicating theequilibrium value ofequilibrium value of i ss

for any assumed level of incomefor any assumed level of income Y but now the but now the IS

scheduleschedule

will also include a given assumption about the supply of intermediation will also include a given assumption about the supply of intermediation77

The resulting model makes many of the same qualitative predictions about theThe resulting model makes many of the same qualitative predictions about the

effects of economic disturbances or policy changes as the standardeffects of economic disturbances or policy changes as the standard ISndashMP modelmodel

(which is simply the special case in which the curve(which is simply the special case in which the curve XS is assumed to be horizontalis assumed to be horizontal

atat ωω == 0) However the dependence of the supply of intermediation on the capital0) However the dependence of the supply of intermediation on the capital

of intermediaries provides a channel for the ampli cation and propagation of theof intermediaries provides a channel for the ampli1047297cation and propagation of the

effects of economic disturbances An increase in aggregate economic activity willeffects of economic disturbances An increase in aggregate economic activity will

generally increase the value of intermediariesrsquo assets (loans are more likely to begenerally increase the value of intermediariesrsquo assets (loans are more likely to be

repaid land prices increase with increases in income and so on) and hence theirrepaid land prices increase with increases in income and so on) and hence theirnet worth This will allow additional borrowing by the intermediaries and hence anet worth This will allow additional borrowing by the intermediaries and hence a

larger volume of credit for any given credit spread Thus the supply of intermedia-larger volume of credit for any given credit spread Thus the supply of intermedia-

tion scheduletion schedule XS will shift down and to the right A reduction in the interest rate will shift down and to the right A reduction in the interest rate

7 In fact we can now solve for both i s and i b as functions of Y but it is the relation between i s and Y that is relevant for the ISndashMP diagram since it is i s mdashthe rate at which intermediaries are able to fundthemselvesmdashthat corresponds to the operating target of the central bank Plotting again the reaction ofthe central bankrsquos target for i s to changes in economic activity as a curve MP we again have a diagram ofexactly the kind shown in Figure 2B to determine simultaneously the equilibrium values of the interestrate and output the only important difference is that now we must clarify that the interest rate on the

vertical axis is the policy rate i s rather than the borrowing rate i b Once the equilibrium values of Y andi s have been determined they can be transferred back to Figures 3A and B to determine the impliedequilibrium values of i b and L as well




i ss at which intermediaries are able to fund themselves can also increase intermedi-at which intermediaries are able to fund themselves can also increase intermedi-

ariesrsquo net worth if (as is often the case) they fund longer-term assets with short-termariesrsquo net worth if (as is often the case) they fund longer-term assets with short-term

borrowing that they must roll over and in this case a reduction inborrowing that they must roll over and in this case a reduction in i ss will shift the will shift the XS

curve down and to the right as wellcurve down and to the right as wellEach of these effects will make theEach of these effects will make the IS curve 1047298atter (more interest-elastic) thancurve 1047298atter (more interest-elastic) than

it would otherwise beit would otherwise be88 This means that a shift in theThis means that a shift in the MP curvemdashdue either to acurvemdashdue either to a

change in monetary policy or to a supply-side disturbance that shifts the aggregate-change in monetary policy or to a supply-side disturbance that shifts the aggregate-

supply curvemdashwill have a larger effect on output as a consequence of these ldquo nancialsupply curvemdashwill have a larger effect on output as a consequence of these ldquo1047297nancial

acceleratorrdquo effects Bernanke and Gertler (1995) discuss evidence for the impor-acceleratorrdquo effects Bernanke and Gertler (1995) discuss evidence for the impor-

tance of such effects in the case of monetary policy shocks Moreover if a disturbancetance of such effects in the case of monetary policy shocks Moreover if a disturbance

leads to an increase or decrease in the capital of the intermediary sector the alteredleads to an increase or decrease in the capital of the intermediary sector the altered

level of capital is likely to persist for some time This can result in effects on economiclevel of capital is likely to persist for some time This can result in effects on economic

activity that are more persistent than the initial disturbanceactivity that are more persistent than the initial disturbance

The presence of an upward-slopingThe presence of an upward-sloping XS curve (representing credit frictions)curve (representing credit frictions)

essentially makes theessentially makes the IS curve steeper and consequently acts to dampen the effectscurve steeper and consequently acts to dampen the effects

on aggregate output of disturbances that shift theon aggregate output of disturbances that shift the MP curve to the extent thatcurve to the extent that

thethe XS schedule is not itself shifted by the disturbances In fact however theschedule is not itself shifted by the disturbances In fact however the XS

schedule may well shift in which case the net effect may well be to amplify outputschedule may well shift in which case the net effect may well be to amplify output

1047298uctuations rather than to dampen them1047298uctuations rather than to dampen them

Consequences of Shifts in the Supply of IntermediationConsequences of Shifts in the Supply of Intermediation

A more important consequence of this extension of the model is the fact that A more important consequence of this extension of the model is the fact that

shifts in theshifts in the XS schedulemdashfor either exogenous or endogenous reasonsmdashbecomeschedulemdashfor either exogenous or endogenous reasonsmdashbecome

an additional source of variations in aggregate demand and hence in economican additional source of variations in aggregate demand and hence in economic

activity and in1047298ationactivity and in1047298ation99 A disruption of the supply of intermediation will shift the A disruption of the supply of intermediation will shift the

XS schedule up so that nancial intermediaries supply less credit at every levelschedule up so that 1047297nancial intermediaries supply less credit at every level

of the credit spreadof the credit spread ωωAs shown in Figure 4A an upward shift in As shown in Figure 4A an upward shift in XS

results in aresults in a

higher equilibrium credit spread and a lower volume of lending for any given levelhigher equilibrium credit spread and a lower volume of lending for any given level

of economic activity (re1047298ected in the location of theof economic activity (re1047298ected in the location of the XD schedule in the gure)schedule in the 1047297gure)

Transferring this larger spread back to Figure 3A one observes that the impliedTransferring this larger spread back to Figure 3A one observes that the implied

value of value of i ss will be smaller and the implied value of will be smaller and the implied value of i bb

higher for the given value ofhigher for the given value of

Y Because this is true for each possible value of Because this is true for each possible value of Y the the IS schedule is shifted downschedule is shifted down

and to the left as shown in Figure 4B (Note thatand to the left as shown in Figure 4B (Note that IS plots the equilibrium value ofplots the equilibrium value of

i ssrather than that ofrather than that of i bb

because the policy reaction function speci es a target for because the policy reaction function speci1047297es a target for

i ss

rather than forrather than for i bb ) In the absence of any change in the monetary policy reaction) In the absence of any change in the monetary policy reaction

8 Of course these reasons for the IS curve to be 1047298atter must be balanced against the observation that asteeper XS curve for a given level of capital in the intermediary sector will imply a steeper IS curve Thisis why the degree of ampli1047297cation from credit frictions that is found in quantitative dynamic stochasticgeneral equilibrium models is sometimes quite modest9 The empirical dynamic stochastic general equilibrium models of Christiano Motto and Rostagno(2010) and Gilchrist Ortiz and Zakrajsek (2009) each attribute a substantial fraction of the short-runvariability of real GDP to disturbances that vary the severity of 1047297nancial frictions




Figure 4

Effects of a Disruption of Credit Supply

Notes XS and XD are the supply and demand for intermediation ω is the spread between i b the interestrate for borrowers and i s the interest rate for savers The IS schedule shows the equilibrium interestrate for any assumed level of current income Y and MP is the monetary policy reaction function (MP)

A Effects on the Equilibrium Credit Spread ω and Volume of Lending L for a Given Level of Aggregate Income Y

B Effects on the Equilibrium Policy Rate and Aggregate IncomeTaking into Account the Monetary Policy Reaction

i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L

Volume of lendingL 2



Michael Woodford 35

function the upward shift infunction the upward shift in XS should result in both a decline in the policy interestshould result in both a decline in the policy interest

rate and a contraction of real activityrate and a contraction of real activity1010

This prediction matches the consequences observed for example when theThis prediction matches the consequences observed for example when the

Carter administration imposed credit controls in the second quarter of 1980 ThisCarter administration imposed credit controls in the second quarter of 1980 Thispolicy was followed by a contraction in real GDP at a rate of minus 8 percent perpolicy was followed by a contraction in real GDP at a rate of minus 8 percent per

year in that quarter while the federal funds rate also fell from a level over 17 percent year in that quarter while the federal funds rate also fell from a level over 17 percent

per annum in April to only 9 percent by July 1980 The effects of a policy tighteningper annum in April to only 9 percent by July 1980 The effects of a policy tightening

of this kind cannot be understood as a shift of theof this kind cannot be understood as a shift of the MP curve (orcurve (or LM curve) in acurve) in a

conventionalconventional ISndashMP (or(or ISndashLM

) diagram but they are easily understood when one) diagram but they are easily understood when one

realizes how changes in the supply of intermediation schedule should be expectedrealizes how changes in the supply of intermediation schedule should be expected

to shift theto shift the IS curvecurve

The dependence of the supply of intermediation on the capital of interme-The dependence of the supply of intermediation on the capital of interme-

diaries also introduces an important channel through which additional types ofdiaries also introduces an important channel through which additional types of

disturbances can affect aggregate activity Any disturbance that impairs the capitaldisturbances can affect aggregate activity Any disturbance that impairs the capital

of the banking sector will shift the scheduleof the banking sector will shift the schedule XS up and to the left with the effectsup and to the left with the effects

just discussed This means that shocks that might seem of only modest signi cance just discussed This means that shocks that might seem of only modest signi1047297cance

for the aggregate economymdashin terms say of the total value of business losses thatfor the aggregate economymdashin terms say of the total value of business losses that

directly result from the shockmdashcan have substantial aggregate effects if the lossesdirectly result from the shockmdashcan have substantial aggregate effects if the losses

in question happen to be concentrated in highly leveraged intermediaries whoin question happen to be concentrated in highly leveraged intermediaries who

suffer signi cant reductions in their capital as a result This was an important reasonsuffer signi1047297cant reductions in their capital as a result This was an important reason

for the dramatic aggregate effects in 2008ndash2009 of the losses in the US subprimefor the dramatic aggregate effects in 2008ndash2009 of the losses in the US subprime

mortgage marketmortgage market

The supply of intermediation can also shift as a result of factors other thanThe supply of intermediation can also shift as a result of factors other thana change in the capital of intermediaries in particular leverage constraints cana change in the capital of intermediaries in particular leverage constraints can

tighten or loosen as a result of changes in the attitudes of intermediariesrsquo creditorstighten or loosen as a result of changes in the attitudes of intermediariesrsquo creditors

regarding the acceptable degree of leverage or in the margin requirements associ-regarding the acceptable degree of leverage or in the margin requirements associ-

ated with borrowing against the securities that intermediaries hold Gorton andated with borrowing against the securities that intermediaries hold Gorton and

Metrick (2009) Adrian and Shin (2009) and Geanakoplos (2010) have all stressedMetrick (2009) Adrian and Shin (2009) and Geanakoplos (2010) have all stressed

the importance of increases in margin requirements in the overnight repurchasethe importance of increases in margin requirements in the overnight repurchase

(or ldquorepordquo) market as a factor that contracted the supply of credit in 2008 and 2009(or ldquorepordquo) market as a factor that contracted the supply of credit in 2008 and 2009

Even when shocks to the supply of intermediation originate in a tightening ofEven when shocks to the supply of intermediation originate in a tightening of

leverage constraints andor margin constraints owing to an increased assessmentleverage constraints andor margin constraints owing to an increased assessment

of the risk associated with intermediariesrsquo assets the effects of the shocks will beof the risk associated with intermediariesrsquo assets the effects of the shocks will beampli ed by the dependence of the supply of intermediation on the capital of theampli1047297ed by the dependence of the supply of intermediation on the capital of the

intermediary sector Intermediaries that are forced to sell assets as a result of tight-intermediary sector Intermediaries that are forced to sell assets as a result of tight-

ened leverage constraints are likely to suffer losses and more so to the extent thatened leverage constraints are likely to suffer losses and more so to the extent that

many of them are forced to sell similar assets at the same time or to the extentmany of them are forced to sell similar assets at the same time or to the extent

that they are the only ldquonatural buyersrdquo of the assets in question These losses willthat they are the only ldquonatural buyersrdquo of the assets in question These losses will

then further reduce their capital further reducing the amount that they are ablethen further reduce their capital further reducing the amount that they are able

10 In this respect the framework sketched here agrees with the one proposed by Bernanke and Blinder(1988) who refer to the relation that I call the IS curve as the ldquocommodities and credit curverdquo instead

precisely because it is shifted by credit-supply shocks in addition to the usual determinants of the IS curve The framework proposed here differs from that of Bernanke and Blinder primarily in offering adifferent model of the supply of intermediation




to borrow and hence requiring further asset sales The result is a vicious spiralto borrow and hence requiring further asset sales The result is a vicious spiral

that under some circumstances can substantially reduce credit supply The resultingthat under some circumstances can substantially reduce credit supply The resulting

contraction of aggregate output may result in further losses to the banks furthercontraction of aggregate output may result in further losses to the banks further

reducing their capital and hence tightening credit supply even morereducing their capital and hence tightening credit supply even more

The Most Recent US Credit CycleThe Most Recent US Credit Cycle

Understanding variations in nancial conditions over the most recent creditUnderstanding variations in 1047297nancial conditions over the most recent credit

cycle requires attention to the behavior of multiple interest rates not just the federalcycle requires attention to the behavior of multiple interest rates not just the federal

funds rate that is targeted by the Federal Reserve As shown in Figure 5 the Fedfunds rate that is targeted by the Federal Reserve As shown in Figure 5 the Fed

Open Market Committee raised its target for the funds rate to a higher level duringOpen Market Committee raised its target for the funds rate to a higher level during

the period 2006ndash07 but nancial conditions did not tighten as much as one mightthe period 2006ndash07 but 1047297nancial conditions did not tighten as much as one might

expect from the increase in the funds rate First of all spending decisions dependexpect from the increase in the funds rate First of all spending decisions depend

more on the level ofmore on the level of long-terminterest rates which in turn depend on the expectedinterest rates which in turn depend on the expected

average level of short rates over the coming decade rather than the current levelaverage level of short rates over the coming decade rather than the current level

of short rates alone Since there was good reason to regard the low level of theof short rates alone Since there was good reason to regard the low level of the

federal funds rate in 2003ndash04 as a temporary anomalyfederal funds rate in 2003ndash04 as a temporary anomaly1111 the long rate implied by thethe long rate implied by the

expected average future level of the short rates did not greatly increase as a result ofexpected average future level of the short rates did not greatly increase as a result of

the increase in the funds rate between 2004 and 2006the increase in the funds rate between 2004 and 2006

Moreover yields on long-term Treasury bonds did not rise by even this muchMoreover yields on long-term Treasury bonds did not rise by even this much

The term premium whichThe term premium which indicates the amount by which the actual yield on aindicates the amount by which the actual yield on a

long-term bond exceeds the expected average level of short-term interest rates overlong-term bond exceeds the expected average level of short-term interest rates overthe term to maturity of the bond declined during this period as Figure 5 illustratesthe term to maturity of the bond declined during this period as Figure 5 illustrates

for the case of a 10-year bond In turn the rates at which private parties can borrowfor the case of a 10-year bond In turn the rates at which private parties can borrow

are not those applicable to the US Treasury the gure also shows for exampleare not those applicable to the US Treasury the 1047297gure also shows for example

that the spread between the average yield on Baa-rated corporate bonds and 10-yearthat the spread between the average yield on Baa-rated corporate bonds and 10-year

Treasuries also fell between 2004 and 2006Treasuries also fell between 2004 and 20061212 Hence corporate borrowing costs actu-Hence corporate borrowing costs actu-

ally fell despite the increase in the federal funds rate owing to the declines in theally fell despite the increase in the federal funds rate owing to the declines in the

two spreads In contrast the increases in the two spreads during the nancial crisistwo spreads In contrast the increases in the two spreads during the 1047297nancial crisis

greatly increased the cost of borrowinggreatly increased the cost of borrowing

Even in the case of short-term borrowing the federal funds rate alone isEven in the case of short-term borrowing the federal funds rate alone is

not always an adequate measure of money market conditions Figure 5 also plotsnot always an adequate measure of money market conditions Figure 5 also plotsthe spread between the three-month US dollar London Interbank Offer Ratethe spread between the three-month US dollar London Interbank Offer Rate

11 For example see the ldquo1047297ttedrdquo long rates implied by the forecasting model of Kim and Wright (2005)Indeed the series plotted in Figure 5 is taken from the estimates of Kim and Wright (2005) their seriesis updated at ⟨httpwwwfederalreservegoveconresdataresearchdatahtm⟩12 The spread between yields on this class of moderately risky corporate bonds and on similar-maturityTreasury bonds is a commonly watched indicator of disturbances to the market for corporate debt

which is strongly correlated with variations in economic activity Gilchrist Ortiz and Zakrajsek (2009)

use an index of corporate bond spreads as a measure of the time-varying 1047297nancial wedge in an estimatedmonetary dynamic stochastic general equilibrium model and 1047297nd that the co-movements of the bondspreads with other aggregate variables are consistent with this interpretation




(LIBOR)(LIBOR)1313 and the overnight interest-rate rate swap (OIS) rate which can be viewedand the overnight interest-rate rate swap (OIS) rate which can be viewed

as essentially a market forecast of the average level of the federal funds rate over thatas essentially a market forecast of the average level of the federal funds rate over that

three-month period The sharp increases in this spread during the crisis indicatethree-month period The sharp increases in this spread during the crisis indicate

that the short-term borrowing costs of many banks (especially late in 2008) werethat the short-term borrowing costs of many banks (especially late in 2008) were

considerably higher than would be indicated by the federal funds rateconsiderably higher than would be indicated by the federal funds rate

It is popular to attribute the credit boom (at least in part) to the Federal ReserveIt is popular to attribute the credit boom (at least in part) to the Federal Reserve

having kept the federal funds rate ldquotoo low for too longrdquo but comparison of thehaving kept the federal funds rate ldquotoo low for too longrdquo but comparison of thepath of the funds rate in Figure 5 with the measures of credit growth inFigure 1A path of the funds rate in Figure 5 with the measures of credit growth in Figure 1A

shows that the increase in lending was greatest in 2006 and the rst half of 2007shows that the increase in lending was greatest in 2006 and the 1047297rst half of 2007

after the federal funds rate had already returned to a level consistent with normalafter the federal funds rate had already returned to a level consistent with normal

benchmarks Instead the fact that spreads were unusually low precisely during thebenchmarks Instead the fact that spreads were unusually low precisely during the

period of strongest growth in lendingmdashas can be seen by comparing the spreadsperiod of strongest growth in lendingmdashas can be seen by comparing the spreads

13 The LIBOR rate is an average of quoted rates at which banks are able to borrow funds for a short term(3 months in the case of the series plotted here) on an uncollateralized basis It is important not onlybecause it is the cost of additional funds for some banks but because other lending ratesmdashsuch as the

interest rate at which commercial and industrial loans are available to 1047297rms under existing loan commit-mentsmdashare often tied to the LIBOR rate For alternative interpretations of variations in the LIBORndashOISspread see Giavazzi (2008) Sarkar (2009) and Taylor and Williams (2009)

Figure 5

The Federal Funds Rate Target and Some Interest-rate Spreads

Sources The FF target is from the Federal Reserve Board the 10-year term premium was calculated byDon H Kim and Jonathan H Wright (available at the Federal Reserve Board website) the BaandashTreasuryspread is from the Federal Reserve Bank of St Louis the LIBOR-OIS spread is from BloombergNotes The ldquoFF targetrdquo is the Federal Funds rate target The ldquo10-year term premiumrdquo is the amount by

which the yield on a 10-year bond exceeds the expected average level of short-term interest rates over

the term to maturity of the bond The ldquoBaandashTreasury spreadrdquo is the spread between Baa-rated corporatebonds and 10-year Treasuries The ldquoLIBORndashOIS spreadrdquo is the spread between the three-month USdollar London Interbank Offer Rate (LIBOR) and the overnight interest-rate rate swap (OIS) rate

2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target

10-year term premium

Baa-Treasury spread

LIBOR-OIS spread

P e r c e n t a g e p o i n t s




shown in Figure 5 with the quantities inFigure 1mdashindicates that an outward shiftshown in Figure 5 with the quantities in Figure 1mdashindicates that an outward shift

of the supply of intermediation scheduleof the supply of intermediation schedule XS was responsible rather than a move- was responsible rather than a move-

ment along this schedule in response to a loosening of monetary policy The reasonment along this schedule in response to a loosening of monetary policy The reason

for the shift seems to have been an increased appetite of investors for purportedlyfor the shift seems to have been an increased appetite of investors for purportedlylow-risk short-term liabilities of very highly leveraged nancial intermediaries inlow-risk short-term liabilities of very highly leveraged 1047297nancial intermediaries in

this journal Brunnermeier (2009) details the changes in nancing patterns duringthis journal Brunnermeier (2009) details the changes in 1047297nancing patterns during

this periodthis period

The effects of such a shift were like those shown in Figure 4 but with theThe effects of such a shift were like those shown in Figure 4 but with the

reverse sign as a consequence the Fedrsquos increase in the funds rate over the periodreverse sign as a consequence the Fedrsquos increase in the funds rate over the period

between 2004 and 2006 did less to restrain demand than would ordinarily have beenbetween 2004 and 2006 did less to restrain demand than would ordinarily have been

expectedexpected1414 The increase in the riskless short-term rate did reduce householdsrsquo andThe increase in the riskless short-term rate did reduce householdsrsquo and

rmsrsquo willingness to hold demand deposits as a conventional money-demand equa-1047297rmsrsquo willingness to hold demand deposits as a conventional money-demand equa-

tion would imply and checkable deposits declined during this period as shown intion would imply and checkable deposits declined during this period as shown in

Figure 1B but this did not prevent a net increase in the overall liabilities of nancialFigure 1B but this did not prevent a net increase in the overall liabilities of 1047297nancial

intermediaries and hence in credit supplyintermediaries and hence in credit supply

The nancial crisis that began in summer 2007 also originated in a change inThe 1047297nancial crisis that began in summer 2007 also originated in a change in

the supply of intermediation It began when increased perceptions of risk resultedthe supply of intermediation It began when increased perceptions of risk resulted

in increases in the margin requirements demanded by creditors in short-termin increases in the margin requirements demanded by creditors in short-term

lending collateralized by mortgage-backed securities creating a liquidity crisis forlending collateralized by mortgage-backed securities creating a liquidity crisis for

issuers of asset-backed commercial paper The effect of deleveraging in this sectorissuers of asset-backed commercial paper The effect of deleveraging in this sector

on the market value of mortgage-backed securities further impaired the capital ofon the market value of mortgage-backed securities further impaired the capital of

nancial intermediaries more broadly requiring further deleveraging in a vicious1047297nancial intermediaries more broadly requiring further deleveraging in a vicious

spiral again Brunnermeier (2009) describes this process in detail in this journalspiral again Brunnermeier (2009) describes this process in detail in this journalIn terms of the model the net result of both reductions in the acceptable degreeIn terms of the model the net result of both reductions in the acceptable degree

of leverage and impairment of the capital of the nancial sector was a sharp leftwardof leverage and impairment of the capital of the 1047297nancial sector was a sharp leftward

shift of the supply of intermediationshift of the supply of intermediation XS As illustrated by Figure 4 the result was a As illustrated by Figure 4 the result was a

simultaneous contraction of the volume of lending as shown in Figure 1 and ansimultaneous contraction of the volume of lending as shown in Figure 1 and an

increase in spreads as shown in Figure 5 The resulting leftward shift of theincrease in spreads as shown in Figure 5 The resulting leftward shift of the IS curvecurve

(Figure 4) meant a contraction of aggregate demand despite the substantial cuts(Figure 4) meant a contraction of aggregate demand despite the substantial cuts

in the federal funds rate shown in Figure 5 The reduction in the riskless short-termin the federal funds rate shown in Figure 5 The reduction in the riskless short-term

rate caused an increased willingness to hold transactions deposits and checkablerate caused an increased willingness to hold transactions deposits and checkable

deposits increased substantially as seen in Figure 1B But plentiful deposits weredeposits increased substantially as seen in Figure 1B But plentiful deposits were

not enough to restore the 1047298ow of credit for an inability to increase the volume ofnot enough to restore the 1047298ow of credit for an inability to increase the volume ofdeposits was not the relevant constraint on the supply of creditdeposits was not the relevant constraint on the supply of credit

Once this process was underwaymdashand given that for a time it appearedOnce this process was underwaymdashand given that for a time it appeared

that the crisis might spiral out of controlmdashuncertainty about the macroeconomicthat the crisis might spiral out of controlmdashuncertainty about the macroeconomic

environment likely caused a further leftward shift of theenvironment likely caused a further leftward shift of the IS curve by increasingcurve by increasing

precautionary saving and increasing the option value of deferring investmentprecautionary saving and increasing the option value of deferring investment

Once theOnce the IS curve shifted suf ciently far it ceased to be possible to maintaincurve shifted suf1047297ciently far it ceased to be possible to maintain

14Under this analysis the fact that the Fed did not tighten policy even further can be said to have contrib-

uted to the credit boom But the problem was not that the Fed failed to conform to the conventionalbenchmark provided by the ldquoTaylor rulerdquo as argued by Taylor (2009) but rather that it followed it toofaithfully rather than taking account of the change in 1047297nancial conditions



Michael Woodford 39

output near potential through cuts in the federal funds rate alone owing to theoutput near potential through cuts in the federal funds rate alone owing to the

zero lower bound on nominal interest rates Of course the fact that reducedzero lower bound on nominal interest rates Of course the fact that reduced

aggregate demand resulted in lower economic activity and employment ratheraggregate demand resulted in lower economic activity and employment rather

than simply in reductions in wages and prices to the extent needed to maintainthan simply in reductions in wages and prices to the extent needed to maintainfull employment depended on the stickiness of wages and prices as described infull employment depended on the stickiness of wages and prices as described in

standard textbook accountsstandard textbook accounts

Implications for Monetary PolicyImplications for Monetary Policy

To what extent does this extension of the standard model imply changes to theTo what extent does this extension of the standard model imply changes to the

conventional conduct of monetary policyconventional conduct of monetary policy

Taking Account of Financial ConditionsTaking Account of Financial Conditions

The modelrsquos most obvious implication is that decisions about interest-rate policyThe modelrsquos most obvious implication is that decisions about interest-rate policy

should take account of changes in nancial conditionsmdashin particular of changes inshould take account of changes in 1047297nancial conditionsmdashin particular of changes in

interest-rate spreads Suppose that onersquos goal is to set a value of the policy rate at each Suppose that onersquos goal is to set a value of the policy rate at each

point in time that is consistent with output equal to potential (or more preciselypoint in time that is consistent with output equal to potential (or more precisely

the ldquonatural rate of outputrdquo in the sense of Friedman 1968) In the model sketchedthe ldquonatural rate of outputrdquo in the sense of Friedman 1968) In the model sketched

above this interest rate can be determined at any time given two other numbersabove this interest rate can be determined at any time given two other numbers

1) the current value of the ldquonatural rate of interestrdquomdashthe real interest rate required1) the current value of the ldquonatural rate of interestrdquomdashthe real interest rate required

for output equal to the natural rate in the absence of nancial frictionsfor output equal to the natural rate in the absence of 1047297nancial frictions1515mdashconvertedmdashconverted

into an equivalent nominal interest rate by adding the current expected in1047298ationinto an equivalent nominal interest rate by adding the current expected in1047298ationrate and 2) the current interest-rate spreadrate and 2) the current interest-rate spread ωω1616

The model therefore suggests that changes in credit spreads should be anThe model therefore suggests that changes in credit spreads should be an

important indicator in setting the federal funds rate the funds rate target should beimportant indicator in setting the federal funds rate the funds rate target should be

lower than would otherwise be chosen given other conditions when credit spreadslower than would otherwise be chosen given other conditions when credit spreads

are larger John Taylor (2008) has proposed in this spirit that his well-knownare larger John Taylor (2008) has proposed in this spirit that his well-known

rule for setting the federal funds rate target (explained in Taylor 1993) shouldrule for setting the federal funds rate target (explained in Taylor 1993) should

be modi ed to specify a funds rate target equal to that prescribed by the standardbe modi1047297ed to specify a funds rate target equal to that prescribed by the standard

ldquoTaylor rulerdquo minus the current value of the LIBORndashOIS spread shown in Figure 5 ldquoTaylor rulerdquo minus the current value of the LIBORndashOIS spread shown in Figure 5

In Cuacuterdia and Woodford (2010a) my coauthor and I show in the context of aIn Cuacuterdia and Woodford (2010a) my coauthor and I show in the context of a

New Keynesian dynamic stochastic general equilibrium model with credit frictionsNew Keynesian dynamic stochastic general equilibrium model with credit frictionsthat such a modi cation of the standard Taylor rule can improve the economyrsquosthat such a modi1047297cation of the standard Taylor rule can improve the economyrsquos

response to disturbances to the supply of intermediationresponse to disturbances to the supply of intermediation

15 This concept derived from the ideas of Knut Wicksell is discussed extensively in Woodford (2003chap 4) One might alternatively de1047297ne the natural rate as the real rate that would be required foroutput equal to the natural rate of output under the assumption of a credit spread equal to some normal(steady state) level the important feature of the proposed de1047297nition is that it abstracts from the effectsof variations in the size of credit frictions16 In Cuacuterdia and Woodford (2009) we derive an intertemporal version of the ldquoIS curverdquo in which thecredit spread appears as a shift factor Gaspar and Kashyap (2006) were perhaps the 1047297rst to propose sucha relation




Alternatively a forecast-targeting approach to monetary policy of the kind I Alternatively a forecast-targeting approach to monetary policy of the kind I

recommended in this journal in Woodford (2007)mdashin which the central bankrsquosrecommended in this journal in Woodford (2007)mdashin which the central bankrsquos

target for the policy rate should be adjusted as necessary in order for its projectionstarget for the policy rate should be adjusted as necessary in order for its projections

of in1047298ation and real activity to satisfy a quantitative target criterionmdashwill automati-of in1047298ation and real activity to satisfy a quantitative target criterionmdashwill automati-cally incorporate responses to changes in nancial conditions to the extent thatcally incorporate responses to changes in 1047297nancial conditions to the extent that

these shift thethese shift the IS curve as in the model sketched above In addition this alternativecurve as in the model sketched above In addition this alternative

approach has the advantage of not requiring the central bank to focus on a singleapproach has the advantage of not requiring the central bank to focus on a single

interest rate spread when multiple aspects of nancial conditions are each relevantinterest rate spread when multiple aspects of 1047297nancial conditions are each relevant

to aggregate demand and supply determinationto aggregate demand and supply determination

ldquoUnconventionalrdquo Monetary PoliciesldquoUnconventionalrdquo Monetary Policies

The model also implies that traditional interest-rate policy alone will not inThe model also implies that traditional interest-rate policy alone will not in

general provide a fully adequate response to a disturbance to credit supply nogeneral provide a fully adequate response to a disturbance to credit supply no

matter how large the cut in the policy rate that may be engineered The reason ismatter how large the cut in the policy rate that may be engineered The reason is

that even if a suf cient reduction in the policy rate can offset the decline in aggre-that even if a suf1047297cient reduction in the policy rate can offset the decline in aggre-

gate demand that would otherwise result from the shift in thegate demand that would otherwise result from the shift in the IS curve this does notcurve this does not

fully undo the distortions created by the increase in credit spreads To the extentfully undo the distortions created by the increase in credit spreads To the extent

that savers would be willing to supply additional funds at an interest rate lower thanthat savers would be willing to supply additional funds at an interest rate lower than

the rate at which borrowers would be willing to borrow additional funds then therethe rate at which borrowers would be willing to borrow additional funds then there

remains a misallocation of expenditure even if the aggregate level of expenditure isremains a misallocation of expenditure even if the aggregate level of expenditure is

optimal on this point in Cuacuterdia and Woodford (2009) my coauthor and I provideoptimal on this point in Cuacuterdia and Woodford (2009) my coauthor and I provide

an explicit welfare analysis Thus to the extent that it is possible for policy to reducean explicit welfare analysis Thus to the extent that it is possible for policy to reduce

the size of the credit spread this is desirable even when interest-rate policy is ablethe size of the credit spread this is desirable even when interest-rate policy is ableto maintain output at potentialto maintain output at potential

But the case for acting to reduce credit spreads becomes even stronger ifBut the case for acting to reduce credit spreads becomes even stronger if

the policy rate is constrained by the zero lower bound on nominal interest ratesthe policy rate is constrained by the zero lower bound on nominal interest rates

In the case of a large enough disturbance to the supply of intermediation theIn the case of a large enough disturbance to the supply of intermediation the IS

curve may shift so far down to the left that the point on it corresponding to thecurve may shift so far down to the left that the point on it corresponding to the

natural rate of output may involve a negative nominal interest rate for quanti-natural rate of output may involve a negative nominal interest rate for quanti-

tative examples see Cuacuterdia and Woodford (2010b) In this case conventionaltative examples see Cuacuterdia and Woodford (2010b) In this case conventional

monetary policy is unable to achieve the required level of aggregate demandmonetary policy is unable to achieve the required level of aggregate demand

because even a massive expansion of the supply of bank reserves cannot drive thebecause even a massive expansion of the supply of bank reserves cannot drive the

policy rate below zero (The Federal Reserve found itself in this situation afterpolicy rate below zero (The Federal Reserve found itself in this situation afterDecember 2008 as shown in Figure 5) Under such circumstances a policy thatDecember 2008 as shown in Figure 5) Under such circumstances a policy that

can reduce credit spreads can further increase aggregate demand (by shiftingcan reduce credit spreads can further increase aggregate demand (by shifting

thethe IS curve to the right) despite the lack of room for any further reduction incurve to the right) despite the lack of room for any further reduction in

the policy ratethe policy rate

Broadly speaking two types of ldquounconventionalrdquo central-bank policies canBroadly speaking two types of ldquounconventionalrdquo central-bank policies can

reduce credit spreads by shifting the supply of intermediation schedulereduce credit spreads by shifting the supply of intermediation schedule XS to theto the

right One is the extension of credit to intermediaries by the central bank on easierright One is the extension of credit to intermediaries by the central bank on easier

terms than are available from private creditors in particular in the case that theterms than are available from private creditors in particular in the case that the

relevant nancing constraint is the existence of too-high margin requirements forrelevant 1047297nancing constraint is the existence of too-high margin requirements for

private lending using assets held by the intermediaries as collateral the centralprivate lending using assets held by the intermediaries as collateral the central

bank may choose to lend against that collateral with a lower margin requirementbank may choose to lend against that collateral with a lower margin requirement




Ashcraft Gacircrleanu and Pedersen (forthcoming) discuss the Federal Reserversquos Term Ashcraft Gacircrleanu and Pedersen (forthcoming) discuss the Federal Reserversquos Term

Asset-Backed Lending Facility which provided nancing for private purchases of Asset-Backed Lending Facility which provided 1047297nancing for private purchases of

asset-backed securities as an example of a policy of this kind and present evidenceasset-backed securities as an example of a policy of this kind and present evidence

of its success at reducing the spreads associated with asset-backed securities eligibleof its success at reducing the spreads associated with asset-backed securities eligiblefor the program Such a policy can relax the constraint on the size of intermediaryfor the program Such a policy can relax the constraint on the size of intermediary

balance sheets resulting from limited capital in the intermediary sector by allowingbalance sheets resulting from limited capital in the intermediary sector by allowing

increased leverageincreased leverage

Alternatively the central bank may directly purchase debt claims issued by Alternatively the central bank may directly purchase debt claims issued by

private borrowers so that total credit extended to the private sector can exceedprivate borrowers so that total credit extended to the private sector can exceed

the size of intermediary balance sheets Examples of policies of this kind duringthe size of intermediary balance sheets Examples of policies of this kind during

the recent crisis include the Fedrsquos purchases of commercial paper through itsthe recent crisis include the Fedrsquos purchases of commercial paper through its

Commercial Paper Funding Facility and its purchases of mortgage-backed secu-Commercial Paper Funding Facility and its purchases of mortgage-backed secu-

rities and agency debt On the motivation for and effects of these programsrities and agency debt On the motivation for and effects of these programs

see for example Adrian Kimbrough and Marchioni (2010) Gagnon Raskinsee for example Adrian Kimbrough and Marchioni (2010) Gagnon Raskin

Remache and Sack (2010) and in this journal Kacperczyk and Schnabl (2010)Remache and Sack (2010) and in this journal Kacperczyk and Schnabl (2010)

In this case as well the supply of intermediationIn this case as well the supply of intermediation XS is shifted to the right evenis shifted to the right even

though the equilibrium relation between the credit spread and the quantity ofthough the equilibrium relation between the credit spread and the quantity of

risky assets that can be held on the balance sheets of private intermediaries doesrisky assets that can be held on the balance sheets of private intermediaries does

not changenot change1717

It should not be assumed that because it is possible in principle for the centralIt should not be assumed that because it is possible in principle for the central

bank to reduce equilibrium spreads through direct intervention in credit marketsbank to reduce equilibrium spreads through direct intervention in credit markets

it is therefore desirable for the central bank to intervene continually to maintainit is therefore desirable for the central bank to intervene continually to maintain

zero spreads In Cuacuterdia and Woodford (2010b) we assume costs of central-bankzero spreads In Cuacuterdia and Woodford (2010b) we assume costs of central-banklending to the private sector that imply that under normal circumstances itlending to the private sector that imply that under normal circumstances it

will not be optimal for the central bank to hold assets other than highly liquid will not be optimal for the central bank to hold assets other than highly liquid

Treasury securities on its balance sheet but even so central-bank lending to theTreasury securities on its balance sheet but even so central-bank lending to the

private sector can be justi ed on welfare grounds in the case of a large enoughprivate sector can be justi1047297ed on welfare grounds in the case of a large enough

disruption of credit supply Gertler and Karadi (2010) reach a similar conclusiondisruption of credit supply Gertler and Karadi (2010) reach a similar conclusion

using a related modelusing a related model

Monetary Policy and Financial StabilityMonetary Policy and Financial Stability

Finally the fact that a reduction in the capital of intermediaries has an adverseFinally the fact that a reduction in the capital of intermediaries has an adverse

effect on the supply of intermediationmdashwhich in turn can seriously disturb both aggre-effect on the supply of intermediationmdashwhich in turn can seriously disturb both aggre-gate demand and the composition of expendituremdashimplies that it is desirable to reducegate demand and the composition of expendituremdashimplies that it is desirable to reduce

how frequently such crises occur The role that monetary policy can or should play inhow frequently such crises occur The role that monetary policy can or should play in

this regard remains controversial However a crisis that sharply reduces intermediarythis regard remains controversial However a crisis that sharply reduces intermediary

capital can more easily occur in the sense that the size of the required exogenouscapital can more easily occur in the sense that the size of the required exogenous

disturbance is smaller when intermediaries are highly leveraged Thus while thedisturbance is smaller when intermediaries are highly leveraged Thus while the

increased volume of lending that a relaxation of leverage constraints makes possibleincreased volume of lending that a relaxation of leverage constraints makes possible

17 Note that on this analysis the effects of targeted central bank asset purchases have nothing to do with

ldquoquantitative easingrdquo as the effects do not depend on the purchases being 1047297nanced by an increase inbank reserves nor do conditions in the market for bank reserves play any role in our analysis See Cuacuterdiaand Woodford (2010b) for further discussion




can improve the short-run allocation of resources this bene t must be weighed againstcan improve the short-run allocation of resources this bene1047297t must be weighed against

the increased risk of occurrence of a crisis that will (if it occurs) increase distortions inthe increased risk of occurrence of a crisis that will (if it occurs) increase distortions in

the future in ways that monetary policy will not then be able to counteract fullythe future in ways that monetary policy will not then be able to counteract fully

The model sketched here implies that increased leverage in the nancial sectorThe model sketched here implies that increased leverage in the 1047297nancial sectoris a natural consequence of looser monetary policy because of the effects of higheris a natural consequence of looser monetary policy because of the effects of higher

incomes on loan demand and supply shown in Figure 2A Other more complexincomes on loan demand and supply shown in Figure 2A Other more complex

mechanisms such as the model of misperception of risk by the funders of interme-mechanisms such as the model of misperception of risk by the funders of interme-

diaries proposed by Dubecq Mojon and Ragot (2009) can make this effect evendiaries proposed by Dubecq Mojon and Ragot (2009) can make this effect even

stronger Given this the consequences of policy for nancial stability need to bestronger Given this the consequences of policy for 1047297nancial stability need to be

considered in making interest-rate decisions alongside the consequences of policyconsidered in making interest-rate decisions alongside the consequences of policy

for aggregate economic activity and in1047298ationfor aggregate economic activity and in1047298ation

The nature of this consideration should not be completely symmetricalThe nature of this consideration should not be completely symmetrical

marginal adjustments of interest rates always have consequences for output andmarginal adjustments of interest rates always have consequences for output and

in1047298ation while they will have nonnegligible consequences for the risk of nancialin1047298ation while they will have nonnegligible consequences for the risk of 1047297nancial

instability only at certain times when the leverage is extreme enough for even smallinstability only at certain times when the leverage is extreme enough for even small

changes in asset values to have substantial effects on intermediary capital Improvedchanges in asset values to have substantial effects on intermediary capital Improved

regulation andor macroprudential supervision could further reduce the range ofregulation andor macroprudential supervision could further reduce the range of

circumstances in which this consideration would matter for monetary policy deci-circumstances in which this consideration would matter for monetary policy deci-

sions and this would be desirable if possible as freeing monetary policy to focussions and this would be desirable if possible as freeing monetary policy to focus

solely on output and in1047298ation stabilization should allow those goals to be moresolely on output and in1047298ation stabilization should allow those goals to be more

effectively achieved But in the absence of a complete solution of that kind it iseffectively achieved But in the absence of a complete solution of that kind it is

dif cult to defend the view that nancial stability can be ignored in monetary policydif1047297cult to defend the view that 1047297nancial stability can be ignored in monetary policy

decisions and the development of practical real-time indicators of risks to nancialdecisions and the development of practical real-time indicators of risks to 1047297nancialstability is accordingly an important challenge of the present momentstability is accordingly an important challenge of the present moment

I would like to thank Tobias Adrian Bill Brainard Vasco Cuacuterdia Jamie McAndrews

Benoit Mojon Tommaso Monacelli Julio Rotemberg and Argia Sbordone for helpful

discussions Luminita Stevens for research assistance and the editors of this journal David

Autor Chad Jones and Timothy Taylor for many useful comments on earlier drafts I would

also like to thank the National Science Foundation for research support under grant number

SES-0820438

References

Adrian Tobias Karin Kimbrough and Dina

Marchioni 2010 ldquoThe Federal Reserversquos Commer-cial Paper Funding Facilityrdquo Federal Reserve Bankof New York Staff Report 423

Adrian Tobias Emanuel Moench and Hyun

Song Shin 2010a ldquoFinancial Intermediation AssetPrices and Macroeconomic Dynamicsrdquo Federal

Reserve Bank of New York Staff Report 422 Adrian Tobias Emanuel Moench and Hyun

Song Shin 2010b ldquoMacro Risk Premium and

Intermediary Balance Sheet Quantitiesrdquo FederalReserve Bank of New York Staff Report 428

Adrian Tobias and Hyun Song Shin 2009ldquoPrices and Quantities in the Monetary PolicyTransmission Mechanismrdquo International Journal of

Central Banking 5(4) 131ndash42 Adrian Tobias and Hyun Song Shin Forth-

coming (a) ldquoThe Changing Nature of FinancialIntermediation and the Financial Crisis of2007ndash09rdquo Annual Review of Economics



Michael Woodford 43

Adrian Tobias and Hyun Song Shin Forthcom-ing (b) ldquoFinancial Intermediaries and MonetaryEconomicsrdquo In Handbook of Monetary Economics

vol 3 ed B M Friedman and M Woodford

Amsterdam Elsevier Ashcraft Adam Nicolae Gacircrleanu and Lasse

Heje Pedersen Forthcoming ldquoTwo MonetaryTools Interest Rates and Haircutsrdquo In NBER

Macroeconomics Annual 2010 ed D Acemogluand M Woodford Chicago University of ChicagoPress

Baker Dean 2010 ldquoBlame It on the BubblerdquoThe Guardian March 8

Beaudry Paul and Amartya Lahiri 2010 ldquoRisk Allocation Debt Fueled Expansion and FinancialCrisisrdquo June httpfacultyartsubccaalahiri

BeaudryLahiripdfBennett Paul and Stavros Peristiani 2002 ldquoAreUS Reserve Requirements Still Bindingrdquo FederalReserve Bank of New York Economic Policy Review

8(1) 53ndash68Bernanke Ben S and Alan S Blinder 1988

ldquoCredit Money and Aggregate Demandrdquo American

Economic Review 78(2) 435ndash39Bernanke Ben S and Mark Gertler 1995

ldquoInside the Black Box The Credit Channel ofMonetary Policy Transmissionrdquo Journal of Economic

Perspectives 9(4) 27ndash48Bernanke Ben S Mark Gertler and Simon

Gilchrist 1999 ldquoThe Financial Accelerator in aQuantitative Business Cycle Frameworkrdquo Chap21 in Handbook of Macroeconomics vol 1C ed J BTaylor and M Woodford Amsterdam Elsevier

Brunnermeier Markus 2009 ldquoDeciphering theLiquidity and Credit Crunch 2007ndash2008rdquo Journal of

Economic Perspectives 23(1) 77ndash100Buiter Willem H 2010 ldquoHousing Wealth Isnrsquot

Wealthrdquo Economics The Open-Access Open Assess-

ment E-Journal vol 4 no 2010-22 httpwww economics-ejournalorgeconomicsjournalarticles2010-22

Christiano Lawrence Roberto Motto and

Massimo Rostagno 2010 Financial Factors in

Economic Fluctuations European Central Bank Working Paper 1192 httpwwwecbeuropaeupubpdfscpwpsecbwp1192pdf

Cuacuterdia Vasco and Michael Woodford

2009 ldquoCredit Frictions and Optimal MonetaryPolicyrdquo httpwwwcolumbiaedu~mw2230credit_0709

Cuacuterdia Vasco and Michael Woodford 2010aldquoCredit Spreads and Monetary Policyrdquo Journal of

Money Credit and Banking 42(6 Supp) 3ndash35Cuacuterdia Vasco and Michael Woodford

2010bldquoThe Central-Bank Balance Sheet as anInstrument of Monetary Policyrdquo NBER WorkingPaper 16208

Dubecq Simon Benoit Mojon and Xavier

Ragot 2009 ldquoFuzzy Capital Requirements RiskShifting and the Risk-Taking Channel of MonetaryPolicyrdquo Banque de France Working Paper 254

httpwwwbanquedefrancefrgbpublicationstelecharnerDT254pdf

Friedman Milton 1968 ldquoThe Role of MonetaryPolicyrdquo American Economic Review 58(1) 1ndash17

Friedman Milton and Anna J Schwartz 1963A Monetary History of the United States 1867ndash1960

Princeton Princeton University PressGagnon Joseph Matthew Raskin Julie

Remache and Brian Sack 2010 ldquoLarge-Scale Asset Purchases by the Federal Reserve Did They Workrdquo Federal Reserve Bank of New York StaffReport 441

Gacircrleanu Nicolae and Lasse Heje Pedersen2010 ldquoMargin-Based Asset Pricing and Deviationsfrom the Law of One Pricerdquo httppagessternnyuedu~lpedersepapersMarginPricingLoOPpdf

Gaspar Vitor and Anil K Kashyap 2006ldquoStability First Re1047298ections Inspired by OtmarIssingrsquos Success as the ECBrsquos Chief EconomistrdquoIn Monetary Policy A Journey from Theory to Practice 86ndash118 Frankfurt European Central Bank

Geanakoplos John 1997 ldquoPromises PromisesrdquoIn The Economy as an Evolving Complex System II ed W B Arthur S N Durlauf and D A Lane285ndash320 Reading MA Addison Wesley

Geanakoplos John 2003 ldquoLiquidity Defaultand Crashes Endogenous Contracts in GeneralEquilibriumrdquo Chap 5 in Advances in Economics

and Econometrics Theory and Applications II ed MDewatripont L P Hansen and S J TurnovskyCambridge Cambridge University Press

Geanakoplos John 2010 ldquoThe LeverageCyclerdquo In NBER Macroeconomics Annual 2009 edD Acemoglu K Rogoff and M Woodford 1ndash65 Chicago University of Chicago Press

Gerali Andrea Stefano Neri Luca Sessa and

Federico M Signoretti 2010 ldquoCredit and Bankingin a DSGE Model of the Euro Areardquo Journal of

Money Credit and Banking 42(S1) 107ndash141Gertler Mark and Peter Karadi 2010 ldquoA Model

of Unconventional Monetary Policyrdquo httpwww carnegie-rochesterrochestereduapril10-pdfsGertler20Karadipdf

Gertler Mark and Nobuhiro Kiyotaki Forth-coming ldquoFinancial Intermediation and CreditPolicy in Business Cycle Analysisrdquo In Handbook of

Monetary Economics vol 3 ed B M Friedman andM Woodford Amsterdam Elsevier

Giavazzi Francesco 2008 ldquoWhy Does theSpread between LIBOR and Expected Future

Policy Rates Persist and Should Central Banks DoSomething About Itrdquo VoxEUorg posted June 2

Gilchrist Simon Alberto Ortiz and Egon




Zakrajsek 2009 ldquoCredit Risk and the Macroecon-omy Evidence from an Estimated DSGE ModelrdquohttpswsbueduaortizbCredit20Risk20and20the20Macroeconomy20Gilchrist20

Ortiz2020ZakrajsekpdfGoodfriend Marvin and Bennett T McCallum

2007 ldquoBanking and Interest Rates in MonetaryPolicy Analysis A Quantitative Explorationrdquo

Journal of Monetary Economics 54(5) 1480ndash1507Gorton Gary B and Andrew Metrick 2009

ldquoHaircutsrdquo NBER Working Paper 15273Greenlaw David Jan Hatzius Anil K Kashyap

and Hyun Song Shin 2008 Leveraged Losses Lessons

from the Mortgage Market Meltdown US MonetaryPolicy Forum Report No 2 Chicago University ofChicago Booth School of Business

Kacperczyk Marcin and Philipp Schnabl 2010ldquoWhen Safe Proved Risky Commercial Paperduring the Financial Crisis of 2007ndash2009rdquo Journal

of Economic Perspectives 24(1) 29ndash50Kashyap Anil and Jeremy Stein 1994 ldquoMone-

tary Policy and Bank Lendingrdquo In Monetary Policy

ed N G Mankiw 221ndash56 Chicago University ofChicago Press

Kim Don H and Jonathan H Wright 2005ldquoAn Arbitrage-Free Three-Factor Term StructureModel and the Recent Behavior of Long-Term

Yields and Distant-Horizon Forward RatesrdquoFinance and Economics Discussion Series No

2005-33 Federal Reserve Board AugustKiyotaki Nobuhiro and John Moore 1997

ldquoCredit Cyclesrdquo Journal of Political Economy 105(2)211ndash48

Romer David 2000 ldquoKeynesian Macro-

economics without the LM Curverdquo Journal of

Economic Perspectives 14(2) 149ndash69Sarkar Asani 2009 ldquoLiquidity Risk Credit Risk

and the Federal Reserversquos Responses to the Crisisrdquo

Financial Markets and Portfolio Management 23(4)335ndash48

Smant David 2002 ldquoBank Credit in theTransmission of Monetary Policy A Critical Reviewof the Issues and Evidencerdquo MRPA paper 19816Munich Personal RePEc Archive

Taylor John B 1993 ldquoDiscretion versus PolicyRules in Practicerdquo Carnegie-Rochester Conference Series

on Public Policy vol 39 pp 195ndash214Taylor John B 2008 ldquoMonetary Policy and

the State of the Economyrdquo Testimony before theCommittee on Financial Services US House ofRepresentatives February 26

Taylor John B 2009 Getting Off Track How

Government Actions and Interventions Caused

Prolonged and Worsened the Financial Crisis StanfordHoover Press

Taylor John B and John C Williams 2009ldquoA Black Swan in the Money Marketrdquo American

Economic Journal Macroeconomics 1(1) 58ndash83 Woodford Michael 2003 Interest and Prices

Foundations of a Theory of Monetary Policy PrincetonPrinceton University Press

Woodford Michael 2007 ldquoThe Case forForecast Targeting as a Monetary Policy Strategyrdquo

Journal of Economic Perspectives 21(4) 3ndash24Zigrand Jean-Pierre Hyun Song Shin and

Jon Danielsson 2010 ldquoRisk Appetite and Endog-enous Riskrdquo Financial Markets Group DiscussionPaper 647



Copyright of Journal of Economic Perspectives is the property of American Economic Association and its

content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holders

express written permission However users may print download or email articles for individual use




Why a New Framework for Macroeconomic Analysis is Needed Why a New Framework for Macroeconomic Analysis is Needed

It may be useful rst to review why familiar macroeconomic models do notIt may be useful 1047297rst to review why familiar macroeconomic models do not

already incorporate the features needed to make sense of recent economic devel-already incorporate the features needed to make sense of recent economic devel-opments I shall argue that it is dif cult to understand why either the signi cantopments I shall argue that it is dif1047297cult to understand why either the signi1047297cant

decline in house prices since 2006 or the substantial losses sustained by nancialdecline in house prices since 2006 or the substantial losses sustained by 1047297nancial

rms should have so seriously affected aggregate employment and economic1047297rms should have so seriously affected aggregate employment and economic

activity except in the context of a model in which nancial intermediaries play aactivity except in the context of a model in which 1047297nancial intermediaries play a

crucial role and in which their ability to ful ll that function can at some times becrucial role and in which their ability to ful1047297ll that function can at some times be

signi cantly impairedsigni1047297cantly impaired

Housing Prices and Aggregate DemandHousing Prices and Aggregate Demand

While the severity of the recent nancial crisis has been extensively discussed While the severity of the recent 1047297nancial crisis has been extensively discussed

some have questioned whether it was really the primary cause of the Great Recessionsome have questioned whether it was really the primary cause of the Great Recession

For example Baker (2010) argues that a substantial reduction in aggregate demandFor example Baker (2010) argues that a substantial reduction in aggregate demand

can be explained as a wealth effect on consumer expenditure given the declinecan be explained as a wealth effect on consumer expenditure given the decline

in US householdsrsquo housing wealth by several trillion dollars In this analysis ldquothein US householdsrsquo housing wealth by several trillion dollars In this analysis ldquothe

problem is not rst and foremost a nancial crisisrdquo But as Buiter (2010) points outproblem is not 1047297rst and foremost a 1047297nancial crisisrdquo But as Buiter (2010) points out

there is no aggregate wealth effect of a decline in housing prices since the house-there is no aggregate wealth effect of a decline in housing prices since the house-

hold sector in aggregate is both the owner of the housing stock and the consumerhold sector in aggregate is both the owner of the housing stock and the consumer

of the services supplied by it A fall in house prices reduces the value of an assetof the services supplied by it A fall in house prices reduces the value of an asset

but also reduces the cost of buying the stream of housing services that people werebut also reduces the cost of buying the stream of housing services that people were

planning to purchase by exactly the same amountplanning to purchase by exactly the same amountIt is possible to have a nonzero effect on aggregate expenditure on other goodsIt is possible to have a nonzero effect on aggregate expenditure on other goods

(when other prices remain unchanged) even without nancial frictions owing to(when other prices remain unchanged) even without 1047297nancial frictions owing to

redistribution of wealth between households with a net ldquolongrdquo position in housingredistribution of wealth between households with a net ldquolongrdquo position in housing

and those with net ldquoshortrdquo positions if the average marginal propensities to consumeand those with net ldquoshortrdquo positions if the average marginal propensities to consume

out of wealth are different between the two types Nonetheless because the positiveout of wealth are different between the two types Nonetheless because the positive

and negative wealth effects will largely offset one another the effect on aggregateand negative wealth effects will largely offset one another the effect on aggregate

demand is likely to be fairly small relative to the size of the aggregate decrease indemand is likely to be fairly small relative to the size of the aggregate decrease in

housing wealthhousing wealth

Larger effects are instead possible if one recognizes that the losses resultingLarger effects are instead possible if one recognizes that the losses resulting

from the collapse of housing prices were disproportionately concentrated in certainfrom the collapse of housing prices were disproportionately concentrated in certainnancial institutions which play a role in the allocation of resources that cannot1047297nancial institutions which play a role in the allocation of resources that cannot

easily be replaced by those to whom wealth was redistributed A model of this kindeasily be replaced by those to whom wealth was redistributed A model of this kind

is sketched below For a quantitative analysis of the effects of the fall in US housingis sketched below For a quantitative analysis of the effects of the fall in US housing

prices that stresses such effects see Greenlaw Hatzius Kashyap and Shin (2008)prices that stresses such effects see Greenlaw Hatzius Kashyap and Shin (2008)

Banking and the Money SupplyBanking and the Money Supply

It is also dif cult to understand why large losses by nancial institutions onIt is also dif1047297cult to understand why large losses by 1047297nancial institutions on

housing-related bets should have such a signi cant effect on the real economyhousing-related bets should have such a signi1047297cant effect on the real economy

without a model that takes account of credit frictions According to the well-known without a model that takes account of credit frictions According to the well-known

monetarist view banking crises affect the economy because they reduce the totalmonetarist view banking crises affect the economy because they reduce the total

supply of money in the economy since the ldquomoney multiplierrdquomdashthe factor by whichsupply of money in the economy since the ldquomoney multiplierrdquomdashthe factor by which



Michael Woodford 23



















































































Figure 1




$

b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash15002 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

Commercial banking





2 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

$ b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash1500

Checkable deposits


Fed funds and repos

Commercial paper




































byby i 11 andand L










Michael Woodford 27

Figure 2







i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y



Volume of lending

Aggregate income











i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43




























































































Michael Woodford 23



















































































Figure 1




$

b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash15002 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

Commercial banking





2 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

$ b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash1500

Checkable deposits


Fed funds and repos

Commercial paper




































byby i 11 andand L










Michael Woodford 27

Figure 2







i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y



Volume of lending

Aggregate income











i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43







































































































































Figure 1




$

b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash15002 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

Commercial banking





2 0 0 3 - Q 1

2 0 0 3 - Q 4

2 0 0 4 - Q 3

2 0 0 5 - Q 2

2 0 0 6 - Q 1

2 0 0 6 - Q 4

2 0 0 7 - Q 3

2 0 0 8 - Q 2

2 0 0 9 - Q 1

2 0 0 9 - Q 4

$ b i l l i o n s

2000

1500

1000

500

0

ndash500

ndash1000

ndash1500

Checkable deposits


Fed funds and repos

Commercial paper




































byby i 11 andand L










Michael Woodford 27

Figure 2







i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y



Volume of lending

Aggregate income











i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43





























































































































byby i 11 andand L










Michael Woodford 27

Figure 2







i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y



Volume of lending

Aggregate income











i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43




























































































Michael Woodford 27

Figure 2







i 1

i 2

L 1 L 2 L

LD

LS i

i 1

i 2

i MP

IS

Y 1 Y 2 Y



Volume of lending

Aggregate income











i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43




































































































i 22 andand L

22















































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43












































































































































Michael Woodford 31















































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43






































































































++ i bb )(1)(1



















scheduleschedule




















































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43
































































































































i ss






Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43





























































































Figure 4





i 1

i 2

i s


MP

IS

Y 1 Y

Aggregate incomeY 2

ω1

ω2

ω

I n t e r e s t

r a t e s p r e a d

( b e t w e e n

s a v e r s a n d

b o r r o w e r s )

XS

XD

L 1 L




Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43




























































































Michael Woodford 35



























































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43













































































































































Figure 5





2003 2004 2005 2006 2007 2008 2009 201000

10

20

30

40

50

60FF target


Baa-Treasury spread

LIBOR-OIS spread













































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43





































































































































Michael Woodford 39















































































































































SES-0820438

References













Michael Woodford 43











































































































































































































SES-0820438

References













Michael Woodford 43




























































































Michael Woodford 43


























































































michael woodford

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