TOPIC 5TOPIC 5

Fed Policy and Money MarketsFed Policy and Money Markets

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Outline

• What is Money?

• What does affect the supply of Money?

– How the banking system works?

– What is the Fed and how does it work?

– What is a monetary policy?

• What does affect the demand of Money?

– Asset Portfolio Decision

– Quantitative Theory of Money

• Equilibrium in the Money Market

• The LM curve

Overview of Money and The Banking SystemOverview of Money and The Banking System

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Money

• “Money” is the economic term for assets that are widely used and accepted as payment.

• The forms of money have been very different: from shells to gold to cigarettes(Eastern Europe and German Prisoners Of the War camps)

• Most prices are measured in units of money → understanding the role of money is important to understand inflation.

• Many economists believe that money has also impact on real variables (mostly in the short run)

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Three Functions of Money

1. Medium of exchange: Money permits trade of goods and services at lower cost (in terms of time and effort)

• Barter is inefficient because is difficult and time-consuming to find the trading partner.

• Other benefit: allows specialization (and rises productivity)

1. Unit of account: Money is the basic unit for measuring economic value

• Given that goods and services are mostly exchanged for money, it is natural to express economic value in terms of money

• Caveat: In countries with volatile inflation, money is a poor unit of account because prices must be changed frequently. More stable units of account used (dollars or gold), even if transactions use local currency.

2. Store of Value: money is a way of storing wealth.

• Other types of assets may pay higher returns, BUT money is also a medium of exchange.

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Measures of Money

• The distinction between monetary and non-monetary assets is controversial.

• Example: MMMFs (money market mutual funds) are organizations that sell shares to the public and invest in short-term government and corporate debt. MMFs pay low return and allow for checks (with fee)…Are they Money?

• There are two main official measures of money stock, called monetary aggregates:

1. M1: the most narrow definition, includes mainly currencies and balances held in checking accounts.

2. M2: includes everything in M1 plus other “money like” components: saving deposits, small time deposits, MMMFs, MMDAs (money market deposit accounts), etc..

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Money Supply

• Money supply is the amount of money available in an economy

• In modern economies, money supply is affected by:

1. Central Banks (the Federal Reserve System in the United States). The central bank is a government institution responsible for monetary policies within an economy.

2. Depositary Institutions. Deposit Institutions are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public.

3. The public. The public includes every person or firm (except banks) that holds money in currency or deposits (think of money in your pocket or money in your firms “petty cash” drawer.

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The Banking System: An Introduction

Bank Assets and Liabilities:

Assets: Loans (TL) + Reserves (TR)

Liabilities: Deposits (TD) (and potentially other stuff).

Reserves = liquid assets held by the bank to meet the demand for

withdrawals by depositors or to pay checks

How do banks make money? They Lend.

How much do they lend? Must keep a minimum amount of reserves (required by law).

Definition: m = required reserve ratio

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The Banking System: An Introduction

Fractional reserve banking: Banks hold only a fraction of their deposits in reserve.

Reserve-deposit ratio: = required reserves/deposits = m

Fractional reserve banking: → m < 1 (100% reserve banking → m = 1)

Assume banks lend all they can:

- TR = m*TD

- Implies banks only hold required reserves

Implications:

- TD = TL + TR (money held within the banking system)

- ΔTD = ΔTL + ΔTR (equation holds in changes)

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The Banking System: An Example

Suppose I put $500 in the bank (remove it from under my mattress).

We call the $500 that starts the process the ‘Initial Deposit’ (ID)

Two Strong Assumptions: 1) Suppose that no one else in the economy holds cash.

2) Suppose banks only hold required reserves.

Minor Assumption: Suppose that m = 0.1.

What happens in the banking system:

Step 1: Deposits increase by $500 (initial deposit).

Step 2: Then, Deposits increase by another $450.

Step 3: Then, Deposits increase by another $405.

Step 4: ………….(keep increasing)

Step infinity: ………….(keep increasing)

Why do deposits keep increasing? LOANS!!!!

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The Banking System: An Example

Step 1: Assets LiabilitiesTR $ 500 TD $500

TRr = .1*500 = 50 → ΔTL = TR – TRr = 450

Step 2: Assets LiabilitiesTR $ 500 TD $950TL $ 450

TRr = .1*950 = 95 → ΔTL = TR – TRr = 405

Step 3: Assets LiabilitiesTR $ 500 TD $ 1355TL $ 855

TRr = .1* 1355 = 135.5 → ΔTL = TR – TRr = 364.5

The process continues ….. Loans and deposits expand up to a point TRr (required reserves) = TR (actual reserves).

That is, TD = TR / m = 5000 !

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The Money Multiplier: Formula Intuition

Total Change in Deposits: = ID + ID (1-m) + ID(1-m)2 + …

= ID (1 + (1-m) + (1-m)2 + … )

= ID (1/m)

Simple Money Multiplier μm = 1/m

TD = (1/m) ID

I want to stress that above equation only holds if:

– There are no holding of currency out of the banking system

– Banks may only hold required reserves

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A More Realist Model: Money Supply and Monetary Base

More Definitions:

MS = Money SupplyTC = Total Currency in Circulation (held outside banking system)BASE = Monetary base

Some Formulas:

MS = TC + TD (Money = money held in banks + money held outside banks)

ΔMS = ΔTC + ΔTD (Equation holds in changes)ΔMS = ΔTC + ΔTR + ΔTL (Substitute in change ΔTD = ΔTR + ΔTL)

BASE = TC + TR (All the physical currency in the economy)

Base = actual currency in the economy (held in the banks as reserves or held by the public outside the banking system)

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Money Supply and Monetary Base

Combining the two definitions (for MS and Base) we get:

MS/BASE = (TC + TD) / (TC + TR)

Define: TC/TD = cu = currency/deposit ratio.Depends on the amount of money the public wants to hold as

currency vs deposits.

• The public can increases or reduces cu, by withdrawing or depositing currency• Recall TR/TD = reserves/deposits ratio determined by the banks + regulation

(Define m* = actual reserve ratio held by banks such that: m* ≥ m ) With some algebra, we can re-write the Money supply as:

MS = [(cu + 1)/(cu + m*) ]* BASE

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More Generally….

Remember: MS = [(cu + 1)/(cu + m*) ]* BASE

If cu > 0 and m* > m, the money multiplier can be expressed as:

μ*m = (cu + 1)/(cu + m*)

- μ*m > 1 as long as m < 1!

- The Money multiplier decreases with cu! Role of the public

- The Money multiplier decreases with m*! Role of the banks

• Holding the base constant, the money supply (MS) will fall if people prefer holding cash outside of banking system (cu increases) or if banks start holding excess reserves (m* increases above m).

Overview of The Federal ReserveOverview of The Federal Reserve

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What is the Fed?

Overview

Quasi Public agency that oversees the U.S. banking system.

For the most part, independent of Executive and Legislative branches.

7 of the governing members (Governors) at the Fed are Presidential Appointments with Senate Confirmation (like Supreme Court Justices).

Has its own budget

12 member governing board – the 7 above members plus 5 rotating members from the Federal reserve branch banks (privately owned).

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What Part of the Money Supply Is Controlled by Fed?

Remember (from previous slide):

MS = [(cu + 1)/(cu + m*) ]* BASE

Fed controls:

Basem (by law - the required reserve ratio)m* (by influencing the discount rate and other policies)

Fed does not perfectly control the money supply any time:

cu > 0 (some people hold currency outside of banking system)m* > m (banks hold excess reserves)

If cu = 0 and m = m*, MS = Base/m = Base μm = TR μm

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How Does the Fed Control Money Supply?

How can the Fed affect money supply (and thereby interest rates)?

By creating reserves.

a) Open Market Operations (increase the monetary base)

b) Reserve Ratio (not used very much – increase the money multiplier)

c) Discount Window (discount rate - increase the money multiplier)

d) New Instruments (TARP, etc. – increase the money multiplier/base)

Note: The discount rate/new instruments could increase the money supply by inducing banks to hold less “excess reserves” (by brining m* close to m).

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Notes on Central Banks

• The Central Bank is The Banks’ Bank. The Central Bank operates a clearinghouse for bank checks. Each member bank has an account with the Central Bank. In the U.S. the deposits that banks have with the Fed are called federal funds.

• A closely related term, which is not specific to the U.S., is banks’ reserves (which consist of federal funds plus “vault cash”, or currency in the bank’ s cash machines, teller drawers, and vault).

• A check written against private bank A and deposited with private bank B reduces bank A’s federal funds and increases bank B’s federal funds. Thus banks want federal funds so they can honor check withdrawals. They want vault cash to honor cash withdrawals. Upshot: banks need reserves to honor withdrawals.

• Neither the Fed nor other major Central Banks target growth rates of the money supply (which consists of currency plus various measures of liquid assets like deposits).

• Fed targets the Federal Funds rate.

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What is the federal funds rate?

• Federal funds are the deposits of private banks with the Fed.

• The federal funds market consists of private banks borrowing and lending their

federal funds amongst each other overnight.

• The federal funds rate is the interest rate on these overnight loans. It is set by

supply and demand, not by the Fed.

• The Fed can change the supply of federal funds through open market

operations, exerting a powerful indirect effect on the fed funds rate.

• The Fed targets the federal funds rate and carries out open market operations to

keep the actual rate near the target rate.

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What are Open Market Operations?

Open market operations = Central Bank purchases and sales of government securities on the open market.

Open market purchase (sale) = Central Bank purchases (sells) government securities. The seller (buyer) receives (uses) federal funds as payment.

federal funds

Government Bonds

Central Bank Private Banks

= reserves

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A Fed purchase of government securities …

• Raises the supply of federal funds. More federal funds means they are cheaper to borrow, so a lower federal funds rate. (An increase in the supply of federal funds lowers their “price”);

• Drives up the price of those securities, which lowers their yield. A lower yield means a lower interest rate on government securities;

• Leaves banks flush with reserves. Banks find it profitable to convert some of their new zero-interest-earning reserves into loans (which in turn creates more deposits, raising the money supply). To get people/firms to borrow more (take the new loans they are offering), banks lower the interest rate on the loans.

Bottom Line: A Fed purchase of government securities lowers i.

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Notes on FOMC directives

The Federal Reserve Open Market Committee (FOMC) meets every 6 weeks and issues a directive to the trading desk of the Federal Reserve Bank of New York.

Fed Time: the Desk carries out open market operations between 11:30 and 11:45 ET each trading day to keep the actual fed funds rate near the target.

The FOMC directive is also asymmetric or symmetric:

Symmetric:

No bias. Neutral stance. Just as likely to raise as to lower the target next.

Asymmetric:

A bias toward easing (more likely to lower than raise the target next) or a bias toward tightening (more likely to raise than lower the target next).

The symmetry of the directive is not public until over 6 weeks after each meeting.

Look at the federal funds rate futures in the WSJ to see what the market thinks.

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Federal Reserve’s Lending

• The discount rate is the interest rate on direct loans from the Fed to private

banks. The Fed sets the discount rate.

• Discount window loans used to play a minor role in Fed policy (primary and

secondary credit discount loan since 2003)

• With the recent crisis, more banks have used discount windows loans together

with new borrowing channels.

• New Monetary Policy instryments: Term Auction Facility (TAF), Term Asset-

Backed Securities Loan Facility (TALF), Commercial Paper Funding Facilities

(CPFF), …

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Reserves and Borrowing (in millions of U.S. dollars)

Monetary Base

Total reserves of depository institutions

Required reserves of depository institutions

Total borrowings of

depository institutions

Non borrowed reserves of depository institutions

2007-12 836,432 42,701 40,932 15,430 27,2712008-01 831,104 44,065 42,425 45,660 -1,5952008-02 828,694 42,799 41,073 60,157 -17,3582008-03 832,358 42,714 39,735 94,523 -51,8102008-04 830,495 43,504 41,658 135,410 -91,9062008-05 833,974 45,106 43,093 155,780 -110,6742008-06 839,084 43,923 41,649 171,278 -127,3552008-07 846,455 44,106 42,129 165,664 -121,5582008-08 847,290 44,107 42,116 168,078 -123,9722008-09 908,029 102,568 42,517 290,105 -187,5372008-10 1,132,519 314,909 47,005 648,319 -333,4102008-11 1,441,048 609,506 50,453 698,786 -89,2802008-12 1,663,861 821,227 53,815 653,565 167,6612009-1 1,700,775 858,418 60,173 563,496 294,9222009-2 1,554,130 700,968 57,459 582,497 118,4702009-3 1,639,588 779,954 55,315 612,111 167,843

source: Federal Reserve Board

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The federal funds rate vs. the discount rate

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The Fed’s Balance Sheet

• The Fed receives interest on its assets (U.S. government securities + loans to banks).

• The Fed pays no interest on its liabilities (currency and fed funds).

• The Fed is highly profitable, which fosters its independence. The Fed returns its profits to the Treasury.

• Hence the interest that the Treasury pays on securities held by the Fed is not a cost for the Government: that portion of public debt is effectively monetized (pays 0 interest)

The Quantity Theory: Money and InflationThe Quantity Theory: Money and Inflation

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The Quantity Theory of Money: Quantity Equation

M*V = P*Y

M = money supply, P = the GDP deflator, Y = real GDP

V = velocity = PY/M. We define V in this way

If V is constant and Y is beyond the Central Bank’s LR control then ...

When the Central Bank doubles M, the result is a doubling of P

“Inflation is always and everywhere a monetary phenomenon”

This Friedman quote is not literally correct because of Y and V movements. But a LR correlation of .95 means it’s close enough.

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The Evolution of Velocity (M1)

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The Evolution of Velocity (M2)

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Notes on the Quantity Equation

V is defined so that the Quantity Equation holds. Identity: P = MV / Y .

Inflation (rising P) is caused by too much money chasing too few goods, i.e. by M rising relative to Y (controlling for how much M we need to transact PY, which is V).

Note inflation could rise despite fixed M because of falling Y or rising V. Across countries, however, most differences in inflation (P growth) are associated with differences in M growth: correlation between M growth and inflation is above .95.

V is not fixed in reality. V rises with financial innovation and with i (the nominal interest rate). Recall that i = r +π. If, like Y, r is beyond the Central Bank’s LR control, then higher inflation translates one-for-one into higher i. Implication: V rises with the rate of inflation.

Thus taking into account that V is not fixed only makes the channel from M growth to P growth stronger: when M growth is high it generates inflation , which raises V, which in turn raises inflation further. This is a big deal in hyperinflations.

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Money Growth and Inflation

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Nominal Interest Rates and π

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Monetizing Government Debt

• When public debt is growing faster than GDP, there is political pressure on the Central Bank to monetize some of the government debt b/c

– public debt pays interest, reserves do not;

– fixed nominal debt is easier to pay off the higher is P.

• Large budget deficits are the underlying cause of hyperinflations. The debt and deficit limits in Europe’s EMU are meant to prevent member countries from pushing for higher inflation.

• Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt.

The Central Bank buys public debt with reserves (increases monetary base!).

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CB Independence & Inflation

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Hyperinflations are ...

• sometimes defined as 30% or more inflation in a year

• usually characterized by accelerating inflation (wage indexation)

• caused by rapid M growth (the Central Bank creating new reserves at a rapid rate)

• exacerbated by rising velocity (efforts to economize on M)

• highly disruptive to Y

• 1985 Bolivia 10,000%, 1989 Argentina 3100%, 1990 Peru 7500%, 1993 Brazil

2100%, 1993 Ukraine 5000%.

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Why Do Governments Grow the Money Supply?

Short Term Political Gains - reduce unemployment (or raise output). If the economy is capacity constrained - prices must rise (however, this usually occurs with a lag!)

Accommodating Supply Shocks - The U.S. in the 70s! (as opposed to breaking the inflation cycle).

Financing Government Deficits by Printing Money!!!

We will deal with these reasons more as the course progresses.

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Websites with more info

The Fed and District Banks (see the Board of Governors website for FOMC minutes and speeches and testimony of FOMC members): http://www.ny.frb.org/links.html

Foreign Central Banks: http://www.bog.frb.fed.us/centralbanks.htm

Fed Points (each explains something, e.g. how currency gets into circulation): http://www.ny.frb.org/pihome/fedpoint/

Details on how open market operations work: http://www.ny.frb.org/pihome/addpub/omo.html

Overview of the Fed: http://www.federalreserve.gov

The Money Market:Money Demand, Money Supply, and the LM Curve

The Money Market:Money Demand, Money Supply, and the LM Curve

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Money Supply (Summary)

Remember: MS = [(cu + 1)/(cu + m*) ]* BASE

Define Nominal Money Supply (Ms):

Fed conducts monetary policy to increase Money Supply:

- Open Market Purchases (increase Base)

- Decrease the reserve ratio (decrease m)

- Decrease the Discount Rate (decrease m*)

Also influenced by the public:

- Bank runs (increase in cu)

- Bank precautionary motives (increase in m* above m)

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Money Demand

• Agents decide how much wealth to keep as money: Portfolio allocation decision

• 3 main characteristics of assets matter:

1. Expected Return: The higher the expected return the higher consumption the agent can enjoy!

2. Risk: Agents are risk-averse, hence to hold a risky asset, it must have a higher expected return

3. Liquidity: The easier is to exchange the asset for goods, services or other assets, the more attractive is the asset. Money is highly liquid!

Money is the most liquid BUT has a low return!

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Money Demand (continued)

• Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions.

• As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions. This is the liquidity demand for money.

• As the nominal interest rate on non-money assets (bonds), i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases.

• Since i = r + πe, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).

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Money Demand (continued)

Other factors affecting Money Demand:

– Wealth

– Risk

– Liquidity of Alternative Assets

– Payment Technologies

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Money Demand Function

Our model for the demand for nominal money balances takes the following form

Md = P·Ld(Y, i)

where

Md = demand for nominal money balances (demand for M1)

Ld = demand for liquidity function

P = aggregate price level (CPI or GDP deflator)

Y = real income (real GDP)

i = nominal interest rate on non-money assets

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Real Money Balances

The demand for real balances

Since the demand for nominal balances is proportional to the aggregate price level, we can divide both sides of the nominal money demand equation by P.

This gives the liquidity demand function or the demand for real balances function:

Md/P = Ld(Y, r + πe)

The left-hand-side of the above equation is the demand for nominal balances divided by the aggregate price level or the demand for real balances (the real purchasing power of money).

The right-hand side is the liquidity demand function. The demand for real balances is decomposed into a transactions demand for money (captured by Y) and a portfolio

demand for money (captured by r and πe).

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Money Demand

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Money Market

The Money Market is in Equilibrium when

Real Money Demand = Real Money Supply

where Real Money Supply = Ms/P

Real Money Demand = Md/P = Ld(Y, r + πe)

Note: The money supply curve does not change with interest rates (it is verticle)

What shifts real money supply: M, P

What shifts real money demand: Y, πe

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Money Market Equilibrium

Md = Ld(Y,πe)

Ms

M/P

Money Market

re

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Money Market Equilibrium – Increasing Y

Md = Ld(Y0,..)

Ms

M/P

Suppose Y increases from Y0 to Y1 (Holding Money Supply fixed!)

Money Market

r0

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Money Market Equilibrium – Increasing Y

Md = Ld(Y0,..)

Ms

M/P

Suppose Y increases from Y0 to Y1 (Holding Money Supply fixed!)

Money Market

r0Y increases

r1

Md = Ld(Y1,…)

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Positive Relationship Between Y and r (in Money Market)

Y Y1 Y

r0

r1

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Positive Relationship Between Y and r (in Money Market)

Y Y1 Y

We will refer to this as the LM curve

r0

r1

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The LM (Liquidity-Money) Curve

LM Curve: (drawn in (Y-r) space) - represents the relationship of Y and r through the money market (specifically - Y’s affect on money demand).

The LM Curve relates real interest rates to real changes in output in the money market.

As Y increases - Md shifts upwards - causing real interest rates to rise (increase in transactions demand increases the demand for money).

What shifts the LM curve?

Money: Increasing Money Supply increases M/P causing the LM curve to the right.

Prices: Increasing Prices causes real Money Balances to fall shifting LM curve to the left.

π e: Increasing expected inflation causes returns on bonds (assets other than money) to increase making it less attractive to hold cash. Causes LM curve to shift right!

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Shifting the LM curve: An Increase in M

Thought experiment: Suppose M increases. What level of Y is needed to hold r constant.

Or, put another way, what would happen to r if Y was held constant?

Money Market LM curve

r0 r0x x

Md(Y0)

Y0

Ms Ms1

zr1 r1 z

LM(M0)

LM(M1)

An increase in the nominal money supply will cause the LM curve to shift to the right (or shift down, if you prefer that metric).

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Interest Rates and Output

There are two effects driving the relationship between interest rates and output.

1) The IS curve. As interest rates fall, Investment increases and Y increases.

r falling causes Y to increase (negative relationship - the IS curve)

2) The transaction motive for holding money. As Y increases, demand for money increases and r increases.

Y increasing causes r to increase (positive relationship - the LM curve)

In equilibrium, both relationships need to be satisfied. We will work through this intuition in the next Topic.

However, before we do, we will see why we need to summarize the money market as the LM curve (as opposed to just Money Supply and Money Demand).

Remember: Everywhere along the LM curve represents equilibrium in the money market.

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An Illustration of “Monetary Feedback” in Money Market

Suppose M increases

Md = Ld(Y,πe)

Ms Ms1

M/P M1/P

Money Market

re

re1

0

1

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An Illustration of “Monetary Feedback” in Money Market

A fall in r, will increase I, causing Y to increase - which causes Md (and r) to increase….

Md = Ld(Y,πe)

Ms Ms1

M/P M1/P

Money Market

re

re1

0

1

2re2

M increases

Y increases

Md1 = Ld(Y1,πe)

• This process is known as monetary feedback - increasing M will cause r to fall, I to increases, Y to increase, money demand to increase and r to increase. The net effect on r will be to fall.

• The IS-LM representation will express this process in a more concise form?

Bonus Material:

The Money Market During The Great Depression and Current Recession

Bonus Material:

The Money Market During The Great Depression and Current Recession

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Banking During the Great Depression

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1929-1933: Bank Runs

From “A Monetary History of the United States 1857-1960” by Milton Friedman and Anna J. Schwartz

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“Flight to Currency”

• Cumulative decrease of bank deposits over 1929-1933 was 48.2%

• Why??? It was not because reserves fell, given that they rose by 8.4%

• A fractional reserve banking system is fragile (cu and m* can change).

• Two possible equilibria:

1. People believe banks have enough reserves to cover withdrawals and hence they do

2. People believe banks do not have enough reserves and hence they don’t

• In 1929-33: three episodes of bank runs in 1930 and 1933

• Aggregate decrease in deposits due to bank failures and preemptive withdrawals from sound banks (flight to currency).

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Optimal Policy During Bank Crises

• How can increased demand for currency precipitate a depression?

• To build up cash reserves, people sell off other assets (Md shifts out!)

• But the economy as a whole cannot get more liquidity if M is fixed (M actually falls from the fractional reserve system – i.e., because of the decline in the money multiplier).

• The only effect of this is that i (and likely r) increases (and chokes off firm investment (as i, and likely r, increase)).

• Spending decline results in both deflation and decline in production.

• Policy mistake as described by Friedman: the Fed could have offset deposit decrease by increasing reserves (M), permitting/encouraging sound banks to expand deposits (increase Base).

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Post Depression Bank Regulation

•After 1933, Roosevelt administration introduced measures to prevent bank runs (e.g. 1933: Glass-Steagall Act set up deposit insurance (FDIC))

- Only commercial banks permitted to issue insured demand deposits and regulated more tightly than investment banks

Unintended consequences

•Regulation, successful in avoiding bank runs BUT commercial banks get no return on reserves while investment banks can hold interest-bearing liquid assets

- Incentive for large depositors to move funds out of regulated banks and into unregulated (and uninsured) interest earning accounts.

- Became routine to move funds out of commercial bank into other higher return assets and then move them back just in time to make payments (“swaps”)

- A legal evasion of the requirements that banks not pay interest on commercial accounts!

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Bank Bailouts in Current Recession

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Financial Crisis 2007-08• By 1990s businesses had moved most deposits out of commercial banks into short run

securities that are thought to be safe from default risk and yield a better return!

• Examples: REPO borrowing , short term government debt and high-grade commercial papers, financial firms created low-risk derivatives out of packages of high risk assets,…

• People extending short term credit to Lehmann to get infinitesimally higher return than T-bill rate did not think (or did not admit) that they were taking on risk.

• The mechanics of short term borrowing is very similar to issue of demand deposits: give cash today and take it back whenever you like (decline to roll it over!)

• The economics of the “credit freeze” is very similar to bank runs!

• The freeze affected financial institutions living on repeated issues of short term debt

• As liquidity supply declines, everyone wants to get in government-insured assets (reserves, currency and insured deposits): flight to government promises to currency!

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Policy Response in this Recession

• As in the early stages of the Great Depression, this reduces spending, affecting output and prices…

What to do?

• According to Friedman and Swhwartz: the Fed needs to act as “lender of last resort”, injecting more reserves into the system fast.

• This is exactly what the Fed is doing! (Bernanke is a student of Friedman’s mindset).

• Bernanke’s speech for Friedman 90th birthday: “…I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

• Increasing reserves will stimulate spending, but the timing is uncertain.

• When Federal Funds market doesn’t work, Fed needs to develop other measures. Hence…..TARP, Fiscal Stimulus, etc.

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The Banking System: An Example (Kaplan 2008)Typical Bank’s Pre-crisis balance sheet:

Assets LiabilitiesLoans and Securities 100 Deposits 70

Short-term debt 10Long-term debt 10Equity 10

Banks made bad loans and bought bad securities (Suppose loans only worth “90”):Assets LiabilitiesLoans and Securities 90 Deposits 70

Short-term debt 10Long-term debt 10Equity 0

The bank is still solvent, but has 0 equity. However, if providers of short-term debt and depositors begin to question the solvency of the bank, they stop lending and withdraw deposits. “Bank run" even if the institution is (or would be) solvent under normal conditions!Everyone is suspicious of everyone else, because no one knows the real value of the equity. No one will provide short-term debt because they worry they will not get paid .

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The Banking System: An Example (Kaplan 2008)

If the value of loans declined badly enough:

Assets LiabilitiesLoans and Securities 80 Deposits 70

Short-term debt 7Long-term debt 3Equity 0

The bank is insolvent because cannot pay debt holders.

TARP 2: inject equity in the banks (worth “5”) + guarantee short term debtors (keep short term debt at “10” – banks continue to loan to each other). What if loans are worth only 90 at beginning of period?

Assets LiabilitiesLoans and Securities 90 Deposits 70Cash 5 Short-term debt 10

Long-term debt 10Equity 5

Bank is still solvent and equity prices are not wiped out.

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The Banking System: An Example (Kaplan 2008)

Suppose that loans declined by “80” instead of “90”. Is a capital injection of “5” enough to prevent bank failure?

Assets LiabilitiesLoans and Securities 80 Deposits 70Cash 5 Short-term debt 10

Long-term debt 5Equity 0

No – equity prices are wiped out AND it cannot pay off its long term debt.

The key issue around TARP is how much are the bank loans actually worth. If the lower the true underlying value of the bank loans, the more money that needs to be injected to prevent the banks from becoming insolvent.

Over the course of the policy response, this is why banks have not “lent” the TARP money. There is still risk over how much the loan portfolios are worth. If the loan portfolios continue to fall, the banks would risk insolvency. As a result, they are hoarding cash until the uncertainty of their loan portfolios are resolved.

When will the uncertainty of their loan portfolios be reduced? When housing prices stabilize.