23.7 How might bank behavior lead to causation running from output to the money supply? What does this say about Friedman and Schwartz’s evidence that there is a strong correlation between money and output? •What other arguments can you make that challenge the monetarist assertion that monetary mischief leads to output fluctuations?•What independent evidence supports the monetarist position? 23.11 In the 1973-1975 recession, the value of common stocks in real terms fell nearly 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of this recession? 23.14 The Nobel laureate Franco Modigliani found that the most important transmission mechanisms of monetary policy involve consumer expenditure. Describe how these work. •Monetary policy and the Tobin q. Discuss. •Financial stability and a Tobin tax. Discuss. •Capital requirements, progress and stability. Discuss.

The stance of monetary policy: what really matters?

Monetary Policy Strategies:Advantages and Disadvantages

Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2008

Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999), updates from the same sources, and www.rbnz.govt .nz/statistics/econind/a3/ha3.xls.

Tools, Policy Instruments, Intermediate Targets and Goals of Monetary Policy

Criteria for Choosing the Policy Instrument

• Ease of observing and measuring• Ability to control• Predictable effect on Goals

Market for Reserves

Target Nonborrowed Reserves:FFRATE varies as reserve demand shifts

Target Federal Funds Rate:Must vary NBRs to accommodateshifts in reserve demand

Taylor Rule for Federal Funds Rate:1970–2008Target fed funds rate = 2% + π + ½ (π – π*) + ½ ((Y-Yfe)/Yfe)

Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.

McChesneyMartin

Arthur F. Burns

Paul Volcker

Wm.Miller

A l a n G r e e n s p a n

BenBernanke

Tools of Monetary Policy

• Open market operations• Discount rate borrowed reserves

– LENDER OF LAST RESORT• Reserve requirements

– Affect the money multiplier…don’t touch/don’t matter• Federal funds rate—the interest rate on overnight loans of

reserves from one bank to another» Primary indicator of the stance of monetary policy

Determined by Supply and Demand for reserves• FOMC Balance of Risks Statement

Public’s expectations of Fed’s intent Behavior supportive of Fed’s intent

The Money Supply Model

• Money = Currency plus checkable deposits: M1

M = C + D• The monetary base (MB)—the assets of the central bank— “backs” the

money supply

• The CB’s assets = MB =The CB’s liabilities = C + R

MB = MBn + BR

• The money supply (M) is a multiple m of the monetary baseM = m x MB = m x (MBn + BR)

m = ( 1 + c ) / ( c + r + e ) = 1 + ( 1 – r – e ) / ( c + r + e )

The Functions of a Modern Central BankGovernment's Bank: • Manages government transactions.• Controls availability of money and credit.Banker’s Bank:

Lender of last resort in crisesOperates clearing system for interbank payments.Oversees financial intermediaries

Functions of Federal Reserve District Banks• Clear checks

• Issue new currency/withdraw damaged currency

• Make discount loans to banks in district

• Evaluate mergers/expansions of bank activities

• Liaison between business community and the Fed

• Examine bank holding companies and state-chartered member banks

• Collect data on local business conditions

• Research Money, Banking and the Financial System

Asymmetric Information and Bank Regulation(OCC, FDIC, Fed, OTS)Government safety net• Deposit insurance/FDIC: Short circuits bank failures and contagion effect

• Payoff method/Purchase and assumption method

• Fed as lender of last resort: Too BIG to Fail• Financial consolidation Exacerbates Too Big to Fail• Safety net extended to non-bank financial institutions

Safety Net Moral Hazard Problems by Depositors and BanksSafety Net Adverse Selection Problems: Risk-loving bankers

Attempted solutions: Constrain banks from taking too much risk• Promote diversification• Prohibit holdings of common stock• Set capital requirements … Capital as cushion

Prompt corrective action: Close ‘em down when capital inadequate• Monitor … CAMELS: Capital adequacy/Asset quality/Mgt/Earnings/Liquidity/

Sensitivity to market risk• Disclosure requirements … mark-to-market issue• Restrictions on competition … make banking boring

Bank ManagementLiquidity Management

Ample excess reservesBorrow reserves

Discount loansFederal funds market

Secondary reservesReduce loans

Asset ManagementReturn/Risk/LiquidityTradeoff/Balance

Liability ManagementDeposits/CDs/Fed funds…

Capital Adequacy ManagementPrevent failureRegulatory requirement

Basel Accord: Risk-based reqmtLeverage ratio

Performance MeasuresReturn on assets: ROAReturn on equity: ROEEquity multiplier: EM

EM = Assets/Equity CapitalCredit Risk

Screening / MonitoringSpecialized lendingRestrictive covenantsCompensating balancesCredit rationingCOLLATERAL

Interest-rate RiskGap and Duration analysis

Off-balance-sheet ActivitiesLoan sales—SecuritizationFee income: SIVs/UnderwritingTrading income

• Value at risk/Stress test/Hedges

Financial Crisesand Aggregate Economic Activity• Crises can be caused by: Increases in interest rates/

Increases in uncertainty/Asset market effects on balance sheets/ Banking sector problems/Government fiscal imbalances

Vicious spiralsFinancial crises we have known: 1819, 1837, 1857, 1873, 1884, 1893, 1907,

1930 - 33, 2008

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt DeflationSpiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Unleashed

Great Depression vs. Great Crisis1929 – 1939

{Lead Up: BOOM Monetary Tightening}•Stock market crash, September 1929

• Fed injects liquidity

•Bank panic (9/30) / Bank of US (12/30)• Passive Fed response• Defend gold! (October 1931)

• Discount rate up 2%• Great Contraction of money supply• Tax increase, 1932• Treasury Secretary Mellon: “…

liquidate labor, liquidate stocks, liquidate the farmer, liquidate real estate…”

•1933 Bank holiday Confidence in banks restored

2008 – 2009 {Lead Up: BOOM Monetary Tightening}•Housing Bubble Burst ~ Fall 2007

• Subprime meltdown MBS decline• Bear Stearns Bailout• Fannie/Freddie Bailout

•Lehman collapse, September 2008• “Swift and bold” policy responses

• AIG nationalization• Innovative “facilities”

maintain credit flow• TARP• Fiscal Stimulus

• 2% of GDP in 2009• 2 ½ % of GDP in 2010

•2009 Stress Tests Confidence in banks restored

Administration Wish – List • Fed as czar?• Council of regulators

– Evaluate systemic risks/Identify emerging financial innovations

• Resolution authority– FDIC model … insurance premiums based on systemic risk?

• Consumer financial protection agencyCan the Fed do it? Has the Fed done it????

Other ideas in the air• Central clearinghouse for ALL derivatives• “Consumer protection” for sophisticated financial products• Deferred compensation / “clawbacks”• Toughened/countercyclical capital requirements• Tobin tax sand in the well-greased gears of speculation

Financing business: Adverse selection & moral hazard Eight Facts

1. Stocks are not most important source of external financing

2. Issuing marketable securities (debt and equity) not the main way businesses finance operations

3. Indirect finance is much more important than direct finance

4. Financial intermediaries the most important source of external funds

5. The financial system is heavily regulated

6. Only large, well-established corporations have (had) easy access to securities markets to finance their activities

need reputation and net worth

7. Debt contracts: trust … but collateral

8. Debt contracts: trust … but restrictive covenants

Long-Term Bond Yields, 1919–2008

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.

Movements over Time of Interest Rates on U.S. Government Bonds with Different Maturities

Sources: Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.

2 1

12

Both bonds will be held only if the expected returns are equal

2

2The two-period rate must equal the average of the two one-period rates

For bonds with longer maturities

et t t

et t

t

t tnt

i i i

i ii

i ii

1 2 ( 1)...

The -period interest rate equals the average of the one-period

interest rates expected to occur over the -period life of the bond

e e et t ni i

nn

n

Expectations Theory of Term StructureBuy a two-year bond yielding i2t or buy a one year bond yielding i1t and turn it over next year at expected yield ie

1t+1 ?

But also need to account for preferred habitats (greater interest rate risk and lesser liquidity of long-term bonds add liquidity premium lnt.

Mon

ey S

uppl

y G

row

th a

nd P

ossi

ble

Inte

rest

Rat

e Re

spon

ses

2 3

Using the same strategy used for the fixed-payment loan:

P = price of coupon bond

C = yearly coupon payment

F = face value of the bond

= years to maturity date

C C C C FP = . . . +

1+ (1+ ) (1+ ) (1+ ) (1n

n

i i i i

+ )ni

2 3

The same cash flow payment every period throughout

the life of the loan

LV = loan value

FP = fixed yearly payment

= number of years until maturity

FP FP FP FPLV = . . . +

1 + (1 + ) (1 + ) (1 + )n

n

i i i i

Present Values and Interest Rates: i PV

Price of a coupon bond summation of “discount bonds”