MACROECONOMIC 2

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Week7and8StudentSlidesTopic5MoneyMarketMonetaryPolicyFinancialInstitutionsGlobalEcoCrisisMelb.pptx

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The Money Market, Financial Markets and Monetary Policy

Topic 5

Financial Markets and Institutions

Financial markets are organized exchanges where securities and financial instruments are bought and sold.

Direct Finance: When borrowers issue securities directly to lenders

Indirect Finance: When borrowers are matched to lenders indirectly via financial intermediaries, who make loans to borrowers and obtain funds from savers, often by accepting deposits.

Direct vs. Indirect Finance

What determines whether savers channel their funds through financial markets or through intermediaries?

Direct finance depends on reputation, which limits transactions to large, well-established corporations.

Role of financial intermediaries

Spreading of risk

Efficient collection of information

The Role of Financial Intermediaries and Financial Markets

Financial

Intermediaries

Banks

Managed Funds

Credit Unions

Financial

Markets

Bond Market

Stock Market

Savers

Households

Firms

Government

Foreigners

Borrowers

Households

Firms

Government

Foreigners

Balance Sheets

A balance sheet sums up a unit’s assets and liabilities.

If assets are greater (less) than liabilities, then the unit has a positive (negative) net worth

Represented by a “T” account

The difference between a bank’s assets and liabilities is referred to as the bank’s equity.

The bank’s equity is often called “bank capital” and is also the same as the bank’s net worth

The ratio of a bank’s equity to the value of its assets is used as a measure of the bank’s financial health – capital ratio

Bank Assets and Liabilities

Bank assets consists mainly of loans of all types as well as financial investments

Examples: Treasury bills, Mortgage-backed securities

Loans are generally risky

Risk is the probability that a given investment or loan will fail to bring the expected return and may result in a loss of the partial or full value of the investment.

Vault cash is also a bank asset

The main liability of banks is the deposits it owes the depositors

Balance Sheet

Banks are subject to reserve requirements and/or capital requirements

Balance Sheet After a Decline in Loan and Investment Values

$110 million

Bank Insolvency and Deposit Insurance

A bank is insolvent when its equity is zero or negative

If this happens, a bank is said to “fail”

Should depositors monitor their bank to make sure it has adequate equity?

1929-1932: Thousands of banks failed as depositor feared for the solvency of banks and rushed to withdraw their deposits

This is known as a bank run

2009: 140 bank failures

Bank Insolvency and Deposit Insurance

Banks make profits by making loans at an interest rate higher than that which they pay to depositors. The more loans that banks grant per dollar of bank equity, the higher the bank’s rate of return on that equity.

Leverage is the ratio of the liabilities (debt) of a financial institution to its equity capital

Leverage increases when banks develop methods to grant more loans with their existing equity capital

Leverage magnifies (reduces) profits when the value of an investment is increasing (decreasing)

The key element that creates wide swings of profit and loss on equity is that the value of the loan stays fixed while the market price of the asset can freely rise or fall.

“Nonbank” Financial Institutions

In Australia we have 3 types of financial institutions:

Authorised Deposit-taking Institutions (ADIs) – banks; building societies and credit unions

Non-ADI Financial Institutions – money market corporations; finance companies; securitisers

Insurers and Fund Managers

“Nonbank” Financial Institutions

“Nonbank” financial institutions make loans like banks, however, they do not accept deposits

Source of funds = borrowing from other financial institution

Not regulated by the Fed in US (other nations differ although regulation is often weaker), so no need to hold reserves

Often hold little equity to boost leverage and thus, profits

Examples: Bear Stearns and Lehman Brothers

Both failed in 2008!

Balance Sheet of the Exotica & Toxic Fund

The Definition of Money

Money is defined as any good or asset that serves the following three functions:

Medium of Exchange

Store of Value

Unit of Account

The Money Supply (MS) is equal to currency in circulation plus checking/current accounts at banks and thrift institutions.

Definitions of Money

M1 is defined as currency in active circulation (CU) plus bank current deposits from the private non-bank sector (D). This measure is used by economists trying to quantify the amount of money in circulation. The M1 is a very liquid measure of the money supply, as it contains cash and assets that can quickly be converted to currency.

Algebraically: M1 = CU + D

M3 is defined as M1 plus all other Authorised Deposit-taking Institution (ADI) deposits from the private non-bank sector plus certificates of deposit issued by banks less ADI deposits held with each other.

rba.gov.au

Definitions of Money

Broad money is the widest definition of money published by the Reserve Bank of Australia (RBA). Broad money is defined as M3 plus borrowings from the private sector by non-bank financial intermediaries (including cash management trusts) less their holdings of currency and bank deposits. This measure is generally used to estimate the entire supply of money within an economy.

Monetary Base or High-powered Money (H) is defined as holdings of banknotes and coins by the private sector (CU) plus deposits of banks with the Reserve Bank of Australia (RBA) and other RBA liabilities to the private non-bank sector (RES)

Algebraically: H = CU + RES

H is also sometimes referred to as the Reserve Money of the banking system.

Banks’ Balance Sheet & Money Creation

The money base consists of:

notes and coins held by the private sector

banks’ deposits at the RBA

other non-private assets with the RBA.

The money supply consists mostly of bank deposits due to the fractional reserve banking system.

Fractional reserve banking is the requirement that banks must keep a fraction of their deposits in cash or the equivalent.

Banks’ Balance Sheet & Money Creation

The money multiplier links money and money base.

The money multiplier:

is defined as the ratio of the supply of money to the supply of money base

has value greater than 1.

The larger the multiplier, the greater the proportion of deposits in the money supply.

Banks’ Balance Sheet & Money Creation

The money supply M consists of currency CU plus deposits D:

M = CU + D

The money base H consists of currency CU plus reserves:

H = CU + reserves

The larger the multiplier, the greater the proportion of deposits in the money supply.

Banks’ Balance Sheet & Money Creation

The behaviour of the public, banks and the RBA in the money supply process is summarised in:

the currency–deposit ratio, c ≡ CU/D

the reserve ratio, e ≡ reserves/D

the money base, H.

The money multiplier mm:

Check Your Knowledge

The stock of high-powered money in the economy is $80 billion. The bank reserve-holding ratio is 0.12 and the public wishes to hold 10% of its deposits as cash. The money supply will be approximately

$363 billion.

$400 billion.

$327 billion.

$425 billion.

Complications

Leakage into excess reserves

extra reserves may be kept by banks for liquidity purposes.

Leakage due to cash withdrawal

not all loaned funds may be deposited into banks.

Variation in the willingness to lend and borrow

consumers may not wish to borrow and banks may not wish to lend.

Demand for Money

Two components:

Transaction Demand for Money: The demand for money as a medium of exchange. We hold money to undertake transactions.

Asset Demand for Money: The demand for money as a financial asset and store of value.

Transactions Demand for Money

Mdt

100

M/P (Real money balances)

If each dollar held for transaction purposes is spent on average 3 times per year, and nominal GDP is assumed to be $300b, than the public would need $100b of money to purchase that GDP. Transactions demand for money is therefore $100b.

Depends on money (nominal) GDP. The larger the number of transactions, the larger the total money value of all goods and services exchanged in the economy, and hence the higher the transactions demand for money:

Asset (Speculative) Demand for Money

Consider an individual who is faced with a choice between holding their wealth as money or holding their wealth in the form of financial assets, such as bonds.

Advantage of holding money

Liquidity

Lack of risk

Advantage of holding bonds

Interest Return

So, how much of your financial assets should you hold in the form of bonds and how much in the form of money?

Asset Demand for Money

Opportunity cost of holding money

M/P (Real money balances)

Mda

200

10%

Interest Rates and the Price of Bonds

Another reason for the slope involved the inverse relationship between the price of bonds and the interest rate.

Lower bond prices are associated with higher interest rates.

Suppose a bond with no expiration date pays a fixed $50 annual interest payment and is selling for its face value of $1000.

: the interest yield on this bond is 5%

Suppose the price of this bond rises to $2000 because of an increase in the demand for bonds. The $50 fixed annual interest payment will now yield 2.5% to whomever buys the bond.

Total Demand for Money

Add Mdt horizontally to Mda to derive total money demand (Md)

Mda

Mdt

100

Mda

200

300

100

Money Demand

The demand for money is determined by people’s need for money to facilitate transactions.

If Income (Y)  Md

If the Price Level (P)  Md

Real money demand = = hY

The demand for money also depends negatively on the cost of holding money, the interest rate (r).

If r  Md as people switch out of money into interest-bearing savings accounts or other financial assets

Algebraically, the general linear form of Md is:

(where h, f > 0)

What Shifts Money Demand?

The main shift factor for real Md is income (Y).

Additional shift factors include:

Interest paid on money: If money pays more interest, Md rises

Wealth: If people become wealthier, some of the additional wealth may be held as money, so Md rises.

Expected future inflation: If people expect P to rise quickly in the future, they will try to hold as little money as possible.

Payment technologies: Any technological development that alters how people pay for goods and services, or the ease of switching between money and non-money assets can change Md (Examples: Credit Cards and ATM’s)

Shifts of Money Demand

h∆Y

Money Market

(M/P)s

M/P

Md0

(Y = Y0)

Md1

(Y = Y1)

Inter-Bank Overnight Rate

U.S.: Federal Funds Rate (Prime Rate) - the interest rate at which depository institutions lend reserve balances to other depository institutions in the overnight money market.

Australia: Cash Rate - the interest rate which banks pay to borrow funds from other banks in the money market on an overnight basis.

Singapore: “The Monetary Authority of Singapore, instead of relying on short-term interest rates or monetary aggregates as its monetary policy instrument, conducts policy by managing the trade-weighted exchange rate index (TWI)” MAS

Central Bank Target Policies

Australia’s Central Bank is the Reserve Bank of Australia (RBA).

The RBA has two major roles:

To maintain the financial integrity and stability of the Australian financial system.

To implement monetary policy. Monetary policy is action taken by the RBA to affect interest rates in order to target inflation.

Goals of monetary policy

Full employment of the labour force

Stability of the Australian currency

Economic prosperity and welfare for the people of Australia

Inflation Targeting

Since 1993 the RBA works to achieve all three aims (goals) through price stability (controlling inflation).

The RBA achieves price stability through committing to a publicly announced inflation rate.

This is known as “inflation targeting”.

The RBA’s target inflation rate is between 2 - 3% on average over the business cycle.

Central Bank Tools for Changing MS

Central banks manage financial liquidity and interest rates via:

Open Market Operations are purchases and sales of government securities made by the central bank in order to change high-powered money

An open market purchase (sale) of bonds would increase (decrease) the money supply, decreasing (increasing) the interest rate

Required Reserves are the reserves that central bank regulations require depository institutions to hold.

An increase (decrease) in the required reserve ratio would tend to decrease (increase) the money supply

Foreign exchange

The RBA sometimes intervenes in the foreign exchange market to affect exchange rates.

The buying and selling of foreign exchange affects the money base.

The instruments of monetary control

The RBA uses open market operations (OMOs) to manage the money base in order to achieve a target for the cash rate.

Consider an open market purchase:

The RBA buys government bonds from a commercial bank.

The bank receives a credit in its exchange settlements account with the RBA.

The bank has just increased its reserves.

These reserves may be used to make payments to other banks or exchanged for currency.

Thus, the RBA has increased the money base.

A Transmission Mechanism

The Investment Demand Channel

(M/P)s1

M/P2

(M/P)s2

M/P1

45°

Ep0

Ep1

Other Transmission Mechanisms of Monetary Policy

Cash flow channel:

Refers to the effect of interest rates not on the incentive to spend, but on the amount of cash available for spending.

An increase in interest payments may squeeze cash flows and contribute to a decline in business investment.

Asset prices:

Higher interest rates can be expected to reduce many asset values because they increase the opportunity cost of holding these assets.

Check Your Knowledge

The RBA should consider cutting interest rates while inflation remains negligible…..

How would the RBA cut interest rates?

Is this an expansionary or contractionary monetary policy?

What impact would this have on the level of output and employment?

What is the relevance of “negligible inflation” to the RBA’s decision of whether or not to reduce interest rates?

The instruments of monetary control

The RBA targets interest rates by affecting system liquidity.

Household sector: money supply can expand or contract as a result of changes in household deposits in banks – affecting credit creation, the money supply and thus interest rates.

Banking sector: amount lent and borrowed will affect credit creation and thus the money supply and interest rates.

The RBA enters the market on a daily basis and announces its intentions to trade; to maintain system liquidly at a particular cash rate, thus interest rate.

The instruments of monetary control

The cash rate

The RBA does not attempt to control the quantity of money base.

The RBA attempts to control a target interest rate: the cash rate.

The RBA allows the money base to vary on a daily basis, consistent with the cash target rate.

That is, the RBA controls the price of short-term liquidity by affecting the supply of exchange settlement accounts available to banks.

Check Your Knowledge

Monetary authorities can influence the money supply or the rate of interest but they cannot set the two independently. True or false?

True

Quantity Theory of Money

Classical economists believe that flexible prices were the self-correcting forces that could stabilize real GDP

Believe that unemployment was voluntary and/or transitory condition

Alfred Pigou (1913) argued that unemployment came from the slow adjustment of wages that kept labor markets from equilibrium

The “Quantity Equation” was a model developed by classical economists:

MSV = PY

Ms is the supply of money

V is the velocity of circulation. It indicates how fast a given stock of money circulates to finance transactions. the rate at which money changes hands

P is the price level.

Y is real GDP

Hence PY = nominal or money GDP

Quantity Theory of Money

The Quantity Theory of Money holds that:

Actual output tends to grow steadily

Velocity is determined by payment practices

MS changes therefore affect the price level and have little effect on output

↑Ms  ↑P  INF

↑Ms  ESM at prevailing interest rates, as a result we can

Consume more; increased demand for goods and services  ↑P

Increased demand for bonds, price of bonds increase and bond yields and interest rates fall. Falling interest rates increase demand for goods and services  ↑P

Quantity Equation

The quantity equation transforms to:

growth rate of Ms+ growth rate of V =

growth rate of P + growth rate of Y

This can be re-arranged as:

inflation rate =

growth rate of Ms+ growth rate of V – growth rate of Y

If velocity is constant, then the growth rate of velocity is zero. The equation can be rewritten as:

inflation rate = growth rate of Ms – growth rate of Y

Check Your Knowledge

A former Governor of the Reserve Bank of India once warned of the potential for inflation as money growth exceeded the expected growth in the real economy.

Using the Quantity Theory of Money, explain the economic thinking behind this concern.

Bubbles and Crashes

An asset bubble is a sustained large rise in the price of an asset relative to its fundamental value, followed by a collapse in prices that eliminates most or all of the initial price gain.

Bubbles originate from an outside shock that changes perceptions about profit opportunities

Main ingredients for bubbles:

High degrees of leverage that boost profit potential

Easy source of credit

In some bubbles, financial innovation makes borrowing easier with complex new financial instruments that are hard to understand

Bubbles and Crashes

Some important bubbles:

Stock price bubble of 1927-29 lead to the Great Depression

Cause: Speculation fuelled by high allowed levels of leverage

Stock price bubble 1996-2000 lead to 50% ↓ in stock prices

Cause: Unbounded optimism in “Dot.com” company profit potential

Housing bubble of 2000-06 lead to the Global Economic Crises

Causes: (1) Very low interest rates from the Central Bank and (2) financial innovations

Financial Innovation and the Subprime Mortgage Market

Securitisation is the process of combining many different debt instruments like home mortgages into a pool of hundreds and even thousands of individual contracts, and then selling new financial instruments backed by the pool

Example: Mortgage-backed securities (MBS)

Banks that originated loans no longer needed to worry about borrower creditworthiness

Financial Innovation and the Subprime Mortgage Market

The subprime mortgage market consists of borrowers who have some combination of low incomes, unstable employment histories, and poor credit records

Risky loan nickname: “NINJA Loans” = “No Income No Job No Assets”

Thrived as long as the Central Bank kept interest rates low and granting home loans to risky borrowers was in harmony with overall government policy

In mid-2004, Fed raised short term rates, and many subprime loans began to “reset”

Borrowers fell behind mortgage payments  foreclosures followed

Why Buy Risky Subprime MBS’s?

Individual investors were misled

Security ratings agencies (like Moody’s and Standard and Poors) gave unrealistic “AAA” ratings to subprime debt

Why did financial institutions buy MBS’s?

Ignorance: No previous housing bubble in history

Greed: Fees and bonuses fueled additional risk-taking

But not all financial institutions where buying…

The End of the Housing Bubble

Risk-taking was fueled by the premise that housing prices would increase indefinitely

But Fed raised the federal funds rate from 1.0% to 5.25% between mid-2004 to mid-2006

Adjustable rate mortgages interest rates rose

Families had to choose between defaulting on mortgages vs. cutting other household expenses

New loans became more difficult to receive  Housing demand↓

“Flippers” became fearful and started to sell

Result: Housing prices plummeted!

Housing price collapse  Onset of financial crisis

Value of MBS collateral↓ MBS value↓ Financial institutions failed

Quantitative Easing

Central Bank policy instrument was to target the federal funds/cash rate. Two problems

“Zero Lower Bound:” The cash rate/federal funds rate cannot be pushed below zero

Firms and households do not borrow at the cash rate/federal funds rate, so even a low rate may not boost investment & consumption

New method to ease the crisis: Quantitative Easing occurs when a central bank purchases assets for the purpose of increasing bank reserves (not lowering short-term interest rates)

Provided liquidity to markets for distressed financial assets like MBS’s, which improved balance sheets of suffering financial institutions

Radically changed the balance sheet of the Central Bank

Bailouts as Unconventional Stimulus

The severity of the 2008-09 crisis necessitated additional policies to prevent economic collapse.

These novel policies have been called “financial policies” or “bailout policies.”

These policies do not count as monetary or fiscal policies because they were carried out by both the Central Bank and the Treasury in cooperation with each other.

The core bailout program was the Troubled Asset Relief Program (TARP).

Initiated two weeks after the fall of Lehman Brothers

Lent government money to financial institutions on the brink of insolvency due to insufficient equity capital

Also prevented the sale of GM and Chrysler Motors

Bailouts as Unconventional Stimulus

Measures of success of bailouts

One study: Without bailouts, Y would have been 5% lower and U = 12.5%

Controversies persist because…

Benefits not widely publicized

Bailout of financial institutions seemed to reward those who caused the crisis

How The Financial Crisis Became Worldwide

U.S. subprime housing market estimated at $250B

World decline in GDP from 2007-09 = 20 times $250B

World decline in stocks equaled 100 times initial shock

Why such an amplification of the subprime shock?

Dramatic jump in interest rate risk premium lead to higher costs of doing business worldwide

Global slowdown in investment and employment

Slowdown in lending by financial intermediaries worldwide

Many foreign financial institutions invested heavily in U.S. subprime debt

These investments were financed by borrowing short-term low-interest USD loans

When short-term loans evaporated, these financial institutions could not renew loans

But value of their MBS investments collapsed  crisis exacerbated