Economics 2 Professor Christina Romer Spring 2016 Professor David - - PDF document

Economics 2 Professor Christina Romer Spring 2016 Professor David Romer LECTURE 23 FINANCIAL MARKETS AND MONETARY POLICY April 19, 2016 I. OVERVIEW

• II. THE MONEY MARKET, THE FEDERAL RESERVE, AND INTEREST RATES
• A. The market for money
• 1. The definition of money
• 2. Money demand
• 3. Money supply
• 4. Equilibrium
• B. The effects of a change in the money supply
• C. The Fed’s ability to influence the real interest rate
• 1. The short run
• 2. The long run
• D. A little about unconventional monetary policy
• III. MONETARY POLICY AND SHORT-RUN MACROECONOMIC FLUCTUATIONS
• A. Definition
• B. An increase in the real interest rate
• C. An example of monetary policy as a source of fluctuations: the Great Depression
• 1. The initial situation
• 2. The Fed’s response
• 3. Effects
• D. An example of monetary policy mitigating fluctuations: the Great Recession
• 1. The initial situation
• 2. The Fed’s response
• 3. Effects
• IV. FINANCIAL CRISES
• A. Introduction
• B. A crisis at a single institution
• C. Contagion
• D. The effects of a financial crisis
• E. Possible policy responses to a financial crisis
• F. Possible policies to prevent financial crises

LECTURE 23

Financial Markets and Monetary Policy

April 19, 2016

Economics 2 Christina Romer Spring 2016 David Romer

Announcement

• The only reading for next time is p. 674 of the

textbook.

Midterm #2 Summary Statistics

• Median: 72.5
• Standard deviation: 13.5
• 25th percentile: 63.5
• 75th percentile: 80

• I. OVERVIEW

Determination of Short-Run Output: The “Keynesian Cross”

Y PAE PAE Y=PAE Y1

• II. THE MONEY MARKET, THE FEDERAL RESERVE, AND

INTEREST RATES

Economists’ Definition of “Money”

• Assets that can be used to make purchases.
• Concretely, you can usually think of money as

meaning currency.

The Nominal Interest Rate and Money Demand

• Because you don’t earn interest on cash, the
• pportunity cost of holding money is what you

could earn on other assets.

• That is, the opportunity cost of holding money is

the nominal interest rate.

• So: Money demand is a decreasing function of the

nominal interest rate.

The Demand for Money

M i MD

Money Supply

• Determined by the central bank.
• The Fed decreases the money supply by selling

bonds in exchange for currency; it increases the money supply by buying bonds in exchange for currency.

• These transactions are known as “open-

market operations.”

• Usually, the bonds are short-term

government bonds.

• We take the money supply as given.

The Supply of Money

M i MS

Equilibrium in the Market for Money

M i MS M1 i1 MD

A Decrease in the Money Supply

M i MS1 M1 i1 MD1 MS2 M2 i2

The Fed sells bonds.

The Fed’s Ability to Influence the Real Interest Rate—the Short Run

• By changing the money supply, the Fed can

change the nominal interest rate, i.

• Recall: r = i − π (or r = i − πe), and there is inflation

inertia (inflation only changes slowly).

• So: When the Fed changes i, it changes r.

Nominal and Real Interest Rates (1-year nominal interest rate, and 1-year nominal rate minus 1-year inflation rate)

Source: FRED.

Nominal Real

The Fed’s Ability to Influence the Real Interest Rate—the Short Run versus the Long Run

• As we have just seen, the Fed can affect the real

interest rate in the short run.

• However, in the long run, r must be at the level

that equilibrates S* and I*.

• The Fed cannot keep r away from this level

indefinitely.

• We will discuss next time what prevents the Fed

from doing this.

Unconventional Monetary Policy—Motivation

• The main motive for unconventional monetary

policy: nominal interest rates cannot go (much) below zero.

• The reason is that there is an asset—currency—

that offers a zero nominal rate of return for sure.

The Two Main Forms of Unconventional Monetary Policy

• Forward guidance: Statements or actions that

influence expectations about future nominal interest rates.

• Quantitative easing: Buying bonds other than

short-term government debt with currency.

• Both forward guidance and quantitative easing

lower at least some real interest rates.

• For simplicity, in our analysis we will continue to

talk about “the” real interest rate, r.

• III. MONETARY POLICY AND SHORT-RUN

MACROECONOMIC FLUCTUATIONS

Monetary Policy

• Actions taken by the central bank to affect

nominal and real interest rates.

• Contractionary monetary policy: Federal Reserve

actions to increase nominal and real interest rates.

• Expansionary monetary policy: Federal Reserve

actions to decrease nominal and real interest rates.

The Real Interest Rate and Planned Aggregate Expenditure (PAE)

Recall: PAE = C + Ip + G + NX.

• Ip is lower when r is higher.
• Saving is higher when r is higher, so C is lower

when r is higher.

• We will see next week that NX is lower when r

is higher.

• We take G as given.

Conclusion: An increase in r reduces PAE at a given Y.

An Increase in the Real Interest Rate

Y PAE1 PAE Y=PAE Y* PAE2 Y2

Industrial Production, 1927–1934

Source: FRED.

The Money Stock, 1923–1933

Source: FRED.

Inflation, 1923–1933

Source: FRED.

Estimated Real Interest Rate (i−πe), 1929–1942

Source: Christina Romer, “What Ended the Great Depression?”

Monetary Policy in the Great Depression

Y PAE1 PAE Y=PAE Y* PAE2 Y2

PAE2 shows the effects of the fall in autonomous consumption (discussed in Lecture 21)

Monetary Policy in the Great Depression

Y PAE1 PAE Y=PAE Y* PAE2 Y2 PAE3 Y3

An example of monetary policy magnifying economic fluctuations

Industrial Production, 1927–1934

Source: FRED.

What happened to PAE in 2008?

• Decline in investment (particularly in housing)
• Housing bust reduced expected future MRPK
• f housing (which is a kind of capital).
• Financial crisis hurt animal spirits and made it

hard for firms to get credit.

• Decline in consumption
• Housing bust and stock market decline

destroyed wealth.

• Financial crisis hurt consumer confidence and

made it hard for households to get credit.

The Federal Funds Rate, 2007–2009

Source: FRED.

Monetary Policy in 2007–2008

Y PAE1 PAE Y=PAE Y* PAE2 Y2

PAE2 shows the effects of the housing bust and the financial crisis (discussed in Lecture 22)

Monetary Policy in 2007–2008

Y PAE1 PAE Y=PAE Y* PAE2 Y2 Y3 PAE3

An example of “countercyclical” monetary policy

Industrial Production, 2005–2010

Source: FRED.

• IV. FINANCIAL CRISES

Financial Intermediation

• The process of getting saving into productive

investment.

• Financial intermediaries are the markets and

institutions that do this.

• Financial intermediaries include banks, investment

banks, money market mutual funds, pension funds, etc.

What Is a Financial Crisis?

• A time when:
• A number of financial institutions are in danger
• f failing.
• People lose confidence in many financial

institutions.

• As a result, there is widespread disruption of

financial intermediation.

A Stylized Financial Institution Balance Sheet

Assets Liabilities Loans Deposits Securities Borrowings Capital Note: Capital is a liability that the institution does not have to pay back.

Why Financial Institutions Are Subject to Crises

• Defaults and changes in asset values can reduce the

value of an institution’s loans and securities.

• If the value of the loans and securities falls by more than

the amount of capital the institution had:

• The amount the institution must pay back (deposits

and borrowings) exceeds the value of its assets.

• That is, the bank is insolvent.
• Because of asymmetric information, concerns about the

solvency of a financial institution may take the form not

• f the institution facing a high interest rate to borrow,

but of it being unable to get funding on any terms.

House Prices, 1987–2015

Source: Federal Reserve Bank of St. Louis, FRED.

50 100 150 200 250

Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15

Case-Shiller House Price Index, January 2000 = 100

April 2006

Nonperforming Loans, 1995–2015

Source: FRED.

Contagion of Crises across Financial Institutions

• Confidence: Troubles at one institution create

doubts about the health of other institutions, even if there are no connections between them.

• Linkage: Troubles at one institution directly harm
• ther institutions because of loans, insurance

contracts, and other direct links among them.

• Fire Sale: Troubles at one institution cause it to sell
• ff assets, driving down the prices of assets held by
• ther institutions.
• Macroeconomic: Troubles at one institution reduce

PAE and hence Y, and so harm other institutions.

Credit Spreads during the Financial Crisis

Source: Economic Report of the President, February 2010.

Reduced Credit Availability in the Great Recession

Source: Federal Reserve, Senior Loan Officer Opinion Survey, January 2016.

Decline in the Number of Banks in the Great Depression

Source: www.econreview.com.

The Effects of a Financial Crisis on PAE

• Makes it harder for firms to get credit, and so

planned investment falls.

• Makes it harder for households to get credit, and

so consumption (at a given level of Y − T) falls.

• Harms firms’ and consumers’ confidence.

The Effects of a Financial Crisis on Output

Y PAE1 PAE Y=PAE Y* PAE2 Y2

Percentage Change in Real GDP

Source: Federal Reserve Bank of St. Louis, FRED

• 10.0
• 8.0
• 6.0
• 4.0
• 2.0

0.0 2.0 4.0 6.0 8.0 10.0

2000-I 2001-I 2002-I 2003-I 2004-I 2005-I 2006-I 2007-I 2008-I 2009-I 2010-I 2011-I 2012-I 2013-I 2014-I 2015-I

Percent Change (at an Annual Rate)

Possible Policies to Respond to a Financial Crisis

• Conventional expansionary fiscal and monetary

policy.

• Government interventions in poorly functioning

credit markets.

• More information about the health of financial

institutions (“stress tests”).

• Government guarantees (such as deposit insurance).
• Help for distressed financial institutions.
• Help for households and firms that are having

trouble borrowing.

Possible Policies to Prevent Financial Crises

• Higher capital requirements for financial

institutions.

• Deposit insurance.
• Regulation of risk-taking by financial institutions

and linkages among financial institutions.

• Using monetary and fiscal policy to keep the

economy stable.