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

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

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Economics 2 Professor Christina Romer Spring 2016 Professor David Romer LECTURE 23 FINANCIAL MARKETS AND MONETARY POLICY April 19, 2016 I. O VERVIEW II. T HE M ONEY M ARKET , THE F EDERAL R ESERVE , AND I NTEREST R ATES A. The market for

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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
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LECTURE 23

Financial Markets and Monetary Policy

April 19, 2016

Economics 2 Christina Romer Spring 2016 David Romer

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Announcement

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

textbook.

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  • I. OVERVIEW
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Determination of Short-Run Output: The “Keynesian Cross”

Y PAE PAE Y=PAE Y1

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

INTEREST RATES

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Economists’ Definition of “Money”

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

meaning currency.

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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.

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The Demand for Money

M i

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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.
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The Supply of Money

M i

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Equilibrium in the Market for Money

M i MS M1 i1 MD

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A Decrease in the Money Supply

M i MS1 M1 i1 MD1

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

Source: FRED.

Nominal Real

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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.

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Unconventional Monetary Policy—Motivation

  • The main motive for unconventional monetary

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

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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.

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  • III. MONETARY POLICY AND SHORT-RUN

MACROECONOMIC FLUCTUATIONS

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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.

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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.

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An Increase in the Real Interest Rate

Y PAE1 PAE Y=PAE Y*

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Industrial Production, 1927–1934

Source: FRED.

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The Money Stock, 1922–1933

Source: FRED.

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Inflation, 1923–1933

Source: FRED.

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

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

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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)

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Industrial Production, 1927–1934

Source: FRED.

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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.

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The Federal Funds Rate, 2007–2009

Source: FRED.

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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)

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Industrial Production, 2005–2010

Source: FRED.

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  • IV. FINANCIAL CRISES
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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.

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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.

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A Stylized Financial Institution Balance Sheet

Assets Liabilities Loans Deposits Securities Borrowings Capital

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Why Financial Institutions Are Subject to Crises

  • If the value of the loans and securities is less than

the value of the deposits and borrowings, the institution is insolvent.

  • Defaults and changes in asset values can reduce the

value of an institution’s loans and securities.

  • Because of asymmetric information, concerns about

the solvency of a financial institution may take the form not of the institution facing a high interest rate to borrow, but of the institution being unable to get funding on any terms.

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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

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Nonperforming Loans, 1995–2015

Source: FRED.

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Contagion of Crises across Financial Institutions

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Credit Spreads during the Financial Crisis

Source: Economic Report of the President, February 2010.

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Reduced Credit Availability in the Great Recession

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

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Bank Failures in the Great Depression

Source: www.econreview.com.

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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.
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The Effects of a Financial Crisis on Output

Y PAE1 PAE Y=PAE Y* PAE2 Y2

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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)

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Possible Policies to Respond to a Financial Crisis

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Possible Policies to Prevent Financial Crises