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 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. M ONETARY P OLICY AND S HORT -R UN M ACROECONOMIC F LUCTUATIONS 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. F INANCIAL C RISES 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
Economics 2 Christina Romer Spring 2016 David Romer L ECTURE 23 Financial Markets and Monetary Policy April 19, 2016
Announcement • The only reading for next time is p. 674 of the textbook.
Midterm #2 Summary Statistics • Median: 72.5 • Standard deviation: 13.5 • 25 th percentile: 63.5 • 75 th percentile: 80
I. O VERVIEW
Determination of Short-Run Output: The “Keynesian Cross” PAE Y=PAE PAE Y 1 Y
II. T HE M ONEY M ARKET , THE F EDERAL R ESERVE , AND I NTEREST R ATES
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 opportunity 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 i MD M
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 i MS M
Equilibrium in the Market for Money i MS i 1 MD M 1 M
A Decrease in the Money Supply i MS 2 MS 1 i 2 i 1 MD 1 M 2 M 1 M 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 − π e ), 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) Nominal Real Source: FRED.
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. M ONETARY P OLICY AND S HORT - RUN M ACROECONOMIC F LUCTUATIONS
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 + I p + G + NX. • I p 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 PAE Y=PAE PAE 1 PAE 2 Y 2 Y* Y
Industrial Production, 1927–1934 Source: FRED.
The Money Stock, 1923–1933 Source: FRED.
Inflation, 1923–1933 Source: FRED.
Estimated Real Interest Rate (i−π e ), 1929–1942 Source: Christina Romer, “What Ended the Great Depression?”
Monetary Policy in the Great Depression PAE Y=PAE PAE 1 PAE 2 Y 2 Y* Y PAE 2 shows the effects of the fall in autonomous consumption (discussed in Lecture 21)
Monetary Policy in the Great Depression PAE Y=PAE PAE 1 PAE 2 PAE 3 Y 3 Y 2 Y* Y 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 MRP K of 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 PAE Y=PAE PAE 1 PAE 2 Y 2 Y* Y PAE 2 shows the effects of the housing bust and the financial crisis (discussed in Lecture 22)
Monetary Policy in 2007–2008 PAE Y=PAE PAE 1 PAE 3 PAE 2 Y 2 Y 3 Y* Y An example of “countercyclical” monetary policy
Industrial Production, 2005–2010 Source: FRED.
IV. F INANCIAL C RISES
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 of 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 of the institution facing a high interest rate to borrow, but of it being unable to get funding on any terms.
Source: Federal Reserve Bank of St. Louis, FRED. Case-Shiller House Price Index, January 2000 = 100 100 150 200 250 50 0 Jan-87 House Prices, 1987–2015 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 April 2006 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15
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 other institutions because of loans, insurance contracts, and other direct links among them. • Fire Sale: Troubles at one institution cause it to sell off assets, driving down the prices of assets held by other 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.
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