Week Eight Linus Yamane Tools of the Federal Reserve 1. Reserve Requirement (re) Determines the ratio of required reserves to deposits Actual reserves = Required reserves + Excess reserves 2. Discount rate (d = 0.75%) Interest rate Fed charges commercial banks for overnight loans 3. Open Market Operations Purchase and sale of Federal government bonds by the Federal Reserve 4. Moral Suasion How do these work? 1
The Mechanics of Open Market Operations If the Fed sells some of its holdings of government securities to the general public, they will pay by writing checks drawn on their banks and payable to the Fed. The required reserve ratio = 20% here. TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences between Those Panels and Panel 1. All Figures in Billions of Dollars) Panel 1 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts $80 Currency Loans $80 $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $180. Panel 2 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $95 $15 Reserves Reserves $15 $95 Deposits Deposits $0 $0 Debts ( $5) ( $5) ( $5) ( $5) ( $5) $80 Currency Loans $80 Securities (+ $5) $5 $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. Panel 3 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $95 $15 Reserves Reserves $15 $75 Deposits Deposits $0 $0 Debts ( $5) ( $5) ( $5) ( $25) ( $5) $80 Currency Loans ( $20) $60 Securities (+ $5) $5 $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155. The final equilibrium position is shown in panel 3, where commercial banks have reduced their loans by $20 billion. This corresponds exactly to our earlier analysis of the money multiplier. The change in money ( -$25 billion) is equal to the money multiplier (5) times the change in reserves (-$5 billion). The Fed buys a $1000 bond The reserve requirement is 10% Money supply expands by $1000 $900 $810 $729 $656 $1000 1 0.9 0.9 0.9 0.9 1 $1000 1 0.9 $1000 1 0.1 $1000 10 $10,000 2
Money Multiplier In general where Money multiplier Assumes no currency holdings Assumes no excess reserves When banks are fully loaned up, they create money All this has nothing to do with income or output Liquidity is increased, but no wealth is created The Discount Rate discount rate The interest rate that banks pay to the Fed to borrow from it. When banks increase their borrowing, the money supply increases. TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) Panel 1: No Commercial Bank Borrowing from the Fed Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Securities $160 $80 Reserves Reserves $80 $400 Deposits $80 Currency Loans $320 Note: Money supply (M1) = currency + deposits = $480. Panel 2: Commercial Bank Borrowing $20 from the Fed Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Securities $160 $100 Reserves (+ $20) Reserves (+ $20) Loans $20 $80 Currency Loans (+ $100) $100 $500 Deposits (+ $300) $420 $20 Amount owed to Fed (+ $20) Note: Money supply (M1) = currency + deposits = $580. moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed. 3
The Required Reserve Ratio TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) Panel 1: Required Reserve Ratio = 20% Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Government $200 $100 Reserves Reserves $100 $500 Deposits securities $100 Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. Panel 2: Required Reserve Ratio = 12.5% Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Government $200 $100 Reserves Reserves $100 $800 Deposits securities $100 Currency Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = currency + deposits = $900. How does the Fed expand MS? 1 1 where Reserves R = Borrowed reserves (BR) + Non-borrowed reserves (NBR) Lower the reserve requirement (re) Lower the discount rate (d) Increases borrowed reserves Buy government bonds through open market operations Increases non-borrowed reserves 4
How does the Fed decrease MS? Increase the reserve requirement Policy used every 10 years or so Increase the discount rate (d) Policy used every 6 months or so Sell government bonds through open market operations Policy used every day Demand for Money You hold wealth in specific assets Spectrum of assets from safe to risky Liquid, Safe Illiquid, Risky Money Near Monies (savings accounts, treasury bills) Bonds (government, corporate) Stocks (blue chip, growth, speculative) Commodities (gold, Picasso, Persian rugs) Capital goods (house, Bridges auditorium) 5
Simplify world into 2 assets Money (non-interest bearing) Bonds (interest bearing) Interest rate Price paid by a borrower for the use of money for a period of time, expressed as percent (%) per annum Cost of holding money Why do we hold money? Transactions demand To carry out normal transactions Precautionary demand Protect against unforeseen emergencies Speculative demand Take advantage of opportunities for profit 6
Money and Interest Rates The nominal interest rate is the cost of holding money When the interest rate rises, people hold less money You delay paying your bills You send out bills faster You move money more often from savings to checking You care more about cash management The money demand curve slopes downward Money Demand Demand for money falls as interest rate i goes up Movement along the demand curve Money demand schedule shifts with income Shift of the demand curve Money demand schedule shifts with ATM machines Shift of the demand curve 7
Money Supply & Money Demand Equilibrium in the money market gives us the equilibrium interest rate The Federal Reserve sets the Money Supply M* M* By controlling money supply, the Federal Reserve controls interest rates 1. Federal Reserve sells bonds through open market operations 2. Money supply contracts 3. Interest rates increase 8
Bonds and Interest Rates Bond: An interest bearing certificate issued by a government or corporation promising to pay interest and to repay a sum of money (the principal) at a specified date in the future. As interest rates rise, bond prices fall. As interest rates fall, bond prices rise. Government Bonds Consider a government bond which pays you $1000 at the end of a year. How much is it worth today? 9
Let i = 5% Present Discounted Value (PDV) 2014 2015 2016 2017 $100.00 105.00 110.25 115.76 95.23 100.00 105.00 110.25 90.70 95.23 100.00 105.00 86.38 90.70 95.23 100.00 100 100 1 100 1 100 1 100 1 100 100 1 100 1 100 100 1 1 100 100 1 100 100 100 1 1 1 100 Bonds and Interest Rates The present discounted value of $1000 paid to us in 2015 is $ today So the price today of a bond which pays $1000 in one year is $ (in the most simple case) When interest rates rise, bond prices fall When interest rates fall, bond prices rise 10
Bond Market Bond prices are set by supply and demand Federal Reserve buys government bonds Demand curve shifts out Bond prices rise So interest rates fall Investment Demand Gross Domestic Investment Plant and equipment Residential housing Additions to inventories Amount of investment increases as the interest rate falls Investment demand curve is downward sloping Cost of borrowing (interest rate) Opportunity cost (interest rate) Factors which affect investment Expectations of future profits (revenue) Business and investment tax incentives (costs) Animal spirits, business psychology (expectations) 11
How Monetary Policy Works Fed increases reserves R (buys government bonds) Money supply increases Interest rates fall Interest sensitive spending increases Housing Business investment (plant and equipment) Net exports (thru $ with floating exchange rates) Consumer durables purchases (cars, washers, dryers ) Aggregate expenditures increase GDP increases through the multiplier 12
Counter Cyclical Monetary Policy Contractionary monetary policy in booms Contract money supply to increase interest rates Selling government bonds Increasing the discount rate Expansionary monetary policy in recessions Expand money supply to decrease interest rates Buying government bond Decreasing the discount rate You can pull a string, but you can t push on it Contracting MS is more effective than expanding MS Ln Money Supply 8 7.8 7.6 7.4 7.2 7 6.8 Money Supply M1 The job of the Federal Reserve is to take away the punch bowl just as the party gets going. William Martin Federal Reserve Chairman 1951-1970 6.6 6.4 6.2 6 1980 1983 1986 1989 1992 1995 Year 1998 2001 2004 2007 2010 2013 13
Case Study of Tight Money Paul Volcker after October 1979 Lower monetary growth from 8% to 6% Interest rates rise from 7% to 14% Housing starts fall 10% Interest sensitive components make up 8% of potential GDP Real GDP constant from 1979 to 1982 GDP gap opened up to $140 billion Unemployment rose from 5.4% to 10.6% Inflation fell from 13% to 4% Power of the FED Federal Reserve has enormous power, particularly after 1971 when we abandoned gold and Bretton Woods President Reagan shot (1981) vs Paul Volcker resigns (1987) Nixon named Arthur Burns as Fed Chair in 1970 with instructions to ensure easy access to credit when Nixon was running for reelection in 1972 Now Federal Reserve reports to Congress on its plans for monetary policy twice a year The Fed can t control the money supply exactly. It is like sailing. You can t just set the rudder. You have to see where you are and make adjustments all the time. 14
Goals of the FED Employment Act of 1946 promote maximum employment, production, and purchasing power creates Council of Economic Advisors Humphrey-Hawkins Full Employment Act of 1978 provide full employment; bring growth in production; bring price stability; and bring balance of trade Fed Chair reports to Congress every February and July The Great Recession 15
Mortgages A mortgage is the pledging of a property to a lender as a security for a mortgage loan Historically we had fixed interest rate mortgages with a down payment of 20% and income verification These are extremely safe assets to hold Conventional Mortgages 20% DOWN PAYMENT Down payment $60,000 Mortgage $240,000 Price $300,000 Unless the price of the home falls below $240,000, the lender is unlikely to lose any money. Very little risk for the lender. 16
Mortgages Financial institutions can bundle mortgages together and sell them in the secondary market A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans MBSs are safer than a single mortgage because of the pooled risk Unconventional Mortgages We eventually move to adjustable interest rate mortgages with no down payment and no income verification. 0% DOWN PAYMENT Down payment $0 Mortgage $300,000 Price $300,000 If the price of the house falls, the lender can lose some money. 17
Risks If interest rates increase, homeowners may not be able to afford the mortgage payments If home prices fall, homeowners may have negative equity Some homeowners choose to walk away from a home with negative equity If there is negative equity, the bank does not get all its money back with a foreclosure Foreclosure when the borrower defaults on the mortgage, the bank repossesses the property Unconventional Mortgages There is a lot of risk here for the borrower and for the lender Financial institutions are okay as long as home prices do not fall If home prices fall, financial institutions can lose some of the money they loaned out 18
250 US Housing Prices 200 Case Shiller Index 150 100 50 0 Mar-86 Dec-88 Sep-91 Jun-94 Mar-97 Dec-99 Sep-02 May-05 Feb-08 Nov-10 Aug-13 Housing Bubble 1990 Home Prices 1890 Home Prices Home prices increase by 3x from January 1994 to June 2006 (mostly after 1997) Home prices peak in May 2006 Home prices dropped about 34% During the Great Depression home prices fell 30% 19
300 Los Angeles Real Estate 250 200 Case Shiller Index 150 100 50 0 Mar-86 Dec-88 Sep-91 Jun-94 Mar-97 Dec-99 Sep-02 May-05 Feb-08 Nov-10 Aug-13 Los Angeles Market Peak in June 1990 Prices fall 27% until March 1996 Prices increase by a factor of 3.75 between 1996 and 2006 Peak in April 2006 Prices fell about 41% from 2006 peak May drop another 30% 20
4,500,000 Foreclosures 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Year March 2007 Subprime mortgage industry collapses 25 subprime lenders declare bankruptcy, announce significant losses, or put themselves up for sale New Century Financial, the largest subprime lender, files for Chapter 11 with liabilities exceeding $100 million 21
Commercial Bank Balance Sheet ASSETS Reserves (cash) Loans outstanding (mortgages) US gov securities Other securities (MBS) LIABILITIES Checking account deposits Savings and time deposits Other liabilities Net Worth Other assets TOTAL $1,234,567 TOTAL $1,234,567 Credit Default Swaps (CDS) Invented in 1997 Contract between two parties The buyer makes periodic payments to the seller The buyer receives a payoff if the underlying financial instrument defaults Like an insurance policy except The seller need not be regulated The buyer need not own the underlying financial instrument Uses include speculation, hedging, & arbitrage Grows to notional value of $62 trillion world-wide 22
Example Iceland Bank has a lot of assets Collateralized debt obligations (CDO) like mortgage backed securities (MBS) Security whose value and payments are derived from a portfolio of fixed-income assets like mortgages All these assets have AAA ratings S&P, Moody s, Fitch The bank also buys some insurance to insure against any default risk in these assets credit default swaps (CDS) from American International Group (AIG) This bank looks extremely prudent and sound Example (cont.) Unfortunately housing prices are about to collapse across the United States Mortgage-backed securities (MBS) will lose enormous value S&P is giving AAA ratings to assets without really understanding their risks CDOs are more complicated financial instruments AIG is selling multiple CDSs on the same assets without enough capital to back up their obligations 23
November 2007 Chuck Prince, CEO and Chairman of Citigroup, retires due to poor 3 rd quarter performance resulting from losses on collateralized debt obligations (CDO) like mortgage backed securities (MBS) May 2008 Bear Stearns, one of the world s largest investment banks and securities trading and brokerage firms, was bought out by JP Morgan Chase. 24
July 2008 IndyMac Bank experiences bank runs, and is seized by FDIC. Largest savings and loan in the Los Angeles area Fourth largest bank failure in US history September 2008 The US government, through the Federal Housing Finance Agency, takes control of Fannie Mae and Freddie Mac by placing them into conservatorship. Fannie Mae and Freddie Mac are private firms which compete in the secondary mortgage market. 25
September 2008 Washington Mutual, the nation s largest savings and loan, is seized by regulators, and purchased by JP Morgan for $1.9 billion. With $307 billion in assets, it is the largest bank failure in history. Lehman Brothers, a global financial services firm, files for Chapter 11 and marks the largest bankruptcy in U.S. history. Lehman Brothers was partially purchased by Barclays. September 2008 Federal Reserve extends credit line of $85 billion (eventually $170 billion) to AIG (American Insurance Group), the largest government bailout of a private company in US history. Bank of America agrees to acquire Merrill Lynch. 26
September 2008 Goldman Sachs and Morgan Stanley change their status from investment bank to bank holding, accepting more regulation in exchange for liquidities from the Federal Reserve Mitsubishi UFJ buys 21% stake in Morgan Stanley. September 2008 Wachovia bites the dust 4 th largest banking chain in the US Banking operations bought out by Wells Fargo Deal brokered by FDIC Had acquired mortgage lender Golden West in 2006 27
Foreclosures 2008 860,000 properties were repossessed in 2008 81% increase over 2007 2.3 million faced foreclosure proceedings More than double the figure for 2007 3.6 million mortgages more than 30 days past due 7.88% of country s 45.4 million homes Problem When housing prices were falling, no one knew the value of these MBSs No one knew the value of another firm s assets No one wants to lend to someone who is insolvent Everyone was hoarding cash Credit markets froze up No loans for housing, college, cars, business 28
Credit Freeze Headlines McDonald's says Bank of America won't boost franchisee loans Credit freeze plunges Detroit 3 into cash crisis In a Credit Freeze, Farmers' Loans Could Dry Up Credit Crunch Squeezes Small-Business Owners Municipalities Also Find Credit Is Scarce Black Monday 2008 September 29, 2008 House fails to pass $700 billion rescue package Dow Jones falls 778 points, largest point drop in US history Markets were down about 9% in one day Loss of $1.2 trillion in market value Worst single day since October 1987 29
Troubled Asset Relief Program TARP is a $700 billion program to purchase assets and equity from financial institutions to strengthen the financial sector Bush signed into law October 3, 2008 Disbursed about $418 billion, ultimately receives over $405 billion in total cash back on TARP investments 16000 Dow Jones Industrials 14000 12000 10000 Index 8000 6000 4000 2000 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 30
10 Log Dow Jones 9.5 9 8.5 Log Index 8 7.5 7 6.5 6 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 1800 S&P 500 1600 1400 1200 1000 Index 800 600 400 200 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 31
8 Log S&P 500 7.5 7 6.5 Log Index 6 5.5 5 4.5 4 1970 1975 1980 1985 1990 Year 1995 2000 2005 2010 2015 Stock Market Dow Jones peaked October 2007 Fell about 49.3% S&P peaked July 2007 Fell about 52.5% So Americans lost about 50% of their stock market wealth, and 33% of their housing wealth. Total loss of about $13 trillion in wealth. 32
35000 Real Household Net Wealth 30000 25000 Real Dollars Billions 20000 15000 Sudden Decline in Wealth 10000 5000 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year Hard Hit Sectors Private domestic investment (15% of GDP) fell 36.4% over 18 months Personal consumption expenditures (69% of GDP) fell 3.4% over 18 months Durables were down 13.2% Nondurables were down 3.2% Services were down 2.0% Government expenditures (18.8% of GDP) were up 5.5% Net exports were up by 42.8% G needed to increase by 24% to make up for the declines in investment and consumption 33
Financial Crises Asset Price Booms and Busts Insolvencies at Financial Institutions Falling Confidence Credit Crunch Recession Vicious Cycle Example: Tulip mania was a period in the Dutch Golden Age (1630s) during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed Who is to Blame? Government Policy Makers U.S. policy has been to promote home ownership Federal Reserve Kept interest rates too low for too long between 2003-2005 Mortgage Brokers Predatory lenders who encouraged people to take out mortgages they could not afford Liar s loans 34
Investment Banks Who is to Blame? Used leverage, and took on too much risk Rating Agencies Could not evaluate the risk borne by investment banks Regulators Did not regulate credit default swaps Home Buyers Between 2000 and 2005 paid more for homes than anyone in history 35
Responses Fiscal Policy (President & Congress) Injection of Government Funds Conventional and unconventional Monetary Policy (Federal Reserve) Lender of Last Resort Conventional and unconventional President Obama US Dept of the Treasury Tim Geithner Council of Economic Advisors Christina Romer National Economic Council Larry Summers Economic Recovery Advisory Board Paul Volcker 36
Fiscal Stimulus Federal fiscal policy needed to be expansionary enough to Offset the decline in housing and stock market wealth Offset most state governments which were raising taxes and cutting spending President and Congress would Run a $1.75 trillion deficit Debt held by the public would increase by $2.56 trillion in 2009 (direct loan accounts, TARP, financing accounts) Gross federal debt would jump from 70% of GDP in 2008 to 102% of GDP in 2012 American Recovery and Reinvestment Act of 2009 Obama signs the Recovery Act in February $787 billion stimulus package, later revised to $831 billion Direct spending in infrastructure, education, health, and energy, federal tax incentives, and expansion of unemployment benefits and other social welfare provisions 37
Ben Bernanke Chair, Federal Reserve PhD Economics, MIT World s foremost expert on the Great Depression 18 3 Month Treasury Bill Rates 16 14 Nominal interest rates are about as low as you can go 12 Percent 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 38
16 Inflation 14 12 Problem here 10 8 Percent 6 No longer deflationary 4 2 0 Problem here -2 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 10 8 Real Interest Rates r = i - 6 Were a problem here 4 Percent 2 0-2 -4 Now negative real interest rates -6 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 39
14 Money Multiplier M2 12 10 8 6 4 You can t push on a string! Money multiplier collapses. 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Year 3500000 Credit Easing Policy Tools 3000000 2500000 Millions of Dollars 2000000 1500000 Fed Agency Debt Mortgage-Backed Securities Purch Liquidity to Key Credit Markets Lending to Financial Institutions Long Term Treasury Purchases Traditional Security Holdings 1000000 500000 0 1/3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012 1/3/2013 40
Quantitative Easing QE1 (December 2008-March 2010) purchase up to $600 billion in mortgagebacked securities (MBS) QE2 (November 2010-June 2011) purchase $600 billion of longer maturity treasuries, at a rate of $75 billion per month QE3 (September 2012 - present) purchase $40 billion in mortgage-backed securities per month until the labor market improves "substantially" Operation Twist September 2011, extended June 2012 Attempt to lower long term interest rates without expanding money supply Fed sells short-term Treasury bonds and buys long-term Treasury bonds Purchase $400 billion of bonds with maturities of 6 to 30 years and sell bonds with maturities less than 3 years 41
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Lower risk in various parts of the U.S. financial system Monitor the performance of companies deemed too big to fail Break up large banks that may pose a risk to the financial system because of their size Prevent predatory mortgage lending Restrict the ways banks can invest and regulate trading in derivatives with the Volcker Rule Improve the accuracy of ratings provided by the rating agencies Conclusion During the 1981-82 recession Unemployment was higher (10.8% vs 10.0%) But output fell less (2.6% vs 4.7%) And less jobs were lost (2.0% vs 5.8%) In the long run we will be fine. But in the long run we will all be dead. John Maynard Keynes 42