Download t - Department of Economics at Illinois State University

Liquidity Preference
• Supply and Demand for Money
– mirrors S&D for bonds
• Assume that people hold their
wealth in money or bonds
• Bonds pay a better return than
money.
• Money is more liquid than
bonds.
Money S&D
• What’s the price of money?
• Who’s doing the demanding?
– Anyone who wants to make a
transaction. (Buy something.)
• Slope of money demand?
• As interest rates rise
– Bonds become more attractive
– Liquidity (money) is more costly
– Md falls
– Md slopes down
Money Supply
• Controlled by the Fed
– doesn’t respond to interest
rates.
– Fed could shift S to change i
• Banks supply money when
they make loans.
• Banks lend more higher
interest rates so Ms slopes up.
• Fed controls Ms to a great
degree - close to vertical.
Determinants of Money
Demand
• Wealth (GDP)
• Prices
• expected inflation
How does a rise in prices affect
interest rates?
Hyperinflation
Example of Fed
operation
• If the Fed wants to lower
interest rates, what does it do?
• Shifts Ms to the right.
How do they do it? Stay tuned.
Tax Cuts and Interest
Rates
How does a tax cut affect
interest rates?
We can analyze this with S&D of
money or bonds.
Bond market analysis is
ambiguous. Depends on
relative strength of the shifts.
Quantity of Money
Quantity Theory of Money:
MV=PY
M – money supply
V – velocity
P – price level
Y – real output
Velocity
V=PY / M
V= nominal GDP / M
Velocity is the number of times
and ‘typical’ dollar is used in a
year.
Often assumed to be stable
(constant).
Monetarism
• Milton Friedman
Assumes:
• Velocity is stable
• Changes in M have uncertain
“real” effects.
– “Long and variable lags”
Monetarist conclusions
• “Inflation is always and
everywhere a monetary
phenomenon.”
• Keep money supply growth
constant.
Monetarism is not completely
correct, but the connection
between the money supply and
prices is important.
Money Supply Growth
• Ms shifts out
– lowers interest rates
– “liquidity effect”
However,
• prices and expected inflation also
rise
– shifts money demand out
– raises interest rates
• Timing
– Liquidity effect operates the quickest.
– Economists use “impulse response
functions” to describe changes over
time
Review Problem
The Fed reduces the money
supply.
• How does the liquidity effect
affect equilibrium interest
rates?
• If the output effect dominates
the liquidity effect, show the
change in interest rates using
money S&D and an impulse
response function.
Risk and Term Structure
of Bond Yields
Risk Structure
Bonds with the same time to
maturity can have different
yields due to:
• Default risk – corporations are
more likely to default on bonds
than (most) countries
• Tax considerations – ex. Muni
bonds are not taxed
• Liquidity
Default Risk
• Gov’t bonds have low default
risk.
• Corporations tend to have
higher default risk.
• Default risk of corporate bonds
varies dramatically
– “blue chip” ex. IBM
– “junk” ex. Esocks.com
• Moody’s and S&P rate
corporations on their reliability
for investors.
Risk Premium
• RP - difference in yields
between a corporate bond and
a government bonds (riskless)
• Show by comparing S&D for
each bond
• Higher default risk leads to
higher risk premia.
Problem: Using bond S&D,
show the effect of a bond
losing its listing on an
exchange on its risk premium.
Muni Bonds
• Municipal bonds are not taxed.
– higher prices
– lower yields
than corporate bonds.
• Muni bond puzzle:
– Yields should be even lower than
they are.
– The RP for muni bonds is
surprisingly large.
Term Structure
• Bond yields vary according to
time to maturity.
• The “yield curve” describes this
relationship.
• Predicting the yield curve is
hard
– Many factors involved
Example
What’s better?:
– 1 year bond with a 5% yield
– 2 year bond with a 6% yield
Depends upon your expectation
about interest rates next year.
If you expect interest rates to fall
in the future, then
you prefer the 2 year bond
at the higher yield.
Question
The yield on a one year bond
(today) is 10%. The expected
yield on a one year bond a
year from today is 8%.
What should the yield on a two
year bond be (today)?
Expectations
Hypothesis
Expected FV of a two year bond
=
Expected FV of two one year
bonds
Why might this be true?
Example
it = 10%
iet+1 = 8%
What should the yield for a 2 year bond be?
Invest $100,
after 1 year receive $110
after 2 years expect to receive
$110(1.8) = 118.8
What yield on a 2 year bond would give the
same amount?
100(1+i2)2 = 118.8
i2=8.995% which is very close to 9%, the
average of 10% and 8%.
Expectations Theory of
the term structure
Assume:
-Expectations Hypothesis
then
Yield on a two year bond
=
average of the yield this year and
the expected yield next year
(for one year bonds)
Expectations theory
In,0 – yield on an n-year bond
(today)
i0 – yield on a one year bond today
iet – expected yield on a one year
bond at time t
The expectations theory assumes
that an n-year bond is equivalent
to a sequence of one year bonds.
Expectations Theory
The yield for an n-year bond should
be the average of the present and
expected future interest rates over
the n-1 years.
in,0 = (1/n)(i0 + ie1 + ie2 + ……+ iet+n-1)
Expectations Theory
The yield on a one year bond is 10%.
The expected rate next year is 4 %
The expected rate the following year is
1%.
What should the yield on a 3 year bond
be?
• Yield on a 2 year bond?
• What does the yield curve look like?
Expectations Theory
If interest rates are expected to
rise in the future, what should
the yield curve to look like?
If the economy is expected to go
into a recession, what should
the shape of the yield curve be
(probably)?
Questions
• If the current one year rate is
5% and the expected one year
rate is 5% for the next 4 years,
what does the yield curve look
like?
• Is the expectations theory
correct?
• What does it ignore?
• What’s a big concern when
buying long term bonds?
Liquidity Premium
If interest rates are expected to
remain unchanged in the future:
• Expectations theory:
– yield curve is flat
– demand for long term bonds is the
same as short term.
• However, long term bonds are
riskier.
Q: How does this affect the yield
on longer term bonds?
Q: How does this affect the yield
curve?
Liquidity Premium
• The liquidity premium model
adds a term to the
expectations theory expression
for long term bond yields.
• The liquidity (term) premium is
higher for longer term bonds.
in,t = (1/n)(it + iet+1 + iet+2 + ……+ iet+n-1)
+ lpn
Liquidity Premium
in,t = (1/n)(it + iet+1 + iet+2 + ……+ iet+n-1)
+ lpn
Example: if it = 6%, iet+1 = 5%,
iet+2 = 6%, iet+3 = 7% and the
liquidity premium is 0.5(n-1)%,
draw the yield curve
Liquidity Premium
Q: What does a flat yield curve
mean for expected interest
rates? (Compared to
expectations hypothesis?)
if i0 = 6%, ie1 = 5%, ie2 = 4%,
ie3 = 3% draw the yield curve
under the expectations hypothesis
(no liquidity premium).
Draw the yield curve if the liquidity
premium is 0.5(n-1).
Liquidity Premium
Q: What does a flat yield curve
mean for expected interest
rates? (Compared to
expectations hypothesis?)
Q: What does a downward
sloping yield curve mean for
the economy?
- interest rates expected to fall
- rates pro-cyclical
- possible recession
Yield Curve and
Forecasting
• “Inverted” (downward sloping)
thought to predict a recession
• “Spreads” – difference
between yields on bonds with
different maturity are used to
report the state of the yield
curve.
Practice Problem
When investors observed that
Lehman brothers could no
longer obtain short term loans,
the price of their stock fell.
Show the corresponding effect
on the risk premium.
Economic Analysis of
Financial Institutions
Banks & Financial
institutions overcome
problems of:
• Connecting Savers and
Borrowers.
• Face problems of asymmetric
information
– Banks don’t know who has a
good chance of paying them
back.
– Banks don’t know whether a
borrower will use the money
wisely (or buy lottery tickets).
Banks & Financial
institutions overcome
problems of:
• Transactions cost – lending
has many legal and accounting
costs
• Moral Hazard – borrowers
have incentive to misuse the
money
• Adverse Selection – firms /
people most in need of loans
tend to be the greatest default
risk
Moral Hazard
Remedies
• monitoring – audits / standard
accounting principles (Enron)
• contract restrictions of the use
of the money
• Collateral
• High Net Worth
• venture capital (specialized
lender) – tech firms
Adverse Selection
Arises when banks lend to
corporations (or consumers) or
buy corporate bonds.
Remedies:
• Ratings
• Required disclosure of
information
• Expertise – some banks
employ industry analysts
Asymmetric Info
All remedies to asymmetric
information problems have
costs.
Financial intermediaries can
deal with these better than
individuals.
Returns to Scale for
Banks
• Accounting & legal tasks
• Assessing risk, dealing with
asymmetric information
– Screening
– Monitoring
– Etc.
• Free riding on information
Why don’t rating agencies sell
information on firms (or stocks)?
Moral Hazard with
stocks and bonds
• Investors (principle) and managers
(agents) of companies have
different incentives.
• Investors want the manager to
maximize firm profits, but the
manager wants to maximize his/her
own salary.
• Extreme example: manager turns
profits into own salary and reports 0
profit.
• Options are one solution, but brings
up other problems.
Banking is one of the most
regulated industries. Why?
• Importance of information.
– Accounting standards
necessary for good banking.
– many customers don’t have
access or understanding of
information
• Problems in banking impact
most firms.
• Banking crises are selfreinforcing and spread to the
entire economy.
– Depression
Financial Crisis Example –
Stock Market Crash
Why can this lead to a broader
financial crisis?
1. Value of firms falls,
2. Firm net worth falls, less
collateral
3. Banks reduce lending to
corporations – MH and AS
4. Firms contract, less profit
5. Value of firms falls
6. Etc.
Firm contraction continues….
recession
Extreme Crisis
• Recession leads to reduced profits,
firms can’t repay their debts and
banks become insolvent.
• Debt deflation
– recession leads to deflation
– increases the value of firms’ debts.
Any increase in uncertainty can lead
to a crisis. (Banks get scared)
High interest rates can also trigger
financial crises – credit rationing.
Credit Rationing – another
“remedy” to adverse selection
problems
• Bank don’t want to lend at
extremely high interest rates
• People willing to borrow are
probably high risk
• If borrowers are not successful,
“When you ain’t got nothin’….”
• Who does lend at higher rates?
How can they succeed?
Banking Industry
Features of U.S.
Banking Industry
• many banks / many sizes
• Dual banking system
• Three major crises
– Great Depression
– S&L crisis in the 80s
– Housing crisis 2008-9
• Trends:
– continual financial innovation
– consolidation
– more fee generating services
– integration of financial services
Some History
• City vs. Country battle
– Gold vs. Silver
– Wizard of OZ / Cross of Gold
• Fed was not established until
1913
– rural states concerned about
econtrol by big city bankers.
– JP Morgan bailed out the U.S.
• McFadden Act (20s)
– outlawed cross state banking
– limited control of a single bank
More History
• Great Depression
– bank failures
– stock market crash, lost savings
• FDIC created
• Glass-Steagall Act separated
commercial banking from
– investment banking
– securities brokers
– insurance
Glass-Steagall was punishment of
big banks.
Bank Consolidation
• Traditional banking in decline
– Regulation Q (1970s)
– Mutual Funds
– Junk bonds
• Consolidation despite McFadden
– Holding companies
– ATMs
• Riegle-Neale, 1994 finished the
job, interstate banking OK
• Pros:
– less transactions cost
– lower risk
• Cons:
– small, local banks may not survive
– new huge bank might engage in risky
behavior
Repeal of GS
• Gramm-Leach Bliley Act
(1999) repeals Glass-Steagall
– State Farm takes deposits
– Banks can make investments
– Holding companies can have
different financial firms.
• Investment banks (What?)
Financial Innovation
• Always happening - banks try to
increase profits
• Old type: foreign bond funds
• New type: derivatives / junk
bonds / CDO / SIV
• All these fill a market void.
– derivatives allow farmers to hedge
against low prices
– junk bonds allow financing for
troubled companies
• Potential problems
– investors don’t fully understand the
risks
– regulators are a step behind (CDS)
Banking Regulation
• FDIC – deposit insurance up to
$250,000
• Prevents runs
– deals with failed (insolvent)
banks
• insurance payoff (dissolution)
• finds a new partner, purchase and
assumption method
• Creates incentives for banks to
take on more risk
– moral hazard
– Less depositor vigilance
• More regulation is needed (!?)
Asymmetric information
• Insured banks tend to be
riskier - MH
• AS - crooks become bankers
Sometimes FDIC does more:
“Too big to fail” creates similar
incentives
MH and AS between regulators
and bankers.
Regulations
• Capital requirements
– min leverage ratio/max EM
• Disclosure regulations
– Show balance sheets
– standard accounting practices
• Consumer protection (CRA)
– anti-discrimination
– standardized contracts
Chartering
Banks chartered by the
• Comptroller of the Currency
(Treasury) for national banks
• State agency
• helps w/ AS problem
• Banks also file periodic call
reports
Examination
• National Banks
– Comptroller
• State banks
– Fed
– state agency
• CAMELS ratings
• Basel accords
– Uniform banking regulation
– Asset quality
Dodd – Frank (2009)
•
•
•
•
•
OTS eliminated
Consumer Protection Agency
Research & Macro oversight
Insurance regulation
Standardized
– CDS
– MBS etc.
• Many other provisions
Nothing about TBTF
S&L crisis of the 80s
Causes:
• lower profits
• higher risk
• little oversight
Profit squeeze
• Regulation Q – hard to attract
funds
• Mutual funds
• Interest rates rise
More causes
Risky assets
• Junk Bonds
• Derivatives (innovations)
• Real Estate
Oversight
• Depositors didn’t pay attention
to risks
– Higher deposit insurance
– Brokered deposits
• Regulation
– S&Ls deregulated (1980)
– Regulators had little expertise
assessing risk of new assets
Bank and S&L failures
• Recession of early 80s
• High interest rates
– affected liabilities more than
assets
– Regulation Q phased out
• Overinvestment in real estate
– commercial buildings
– High risk typical of large
ventures
• Large number of insolvent
banks and S&Ls
Role of Regulators
• Regulators (FSLIC) let S&Ls
continue to operate
– Effect on S&Ls?
• Huge Moral Hazard Problem –
S&L engaged in extremely
risky behavior (why not, they’re
already dead)
“Zombie S&Ls”
Politics
• S&Ls contribute to politicians
who pressure regulators
(Keating 5)
• Politicians didn’t give
regulators enough money
• Regulators didn’t want to admit
mistake
Deal with it
1987 – Congress lends money to
FSLIC, not nearly enough –
more defaults
1989 – FIRREA,
• eliminates FSLIC
• creates OTS
• restricted S&L asset holdings
• created RTC to take over
insolvent S&Ls and sell off
assets – cost of $150 billion
Dealing with it
1989 – FDICIA
• FDIC’s insurance fund was
running out of money
• Congress lends them money
• Mandate - FDIC must close
insolvent banks using the least
costly method available –
counters moral hazard problem
• Required regulators to assess
capital/risk conditions of banks
• Provided for Treasury dept.
lending to regulators in times of
crisis.
S&L Debacle Summary
• Initial crisis due to
– squeeze on profits
– increase in real interest rates ’79-’80
• Crisis extended because of
weakness of regulators
– under-funded
– tended to use assumption method, in
effect all deposits were guaranteed
– politically influenced
• FDICIA helps prevent future crises
– mandates dealing w/ insolvency
– mandates using the cheapest method
– give financial backup to regulators
Banking Crises
The rule not the exception
• Financial innovation is always
occurring.
• Regulators struggle to keep up.
• Consequently
– banks are regulated
– regulators are regulated
– enough regulation?
Monetary Policy
Institutions
Federal Reserve
• check clearing
• Economic research / data
• Regulates Banks
– charters national banks and
state banks that choose to join
(about 1/3 of all banks)
– approves bank mergers
• Controls the Money Supply
• Discount loans (original
purpose)
Structure of the Fed
System
• Board of Governors (Washington D.C.)
– Chairman
– appointed by president / confirmed by
Senate
– Board Members have 14 year terms
– Chairman has a 4 year term
• 12 Branch Banks
• FOMC
– Makes decisions on monetary policy
every 6 weeks
– 7 members of the board (including the
chairman) and 5 branch presidents
(always including NY)
Tools of Monetary
Policy
• Reserve Requirement
• Discount Rate/lending
• OMO – decision of the FOMC
– most important in practice
– Chairman rules
Fed Independence
How?
• Congress/President can’t fire
Board members or dictate
policy
• Governors have 14 year terms
and can be reappointed.
• Fed has its own source of
funds and budget.
Fed Independence
Why?
• Avoid continual print & spend
policy
– excessive seignorage
• Gov’t revenue from inflation
– Fed can think long term
– independence lowers inflation
• avoid the temptation to print
money before an election
Fed Independence
Arguments against:
• too much power in too few
hands
• undemocratic
• fiscal and monetary policy
uncoordinated
Fed Balance Sheet
Assets:
• Bonds
• Discount Loans
• Gold etc.
• Foreign currencies
Liabilities:
• Reserves deposits from banks
• Legal tender (green stuff)
Very profitable business model.
Money Supply Process
Monetary Base or “High Powered
Money” is
MB = C + R
(liabilities of the Fed)
C – Currency in circulation
R – Reserves
Changes in MB lead to large changes
M=C+D
The Fed affects the MB through OMO
and discount loans.