What is money?

How people decide to allocate their wealth among various assets?

What are the determinants of demand for and supply of money?
How money and price level are related?

PART 1:

The asset market: financial and non-financial (real estate stocks bonds gold)
Entire set of markets in which people buy and sell real and financial assets
Money: an asset widely used and accepted as payment
Functions of money: medium of exchange (transactions at less cost in time and
effort) – unit of account (basic unit for measuring economic value; pricing goods) – store of
value (way of holding wealth)

Measures/ Money Aggregates: widely used to measure quantity of money supplied in

economy – different measures of the money stock
M1: currency and balances held in chequing accounts (cash in circulation and
bank accounts with no maturity no interests)
M2: M1 + personal saving deposits, including those with a fixed term
(broader than M1)
M3: M2 + term deposits (bank accounts with 1-2 year maturity) (broader
measure)

Money supply: amount of money available in an economy

Central bank is the entity that determines money supply (BDL)

How does the central bank influence money supply?

Open market operations: open market purchases and sales of government bonds to
the public. A purchase of gov bonds from the public increases the money supply
MS goes up interest rate goes down (stimulate investments and consumption). CB
purchases bonds from the market and paying back liquidity. We can have an open market
sale of government bonds; CB sells bonds to the public and gets cash in return; sucks
liquidity, reduce MS, increase interest rate.
Another way to influence the MS is to purchase and sell government bonds directly
to the government. If the government wants to borrow, it goes to CB to get cash CB issues
bonds to government. So, CB prints money and gives to government. CB will be contributing
to inflation or hyperinflation. (In Lebanon 7b to 30b money supply.) This means the
government is financing its expenditures by printing money. It induces inflation or
hyperinflation.

Portfolio allocation and the demand for assets:

A portfolio: set of assets that a holder of wealth chooses to own (house, bank account,
stocks, bonds)
The portfolio allocation decision is based on expected return, risk, and liquidity of an asset.
Expected Return: u purchase a stock based on E.R
Rate of return to an asset is the rate of increase in its value per unit of time.
Return on a stock is the dividend paid by the stock plus any increase or decrease in
the stock’s price which is capital gain or loss.
Expected return is the best guess about the return on an asset.
Everything else equal, the higher an asset’s expected return, the more desirable the
asset is and the more of it holders of wealth will want to own.
2 sources of return when u purchase a stock: capital gain and dividends.
Risk:
An asset has a high risk if there is a significant chance that the actual return received
will be different from the expected return.
Everything else equal, a riskier asset is less desirable.
Liquidity:
Liquidity of an asset is the ease and speed with which it can be exchanged for goods,
services, or other assets. (transform an asset to cash)
Money is a highly liquid asset. (chequing deposits are also liquid; long term deposits
with high maturity are less liquid)
The more liquid an asset is, the more desirable it will be to wealth holders.
Time to maturity:
The yield curve depicts the relationship between time to maturity and yield on
certain bond. The higher the maturity of a bond the higher the expected yield, this is
why a normal yield curve is upward sloping.
Bonds with different terms to maturity (1 or 5- or 10-year bond) often have different
rates of return. Short term bond is expected to pay a lower yield than long term
bond.
[There are theories that try to explain the shape of the yield curve (expectations
hypothesis-liquidity hypothesis)]
The expectations hypothesis tells us the expected return on a 10-year bond should
equal the average return on all the 1-year bonds in the previous 9 years. Long term
interest rates are average of short-term interest rates.
Bonds with high maturity are risky because over the lifetime of the bond the interest
rate is going to change impacting the price of bonds. So long term prices are
sensitive to changes in market interest rate. Price of a bond is inversely related to
the interest rate in the economy.
So, if interest rate goes up which is the case over time:
Nominal rate = real rates + expected inflation. Inflation over time goes up, nominal
interest rate goes up and that will reduce the price of bond, so longer term bonds
are riskier. So, bond holders will demand to be compensated for assuming this type
of risk. The term premium compensates bondholders for the increased risk. This is
another factor that explains the positively sloped yield curve.
Asset Demands:
There is a trade-off among the four characteristics that make an asset desirable: a high
expected return, low risk, liquidity and term to maturity.
[A high expected return with low risk and liquid can’t happen… higher maturity more
expected yield, short term liquid low expected return]
can’t have all 4, the investor will choose to see priorities when investing.
Demand for assets: the amount of each particular asset that a holder of wealth desires to
include in her portfolio.

Types of Assets:
Money: highly liquid, inflation risk, short term to maturity
Bonds: differing default risk, term to maturity and liquidity
Stocks: dividends not guaranteed, substantial price fluctuations, most shares in large
corporations is liquid, no maturity.
Real estate: very illiquid, provides protection services against inflation, no maturity.

The Demand for Money: the quantity of monetary assets that people choose to hold in their
portfolios.
Money is the most liquid asset but pays a low return – 0 nominal return.
DM will depend on the expected return (0), risk (inflation risk), and liquidity of money
relative to other assets.
Macroeconomic variables that have the greatest effects on MD are price level, real income,
and interest rates (OC).

The price level:

The higher the general level of prices, the more dollars people need to conduct daily
transactions and the more dollars people will want to hold.
The nominal demand for money is directly proportional to the price level. Higher price level
-> more demand for money

Real income:
Higher real income means more transactions and a greater need for liquidity so the amount
of money should increase. (Higher real income -> wealthier -> spending more)
The increase in money demand is not proportional to the increase in real income.
Income elasticity of money demand will tell us what would be the percentage change in
income, and how that would result in a percentage change in demand for money.

Interest rates: (opportunity cost of holding cash)

Increase in interest rate will mean people will hold less cash and deposit in bank so there’s a
negative relationship between interest rate and demand for money.
An increase in the expected return on alternative assets (i) causes holders of wealth to
switch from money to higher-return alternatives.
The Money Demand Function: money is a function of real income and nominal interest rate.
Md = P x L(Y,i) where Md is the aggregate demand for money, P: price level, Y: real income or
output, i: interest rate earned by nonmonetary assets, L is a function relating M d to Y and i

Nominal rate = real rate + inflation rate

So Md = P x L(Y, r+ pie) where r is the expected real interest rate, pie is the expected rate of
inflation.
Money demand depends on the interest rate on nonmonetary assets, which tends to
change more often and is a likely reason for a change in the money demand.

Real money demand or demand for real balances: Md/P = L(Y, r +pie)
The function L that relates real money demand to output and interest rates is called the real
money demand function.

Other factors affecting money demand:

Not only nominal rates and real income
Higher wealth
Higher riskiness of alternative assets
Lower liquidity of alternative assets
Higher efficiency of payment technology
If you have more wealth you have more money so Md increase
When stocks and bonds become riskier people won’t invest in them keeping cash at home
so Md increase
If alternative assets aren’t liquid, you’ll demand more money
If payment technology becomes more efficient people will use payment systems instead of
money. More Money u have more spending

Elasticities of money demand:

Income elasticity of money demand is the percentage change in money demand resulting
from a 1% increase in real income
The interest elasticity of money demand is the percentage change of money demand
resulting from a 1% increase in the interest rate.
The empirical evidence is that the income elasticity of money demand is positive but less
than 1 (about 0.5)
The empirical studies find a small negative value (about -0.3) for the interest rate elasticity
of money demand.
 PART 2:

Velocity and quantity theory of money:

Velocity (V) of money is the speed at which money passes from one hand to another. More
economic activity -> higher v. In a boom V will go up. In a recession V would be a small
number
V is PY/M [nominal GDP: P times Y; M: nominal money stock]
The quantity theory of money: (MV=PY) real money demand (m/p) is proportional to real
income.
Md/P = kY (where k is a constant). The real money demand function L(Y,r+pi e) takes the
simple form kY. This is a strong assumption that velocity is a constant, 1/k, and doesn’t
depend on Y and r+pie.

Asset Market Equilibrium:

When quantity demanded of each asset equals quantity supplied of that asset; when the
quantity of each asset that holders of wealth demand equals the available supply of assets.
We assume all assets are divided into 2 groups: monetary assets and nonmonetary assets.
Monetary: money in circulation, liquid assets
Nonmonetary: Real estate, stocks, bonds
Asset market equilibrium reduces to the condition that the quantity of money supplied
equals the quantity of money demanded.

Md + NMd = aggregate nominal wealth (Md: aggregate demand for money, NMd: aggregate
demand for nonmonetary assets)
The sum of all individual demands equals the economy’s total nominal wealth

M+NM = aggregate nominal wealth (M: fixed nominal supply of money; NM: fixed nominal
supply of nonmonetary assets)

So, equilibrium equation: S=D =>

(Md-M) +(NMd-NM) =0

Asset Market Equilibrium Condition:

As long as the amount of money supplied and demanded are equal, the entire asset market
will be in equilibrium
M/P = L(Y, r+pie)  P=M/L
M/P is the total supply of money; L is the demand function
Solve for P to get a theory of inflation (using logs and derivatives)
P is determined by the asset market equilibrium condition
M is determined by the central bank
Y and r are determined by equilibrium conditions in labor and goods market (LM equation)

Money growth and inflation:

The rate of inflation equals the growth rate of the nominal money supply minus the growth
rate of real money demand.
ΔP/P = ΔM/M - ΔL(Y, r+pie)/L(Y, r+pie)
No change in demand of money, only supply of money => inflation
We show that the rate of inflation is directly proportional to deltaM over M which is the
growth rate of nominal money supply.
In long run growth rates will be constant.
The rate of inflation in a full-employment economy also depends on the percentage change
in real income (deltaY/Y) and the income elasticity of money demand
Pi=deltaM/M – elasticity(deltaY/Y)
Any increase in MS will directly be converted to higher inflation.
In a recession when deltaY is close to 0, any increase in MS will only produce inflation

The expected inflation rate:

In practice, the expected inflation rate is fixed, and the current inflation rate often
approximates the expected inflation rate, as long as people don’t expect changes in M or Y
Policy actions (if CB decides to increase MS) cause people to assume this will increase
inflation so the nominal interest rate will go up. (nominal is real plus expected)

CHAPTER 2
Monetary/fiscal policy targets and goals
Interest rates in money market

To evaluate macroeconomic performance of a country, central bankers look at GDP, the

unemployment rate and inflation
Any central bank/monetary policy will try to achieve:
High level and rapid growth in GDP or output
High level of employment
Exchange rate and price level stability with prices and wages determined by supply
and demand in free markets

To achieve these objectives:

Monetary policy by CB: adjusting interest rates
Fiscal policy by ministry of finance: government expenditures/revenues and budget
of government
Income policies: minimum wage and price legislation; could be part of fiscal policy

Monetary Policy:
Conducted by managing the nation’s money supply, credit, and banking system
Changing money supply can affect the interest rates, stock prices (fed increases interest rate
-> stock market declines; high interest rates impacts negatively on investment & cash flow)
and the exchange rate (interest rate high, capital flowing, appreciation of currency -good)
Monetary policy is conducted by CB
Through monetary policy, the CB can affect aggregate demand (shifts right if MS increase)
and therefore output, employment, and inflation

[Monetary and fiscal policies are demand side; no effect on supply]

MS measures: M1, M2, M3 [ch1]: this is how CB determines total MS

To conduct monetary policy CB has certain instruments:

Open market operations: buying and selling treasury bills
Discount rate: the rate at which CB lends to commercial banks
Reserve requirements: the portion of deposits commercial bank have to deposit in
CB (about 10%)

Using these instruments, CB tries to affect certain targets:

Bank reserves
Money supply
Interest rates
To achieve these objectives:
Stable prices: exchange rate stability and inflation
Low unemployment
Rapid growth in GDP
 Open market operations:
The buying and selling of government bonds
Through that, CB can lower or raise bank reserves. If government is buying bonds from
commercial banks, that would raise their reserves. If CB buying bonds from commercial
banks increase reserves and MS.
The CB’s most stabilizing instruments; most used
Purchase of securities: MS ↑ -> i ↓ -> I, C, X ↑ -> real GDP ↑ -> Un ↓ -> P ↑
Sale of securities: MS ↓-> i ↑ -> I, C, X ↓ -> real GDP ↓ -> Un ↑ -> P ↓
[i: interest rate; I: investments; C: consumption; X: net exports; Un: unemployment]

The discount rate:

The interest rate banks pay to borrow money from CB when their required reserves fall
below the requirements
If CB increases the discount rate: MS ↓ -> i ↑ -> I ↓ -> GDP ↓ -> Un ↑ -> P ↓
If CB decreases the discount rate: MS ↑ -> i ↓-> I ↑ -> GDP ↑-> Un ↓ -> P ↑
This is not a popular policy because the effect of discount rate policies on the money supply
is not very clear.

Reserve requirements policy:

Changing the required reserve ratio and through the reserve requirements, the CB controls
the supply of money. [rrr: portion of commercial banks deposits that should be in CB (5-
15%)]
If CB increases RR: MS ↓ -> i ↑ -> I ↓ -> GDP ↓ -> Un ↑ -> P ↓
If CB decreases RR: MS ↑ -> i ↓-> I ↑ -> GDP ↑-> Un ↓ -> P ↑
These processes are very disruptive for the economy so reserve policy isn’t widely used;
OMO (open market operations) can achieve the same results in a less disruptive manner.

Monetary Policy in an open economy:

If CB tightens MS at home -> i↑ -> foreign capital inflows seeking high yielding assets
To buy these assets one should convert foreign currency into domestic currency
So, there’s an increased demand for domestic currency:
Domestic currency will appreciate
Domestic exports are now more expensive, and imports are cheaper (exports ↓;
imports ↑; trade balance moves to deficit)
Net exports are now negative -> GDP ↓ -> Un↑ -> P↓
 Tightening monetary policy can reduce inflation through the exchange rate channel

Other functions of a central bank:

Buying and selling of foreign currencies: to affect the value of the domestic currency; to
keep exchange rate fixed at a certain level
Insuring bank deposits: to restore confidence in the banking system after any failure or runs
on bank deposits; ex: bankruptcy, CB will intervene and pay a portion of these deposits
(fixed amount now in Lebanon it’s about 75 million)
Monetary policy more effective tool than fiscal policy (direct effect)
Fiscal policy is a policy in which government changes tax rates or spending programs by
passing new legislation (↓t -> ↑DI -> ↑C -> ↑GDP -> combat recession)
[DI: disposable income]
Fiscal policy needs more time to be implemented (building a bridge, approval of tax cuts)
Monetary policy can be implemented on the spot, it doesn’t need the approval of
parliament to change the interest rate and credit conditions in the economy, and it has
shown great effectiveness in expanding or contracting the economy.

This is why most economists prefer monetary policy when it comes to short run stabilization
policies; short run recessions, low growth rates of GDP, high inflation rate
Fiscal policy has to be used with monetary policy to be effective; alone not very effective in
affecting macroeconomic variables
Objectives of CB is primarily to fight inflation because of its distortionary impacts on income
distribution (eats up purchasing power of wages of private sector), relative prices, and
economic efficiency (through distorting price signals)
But one should be careful in fighting inflation because of the tradeoff between inflation and
unemployment; high GDP: high inflation, low unemployment – low GDP: low inflation, high
unemployment rate (Phillip’s curve negatively sloped depicting the negative relationship
between inflation and unemployment)

The Money Market:

how interest rates are determined
Keynesian approach of the determination of interest rates
Demand for money negatively sloped because of the negative relationship between interest
rates and demand for money
Investment negatively related to interest rates

Fiscal Policy

Fiscal policy can lead to a debt crisis

The government budget for a given year shows the planned expenditures (G) of government
programs and the expected returns from taxes (T)
The government debt is the accumulated amount of what government has borrowed to
finance past deficits, or it is the total dollar value of government bonds owned by the public:
If G<T => budget surplus
If G>T => budget deficit
And here the government must borrow from the private sector to cover its
expenditures. Borrowing is achieved through the issue of government bonds; by selling
treasury bills and bonds
If G=T => balanced budget

The economic consequence of the debt:

 The negative impacts of deficits and debt on the economy
2 indicators to show how the economy is doing in terms of debts and deficits:
Debt/GDP=60% (Maastricht treaty requirement, maximum to join EU) in leb 190% 3 rd
most indebted country after Greece and japan
Deficit/GDP=3% (EU counties Maastricht treaty 1995) in leb 20% used to be 10% in
last 2 3 decades
When the gov has to borrow by selling treasury bills, CB sells to economy its sucking liquidity
which could be used to invest in productive sectors of economy, i goes up I go down lower
GDP growth rates and maybe recession
Interest rates:
The deficit and debt imply a growing demand for the national currency pushing its
price which is the interest rate upwards and crowding out private investment leading
to lower GDP growth rate
Ex: spending the nation’s savings on healthcare programs instead of investing these
funds in productive projects; lower private investment -> ↓K -> lower economic
growth -> future standard of living will decline
Risk of inflation:
The debtor government might implement inflation policies in order to reduce the
value of its real debt and make its service easier and less expensive
Vicious cycle:
More deficits more debts
The government might fall in the trap of public debt
The increase in the interest rates may make the service of the debt impossible and the
only solution will become bankruptcy

 Financing the deficit:

How can the debt be financed? If selling treasury bills is no longer possible because of high
debt/GDP ratio, CB might resort to:
Money printing
What BDL is doing; consists of printing money in order to pay for all government
expenses (also debt, households deposits at commercial banks) (MS tripled 7t to 30t)
Using foreign exchange reserves
To finance government expenses may shake the confidence in the national economy
and currency. If those reserves are used extensively to pay for your imports bills,
they may go down to 0 which might shake confidence
Taxation
This needs parliament approval to increase taxes. Taxes have important distortionary
effects on incentives ↑t ->↓D.I -> work less save less -> GDP and I ↓
Domestic borrowing
Issuing treasury bills may lead to increases in interest rate and limit the sources of
financing to the private sector. Moreover, this policy will absorb national savings that
should be invested in private projects in productive economic sectors. Because the
CB paid high interest rates on treasury bills, commercial banks stopped giving loans
to private sector that could’ve been used for productive investments and lend that
money to the government which defaulted on the debt and wiped out savings of
Lebanese
External borrowing from international markets (selling Eurobonds)
From which emerge all kinds of problems related to the cost and volume of external
debt and the appreciation of the exchange rate (because i is high, capital flowing in,
u need to sell those bonds, so u offer high interest rates on those bonds). This
appreciation is not caused by economic growth or prosperity but by high and costly
external debt which is very harmful economy; will lead to huge current account
deficits, and to the twin deficit, budget deficit
Privatization
It means selling public institutions to the private sector in order to make them more
efficient. It contributes to creating and boosting the financial markets and create
better opportunities for investments and savings. You need to have an economic
sector that isn’t corrupt.
 The effects of debt on economic growth
Economic growth is the expansion of a country’s potential output or real GDP
To achieve growth a country should:
Increase capital (lowering i)
Encourage research and development
Have a better educated labor force; invest in human capital
External vs internal debt:
Internal debt: owed by a nation to its own citizens
External debt: owed by a nation to foreigners
Many economists believe that external debt is worse than internal debt and involves a net
subtraction from the nation’s resources available to pay it back (reduction in the nation’s
consumption possibilities). Internal debt can be solved domestically, external debt is owed
to foreigners you can enter into lots of problems. Also, to service external debt you have to
do that with foreign currency which will eat up nation’s resources reducing nation’s
consumption possibilities
Incurring higher debt through the issue of government bonds -> people will invest savings in
government bonds instead of in productive projects -> K↓ -> economic growth ↓
[K: capital]
Agency theory, the economic analysis of the effects of asymmetric information (adverse
selection and moral hazard) on financial markets to see why financial crises occur and why
they have devastating effects on the economy

A financial crisis occurs when there is a particularly large disruption to information flows in
financial markets, with the result that financial frictions increase sharply, and financial
markets stop functioning. (asymmetric information, banks start giving loans to wrong
investors or investors taking wrong decisions). Interest rates will go up. When you don’t
know quality of borrower if they can pay back the loan, you raise interest.

3 stages of a financial crisis:

Stage 1: initiation of a financial crisis
Credit boom and bust: mismanagement of financial liberalization/innovation leading
to asset price boom and bust. Banks giving out loans without appropriate info about
borrowers (2008 crisis). Too much credit in the economy leads to crisis. Open up
financial markets too quickly mostly the case in emerging economies.
Asset price boom and bust: Creation of news assets (innovation) followed by asset
price go up and down high risk.
Increase in uncertainty
Stage 2: banking crisis
Stage 3: debt deflation/default

Sequence of events in financial crises in advanced economies:

-Start with asset price decline, increased uncertainty, adverse selection, moral hazard, no
giving loans to right borrowers
When asset prices start to decline there will be deterioration in balance sheets of
corporations
Accompanied by a decrease in lending, banks will be reluctant to give out loans
-If this doesn’t stop there will be banking crisis, the economy moves to recession, banks
assets are hit hard
-decline in prices, deep recession, real value of debt debt/prices will go up
The Great Depression 1930:
Stock market crash
Bank panics; people trying to withdraw their money
Continuing decline in stock prices
Debt deflation US economy entered into deep recession, prices started falling sharply

US treasury bill: low risk

The Global Financial Crisis 2007-2009

Causes:
 Financial innovations emerge in the mortgage markets
Some investors started creating news assets
Subprime mortgage: mortgages below minimum quality mortgage, some inv firms started
giving mortgages below par (borrowers most likely not able to pay them back)
Mortgage-backed securities: other financial corporations took those loans put them in a
basket and issued securities in return
Collateralized debt obligations (CDOs): financial tools banks use to repackage individual
loans into a product sold to investors on the secondary market
All of these led to high demand on real estate, people were taking loans easily and
purchasing houses easily leading to housing bubble
 Housing price bubble forms
Increase in liquidity from cash flows surging to US; not only domestic also foreigners
Development of subprime mortgage market fueled housing demand and housing prices
 Agency problems arise
‘Originate-to-distribute’ model is subject to principal-(investor) agent (mortgage broker)
problem. (Corporations didn’t have enough info about financial soundness of investor)
Borrowers had little incentive to disclose information about their ability to pay (leads to
adverse selection; bank not selecting right borrower)
Commercial and investment banks (as well as rating agencies) had weak incentives to assess
the quality of securities
 Information problems surface: asymmetric info, moral hazard, adverse selction
leading to inflation
 Housing price bubble bursts
CDOs:
The creation of a collateralized debt obligation involves a corporate entity called a special
purpose vehicle (SPV) that buys a collection of assets such as corporate bonds and loans,
commercial real estate bonds, and mortgage-backed securities.
The SPV separates the payment streams (cash flows) from these assets into buckets that are
referred to as tranches.
The highest rated tranches/buckets, referred to as super senior tranches, are the ones that
are paid off first (in case any of those assets default) and so have the least risk
The lowest tranche of the CDO is the equity tranche and this is the first set of cash flows
that aren’t paid out if the underlying assets go into default and stop making payments. This
tranche has the highest risk is often not traded

Effects:
-We had a bubble in the real estate market, and it started to burst
-After a sustained boom, housing prices began a long decline beginning in 2006
-The decline in housing prices contributed to a rise in defaults on mortgages and a
deterioration in the balance sheets of financial institutions (who had these mortgages as
assets)
-This development in turn caused a run on the shadow banking system (non-bank financial
institutions that provide services similar to traditional commercial banks but outside normal
banking regulations; like hedge and mutual funds)
-Crisis spreads globally:
A sign of the globalization of financial markets (interrelated)
Stock markets in Europe were also affected
TED spread (3 months interest rate on Eurodollar minus 3 months treasury bills interest
rate) increased from 40 basis points to almost 240 in August 2007. Important sign that
financial markets were being affected
-Deterioration of financial institutions’ balance sheets:
Write downs (it is an accounting term for the reduction in the book value of an asset when
its fair market value has fallen below its book value, and thus becomes an impaired asset;
ex: Lebanese Eurobonds lost more than 80% of their value)
Led to sell of assets and credit restriction
-High profile firms fail (Bear Stearns March 2008 – Fannie Mae and Freddie Mac July –
Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (mutual fund), and Washington
Mutual September)
This is what triggered an immediate action from US government to rescue corporations and
prevent failures:
Bailout package debated: (fiscal stimulus packages)
House of representatives voted down the $700B bailout package on September 29 2008
It passed on October 3 2008
Congress approved a $787B economic stimulus plan on February 13 2009
Combination of fiscal and monetary through quantitative easing, pumping liquidity, and
fiscal package that was approved by congress
By 2009 lost 30% of its value

Lost about 50% of its value

Bubble that burst in real estate and stock market

How monetary policy may affect those markets and trigger a crisis?
Was the Fed to blame for the housing price bubble?
Some economists argue that the low interest rate policies of the fed in 2003-2006 caused
the housing price bubble; following a loose monetary policy
Low interest rates led to low rates on mortgages which stimulated housing demand and
encouraged the issuance of subprime mortgages, both of which led to rising housing prices
and a bubble (Taylor)
Chairman of Fed: culprits of crisis were financial innovators and lowering mortgage
payments, and relaxation of lending standards that brought more buyers into the housing
market, and capital inflows from emerging market countries
The debate whether monetary policy was to blame is still going

Global: the European sovereign debt crisis:

Because of globalization and that mature financial markets are interrelated
After US financial crisis, the increase in budget deficits led to international investors started
fearing a government default due to the surge in interest rates
The sovereign debt crisis began in Greece then Ireland, Portugal, Spain, and Italy
The stresses created by this threaten the viability of the Euro

Height of the 2007-2009 financial crisis:

-the stock market crash gathered pace in the fall of 2008, with week October 6 2008,
showing the worst weekly decline in US history
-surging interest rates faced by borrowers led to sharp declines in consumer spending and
investment (both US and EU, mostly US)
-the unemployment rate shot up going over the 10% level in late 2009 in the midst of the
Great Recession, the worst economic contraction in the US since WW2

Government intervention and the recovery:

Government: fiscal stimulus package
CB: Monetary stimulus package; quantitative easing policy
Due to gov and CB intervention, the consequences on 2008 crisis were smaller in magnitude
than the Great Depression
All of these assets that became impaired were brought by the treasury from institutions that
had liquidity problems
The Troubled Asset Relief Program (TARP), the most important provision of the Bush
administrations’ emergency economic stabilization act passed in Oct 2008, authorized the
treasury to spend $700B purchasing subprime mortgage assets from troubled financial
institutions or to inject capital into these institutions.

Response of financial regulation:

Macroprudential vs. microprudential supervision: more focus on macro; micro is supervising
financial institutions, what is being suggested is looking at all the financial market/system,
not only regulations that target small or medium sized corporations but whole sytem
Dodd-Frank wall street reform and consumer protection act of 2010 was trying to address
the type of regulation that was needed to deal with financial crisis and prevent other crisis:
Consumer protection: when interest rate go up directly affect spending
Annual stress tests on assets of financial intermediaries and commercial banks
Resolution authority: gov needs to be more proactive to make sure regulations are
implemented
Systemic risk regulation: bankruptcy of one corporation can lead to the bankruptcy of the
whole sector or industry which can trigger the collapse of the whole financial sytem
Volcker rule
Derivatives: limit trade in derivatives

Too big to fail and future regulation:

3 approaches to solving this:
Break up large financial institutions
Higher capital requirements
Leave it to Dodd-Frank
Issues for future regulation:
Consumer protection
Compensation in the financial sector; pump in liquidity
Volcker rule
Derivatives trading
Government-sponsored enterprises
Credit rating agencies: make sure those corporations, mortgages, borrowers are well rated
The danger of overregulation

PART2: Financial Crisis in Emerging Market Economies

 Stage 1:
-Path A: Credit boom and bust
Weak supervision and lack of expertise lead to a lending boom
Domestic banks borrow from foreign bank
Fixed exchange rates give a sense of lower risk
Banks play a more important role in emerging market economies, since securities
markets are not well developed yet.
-Path B: Severe fiscal imbalances
Gov budget deficits
Governments in need of funds sometimes force banks to buy government debt
(treasury bonds and bills); to finance gov deficit
When gov debt loses value, banks lose and their net worth decreases, leading to
bank crisis
-Additional factors:
Increase in interest rates
Asset price decrease (emerging markets that invest in mature markets)
Uncertainty linked to unstable political systems
 Stage 2: Currency crisis
-Deterioration of bank balance sheets triggers currency crises:
Gov can’t raise interest rates, more banks will go bankrupt, speculators expect a
devaluation, people will sell local currency and buy foreign currency which will lead to
further depreciation
-Severe fiscal imbalances:
Foreign and domestic investors sell the domestic currency
 Stage 3: full-fledged financial crisis (collapse of financial system)
The debt burden in terms of domestic currency increases (net worth decreases)
Increase in expected and actual inflation reduces firms’ cash flow
Banks are more likely to fail:
Individuals/private sector are less able to pay off their debts (value of assets falls)
Debt denominated in foreign currency increases (value of liabilities increases)
Crisis in South Korea 1997-98 (Asian Crisis)
Triggers: fast liberalization and globalization of Asian economies, opened up their capital
account and stock market without regulations which led to a disruption in their financial
markets. Hot short term capital is dangerous, seeking profit leaving quickly not long term
investments to stimulate growth.
-financial liberalization and globalization mismanaged
-perversion (disruption) of the financial liberalization and globalization process
-stock market decline and failure of firms increase uncertainty
-adverse selection and moral hazard problems worsen and the economy contracts
(recession)
-currency crisis ensued as a result of the ‘capital flight’
-final stage: currency crisis triggers full-fledged financial crisis
-recovery commences (help from imf and international institutions)

The Argentine Financial Crisis 2001-2002

Triggers:
-several fiscal imbalances mainly budget deficits and accumulated public debt and current
account deficits
-adverse selection and moral hazard problems worsen

-bank panic begins: people withdrawing deposits from banks
-currency crisis triggers full-fledged financial crisis
-recovery begins

The Icelandic financial crisis of 2008:

As a result of the US financial crisis
Wealthy economy, but crisis is similar to Asian crisis
Trigger: fast liberalization of the capital account and capital inflows into stock market. When
severe recession developed that capital reverted back and led to decline in stock market.
Financial liberalization led to rising stock market values and currency mismatch
Foreign capital fled the country as a severe recession developed
Preventing emerging market financial crisis:
-increase prudential regulation and supervision of banks because banks might be giving
loans to borrowers that can’t pay them back
-encourage disclosure and market-based discipline; publish balance sheets need more info
to give right loan to right borrower
-limit currency mismatch: don’t allow capital to flow in don’t allow people to invest abroad
(Eurobonds) any devaluation will lead to bankruptcies and full collapse of financial system
-sequence financial liberalization: don’t open up quickly your capital account you have to
have right financial regulations before opening and allowing foreign investors to enter
financial market
 Lebanon Crisis

Lebanon is a perfect storm; many factors coming into play at the same time
Unlike other financial and debt crises, Lebanon’s interrelated political + social (50-
60% under poverty line, high unemployment 60%) + economic crisis = a perfect
storm

US: real estate bubble

EU: budget deficits and public debt
Argentina: fiscal imbalances
East Asia: fast liberalization of financial markets
Egypt & Turkey: currency crisis
Iceland & Cyprus: banking crisis

Is it a currency crisis? Yes

Official 1515
Market value 7500
Huge depreciation

Is it a balance of payment crisis? Yes

Past few years current account deficits 25% of GDP or $15B/year
We have been having chronic current account deficits because of a structural problem
80% of consumption imported
Export $4-5B/year

Twin deficit phenomena: current account deficit & government deficit

Corruption is worsening both
Is it a debt crisis? Yes
The government has defaulted on its Euro Bonds (on its external debt)
Lebanon’s treasury bills and bonds are downgraded to selective default by major rating
agencies (Standard and Poor’s, Fitch, and Moody’s)

Because of accumulation of past budget deficits led to accumulation of huge debt on which
the government defaulted on in March. Corruption; high government expenditure isn’t
going where it should, low tax revenue.

Lebanon: 3rd most indebted country in the world after Japan and Greece
Debt to GDP ratio: 170%
Gross public debt: $87B
Total debt: $100B or 175% of GDP
(including debt to the healthcare sector, pension fund, and council of reconstruction and
development)
Lebanon’s debt and debt service are unsustainable: a debt default

Today it is 20-25% in 2019 15%

Government is unable to collect revenues because of recession, we have a huge decline in
GDP (55-> 35B)
Money was going to pay interest on debt
Other portion of revenue going to pay public wage bill
Only those 2 items (also 2B to EDL) lead to budget deficit no more money is left to spend on
social services health care infrastructure water electricity…

Direct financing of gov by CB around $30B worth of debt in local currency

Also, commercial banks were financing gov by buying treasury bills
Local currency debt mostly held by CB and commercial banks

Chart b debt in foreign currency mostly held by commercial banks

So, the debt default will impact BDL and banking sector

Is it a banking crisis? Yes

Banks have lent the gov around 40B$ (purchases bills and bonds 20 foreign 20 local)
70% of bank assets are in the form of CDs (certificate of deposits: deposits that commercial
banks put with CB and earn interest on them), TBs (local) and Bonds (foreign) -> given to CB
or gov
Banking system losses estimated at $80B; 40 from investment in bills and bonds
(commercial banks’ assets) 40 from direct placements with CB, CD
Gov has defaulted on debt so banks have been hardly hit; lent money to corrupt gov who
spent money, bank shareholders transferred money to banks outside
Bank deposits are blocked: no access to foreign currency deposits
BLOM Bank MED and AUDI are downgraded to the SD (selective default) category
Current account deficit has been fed by Lebanese working abroad and sending money to
cover for current account deficits 8-10B$ per year (remittances)
Those remittances stopped in 2016; sudden stop in capital because of social political
economic instability so we experienced liquidity squeeze in dollars
CB has to resort to Ponzi scheme by raising interest rate to attract diaspora’s money and
also local to continue to lend money to a corrupt government which defaulted on its debt
Ponzi scheme: entity tells u give me money I give u high interest as long as they can find
people willing to lend money
When no one is willing to lend money to that entity anymore they go bankrupt
Losses are estimated at around 50B$
Banks CB gov are to blame

The % of commercial banking system given to government

Figure 11 sums up:

Also, private sector default on loans
Commercial banks borrowed from CB about 10B$
Strategic imports: medication fuel wheat. CB said that once those 2B are spent they will no
longer provide any subsidy on those imports so pricex4

Is it a political and social crisis? Yes

Political deadlock that has been unfolding since uprising of last year; takes 6 7 months to
form government corruption has eaten up all gov institutions
50% of population living under poverty line
40% is the youth unemployment rate expected to go to 60%

Options for government and BDL:

Debt default
Debt restructuring appears unavoidable
Official devaluation and capital controls
Haircut on debt and on bank deposits

The way out of the crisis:

Lebanon is in the eye of an economic and financial storm heading towards the full collapse
of the whole financial system
If the gov doesn’t call upon IMF and no deal is reached our last chance is what the French
government is trying to do
If the gov won’t take necessary steps, we are heading towards full collapse of economy and
Lebanon will be a failed state
Gov no longer able to service debt
To stop the downfall, the economy will need an immediate injection of $25B in fresh capital
to prevent the full collapse of the banking system and the government (which could come
from recovery of money appropriated through government corruption unless they strike a
deal with IMF and we get our Cedre money but it won’t be enough to prevent full collapse)
BDL will not continue to buy government maturing debt it’s barely able to secure strategic
imports
Total debt repayments due in 2020 are 5.2B$ and $10.7B on debt in LBP; $3.9B in 2021;
$3.7B in 2022; $3.2B in 2023 and $8B in maturing CDs in 2022 and 2023
Government has already defaulted on its debt and the CDs have vanished no longer with CB

Lessons learned from past debt and financial crises:

All had
Fixed exchange rate
High debt to GDP ratios and debt levels (twin deficit phenomena)
High current account and budget deficits

All favor the hard landing scenario (perfect storm) sovereign debt crisis exchange rate crisis
and balance of payment crisis

In the current Lebanese crisis:

Lebanon has a huge public debt much higher than the crises cases we reviewed
Has the highest budget and current account deficits among the crises stricken countries
Has a fixed exchange rate
All those led to a perfect storm scenario

Lebanon will not be able to inject the much needed US$ liquidity through quantitative
easing. In the US the stimulus packages by fiscal or monetary we don’t have either.
Has no fiscal space and therefore cannot introduce a fiscal stimulus package to deal with the
crisis
No support from the EU, ECB, IMF, or world bank. Only hope is IMF

Tough times ahead Lebanon will be under tremendous financial pressure during next 3 5
years we need extraordinary measures.
Origins of the Federal Reserve System
Beginning of 1900s
Resistance to the establishment of a CB
Due to fear of centralized power and an entity that is printing money (distrust of
moneyed interests)
No lender of last resort
If commercial bank facing liquidity problems CB helps to not cause chain of
bankruptcies
Nationwide bank panics on a regular basis
Panic of 1907 so severe that the public was convinced a CB was needed
Federal Reserve Act of 1913
The act that moved into establishing a CB that is accountable
Elaborated system of checks and balances
Decentralized

The senators that wrote that act wanted to diffuse power along regional lines, between the
private sector, the government, bankers, business people, and the public
The initial diffusion of power has resulted in the evolution of the Federal Reserve System to
include the following entities:
The Federal Reserve Banks (main CBs 12)
Board of Governors of the Federal Reserve System
The federal open market committee (FOMC) manages open market operations
The federal advisory council
Around 2,900 member commercial banks

Main entity that manages Fed is board of governors

Federal Reserve Banks (12)
Quasi-public institution owned by private commercial banks in the district that are members
of the Fed system.
Member banks elect 6 directors for each district, 3 more are appointed by the board of
governors
3 categories of directors:
3 A directors are professional bankers
3 B directors are prominent leaders from industry, labor, agriculture, or consumer
sector
3 C directors appointed by the Board of Governors aren’t allowed to be officers,
employees, or stockholders of banks; outside banking system
Designed to reflect all constituencies of the public
9 directors appoint the president of the bank; subject to approval by Board of Governors

map that shows how districts are divided

Functions of federal reserve banks:

Clear checks
Issue new currency; printing money, manage MS
Withdraw damaged currency from circulation
Administer and make discount loans to banks in their districts (like last resort)
Evaluate proposed mergers and applications for banks to expand their activities
(M&As between commercial banks have to be submitted and approved by Fed in the
district)
Act as liaisons between the business community (private sector or corporate sector)
and the federal reserve system (if business community has a say on monetary policy)
Examine bank holding companies (bank holding company: corporation that owns a
controlling interest in one or more banks but does not itself offer banking services) and
state-chartered member banks (commercial banks owned by the state; abide by state rules
and regulations)
Collect data on local business conditions (processed to come up with right monetary
policy response)
Use staffs of professional economists to research topics related to the conduct of
monetary policy
Federal Reserve Bank of New York:
Plays a special role in the Federal Reserve System for many reasons:
Its district contains many of the largest commercial banks in the US, the safety and
soundness of which are paramount to the health of the US financial system
Its active involvement in the bond and foreign exchange markets
It’s the only federal reserve bank to be a member of the Bank for International
Settlements (BIS) being an international financial institution owned by CBs that fosters
international monetary and financial cooperation and serves as a bank for CBs
Its president is the only permanent voting member of the FOMC among the federal
reserve bank presidents, serving as the vice-chair of the committee. Thus, he/she and the
chair and the vice-chair of the board of governors are the 3 most important officials in the
federal reserve system.

Federal Reserve Banks and Monetary Policy:

Directors establish the discount rate
Decide which banks can obtain discount loans
Directors select one commercial banker from each district to serve on the Federal Advisory
Council which consults with the Board of Governors and provides info to help conduct
monetary policy
5 of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC)

Member Banks:
All national banks are required to be members of the Federal Reserve System
Commercial banks chartered by states are not required but may choose to be members
Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks
to the same reserve requirements as member banks and gave all banks access to Federal
Reserve facilities (liquidity facility that is provided when a bank is in need of liquidity)

Board of Governors:
7 members headquartered in Washington, DC elect a chair
Appointed by the president and confirmed by the Senate
14-year non-renewable term
Required to come from different districts
Chairman is chosen from the governors and serves 4-year term

Duties:
Votes on conduct of open market operations (whether to buy or sell tb)
Sets reserve requirements
Controls the discount rate through ‘review and determination’ process
Sets margin requirements (has to do with amount of borrowing in financial market; if u want
to buy a future contract u pay a certain margin; very important in regulating stock market
and financial market mostly markets for derivatives and futures and forwards)
Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank’s
budget
Approves bank mergers and applications for new activities
Specifies the permissible activities of bank holding companies
Supervises the activities of foreign banks operating in the US
Chairman of the Board of Governors: (Jeremy Powel)
Advises the president on economic policy
Testifies in Congress (justify monetary policy taken by Fed)
Speaks for the Federal Reserve System to the media
May represent the US in negotiations with foreign governments on economic matters

The Role of the Research Staff:

The Federal Reserve System is the largest employer of economists in the world
The most important task of the Fed’s economists is to follow the incoming economic data
from government agencies and private sector organizations and provide guidance to the
policy makers on the direction in which the economy might be headed and the potential
impact of monetary policy actions on the economy (gather process data see where it’s going
and gives advice)

Federal Open Market Committee (FOMC):

Meets 8 times a year every 6 weeks
Consists of 7 members of the board of governors, the president of the federal reserve bank
of New York, and the presidents of 4 other reserve banks
Chairman of the board of governors is also the chair of FOMC
Issues directives to the trading desk at the federal reserve bank of New York; it manages the
federal reserve bank of New York as far as the (? Idk) market is concerned so this is where
the conduct of open market operations takes place - these operations are directly
supervised by FOMC which decides what to do with US interest rates

The FOMC Meeting:

Report by the manager of system open market operations on foreign currency and domestic
open market operations and other related issues
Presentation of Board’s staff national economic forecast
Outline of different scenarios for monetary policy actions
Presentation on relevant Congressional actions
Public announcement about the outcome of the meeting

Why the chairman of the board of governors really runs the show?
Spokesperson for the Fed and negotiates with Congress and President
Sets the agenda for meetings; he decides the issue to be discussed
Speaks and votes first about monetary policy
Supervises professional economists and advisers
Should the CB be independent?
When the CB is fully independent, the goal of monetary policy is price stability not GDP
The case for independence:
The strongest argument for an independent CB rests on the view that subjecting it to more
political pressures the inflation goal will be in danger and monetary policy will not focus on
inflation but will be pressured by politicians to focus on business cycle.
The case against independence:
Argue that it is undemocratic to have monetary policy (which affects almost everyone in the
economy) controlled by an elite group that reports to no one; not democratically elected

The Case for Independence:

Political pressure would impart an inflationary bias to monetary policy (politicians may ask
CB to do expansionary monetary policy which will lead to inflation)
Political business cycle driving monetary policy (before election increase MS loose monetary
policy low interest rate stimulate GDP even at expense of inflation then after election fight
inflation; tighten monetary policy reduce MS increase interest rate) politicians shouldn’t
have impact on monetary policy
Could be used to facilitate Treasury financing of large budget deficits: accommodation
Too important to leave to politicians – the principal-agent problem is worse for politicians;
principal: politicians, agent: CB

The Case Against Independence:

Undemocratic
Unaccountable
Difficult to coordinate fiscal and monetary policy
Has not used its independence successfully

Explaning CB Behavior:
One of view of government bureaucratic behavior is that bureaucracies serve the public
interest (this is the public interest view). Yet some economists have developed a theory of
bureaucratic behavior that suggests other factors that influence how bureaucracies operate
in the sense that they’re not there to serve the public interest but they’re there to serve the
public interest of the bureaucrats themselves
The theory of bureaucratic behavior may be a useful guide to predict what motivates the
Fed and other CBs.
Theory of bureaucratic behavior:
Objective is to maximize its own welfare that is related to power and prestige
Fight vigorously to preserve autonomy so that they are able to preserve prestige and
promote corruption to gain more power and money
Avoid conflict with more powerful groups
Does not rule out altruism
So, shouldn’t be independent because of above
The evolution of the Fed’s communication strategy:
The fed has dramatically increased its transparency
The chair holds a press conference to clarify monetary policy communications
Greater transparency has been provided with the announcement of a specific
numerical target for the inflation rate
More communication with the media
Moved the fed into becoming an institution that responds to public welfare

Structure and Independence of the European Central Bank:

Inspired by Fed
12 in US similar to 27 CBs in each EU country
CBs from each country play similar role as Fed banks
Monetary by CB Fiscal by treasury
In US they have a complete financial monetary and political union not the case in EU, they
have unified monetary policy 1 CB conducting monetary policy for all member states but
fiscal policy is conducted by each individual ministry of finance and this is a factor in the
debt crisis in Europe in 2012 because monetary and fiscal policy aren’t coordinated to
achieve certain objectives
ECB most independent CB in the world conducting monetary policies with inflation objective

Executive board:
President, VP, 4 other members
8-year nonrenewable terms
Governing council

Differences Between ECB and Fed:

National CBs control their own budgets and the budget of the ECB
Fed banks don’t have that advantage
Monetary operations are not centralized, the conduct of monetary policy is centralized but
monetary operation is done through cooperation of the ECB and the various member states
CBs
ECB does not supervise and regulate financial institutions while Fed does extensively

Governing Council:
Monthly meetings at ECB in Frankfurt, Germany
19 national CB heads and 6 executive board members
Operates by consensus (any decision about monetary policy or MS)
Transparent; ECB announces target inflation rate and takes questions from media
To stay at a manageable size as new counties join, the governing council will be on a system
of rotation

How independent is the ecb

Most in the world
Main goal is price stability
Members of the executive board have long terms
Determines own budget
Charter cannot be changed by legislation, only by revision of Maastricht treaty
Structure and independence of other CBs:

Banks of Canada; very independent

Essentially controls monetary policy; goal is price stability

Bank of England; less independent

Has some instrument independence; they can decide on the instruments of monetary policy
without getting treasury’s approval

Bank of Japan; moving into more independence

Recently gained more independence (1998); more pursuing inflation goal than trying to
stimulate economy

CB independence is very important; it can be used in a non-welfare maximizing situation; it

can lead to corruption if not properly implemented
3 players in MS process
The central bank (main player)
Banks: depository institutions, financial intermediaries
Depositors: individuals and institutions
Banks and depositors could represent leakages and reduce effect of CB change in MS

The Fed’s Balance Sheet:

Assets:
Securities (gov treasury bills and bonds; holdings by Fed that affect MS and earn
interest) (euro bonds not held by CB, by banks and international investors)
Loans to financial institutions: provide reserves to banks and earn the discount rate
Liabilities:
Currency in circulation: in the hands of the public
Reserves: bank deposits at the Fed and vault cash

Banks have also placed money under CDs in CB (securities)

Deficit financing: print money to finance government expenditures

Control of the Monetary Base:

High powered money
MB = C+R
C: currency in circulation
R: total reserves in the banking system
Whenever there is open market operation it is amount of reserves that will change to reflect
if it is a purchase or sale of treasury bills and bonds

Open Market Purchase from a Bank:

CB purchased securities from bank in order of 100M

CB gives banks 100M which goes into reserves

CB pays by increasing reserves by 100M
No change in currency
R increased by 100M
Monetary Base increase by 100M
Open Market Purchase from the Nonbank Public:

CB purchases bonds from private sector amount 100M

Whoever sold them deposits money in bank (checkable deposits)
Reserves of that bank also go up 100M
Fed assets go up 100M securities
Fed liabilities reserves also +100M
Person selling bonds to the Fed deposits the Fed’s check in bank
Reserves went up so monetary base also go up
No change in C, check deposited directly in banking system

Person selling the bonds cashes the Fed’s check

Amount of bonds by private sector goes down by 100M in securities and transformed in
currency; no change in liability
Currency in circulation increased by 100M, no change in R (cash)
MB increases by amount of open market purchase

The effect of an open market purchase on reserves depends on whether the seller of the
bonds keeps the proceeds from the sale in currency or in deposits
The effect of OMP on the MB always increases the MB by amount of purchase; whenever CB
wants to loosen monetary policy - increase MS reduce interest rate - they will purchase
bonds from private sector; not MS will increase directly but MB will

Open Market Sale:

Tighten monetary policy, reduce MS and increase interest rate (fight inflation)

Private sector
Open market sale will reduce MB by 100M; reserves are unchanged
Shifts from Deposits into Currency:
Withdrawing money and keeping cash at home (bank run) (private sector loses confidence
in banking system)

Net effect on monetary liabilities is zero

MB is relatively stable variable
Only a change in balance sheet

Loans to financial institutions:

Monetary liabilities of the banking system have increased by 100M

MB increase by this amount (R)

Other factors that affect MB:

Float: is money within the banking system that is briefly counted twice due to time gaps in
the registering of a deposit or withdrawal, usually due to the delay in processing paper
checks. A bank credits a customer’s account as soon as a check is deposited. However, it
takes some time to receive a check from the payer’s bank and record it. Until the check
clears the account it’s drawn on, the amount it’s written for ‘exists’ in 2 different places,
appearing in the accounts of both the recipient’s and payer’s banks
Treasury deposits at CB: if gov generates a surplus it can be deposited at CB; never happens
gov always produce deficits very rare cases to see gov surplus
Interventions in the foreign exchange market: if CB pumping dollars it is sucking liquidity in
local currency reducing MS increasing interest rate

Overview of Fed’s ability to control MB:

Open market operations are controlled by Fed
Fed can’t determine amount of borrowing by banks from Fed; decided by commercial
banking system
Split the MB into 2 components: MBn = MB – BR
MS is positively related to both the non-borrowed MBn and to the level of borrowed
reserves BR from the Fed
Multiple Deposit Creation:
Single bank

FNB decides to sell securities 100M, that money from sale of TB goes to reserves
Money goes to checkable deposits and loans out 100M
Excess reserves go up, bank loans out the excess reserves, create a checking account,
borrower makes purchases, MS has increased
Converted 100M of securities to cash

If rrr is 10%
Deriving the formula for multiple deposit creation:
Assuming banks don’t hold excess reserves
RR=Total Reserves R
RR= r x D = R
D=R/r
deltaD=deltaR x 1/r

Critique of the Simple model:

If one of the customers in the process above takes the loan and keeps money at home this
will stop the deposit creation process
Banks may not use all their excess reserves to buy securities or make loans
Depositors’ decisions (how much currency to hold) and bank’s decisions (amount of excess
reserves to hold) also cause the MS to change

Factors that determine MS:

Changes in the non-borrowed monetary base MBn
MS is +vly related to MBn
Changes in borrowed reserves from Fed
MS is +vely related to level of BR
Change in rrr
MS is negatively related to the rrr
Changes in currency holdings
MS is negatively related to currency holdings; if people decide to take loan and keep
at home, the amount won’t go through banking system to increase MS
Changes in excess reserves
MS is negatively related to amount of excess reserves

Overview of MS process:

The Money Multiplier:

Define money as currency + checkable deposits: M1
Link MS to MB by money multiplier: MS=m x MB
Deriving Money Multiplier:
Assume the desired holdings of currency C and excess reserves ER grow proportionally with
checkable deposits D
c = C/D = currency ratio
e = ER/D = excess reserves ratio
R=RR+ER
RR=r x D
 R= (r x D) + ER
MB = C + R = C + (r x D) + ER
This equation shows the amount of the MB needed to support the existing amounts of
checkable deposits, currency, and excess reserves

Numerical example:
Simple deposit multiplier: 1/r; this is less than that. Above reflects leakages that can reduce
money multiplier; 3 sources: excess reserves (e), currency in circulation (c), and required
reserves. Rrr decrease ability of banks to give out loans, c whatever money is in circulation
outside banking system, e if banks decide not to give out total liquidity they have in loans

Quantitative Easing and MS 2007-2017:

When the global financial crisis began in fall 2007, the Fed initiated lending programs
(pumping liquidity) and large-scale asset purchase programs in an attempt to bolster the
economy
BDL offered to give liquidity to banks at rate 20% instead of acting as last resort, Fed bought
impaired assets and securities from commercial banks
When gov defaulted on Eurobonds BDL was watching banks losing half of their assets
By fall of 2017, these purchases of securities had led to a quintupling (x4) of the Fed’s
balance sheet and a 350% increase in the MB
Commercial banks in US decided to keep money as excess reserves and not give out loans

These lending and asset purchase programs resulted in a huge expansion of the monetary
base and have been given the name ‘quantitative easing’
This increase in the MB didn’t lead to an equivalent change in the MS because excess
reserves rose dramatically

No loans mean no investment no consumer loans

So, pumping of huge liquidity didn’t result in increases in economic activity GDP inflation
rate until 2015 2016 when US started going out of recession
Bottom line: liquidity helped US banks not go bankrupt but not the economy to get out of
recession
Huge increase in e because of purchase of assets and pumping of liquidity, kept on
increasing till 2015 when US economy started recovering from recession
c more or less stable
The Market for Reserves and the Federal Funds Rate
Equilibrium interest rate is determined by forces of supply and demand in market for
reserves
What happens to the quantity of reserves demanded by banks if federal funds rate changes?
Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could have been earned minus the
interest rate that is paid on these reserves, ior (rate commercial banks receive from
depositing excess reserves in CB)

Demand in the Market for Reserves

Since fall 2008, the Fed has paid interest on reserves at a level that is set at a fixed amount
below the federal funds rate target
When the federal funds rate is above the rate paid on excess reserves ior, as the federal
funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity
of reserves demanded rises
Downward sloping demand curve for reserves that becomes flat (infinitely elastic) at i or

Supply in the Market for Reserves

2 components: non-borrowed and borrowed reserves
Cost of borrowing from the Fed is the discount rate (upper bound of band)
Borrowing from the Fed is a substitute for borrowing from other banks
If iff<id then banks will not borrow from Fed and borrowed reserves are 0
The supply curve will be vertical
As iff rises above id, banks will borrow more and more at id and relend at iff (happens very
rarely)
The supply curve is horizontal (perfectly elastic) at id

Effect of Changes in Tools of Monetary Policy on Federal Funds Rate:

Effects of an OMO depends on whether the supply curve initially intersects the demand
curve in its downward sloped section vs its flat section
An open market purchase causes the federal funds rate to fall whereas an open market sale
causes the federal funds rate to rise (when intersection occurs at the downward sloped
section)
OMO have no effect on the federal funds rate when intersection occurs at the flat section of
the demand curve
If the intersection of the supply and demand curves occurs on the vertical section of the
supply curve, a change in the discount rate will have no effect on the federal funds rate
If the intersection of supply and demand occurs on the horizontal section of the supply
curve, a change in the discount rate shifts that portion of the supply curve and the federal
funds rate may either rise or fall depending on the change in the discount rate
When the Fed raises reserve requirement, the federal funds rate rises and when the Fed
decreases reserve requirements, the federal funds rate falls
Decreasing reserve requirements, the CB is increasing the ability of banks to create money,
increasing money multiplier, more loans… increasing money supply
Application: How Fed’s OMO Limit Changes in Federal Funds Rate
Supply and demand analysis of the market for reserves illustrates how an important
advantage of the Fed’s current procedures for operating the discount window and paying
interest on reserves is that they limit fluctuations in the federal funds rate
By intervening in the market through OMO the CB can leave the federal fund rate within the
band; between the discount rate and the rate paid on excess reserves (discount window);
the Fed operates the discount window to limit fluctuations in federal funds rate by playing
with id or ior
Conventional Monetary Policy Tools
During normal times, the Fed uses 3 tools of monetary policy – open market operations,
discount lending, and reserve requirements – to control the money supply through the
impact of these tools on MB and interest rates

A Day at the Trading Desk; How does CB use these tools?

The manager of domestic open market operations supervises the analysts and traders who
execute the purchases and sales of securities in the drive to hit the federal funds rate target

Discount Policy and the Lender of Last Resort

Changing the discount rate; rate at which CB gives loans to banks
Discount window; CB can manipulate to facilitate primary credit to banks
Primary credit: standing lending facility; if a bank doesn’t meet reserve requirements it can
borrow money from Fed
Secondary credit; banks borrow from each other, if discount rate is low so federal funds rate
is also low so that provides more lending facilities to banks
Seasonal credit; would depend on type of operations or business banks are involved in, CB is
ready to provide credit based on seasonal factors
Lender of last resort to prevent financial panics; provide liquidity in a financial crisis
Creates moral hazard problem because banks know they can borrow from CB so they
might take excessive risks in investments knowing they can be bailed out by CB

Reserve Requirements:
Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve
requirement the same for all depository institutions
Reserve requirements are equal to 0 for the first $15.5M of a bank’s checkable deposits, 3%
on checkable deposits from $15.5M to $115.1M, and 10% on checkable deposits over
$115.1M.
The Fed can vary the 10% requirement between 8% and 14%
Tightening monetary policy, increase to 14
Loosening, decrease to 8

Interest on Excess Reserves:

The Fed started paying interest on excess reserves only in 2008
The interest on excess reserves tool came to the rescue during the crash (extend liquidity to
banks) as banks were accumulating huge quantities of excess reserves because it can be
used to raise the federal funds rate

Using Discount Policy to Prevent a Financial Panic

To prevent the collapse of the financial sector, the governor of Fed on October 20 2008, the
Fed’s “readiness to serve a source of liquidity to support the economic and financial
system”. It would provide discount loans (very low discount rate) to any bank that would
make loans to the securities industry.
Outcome: financial panic averted.
Relative Advantages of the Different Monetary Policy Tools
Open market operations are the dominant policy tool of the Fed since it has
complete control over the volume of transactions (amount of TBs to be purchased and sold),
these operations are flexible and precise, easily reversed, and can quickly be implemented.
The discount rate is less well used since it is no longer binding for most banks (banks
are not obliged to borrow money from Fed, if Fed changes discount rate, that doesn’t mean
banks will borrow from it and increase MS in economy) can cause liquidity problems (if
discount rate set at high level/can compromise lender of last resort function), and increase
uncertainty for banks.
The discount window remains of tremendous value given its ability to allow the Fed to act as
a lender of last resort.

Failure of Conventional Monetary Policy Tools in a Financial Panic

When the economy experiences a full-scale financial crisis, conventional monetary policy
tools can’t do the job for 2 reasons;
The financial system seizes up to such an extent that it becomes unable to allocate
capital to productive uses, and so investment spending and the economy collapses; the flow
of information is not processed properly (moral hazard, adverse selection, agency
problems…).
The negative shock to the economy can lead to the zero lower bound problem.
Interest rates close to 0, increasing MS will not decrease interest rates or lowering rrr will
not also. We need unconventional tools (quantitative easing)

Nonconventional Monetary Policy Tools During Global Financial Crisis

Liquidity provision: The Fed implemented unprecedented increases in its lending facilities to
provide liquidity to the financial markets (0 interest rate)
Expanded discount window, lowered discount rate so troubled financial institutions
can have access to liquidity at very low rates
Term auction facility: program used by Fed to help pump in liquidity in credit
markets. TAF allows Fed to auction set amounts of collateral-backed short-term loans to
commercial banks
New lending programs:
Large scale asset purchases: buying those assets that banks had; Fed started 3 new asset
purchase programs to lower interest rates for particular types of credit:
Government sponsored entities purchase program; buying assets from troubled
institutions making them half owned by government
QE2
QE3
Extensive buying of those bonds led to the expansion of the Federal balance sheet:

in 2015 Fed stopped buying assets and loans

Nonconventional Monetary Policy Tools During Global Financial Crisis:
Quantitative Easing vs. Credit Easing
During the crisis, the Fed became very creative in assembling a host of new lending
facilities to help restore liquidity to different parts of the financial system
Forward Guidance
By committing to the future policy action of keeping the federal funds rate at 0 for
an extended period, the Fed could lower the market’s expectations of future short-
term interest rates, thereby causing the long-term interest rate to fall
Negative (real) Interest Rates on Banks’ Deposits
Setting negative interest rates on banks’ deposits is supposed to work to stimulate
the economy by encouraging banks to lend out the deposits they were keeping at
CB, thereby encouraging households and businesses to spend more. Negative
interest rates on banks’ deposits on certificate of deposits or on excess reserves
deposited in CB so the Fed wanted banks to loan them out. This didn’t work; banks
weren’t able to give out loans because the private sector was scared because of the
recession and didn’t want to undertake investments in the economy. This helped
keep US in recession. So, there are doubts that negative interest rates on deposits
will have the intended expansionary effect.

Fed Lending Facilities During the Crisis:

Not only did the Fed lend to commercial banks but also loans to AIG and JP Morgan.
New lending facilities to help restore liquidity to different parts of the financial system

Monetary Policy Tools of the ECB:

Open Market Operation:
Main refinancing operations (short and long term)
Weekly reverse transactions
Lending to Banks
Marginal lending facility/marginal lending rate
Discount window
Deposit facility
Reserve Requirements
2%
Pays interest on these deposits so cost of complying is low

During crisis also implemented quantitative easing

Inflation main goal of monetary policy

The Price Stability Goal and Nominal Anchor

Over the past few decades, policy makers have become increasingly aware of the social and
economic costs of inflation and more concerned with maintaining a stable price level as a
goal of economic policy
The role of a nominal anchor: a nominal variable, such as the inflation rate or the money
supply, which ties down the price level to achieve price stability
A nominal anchor for monetary policy is a single variable which the CB uses to pin
down expectations of private agents about the nominal price level or its path
What’s good about choosing inflation rate as goal of monetary policy is that you circumvent
the negative effects of time inconsistency problem
The time inconsistency problem of monetary policy
Time consistent monetary policy: CB announces it will do something, it will; the
implementation of the policy will reflect the announcement. This will increase credibility of
CB and private sector will trust CB and move along CB actions

Other Goals of Monetary Policy

(Hierarchal mandate: price stability number 1, others come after)
5 goals:
1. High employment and output stability; high GDP growth rates u don’t want
fluctuations in business cycle
2. Economic growth
3. Stability of financial markets
4. Interest rate stability; fluctuating interest rate distorts financial decisions and
markets
5. Stability in foreign exchange markets; u don’t want your currency to depreciate

Should Price Stability be the Primary Goal of Monetary Policy?

Hierarchical mandates put the goal of price stability first, and then say that as long as it is
achieved other goals can be pursued
Dual mandates are aimed to achieve 2 coequal objectives: price stability and maximum
employment (output stability)
Price stability as the primary, long run goal of monetary policy
Either type of mandate is acceptable as long as it operates to make price stability the
primary goal in the long run but not the short run

Inflation Targeting:
CB announces a rate of inflation to achieve in the medium term
Institutional commitment to announcement; credible CB, cant change goal between
announcement and implementation
Information inclusive approach in which many variables are used in making decisions
Increased transparency of the strategy
Increased accountability of the CB
Examples:
New Zealand 1990
Full control of inflation, inflation was brought down and remained within target
mostly, growth has been high, and unemployment has come down (dual)
Canada 1991
Inflation decreased but some costs in term of unemployment (hierarchal mandate)
UK 1992
Inflation close to target
Growth has been strong and unemployment decreasing (dual)

Advantages:
Does not rely on 1 variable to achieve target
Easily understood; private sector expectation will quickly adapt
Reduces potential of falling in time-inconsistency trap
Stresses transparency and accountability
Disadvantages:
Too much rigidity; what if in the meantime a crisis happens you will have to change
Potential for increased output fluctuations
Low economic growth during disinflation; dragged some economies into recession

Evolution of Fed’s Monetary Policy Strategy:

The US has achieved excellent macroeconomic performance (low stable inflation, high
employment and GDP) until the global financial crisis without using an explicit nominal
anchor such as an inflation target
History:
In 1975 Fed began to publicly announce targets for MS
Paul Volker governor in 1975 focused more on nonborrowed reserves; what is the banking
system doing with excess reserves
Greenspan announced in 1993 that the Fed would not use any monetary aggregates as a
guide for conducting monetary policy

No explicit nominal anchor for the Fed; keep some room if US economy moves into
recession to deviate from any inflation targeting announcement
Forward looking behavior (forecasts) and periodic ‘preemptive strikes’; if they see
unemployment rate going up, they deviate from price stability objective and interfere in
GDP
The goal is to prevent inflation from getting started
Advantages:
Uses many sources of information
Demonstrated success
Disadvantages
Lack of accountability
Inconsistent with democratic principles

Fed’s ‘Just Do It’ Approach:

Whenever you see a problem intervene and solve the problem
Advantages:
Always forward-looking behavior, make forecast of economy, keep price stability objective
in mind, don’t follow expansionary monetary policy unless needed, don’t follow time-
inconsistency problem, be transparent even if no accountability
Disadvantages:
Lack of transparency, strong dependence on preferences of governors and board, do they
have the right skills, do you trust them

Ben Bernanke’s Advocacy of Inflation Targeting:

Professor at Princeton
Argued that inflation targeting would be a major step forward for the Fed and would
produce better economic outcomes (GDP and employment). When he became governor of
Fed 2002-2005, he continued to advocate the adoption of an inflation target and moved Fed
to a more transparent direction that is after controlling price stability and was able to
achieve a good macroeconomic performance of US economy (dual mandate)

ECB’s Monetary Policy Strategy:

ECB was slow to move towards inflation targeting, they adopted a hybrid monetary strategy
that includes some elements of inflation targeting. Now they’re the most independent CB in
the world with inflation target as their main goal.
Lessons for Monetary Policy Strategy from Crisis:
Policy makers became more concerned about the fact that financial sector developments
can have a great impact on economic activity/ business cycle and performance of overall
macroeconomy
Before not much attention on financial sector
The 0 lower bound on interest rates can be a serious problem; that makes many monetary
tools not effective; if interest rates are already close to 0 u can’t do anything to stimulate
economy out of recession
Cost of cleaning up after a financial crisis is very high; take measures to prevent better
Price and output stability do not ensure financial stability

Implications for Inflation Targeting:

Level of the inflation target
Flexibility of inflation targeting

Should CBs Respond to Bubbles?

Asset price bubble: pronounced increase in asset prices that depart from fundamental
values which eventually burst; overall increase in stocks when economy not doing well
(not justified)
Types:
Credit driven bubbles: low interest rates, banks giving loans to everyone…
Subprime financial crisis
Bubbles driven by irrational exuberance; investors behaving in irrational way,
buying stocks without looking at company’s fundamentals / u see your
friends buying houses u go get a loan and buy a house without thinking

Strong argument for not responding to bubbles driven by irrational exuberance

Bubbles are easier to identify when asset prices and credit (loans to private sector) are
increasing rapidly at the same time; monetary policy makers ask do we prick those bubbles
or leave them?

Best response is macroprudential policy: have regulations in place that won’t permit banks
to extend credit to those customers that aren’t credit worthy, make sure bubbles don’t
form; regulatory policy to affect what is happening in credit markets in the aggregate
Monetary policy: CBs and other regulators should not have a laissez faire attitude and let
credit driven bubbles proceed without any reaction; CBankers need to be interventionists, if
banks are giving too much credit, they need to do something (increase interest rate, put
better regulations)
Tactics: Choosing the Policy Instrument
Tools:
Open market operation
Reserve requirements
Discount rate
Policy instrument (operating instrument)
Reserve aggregates; borrowed, nonborrowed reserves
Interest rates
May be linked to an intermediate target; can’t choose an instrument that doesn’t tell
you anything about the target

Interest rate and reserve aggregate targets are incompatible (must choose one or the other)

Last 2 tools came to respond to financial crisis (forward guidance is announcing u want to
achieve low interest rates to influence private sector’s expectations)
Reserve aggregates affected by OMO
The 2 instruments are incompatible
Price stability will more or less stabilize interest rate because of Fischer Equation and the
fact that nominal interest rate= real + expected inflation
Steep exchange rate appreciation could trigger recession

When it comes to the choice of intermediate target there is 3 important criteria to choose
the target:
1. Target should be controllable with the instrument; reserve aggregates can have an
impact on MS through MB, but short-term interest rate may not have any impact
2. Target should tell you something about the goal; it should lead to achieving the goal;
if you choose MS as your target that might have no impact on foreign exchange
market stability or financial market stability
3. Target should be observable; you need to have data for your target to see when u
change the policy instruments whether you’re achieving your intermediate target to
achieve your goal
This is how monetary policy can use non borrowed reserves to achieve a certain level of iff:

By shifting demand for reserves right could come from an increase in reserve requirements
will increase the federal fund rate, whereas a decrease will lead to a decrease in iff

How CB can play around with supply of reserves to keep iff stable:

Rightward shift in demand -> CB Shifts supply to right by purchasing bonds from banks
increasing their reserves and so increasing MB that will shift supply curve to right keeping iff
stable
Net result: fluctuations in non-borrowed reserves while keeping iff fixed at equilibrium value
Through OMO CB can target federal fund rate and keep it at its value

Criteria for choosing policy instrument:

Observability and measurability
Controllability
Predictable effect on goals
The Taylor Rule:
Very popular tool that tells CB where interest rate should be
Federal funds rate target = inflation rate + equilibrium real fed funds rate + ½(inflation gap)
+ ½(output gap)

Inflation + real: nominal

Inflation gap: deviation of current inflation rate from potential
Output gap: deviation of current output from potential

Taylor rule: Stabilize real output so output gap is under control; you don’t want actual GDP
to deviate much from potential level, stabilize output have an actual level close to potential
level. According to Philips curve this is an indicator of inflation; if today’s output is above
potential, we know this will produce inflation, if below potential it will not produce inflation.

Stabilizing real output is an important concern, output gap is an indicator of future inflation
as shown by Phillips curve

NAIRU: rate of unemployment at which there is no tendency for inflation to change; like
saying the economy is at its potential so there is no inflation, so unemployment is more or
less stable

Has Fed used Taylor rule to decide where iff should be?

More or less they have been moving together over time except mid 70s and after financial
crisis because of zero bound policy during and after crisis
Taylor rule good indicator

Putting monetary policy on autopilot by using Taylor rule is not ideal. You cannot blindly
follow Taylor rule, CBankers should use Taylor rule as a guide to monetary policy to have an
idea of where short term interest rate should be, not really follow the rule very closely
because that could be problematic and could produce problems in monetary policy in world
economy

Fed Watchers:
Gurus hired by big financial companies they like people who have had experience with Fed,
monetary policy making, how Fed thinks/behaves/sets interest rates. We know how much
monetary policy and change in interest rates have an impact on stock market. So any
announcement by governor will have an impact on stock market due to changes in interest
rate, this is why those companies look for Fed watchers; they guide those corporations
regarding monetary policy and how movements in short term interest rate are decided
within the Fed.
Interest rates have a major impact on investors’ and financial institutions’ profits. So, these
parties are interested in scrutinizing the Fed’s behavior. To assist in this, financial
institutions hire Fed watchers, experts on Fed behavior and have an insider’s view of Fed
operations.