19Money Banking - Lecture notes with Prof. Jon Steinsson PDF

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Lecture notes with Prof. Jon Steinsson...

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IntermediateMacroeconomics EconomicsW3213

Professor:JónSteinsson Lecture19

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Announcements • ProblemSetisduenow • ReadingsforToday: – ReadingsfromFriedman(1994) – Ray(1998):pages757‐775

• ReadingsforTuesday: – Hume – TwoBernankereadings

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BacktoGoldStandard • ResumptionActof1875: – Fullconvertibilityofpapermoneyintogold andvice‐versa(atpre‐warrate) – ShouldtakeplaceJan1,1879

• Manyothercountriesadoptedgold atsimilartime – Britain(defacto1717) – France(defacto1840s) – Germany(1873)

• 1880‐1914:InternationalGoldStandard 3

Friedman(1994)

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U.S.ExperiencewithGoldStandard • Hugedeflation!!(Why?) • Tworeasons: – Startedoffwithapricelevelthatwashigh becauseofwartimeinflation(i.e.,doubtabout valueofGreenbacks).Resumptionraisevalueof Greenbacks. – Periodofhigheconomicgrowth.Productionof golddidn’tkeepupwithincreaseindemandfor gold ௧

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PoliticsofU.S.GoldStandard • Persistentdeflation.Largelyunanticipated. • Howdidthismatter?Whogainsandlooses? – Goodforcreditors(bankersinNewYork) – Badfordebtors(farmers)

• “Crime”of1873? – Demonetizationofsilver

• Valueofsilverfelldramaticallyin1880s

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Crimeof1873 • Whatdifferencedidthismake? – U.S.likelywouldhaveswitchedtoa silverstandardifnotfor“crime”of1873 – Thiswouldhavereduced/eliminateddeflation – Perhapsevenleadtosubstantialinflation (althoughthisisnotclearsinceU.S.beingonsilver standardwouldhavechangesdemandforsilver andraiseditspricerelativetowhathappened)

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PoliticsofU.S.GoldStandard • Deflationimpliedthatmonetarypolicywas themajorelectionissueinthepresidential electionof1896 – WilliamJenningsBryan:“Youshallnotcrucify mankinduponacrossofgold”

• Bryanlost.Lostbybiggermarginin1900. – Movementpeteredout

• Whatsolvedthe“problem”? – Successfulapplicationofthecyanideprocess ingoldproductioninSouthAfrica 9

Friedman(1994)

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LessonAboutGoldStandard • Underthegoldstandard,inflationisdictated byworldproductionofgold(supplyofgold) relativegrowthinworldeconomy(demandfor goldasmoney)andotherdemandforgold ௧

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• Notclearwhywewantsupplyofgoldto dictateinflation 11

PaperMoneyInAmerica • TheU.S.wasonacommoditystandard (bimetalic andthengold)from1792until 1933(exceptfor1861‐1879) • Butthisdidnotmeanthatpeopleonlyused goldandsilvercoinsasamediumofexchange • Banknotes(papermoney)wereanimportant mediumofexchange

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CreditasMoney • IOUsforbreadcanbemoney – Butbakermaydefault – Bakerfacesacommitmentproblemandthis affectsvalueofmoneyhecanissue

• 19th CenturyAmerica: – Banknotescirculatedasmoney – IOUsofprivatebanks(promisetopaygold) – Butbankscoulddefault – Banknotestradedatadiscountbecauseof defaultrisk 13

FreeBankingEra(1837‐1863) • Hundredsofdifferentbanknotesincirculation simultaneously • Theytypicallytradedatadiscountfrom“par” duetoriskofbankdefault • Discountsraisedtransactionscosts – Shopkeepermustlookupdiscountin newspaperscalled“banknotedetectors” – Notebrokershadsuperiorinformation 14

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AdverseSelectionandMoney • Purposeofmoneytolowertransactioncosts • Butifabanknotehasuncertainvalueitisrisky • Worsestill,somepeoplemayknowmorethan othersaboutvalueofparticularbanknote • Wheneversomeonepayswithabanknote,you mustworrythattheyknowmoreaboutitand aretakingadvantageofyou (adverseselectioninbillsyouget) • Createstransactioncostsinexchange 16

NationalBankingActof1863‐4 • “NationalBanks”couldonlyissuebanknotes backedbyU.S.Treasuriesascollateral • Twoconsequences: 1. Madeallbanknotesuniform (allbackedbythesamecollateral) 2. CreateddemandforU.S.Treasuries(CivilWar)

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GovernmentsandMoney • Governmentsfrequentlymonopolizethe issuanceoflegaltender(Why?) • Onereason:Tocreateaperfectlysafemedium ofexchangeandthuslowertransactionscosts (counteramarketfailure) • Anotherreason:Toraiserevenue – NationalBankingActcreateddemandforU.S. TreasuriesduringCivilWar.Helpedfinancethewar. 18

FinancialInnovation • NationalBankingactlimitedprofitabilityof creatingbanknotes(needtoholdcollateral) • Thisleadtoanewformoffinancialinnovation • Deposits – Apromisetopaybanknotesondemand – Banksholdreservesofbanknotes – Butpeoplerarelyaskforbanknotes – So,banksissuemoredepositsthanthey havebanknotes(fractionalreservebanking) 19

BanksandLeverage • Leverageisfundamentaltobanking • Banksborrowfromdepositors(andothers) andmakeloans • Examplebankbalancesheet: – 10to1leverageratio

Assets $1,000ofLoans

• NB:Jonesdefinesleverage ratiotobe9to1inthiscase.

Liabilities $900ofDeposits $100ofEquitycapital

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LeverageandRisk • Leverageincreasesrisk • Sayvalueofassetsfallsby2% • Howmuchdoesnetworthfallif: – Ifleverageratiois10to1? • Networthfallsby20%

– Ifleverageratiois20to1: • Networthfallsby40%

– Ifleverageratiois50to1: • Networthfallsallthewaytozero! 21

MaturityMismatchinBanking • Fundamentalaspectofbanking: – Banksborrowshortterm(demanddeposits) – Bankslendlongterm(investmentprojects) – “Maturitymismatch”

• Ifdepositorslooseconfidence,banksare illiquid andwillsufferlargelosses. – Eventhebestrunbanksarefragileinthisway

• Depositorsknowthisandarescaredthat thiswillhappen – Fearscanbecome“self‐fulfillingprophesies” 22

BankRuns • Tobeabletoanalyzebankrunsformallywe needtointroducesomeconceptsfrom gametheory • Thiswillallowustounderstandhow self‐fulfillingprophasescanarise

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Prisoner’sDilemma • TwoPrisonersoftheKGBareseparatelytold: – Ifyouconfessbuthedoesn’t,yougofree – Ifheconfessesbutyoudon’t,youget10years – Ifyoubothconfess,youbothget5years – Ifneitherconfess,youbothget2years Bconfesses

Bdoesnotconfess

Aconfesses

5years, 5years

go free,10years

Adoesnotconfess

10years, gofree

2years,2years 24

NashEquilibrium • NashEquilibrium: – Eachplayerchoosesthestrategythatyields him/herthehighestpayoffgiventhestrategies chosenbyotherplayers

• Eachplayerissaidtochoosehis/her“best response”strategy • TobeaNashequilibrium,eachplayermust chooseabestresponseassumingthat everyoneelseisalsochoosingabestresponse (rationalexpectations) 25

Prisoner’sDilemma Bconfesses

Bdoesnotconfess

Aconfesses

5years, 5years

go free,10years

Adoesnotconfess

10years, gofree

2years,2years

• UniqueNashequilibrium:(confess,confess) • Confessionisactuallyadominantstrategy: – Bestresponsenomatterwhatotherplayerdoes 26

Diamond‐Dybvig ModelofBankRuns • Banktakesdepositsof$1frommanyborrowersandlends outtoprojectthatyieldsagrossreturnofR>1in2years • Bankcancallinloanbeforeprojectisfinished.Butonlyat asubstantialloss(grossreturn0...