Lecture 5 i Pad - GuangYu Pei PDF

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BASIC MACROECONOMICSECON 2021CLecture 5Spring, 2020Annoucements Assignment 2 deadline: 9 a. next Monday Tutorials will be arranged next week Midterm Exam: March 20 from 9:00 a. to 10:30 a. online testing using Respondus on Blackboard instructions to be uploaded onto Blackboard Mock midterm from Mond...

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BASIC MACROECONOMICS ECON 2021C Lecture 5

Spring, 2020

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Annoucements

• Assignment 2 - deadline: 9 a.m. next Monday

• Tutorials will be arranged next week • Midterm Exam: - March 20 from 9:00 a.m. to 10:30 a.m. - online testing using Respondus on Blackboard * instructions to be uploaded onto Blackboard

- Mock midterm from Monday to Thursday next week * to test lock down browser * check the availability of your camera

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Towards the Short Run Dynamics

• The Goods Market - demand for goods • The Financial Markets - monetary policy and interest rate • IS-LM - role of monetary and fiscal policy • Extended IS-LM with a richer financial market - a closer look at the recent crisis

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The Extended IS-LM Model

• Until now, we assumed that there were - only two financial assets - money and bonds - just one interest rate - the rate on bonds, which is determined by monetary policy.

• The financial system is vastly more complicated: - there are many interest rates and many financial institutions

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The Extended IS-LM Model • The above simplification is theoretically fine - if all interest rates move together with the rate determined by the monetary policy (e.g. FFR). - the exact reason why importance of financial system was downplayed in macroeconomics before the financial crisis.

• The 2008 crisis made it painfully clear that - it was too simplistic and - the financial system can be subject to crisis with major macroeconomic implications.

• We take a closer look at the role of the financial system and its macroeconomic implications

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Extended IS-LM Model: Plan for Today

• Nominal versus Real Interest Rates • Risk and Risk Premia • Role of Financial Intermediaries • Extended the IS-LM • The Recent Financial Crisis

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Nominal versus Real Interest Rates

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Nominal versus Real Interest Rates

• In Jan. 1980, the one-year U.S. T-bill rate was 10.9%. • In Jan. 2006, the one-year U.S. T-bill rate was 4.2%. Question: Was borrowing cheaper in 2006 than it was in 1981?

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Nominal versus Real Interest Rates

Answer: Both Yes and No! • Yes in terms of dollars; Probably no in terms of goods. • The KEY here is we borrow in order to exchange consumption tomorrow with consumption today. - (expected) change of price level matters.

• The presence of inflation makes the distinction important. • This is where the distinction between nominal interest rates and real interest rates comes in.

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Nominal versus Real Interest Rates • Nominal interest rate it is the interest rate in terms of dollars. - all the interest rates printed in the financial pages of news papers - e.g. one-year T-bill is 4.2% ⇔ for every one dollar borrows by the government, it promises to pay 1.042 dollars a year from now on.

• Real interest rate rt is the interest rate in terms of a basket of goods. - borrowing the equivalent of one basket of goods this year requires you to pay the equivalent of 1 + rt baskets of goods next year

• To get the real interest rate, we must adjust the nominal interest rate to take into account expected inflation

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Nominal versus Real Interest Rates

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Nominal versus Real Interest Rates • One-year real interest rate rt : 1 + rt = (1 + it )

Pt Pte

(1)

• Denote expected inflation between t and t + 1 by:  e  P t − Pt e πt+1 = Pt • So that equation (1) becomes 1 + rt =

(1 + it ) 1 + π et+1

(2)

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Nominal versus Real Interest Rates • If the nominal interest rate and expected inflation are not too large, a close approximately to equation (2) is: e rt ≈ it − πt+1

- When expected inflation equals zero, the nominal interest rate and the real interest rate are equal. - Because expected inflation is typically positive, the real interest rate is typically lower than the nominal interest rate. - For a given nominal interest rate, the higher expected inflation, the lower the real interest rate.

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Nominal versus Real Interest Rates

Question: Was borrowing cheaper in 2006 than it was in 1981? • In Jan. 1980, the one-year U.S. T-bill rate was 10.9%. • In Jan. 2006, the one-year U.S. T-bill rate was 4.2%. • In Jan. 1980, the expected inflation was 9.5%. • In Jan. 2006, the expected inflation was 2.5%.

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Nominal versus Real Interest Rates

Question: Is it the policy rate or the real interest rate that enters the IS relation?

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Nominal versus Real Interest Rates • The real interest rate (i − π e ) is based on expected inflation, so it is sometimes called the ex-ante ("before the fact") real interest rate. • The realized real interest rate (i − π) is called the ex-post ("after the fact") interest rate. • The interest rate that enters the IS relation is the real interest rate. • The zero lower bond of the nominal interest rate implies that the real interest rate cannot be lower than the negative of expected inflation. -

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Nominal versus Real Interest Rates Nominal and Real One-Year T-Bill Rates in the United States since 1978

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Nominal versus Real Interest Rates • Real interest rate was 1.7% in 2006 and 1.4% in 1981 - despite the large decline in nominal interest rates, borrowing was actually more expensive in 2006 than it was in 1981. - this is due to the fact that inflation (and with it, expected inflation) has steadily declined since the early 1980s.

• Running into the zero-lower bound in recent financial crisis

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Risk and Risk Premia

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Risk and Risk Premia

• Until now, we assumed there was only one type of bond. However, bonds differ in a number of ways: - maturities - the length of time over which they promise payments - risk - measured by the probability of no repayment from the borrowers * some bonds are nearly riskless, e.g. U.S. treasury bills; * some bonds are risky e.g. corporate bonds

• From now on, we shall focus on risk, leaving aside the issue of maturity

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Risk and Risk Premia

• For risky bonds, bond holders require a risk premium. - we cannot borrow at the same rate as the U.S. government - to compensate the risk, borrowers require higher return

Question: What determines the risk premium?

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Risk and Risk Premia • Let i be the nominal interest rate on a riskless bond, x be the risk premium, and p is the probability of defaulting. • To get the same expected return on the risky bonds as on the riskless bond: 1 + i = (1 − p) (1 + i + x) + (p) (0)

x = (1 + i) p/ (1 − p)

- if the interst rate on a riskless bond is 4%, and probability of default is 2%, - then the risk premium required to give the same expected rate of return as on the riskless bond would be 2.1%.

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Risk and Risk Premia

1 + i = (1 − p) (1 + i + x) + (p) (0) ⇒ x = (1 + i) p/ (1 − p)

• NOTE: here we implicitly assume that agents are risk neutral, i.e. they care about expected rate of return only. • However, in reality, agents are risk averse. - even if the expected return on the risky bond was the same as on a riskless bond, the risk itself will make borrowers reluctant to hold the risky bond. - degree of risk aversion matters * higher risk aversion, higher the risk premium

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Risk and Risk Premia

• Question: What determines the risk premium? - probability of default - degree of risk aversion

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Risk and Risk Premia Yields on 10-Year U.S. Government Treasury, AAA, and BBB Corporate Bonds, since 2000

Question: Is it reasonable to assume that it is the policy rate that enters the IS relation?

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Role of Financial Intermediaries

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Role of Financial Intermediaries • Until now, we have looked at direct finance - borrowing directly by the ultimate borrowers from the ultimate lenders. - e.g. borrowing directly by the corporate from the households

• In fact, much of the borrowing and lending takes place through financial intermediaries - financial institutions that receive funds from investors and then lend these funds to others * banking * shadow banking: mortgage companies, money market funds, hedge funds, and so on.

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Role of Financial Intermediaries • In a frictionless world, existence of financial intermediaries have no essential impacts. • In reality, financial intermediaries perform an important function: screening and monitoring - developed expertise about specific borrowers and tailor lending to their specific needs - efficient screening and monitoring

• In normal times, financial intermediaries run smoothly and earn profit by an interest rate differential. • In crisis, they run into problem due to - lack of liquidity or insolvency - higher risk of insolvency due to leverage using - fire sale of assets, bank run

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Role of Financial Intermediaries: Leverage

• Capital: private money of the banker - inessential in Lecture 3 - important in understanding the recent financial crisis

• Capital ratio: - the ratio of capital to assets = 20/100 = 20%

• Leverage ratio: - the ratio of assets to capital) = 100/20 = 5

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Choice of Leverage

• When choosing the leverage ratio, the bank has to balance the followings: - higher leverage ratio implies higher profit rate - higher leverage ratio implies higher risk of insolvency * a bank is insolvent if the value of its liabilities exceeds the value of its assets

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Choice of Leverage

• A numerical example: -

expected rate of return on assets: 5% expected rate of return on liability: 4% assets value decreases to 85 with a leverage ratio of 10 assets value decreases to 85 with a leverage ratio of 10

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Leverage and Lending

• Higher preferred leverage implies more profound decrease in lending in response to a decrease in asset value • Higher preferred leverage implies higher probability of bankruptcy. • A numerical example Adverse macroeconomic effects of credit tightening

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Liquidity

• Consider a case in which investors are unsure of the value of the assets of the bank. • And they believe, right or wrong, that the value of the assets may have come down. • In such a situation, leverage can have disastrous effects.

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Liquidity • If investors have doubts about the value of the bank assets, the safe thing for them to do is to take their funds out of the bank. • Questions of interest in such a scenario: - how much and how urgent to repay the investors? - investors can ask for their funds at short notice such as checkable deposits (or demand deposits) at banks - funding liquidity of liabilities

- how does the bank manage to repay the investors? * fire sale of the assets (i.e., sales with price far below the true value of the loans) * market liquidity of assets * fire sale of the assets may turn liquidity problem into solvency problem

• In general there is mismatch between the market liquidity of assets and the funding liquidity of liabilities - risk of bank runs - self-fulfilling, traditional versus modern - leverage worsens such concerns 34 / 59

Liquidity

• The lower the liquidity of bank assets means the more difficult they are to sell, the higher the risk of being sold at fire sale prices (prices far below the true value) and the risk that the bank becomes insolvent. • The higher the liquidity of the liabilities (e.g., checkable or demand deposits), the higher the risk of fire sales, and the risk that the bank becomes insolvent and thus faces bank runs.

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Bank Runs • The U.S. financial history up to the 1930s is full of bank runs. • One potential solution to bank runs is narrow banking, which restricts banks from making loans, and to hold liquid and safe government bonds. • To limit bank runs, the United States introduced federal deposit insurance in 1934. - moral hazard - alternative sources of funds than deposits - banks v.s. other institutions

• The Fed also implemented liquidity provision . - central bank lend to a bank against the value of the assets - banks v.s. other institutions - difficulty to assess value of the assets in crisis: insolvency and illiquidity 36 / 59

The Extended IS-LM Model

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The Extended IS-LM Model • We extend the IS-LM to reflect the distinction between: - the nominal interest rate and the real interest rate - the policy rate set by the central bank and the interest rates faced by borrowers

• Rewrite the IS-LM IS relation : Y = C (Y − T ) + I (Y , i − π e + x ) + G LM relation : i = i - expected inflation and the risk premium enter the IS relation - risk-premium captures, in a simplistic way, factors such as probability of default, degree of risk aversion and solvency or liquidity worries about financial intermediaries - typically, we treat x as exogenous; whereas it can depend on output in general. 38 / 59

The Extended IS-LM Model

• The central bank now chooses the real policy rate r , which enters the IS equation as part of the borrowing rate (r + x ) for consumers and firms IS relation : Y = C (Y − T ) + I (Y , r + x ) + G LM relation : i = r - expected inflation and the risk premium enter the IS relation - monetary policy does not affect expected inflation.

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The Extended IS-LM Model Financial Shocks and Output

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