Modeling Macroeconomic Instability in Financial Markets using the IS/LM Model

1. Chapter 5 Financial Markets, Financial Regulation, and Economic Instability

2. Financial Markets and the IS/LM Model How can fundamental macroeconomic instability that originates in financial models be modeled using the IS/LM model? Wealth effect: W↓  Cα↓ IS shifts ← Stock market crash Housing bubble bursts Households borrow too much so that interest payments become burdensome, especially if variable r’s rise Ease of lending: More loans  Cα↓ IS shifts → New assumption for the LM curve: More than one interest rate As risk in financial markets↑  difference between the federal funds rate and r charged to households and corporations↑

3. Figure 5-1 The Log Percent Output Gap for the United States, the Euro Area, and Japan, Index with 2007 = 0, 2000 – 2011

4. Figure 5-2 The Log Percent Output Gap for the United States in Two Episodes, 1981-85 and 2007-10

5. Figure 5-3 The Log Percent Employment Gap for the United States, 1960-2010

6. Figure 5-4 Percent of the Labor Force Unemployed More Than 26 Weeks in Two Episodes, 1981-85 and 2007-10

7. Financial Markets and Institutions Financial markets are organized exchanges where securities and financial instruments are bought and sold. Direct Finance: When borrowers issue securities directly to lenders Indirect Finance: When borrowers are matched to lenders indirectly via financial intermediaries, who make loans to borrowers and obtain funds from savers, often by accepting deposits.

8. Direct vs. Indirect Finance What determines whether savers channel their funds through financial markets or through intermediaries? Direct finance depends on reputation, which limits transactions to large, well-established corporations. Role of financial intermediaries Spreading of risk Efficient collection of information

9. Figure 5-5 The Role of Financial Intermediaries and Financial Markets

10. Balance Sheets A balance sheet sums up a unit’s assetsand liabilities If assets are greater (less) than liabilities, then the unit has a positive (negative) net worth Represented by a “T” account (see next slide) The difference between a bank’s assets and liabilities is referred to as the bank’s equity. Note: The bank’s equity is often called “bank capital” and is also the same as the bank’s net worth The ratio of a bank’s equity to the value of its assets is used as a measure of the bank’s financial health

11. Table 5-1 The Initial Balance Sheet of the First Reliable Bank

12. Bank Assets and Liabilities Bank assets consists mainly of loans of all types Examples: Treasury bills, Mortgage-backed securities Loans are generally risky Risk is the probability that a given investment or loan will fail to bring the expected return and may result in a loss of the partial or full value of the investment. Vault cash is also a bank asset The main liability of banks is the deposits it owes the depositors

13. Leverage Leverage is the ratio of the liabilities of a financial institution to its equity capital Leverage increases when banks develop methods to grant more loans with their existing equity capital Leverage magnifies (reduces) profits when the value of an investment is increasing (decreasing)

14. Table 5-2 The New Balance Sheet of the First Reliable Bank After a Decline in Loan and Investment Values of $800 Billion

15. Bank Insolvency and Deposit Insurance A bank is insolvent when its equity is zero or negative If this happens, a bank is said to “fail” Should depositors monitor their bank to make sure it has adequate equity? 1929-1932: Thousands of banks failed as depositor feared for the solvency of banks and rushed to withdraw their deposits This is known as a bank run 1933: FDR established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits against loss FDIC insures deposits up to $250,000 FDIC also responsible for shutting down insolvent banks 2009: 140 bank failures

16. “Nonbank” Financial Institutions “Nonbank” financial institutions make loans like banks, however, they do not accept deposits Source of funds = borrowing from other financial institution Not regulated by the Fed, so no need to hold reserves Often hold little equity to boost leverage and thus, profits Examples: Bear Stearns and Lehman Brothers Both failed in 2008!

17. Table 5-3 The Balance Sheet of the Exotica & Toxic Fund

18. Bubbles and Crashes An asset bubble is a sustained large rise in the price of an asset relative to its fundamental value, followed by a collapse in prices that eliminates most or all of the initial price gain. Bubbles originate from an outside shock that changes perceptions about profit opportunities Main ingredients for bubbles: High degrees of leverage that boost profit potential Easy source of credit In some bubbles, financial innovation makes borrowing easier with complex new financial instruments that are hard to understand Some important bubbles: Stock price bubble of 1927-29 lead to the Great Depression Cause: Speculation fueled by high allowed levels of leverage Stock price bubble 1996-2000 lead to 50% ↓ in stock prices Cause: Unbounded optimism in “Dot.com” company profit potential Housing bubble of 2000-06 lead to the Global Economic Crises Causes: (1) Very low interest rates from the Fed and (2) financial innovations

19. Figure 5-6 Ratio of S&P 500 Stock Price Index to Earnings of S&P 500 Companies, Index with 1995=100, 1970-2010

20. Figure 5-7 Ratio of Housing Price Index to an Index of Rents of Houses and Apartments, Index with 1995=100, 1970-2010

21. Financial Innovation and the Subprime Mortgage Market Securitization is the process of combining many different debt instruments like home mortgages into a pool of hundreds and even thousands of individual contracts, and then selling new financial instruments backed by the pool Example: Mortgage-backed securities (MBS) Banks that originated loans no longer needed to worry about borrower creditworthiness The subprime mortgage market consists of borrowers who have some combination of low incomes, unstable employment histories, and poor credit records Risky loan nickname: “NINJA Loans” = “No Income No Job No Assets” Thrived as long as the Fed kept interest rates low and granting home loans to risky borrowers was in harmony with overall government policy In mid-2004, Fed raised short term rates, and many subprime loans began to “reset” Borrowers fell behind mortgage payments  foreclosures followed

22. Why Buy Risky Subprime MBS’s? Individual investors were misled Security ratings agencies (like Moody’s and Standard and Poors) gave unrealistic “AAA” ratings to subprime debt Why did financial institutions buy MBS’s? Ignorance: No previous housing bubble in history Greed: Fees and bonuses fueled additional risk-taking

23. The End of the Housing Bubble Risk-taking was fueled by the premise that housing prices would increase indefinitely But Fed raised the federal funds rate from 1.0% to 5.25% between mid-2004 to mid-2006 Adjustable rate mortgages interest rates rose Families had to choose between defaulting on mortgages vs. cutting other household expenses New loans became more difficult to receive  Housing demand↓ “Flippers” became fearful and started to sell Result: Housing prices plummeted! Housing price collapse  Onset of financial crisis Value of MBS collateral↓ MBS value↓ Financial institutions failed

24. Figure 5-8 A Negative Demand Shock Followed by a Monetary Policy Stimulus

25. Figure 5-9 An Unusually Large Negative Demand Shock Cannot BE Fully Offset by Monetary Policy

26. The Term and Risk Premiums The term premium is the average difference over a long period of the interest rate on long-term bonds and the interest rate on the short-term federal funds rate The Fed can push the federal funds rate to zero, but not the long term bond interest rate Long term interest rates are generally higher than short term interest rate Compensates for the risks of investing money for many years (e.g. inflation) Consumer and firms borrowing at the long term interest rate are riskier borrowers than the government The risk premium is the difference between the corporate bond rate and the risk-free rate of Treasury bonds having the same maturity Gives the additional interest bond purchasers require on home mortgages and corporate debt Provides a measure of financial panic

27. Figure 5-10 The Federal Funds Rate, the Ten-Year Treasury Bond Rate, and the Baa Corporate Bond Rate, 1987-2010

28. Figure 5-11 The Risk Premium and the Term Premium Make a Bad Situation Even Worse

29. The IS/LM Summary of the Causes of the Global Economic Crisis Causes that pushed the IS curve to the left Negative wealth effect from the collapse of the housing bubble  C↓ Negative wealth effect from the 50% decline in the stock market  C↓ End of cash-out mortgage refinancing  C↓ Growing unwillingness of financial intermediaries to grant loans  I↓ Causes that prevented a monetary stimulus from eliminating the output gap Negative interest rate required, but Fed limited to lowering i to zero Businesses cannot obtain financing at the federal funds rate, they must borrow at the higher long term i Higher risk premium lead to higher long term i

30. New Fed Instrument: Quantitative Easing Before: Fed’s policy instrument was to target the federal funds rate Two problems “Zero Lower Bound:” The federal funds rate cannot be pushed below zero Firms do not borrow at the federal funds rate, so even a low rate may not boost investment New method to ease the crisis: Quantitative Easing occurs when a central bank purchases assets for the purpose of increasing bank reserves (not lowering short-term interest rates) Provided liquidity to markets for distressed financial assets like MBS’s, which improved balance sheets of suffering financial institutions Radically changed the balance sheet of the Fed (see next two slides) IS/LM model interpretation Quantitative easing increases demand for long term and risky financial assets, thereby reducing the term and risk premiums

31. Table 5-4 The Balance Sheet of the Federal Reserve, January 9, 2008

32. Table 5-5 The Balance Sheet of the Federal Reserve, August 11, 2010

33. Figure 5-12 Major Components of Federal Reserve Assets and Liabilities, January 2008 to August 2010 (1 of 2)

34. Figure 5-12 Major Components of Federal Reserve Assets and Liabilities, January 2008 to August 2010 (2 of 2)

35. How The Financial Crisis Became Worldwide U.S. subprime housing market estimated at $250B World decline in GDP from 2007-09 = 20 times $250B World decline in stocks equaled 100 times initial shock Why such an amplification of the subprime shock? Dramatic jump in interest rate risk premium lead to higher costs of doing business worldwide Global slowdown in investment and employment Slowdown in lending by financial intermediaries worldwide Many foreign financial institutions invested heavily in U.S. subprime debt These investments were financed by borrowing short-term low-interest USD loans When short-term loans evaporated, these financial institutions could not renew loans But value of their MBS investments collapsed  crisis exacerbated