978-0133780581 Chapter 6 Lecture Note

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Chapter 6. Financial Markets II: The

EXTENDED IS-LM model

I. MOTIVATING QUESTION

What are the macroeconomic implications of a more complex financial system?

Prior to the financial crisis in the late 2000s that precipitated a global recession the role of the financial

system was downplayed in macroeconomics. All interest rates were assumed to move in tandem so

monetary policy was easy to implement via expanding or contracting the money supply using only

short-term bonds. However, we know now that the financial system is subject to crises which can have

significant long-term impacts on the overall economy.

II. WHY THE ANSWER MATTERS

In the U.S. the financial system comprises 7% of the GDP and touches every aspect of our lives. And, as

we learned in the late 2000s the complexity of the system makes it more challenging to understand the

true impact of policy changes. This chapter presents some of the key elements that will help us understand

how the financial markets impact macroeconomics and later understand some of the Fed’s actions with

regard to the financial crisis (see chapter 23).

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS

1. Tools and Concepts

i. The chapter introduces the nominal versus real interest rates and how risk factors into the market

returns of different bonds.

ii. The chapter discusses the macroeconomic role of financial intermediaries.

iii. The chapter extends the IS-LM model developed in chapter 5 to account for more than one interest

rate.

2. Assumptions

i. This chapter abandons the single interest rate assumption of earlier chapters in favor of multiple

interest rates.

ii. The chapter continues to assume the economy is closed.

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IV. SUMMARY OF THE MATERIAL

1. Nominal Versus Real Interest Rates

Nominal interest rates, often called quoted rates or stated rates, differ from real interest rates based on the

rate of inflation. Nominal rates are the rates quoted by various lenders. In contrast the real interest rate is

the interest rate expressed in terms of a basket of goods. A simple way to express the relationship between

the two rates follows,

rt ≈ it –

πt+1

(6.4)

where rt is equal to the real interest rate, it is equal to the nominal interest rate, and

πt+1

inflation

expected next period or year. In other words, the real interest rate is approximately equal to the nominal

interest rate minus the expected rate of inflation. This equation has several implications:

When the expected inflation rate is zero the nominal rate and the real rate are equal.

Since inflation is typically positive the real rate is usually lower than the nominal rate.

For a given nominal interest rate higher inflation will lead to a lower real interest rate.

Figure 6-2 shows historical nominal interest rates and real interest rates for the U.S. since 1978. As you

can see the spread varies over that time period. Note that the nominal rate is always positive but the real

interest rate can fall below zero. Nominal rates cannot fall below zero (i.e. zero lower bound condition) or

people will refuse to hold bonds. This zero lower bound condition keeps the Fed from lowering interest

rates to stimulate growth once they reach that boundary.

2. Risk and Return Premia

Until now we have assumed only one type of bond exists. However bonds differ based on several factors

including maturity and default risk. For example, government bonds are almost risk-free but can vary in

maturity substantially and bond investors typically require an interest-rate premium to hold longer–term

bonds. In addition bond investors will demand a risk premium to hold bonds with higher levels of default

risk. Two factors determine the risk premium;

1) Higher probabilities of defualt require higher interest rates to entice bond buyers.

2) The degree of risk aversion of bondholders. More risk averse bondholders demand higher

premiums.

In Figure 6-3 you can see the differences in bond rates over time. Note that higher rated bonds (i.e. those

with lower default risk) pay lower nominal interest rates. Also note the U.S. government bonds

consistently pay lower interest rates due to the lack of default risk. The key takeaway is that bonds rates

have substantial variance based on several factors and investors demand compensation in the form of

higher interest rates to take on more risk.

3. The Role of Financial Intermediaries

Until now we have looked at direct finance, or borrowing and lending between two parties. Most financial

transactions occur through financial intermediaries like banks and credit unions. These intermediaries

play an important role in the economy by matching borrowers and savers. However, as illustrated by the

financial crisis this system can run into trouble. To illustrate how and why we need to understand how a

bank operates.

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Figure 6-4 displays a simple example of a bank’s balance sheet to introduce terms such as capital ratio

and leverage ratio to the reader. Where capital ratio is defined as the ratio of capital to assets and the

leverage ratio is the ratio of assets to capital (the inverse of the capital ratio).

The following example applies the role of the impact of a high leverage ratio on banks

Consider two banks. As in Figure 6-4, bank A has assets of 100, liabilities of 80, and

capital of 20. Its capital ratio is defined as the ratio of capital to assets and is thus equal

to 20%. Its leverage ratio is defined as the ratio of assets to capital (the inverse of the

capital ratio) and is thus equal to 5. Bank B has assets of 100, liabilities of 95, and capital

of 5. Thus, its capital ratio is equal to 5%, and its leverage ratio to 20.

Now suppose that some of the assets in each of the two banks go bad. For example,

some borrowers cannot repay their loans. Suppose, as a result, that for both banks, the

value of the assets decreases from 100 to 90. Bank A now has assets of 90, liabilities of 80,

and capital of 90 – 80 = 10. Bank B has assets of 90, liabilities of 95, and thus negative

capital of 5 (90 – 95). Its liabilities exceed its assets: In other words, it is bankrupt. This

is indeed what happened during the crisis: Many banks had such a high leverage ratio

that even limited losses on assets very much increased the risk of bankruptcy.

During the crisis, many banks opted for a higher leverage ratio thus more risk making it the more likely

that they would go bankrupt. As the bank’s assets declined in value many banks ended up in a situation

where the value of their assets fell below the value of their liabilities. This technical insolvency eliminated

these banks’ ability to lend, even to good customers. Some of these bank assets were very difficult to

value which resulted in the inability to sell the assets, or forced them to sell at fire sale prices. Investors

also became worried about the banks’ long-term solvency and the safety of their deposits which resulted

in rapid requests to withdraw demand deposits and created bank runs. (See the text box on page 120 for a

history of the Great Depression and bank runs).

4. Extending the IS-LM

Our initial introduction to the IS-LM model in chapter 5 used only one central bank determined interest

rate (i.e. horizontal LM curve). Now we revisit the IS-LM model with the addition of inflation and risk

premia embedded in market interest rates. Now our model looks like this,

IS relation: Y = C(Y – T) + I(Y, i – πe + x) + G

LM relation: i =

Where πeis equal to expected inflation and xis a risk premium. Note that the LM relation remains the same

since interest rates are still set by the central bank. However, the IS relation changed in two ways;

1) Spending depends on the real interest rate rather than the nominal interest rate.

2) The risk premium captures higher perceived risk and/or risk aversion.

You can now see that the interest in the LM and IS equations are now different rates. The LM interest rate

is the policy rate (nominal rate) while the IS interest rate is the borrowing rate (real rate). Now the

equations become;

IS relation: Y = C(Y – T) + I(Y, r + x) + G (6.5)

LM relation: r =

´r

(6.6)

The central bank sets the nominal rate (r), but spending decisions are determined by the borrowing rate (r

+ x) which factors in a risk premium.

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Now we can see what happens when there is a change in overall risk. If the risk premium increases it will

shift the IS curve to the left resulting in lower output (see Figure 6-5). As the borrowing rate increases

spending will fall which potentially leads to recession. However, this lower spending can be offset by

higher government spending (i.e. fiscal policy) or the central bank lowering interest rates (i.e. monetary

policy). However, monetary policy may not be possible if interest rates are zero lower bounded.

5. From a Housing Problem to a Financial Crisis

Falling housing prices beginning in 2006 started a process leading to the financial crisis. Prior to that

point in time U.S. housing prices increased due to low interest rates, high demand and mortgage lenders

willing to lend to risky borrowers through what is known as subprime mortgages.

After 2006, housing prices begin to decline. Once the decline occurred many mortgages were considered

to be underwater (this is when the value of the mortgage exceeds the value of the house). It was realized

that the mortgages offered were in fact much riskier than either the lender pretended or the borrower

understood. This in turn caused many borrowers to default on their mortgages thus creating a large loss

for many banks.

The section then moves from the evolution of the housing prices to the practices undertaken by the

banking system prior to the crisis. The authors highlight terms such as Financial intermediaries,

solvency, and illiquidity to explain the dynamic role that banks played in the relationship between assets

and liabilities held on the institutions’ balance sheet. Highlighting the scenario that if the assets the bank

held went down in value and the liabilities remained the same, liabilities would exceed assets, and the

bank would then be considered bankrupt.

The complexity of assets held by banks through a process called securitization was an additional

undertaken by banks. Mortgage-backed securities (MBS) offered banks a mechanism by which to

diversify the risk of holding an individual mortgage. MBS are interests in pools of mortgages.

Ordinarily, a pool of mortgages has a more predictable repayment profile than an individual mortgage,

because repayment of the latter is dependent on the individual circumstances of the mortgage borrower.

In principle, the advent of MBS should have reduced the cost of mortgage borrowing by making

mortgage financing more attractive to lenders.

Securitization went further with the development of collateralized debt obligations (CDOs), which

became increasingly popular in the 1990s and 2000s. CDOs divided up the payments from a pool of

mortgages into different streams—for example a senior tranche paid first, and junior tranches paid

afterwards (as long as sufficient funds were available). The tranches were designed to match different

appetites for risk among investors. The complexity of CDOs can increase substantially with further

securitization. There are CDOs on CDOs and so on.

Securitization created a risk that evidently was not well understood. The assessed value of the payment

streams was contingent on housing prices continuing to rise. Once housing prices fell, many mortgages in

a given pool were at risk, and the value of MBS and of the individual payment streams on CDOs became

extremely difficult to assess.From a liquidity perspective, banks also relied heavily on liabilities from

banks which is known as wholesale funding. During the crisis, investors or other banks, worried about

the value of the assets held by the bankstopped lending to banks.

Once the lending to banks through wholesale funding became a problem, many banks found themselves

short of funds and were forced to sell assets. The securitized assets were complex and hard to value,

therefore banks had to sell some assets at very low prices, a practice often referred to as fire sale prices.

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The immediate effects of the crisis were higher consumer interest rates which lowered spending and

plummeting consumer confidence. The result was a sharp leftward shift in the IS curve.

The government implemented both fiscal and monetary policy responses to the crisis. These responses

included;

The provision of higher liquidity to the financial system.

An increase in deposit insurance limits from $100k to $250k to prevent runs

Passed the Troubled Asset Relief Program (TARP) to clean up problem assets from banks (called

the bank bailout bill).

Implemented unconventional monetary policy given the fed funds rate was zero.

Passed the American Recovery and Reinvestment Act which temporarily reduced taxes to

encourage consumption and increase government spending.

The net effect of these policies was to shift the IS curve back to the right and shift the LM curve down.

Both of these shifts resulted in higher output. (See Figure 6-9).

V. PEDAGOGY

1. Points of Clarification

i. Balance Sheets. A refresher on balance sheets would probably be useful to students. In the

context of this chapter, it is important to distinguish between changes in the value of existing capital and

raising new capital. When the value of a bank’s assets declines, the value of its existing capital declines.

This happened of course in the financial crisis as the value of MBS and CDOs declined. Faced with a

loss in the value of capital, a bank can raise new capital by selling equity in the institution. The bank then

uses proceeds of the sale to purchase assets. In principle, this option was open to banks during the

financial crisis. Goldman Sachs, for example, received a capital infusion from Warren Buffett. But for

most institutions, this was not a viable option as investors were reluctant to purchase shares of potentially

insolvent banks. Ultimately, the government provided capital to the banks by purchasing equity with

Treasury bonds. Indeed, Goldman Sachs also received capital from the government under the TARP

program. (Note that Goldman changed its status from an investment bank to a bank holding company

after the financial crisis began.)

ii. Monetary Policy and the IS Curve. Traditional monetary policy—changing the money supply—

affects the position of the LM curve. The nontraditional monetary policies pursued during the crisis did

have an effect on the LM curve, since these policies ended up increasing the money supply, but given the

liquidity trap, these policies had no effect on output. The nontraditional monetary policies also affected

the position of the IS curve by changing the premium included in the interest rate charged to firms that

wanted to finance investment spending. Student may find this confusing. It is important to distinguish

carefully the different channels of monetary policy, traditional and nontraditional.

iii. TARP Versus Traditional Fiscal Stimulus. There was substantial confusion in the popular press,

and consequently among students, about the difference between bank bailouts and fiscal stimulus. Bank

bailouts and the TARP program constituted neither increases in government purchases of goods and

services nor reductions in taxes, so they did not amount to fiscal stimulus as traditionally defined.

Instead, for the most part the bailouts were purchases of assets by the government. (There was also some

provision of government insurance, in the form of guarantees provided free of charge.) The bailouts may

have helped the economy by shoring up the financial system and allowing lending to continue to finance

productive activities (or at least by preventing further deterioration in the availability of credit). But the

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bailouts did not provide direct stimulus in the form of increased government purchases of goods and

services or indirect stimulus in the form of increasing the after-tax income of consumers. Such a stimulus

bill—the American Recovery and Reinvestment Act—was passed by Congress and signed by President

Obama in February 2009. But this was not the TARP legislation.

2. Alternative Sequencing

This chapter fits naturally before Chapter 23, or even chapter 14, if instructors wished to move quickly to

the most topical material. In any case a discussion of the financial crisis can be used to provide numerous

examples of both fiscal and monetary policy in action.

3. Enlivening the Lecture

Students might enjoy a little background on these policy decisions regarding the bank regulation and the

bail out. There are a number of entertaining blow-by-blow accounts readily available. Such a discussion

could also serve as a basis for introducing the “too big to fail” issue. A review of AIG and that firm’s role

in the crisis is also very interesting.

VI. EXTENSIONS

1. Aggregate Versus Idiosyncratic Risk

Instructors may wish to discuss in greater depth the difference between aggregate and idiosyncratic risk,

and the risks posed by assets whose payments derived from mortgage pools. The idea of securitizing

mortgages is premised on the notion that the returns on a diversified pool of mortgage are less risky than

the returns on any one mortgage. The idea makes sense as far as it goes, but in practice risk assessment

was premised (implicitly or explicitly) on the notion that housing prices would not decline. The fall in

housing prices was an aggregate event that affected the value of all mortgages at the same time. The fall

in housing prices made the returns on every mortgage less certain and more difficult to value. No one

was sure how to quantify the effect on any given mortgage pool or payment stream derived from a

mortgage pool. Thus, the development of CDOs ended up exposing investors (including those in senior

tranches perceived to be relatively safe) to an aggregate risk, namely the risk of a fall in housing prices.

To make this point, consider a pool with two mortgages. (This example is drawn from Ricardo Caballero,

“The ‘Other’ Imbalance and the Financial Crisis,” Paolo Baffi Lecture, The Bank of Italy, December

2009.) Absent a crisis in the housing markets, each mortgage pays $1 with probability 0.9 and $0 with

probability 0.1. The payments on the mortgages are independent of one another. Now consider

separating the payments on the mortgage pool into a $1 senior tranche, paid first, and a $1 junior tranche,

paid after the senior tranche is paid. The senior tranche receives its payment of $1 with a probability of

99%, so it looks relatively safe. But investors in the senior tranche are exposed to an aggregate risk.

Suppose that in the event of a housing crisis (a large enough decline in housing prices), each mortgage

pays $0 (an extreme example to make the point). Now the senior tranche is completely exposed to a risk

of a housing crisis. Other safe assets whose payments are not correlated with mortgage payments are not

exposed to this risk. Evidently, holders of MBS and CDOs did not perceive the aggregate risk to which

they were exposed.

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2. Systemic Versus Nonsystemic Risk

On the theme of regulation, instructors could discuss the relative merits of the “too big to fail” policy, and

distinguish between systemic and nonsystemic risk. Existing bank regulation focuses on the solvency of

individual institutions, and does not assess the degree to which the activities of an individual institution

pose risks for the entire financial system. In a time of crisis, institutions whose bankruptcy might threaten

the financial system are either bailed out by the government or bought out by private investors under

pressure by the government. But many analysts argue that such after-the-fact policy is insufficient and

perhaps dangerous, because it does nothing to curb activities that might pose systemic risk and indeed

probably encourages some institutions to undertake too much risk because they believe they will be bailed

out by the government if things go poorly. A number of proposals have been offered

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