20 in Loans Go Uncollectable Solvent Bank Assets Liabilities Reserves 30 Loans 90 Invests 90 Premises 5 Deposits 200 Capital 15 Insolvent Bank Assets Liabilities Reserves 30 Loans 70 Invests 90 Premises 5 Deposits 200 Capital -5 FDIC closes bank

Number US Bank Failures Total GA Failures Portion 2007 3 1 2008 25 5 2009 140 2010 151 21 2011 123 23 2012 51 10 2013 24 2 2014 18 2015 8 2016 2017 FDIC usually closes banks on Fridays. Why?

Six Goals of Monetary Policy Set by the Humphrey-Hawkins Act of 1978 Price stability Full employment Economic growth Interest rate stability Stability of the financial system Stability of foreign exchange markets with first two being primary goals. Monetary policy first impacts the financial sector. Then financial sector affects the real sector. Two schools of thought on how this works.

Money Supply Measures Monetary Base = Federal Reserve notes outstanding + depository institution balances at the Fed Money supply is total amount of money in economy. Two money supply measures are (CDs) money aggregates Monetary base and money supply are not same thing (definitions are different).

Monetary Base Graph

Money Supply Comments M1 focuses on money as a medium of exchange such as for settling a debt. M2 includes money as a “store of value.” There are also other money supply measures M3, MZM, etc. Different money supply measures are studied because they have different abilities to help understand employment, inflation, interest rates, . . Money supply is what is believed to be important, but Fed can only control it imprecisely through monetary base, because Fed can’t force banks to lend and most money supply aggregates are determined by private decisions.

M1 Graph

Repos & Reverse Repos on Fed Bal Sheet Used by Fed for temporary adjustments to monetary base. Repurchase agreements. Securities sold by dealers under agreement to repurchase on a certain date at a certain price. (adds reserve balances to the banking system) Reverse repurchase agreements. Securities purchased by dealers under agreement to resell back on a certain date at a certain price. (drains reserve balances from the banking system) repo -- economic equivalent of a collateralized loan reverse repo -- economic equivalent of collateralized borrowing

Repos & Reverse Repos on Fed Bal Sheet Repurchase agreement (dealer borrows from Fed) Fed buys securities from dealer for X Dealer repurchases securities from Fed for X+interest Reverse repurchase agreement (dealer loan to Fed) Fed sells securities to dealer for X Fed repurchases securities from dealer for X+interest Repos are used all over the financial world. Need to study repos hard. It is called a repo or reverse repo depending upon how it looks to a dealer.

Monetarist Economists Monetarists believe key explanatory variable is the money supply people will buy more if feel they have “more money,” and spend less if feel they have “less money.” idea is to use monetary policy to influence the money supply. in this way, adding reserves should promote economic growth, reducing reserves should slow the economy.

Keynesian Economists Keynesians believe key explanatory variable is the interest rate John Maynard Keynes was influential British economist of 1930s. money supply does not make that much difference believe economic growth is stimulated by falling interest rates, and slowed by rising rates

Market Rate of Interest Rate Market rate of interest performs an allocative function by assuring SSUs rate will be low enough so someone will borrow from them DSUs rate will be high enough so someone will lend to them.

Production Opportunities In addition to Fed affecting the Fed Fund rate, interest rates are affected by business opportunities (production opportunities, in book). The lower the rate of interest, the greater the number of business ventures that should be profitable.

Nominal vs. Real Rate of Interest Nominal interest rate is the observed rate (the market rate). Real rate of interest is nominal rate minus inflation. Prior to 10 years ago, real rate of interest had historically been between about 2% and 4%, getting back to that now.

Fisher Effect Inflation is built into interest rates.

Fisher Equation i nominal rate of interest r real rate of interest (i.e., rental rate) expected rate of inflation. Regular Fisher equation Exact Fisher equation The three terms see to it that lender gets compensated for: rental of purchasing power anticipated loss of purchasing power on the principal anticipated loss of purchasing power on the interest

Example 1 Willing to lend $3 billion to a company going through a difficult time for rental rate of 10% plus full protection against inflation which is forecast at 4%. Boss says figure out interest rate to charge. What is difference between regular and exact? 10/8

Ex ante vs. Ex post ex ante means based upon anticipated effects (i.e., what lies ahead) here, we assume r and forecast (e is expected) ex post means based upon analysis of past performance (i.e., what lies behind) here, we know both i and (a is actual)

Other Forms of Fisher Equations regular for ex ante use: exact for ex ante use: regular for ex post use: exact for ex post use:

Example 2 Suppose a loan were set up with a nominal interest rate of 12%. What would be exact real rate of return if inflation turned out to be 4%?

When Inflation Deviates From Anticipated Inflation greater than anticipated: benefits borrowers, Results in an unintended transfer of PP from lender to borrower. Inflation less than anticipated: benefits lenders. Results in an unintended transfer of PP from borrower to lender. So what is Fisher Effect? …that embedded in nominal interest rates are inflation expectations.