Macroeconomics ch14

Silicon Valley Bank Case Study and Banking Fragility

• Silicon Valley Bank (SVB) Timeline (2023):     * Wednesday, March 8, 2023: SVB appeared sound with assets exceeding $200 \text{ billion}$ and deposits over $175 \text{ billion}$.     * Friday, March 10, 2023: SVB failed and was taken over by the Federal Deposit Insurance Corporation (FDIC).

• Importance of Banking: Banks are critical to the economy, but they involve higher risks than most other businesses, requiring rigorous government supervision.

Defining Money and Its Functions

• Money Definition: Any asset people are generally willing to accept as payment for goods and services or debts.

• Asset: Anything of value owned by a person or a firm.

• Barter and Trade History:     * Before money, societies used barter, which is trading goods and services directly for other goods and services.     * Barter requires a double coincidence of wants, where each party wants what the other is offering.     * Commodity Money: Goods used as money that have value independent of their use as money (e.g., animal skins, precious metals).

• The Four Primary Functions of Money:     1. Medium of Exchange: Generally accepted as payment for goods and services.     2. Unit of Account: A standard way of measuring value.     3. Store of Value: Allows for the deferral of consumption to a later date. Money is particularly effective at this due to its liquidity (ease of exchange for goods).     4. Standard of Deferred Payment: Facilitates exchanges across time when future value/purchasing power is predictable.

• Characteristics of an Effective Medium of Exchange:     * Must be acceptable to most people.     * Must be of standardized quality (any two units are identical).     * Must be durable (no loss of value from wearing out).     * Must have high value relative to weight (easy to transport in large quantities).     * Must be divisible (usable for low-priced and high-priced goods).

Commodity Money and Fiat Money Evolution

• Commodity Money Examples:     * Cowrie shells in Asia (the classical Chinese character for money is a pictograph of a cowrie shell).     * Precious metals (gold, silver).     * Animal pelts and skins (colonial North America).     * Cigarettes (prisons and prisoner-of-war camps).

• Paper and Fiat Money:     * Paper money originated in China in the 10th century, initially exchangeable for commodities like gold.     * Fiat Money: Money authorized by a central bank or government that does not have to be exchanged for gold or any other commodity.     * Advantages: Central banks have more flexibility in managing the money supply.     * Disadvantages/Requirements: Acceptability depends entirely on the confidence of households and firms that the currency will not lose significant value while held.

• Modern Payment Trends:     * Cashless Society: In 2017, Dig Inn (Manhattan) stopped accepting cash to speed up service and prevent robberies. This is legal as firms are not required to accept currency as payment (though debts are handled differently).     * Contactless Payments: The Covid-19 pandemic accelerated the shift toward contactless purchases in the United States. Countries like Sweden are already almost cashless.

Measuring Money in the United States

• M1 (Narrow Definition): The sum of currency in circulation, checking account deposits, and savings account deposits.

• M2 (Broad Definition): Includes M1 plus small-denomination time deposits and noninstitutional money market fund shares.

• Money Supply Statistics (September 2023):     * M1: Approximately $18.1 \text{ trillion}$.     * M2: Approximately $20.8 \text{ trillion}$.     * Currency in M1: $2.3 \text{ trillion}$ (about $13 \%$, or more than $6,600$ per person in the U.S.).     * $75 \%$ of U.S. paper currency is in the form of $100$ bills.

• Global Use of U.S. Currency: Held by people in other countries when local currency confidence is low or to facilitate large underground economies.

• Card and Digital Payments:     * Debit Cards: Access checking account balances; the balance is money, not the card itself.     * Credit Cards: Represent short-term loans, not money; transactions are finished only when the loan is repaid.     * Bitcoin: A form of e-money created by a decentralized computer system. It is currently not included in money supply measures but could be if popularity grows.

The Mechanics and Economic Importance of Banking

• Bank Operations: Banks are profit-making private firms. They create money because there is more in checking accounts than actual currency exists.

• Typical Large Bank Balance Sheet:     * Assets: Reserves ($135 \text{ billion}$), Loans ($900 \text{ billion}$), Securities ($700 \text{ billion}$), Buildings/Equipment ($15 \text{ billion}$), Other ($550 \text{ billion}$). Total: $2,300 \text{ billion}$.     * Liabilities and Equity: Deposits ($1,000 \text{ billion}$), Short-term borrowing ($400 \text{ billion}$), Long-term debt ($360 \text{ billion}$), Other liabilities ($275 \text{ billion}$), Stockholders' equity ($265 \text{ billion}$). Total: $2,300 \text{ billion}$.

• Reserves: Deposits kept as cash in vaults or at the Federal Reserve.     * Fractional Reserve Banking System: Banks keep less than $100 \%$ of deposits as reserves.     * Reserve Requirements: Historically $10 \%$ for checking deposits; however, in March 2020, the Fed set requirements to $0 \%$.

• Economic Functions of Banks:     * Reducing Transaction Costs: Using economies of scale to specialize in loan evaluation and processing.     * Asymmetric Information Mitigation: Solving situations where one party has less information than the other through statistical analysis and relationship banking (using private information to assess credit risk).

• Fintech and Interest Rates:     * Peer-to-peer Lending (e.g., LendingClub, UpStart): Facilitate loans for fees without taking default risk; evidence suggests this may lead to high-risk loans.     * Interest Rate Caps: Politicians have proposed a $15 \%$ cap on credit cards. Bankers argue this would hurt those with low credit scores or non-traditional income by making loans harder to get.

Money Creation and the Money Multiplier

• T-Account Example:     * If a user deposits $1,000$, reserves and deposits increase by $1,000$. Initially, the money supply (M1) is unchanged because currency in circulation decreases while checking deposits increase.     * Lending: If the bank lends $900$ (keeping $10 \%$), a new checking account is created. The original $1,000$ deposit leads to a multiple expansion of deposits.

• Money Multiplier: The ratio of the money supply (M) to the monetary base (B).     * Formula: $\text{Money Multiplier} = \frac{M}{B}$.     * The monetary base (B) is the sum of currency in circulation and bank reserves.

• Regimes of Reserves:     * Scarce-reserves Regime (Pre-2008): The Fed didn't pay interest on reserves; banks held very few reserves beyond requirements.     * Ample-reserves Regime (Post-October 2008): The Fed pays Interest Rate on Reserve Balances (IORB); banks hold significantly more reserves than required.

• Multiplier Fluctuations:     * Caused by changes in the amount of reserves banks hold relative to deposits.     * Caused by changes in the amount of currency households/firms hold relative to deposits.

The Federal Reserve System and Monetary Policy

• Bank Runs and Panics:     * Bank Run: Many depositors simultaneously withdraw funds.     * Bank Panic: Multiple banks experience runs at the same time.

• Lender of Last Resort: The Fed's role in providing funds to banks during panics to ensure depositors can be paid.

• Establishment and History:     * Established in 1914.     * Discount Loans: Loans made by the Fed to banks; interest charged is the discount rate.     * Great Depression Failure: The Fed refused many discount loans in the early 1930s, causing over $9,000$ bank failures and worsening the depression.

• Federal Deposit Insurance Corporation (FDIC): Established in 1934 to insure deposits (current limit is $250,000$).

• Fed Structure:     * Board of Governors: 7 members appointed by the President for 14-year terms. The Chair serves a 4-year renewable term (e.g., Jerome Powell in 2023).     * 12 Districts: Provide local services to banks.     * Federal Open Market Committee (FOMC): 12 members (7 Governors, NY Fed President, 4 rotating District Presidents). Meets 8 times a year to manage the money supply.

• Monetary Policy Tools:     * Open Market Operations (OMO): Buying or selling Treasury securities (bills, notes, bonds).     * Open Market Purchase: Buying securities to increase bank reserves and the money supply.     * Open Market Sale: Selling securities to decrease bank reserves and the money supply.     * Treasury Securities: Bills ($\le 1 \text{ year}$), Notes ($2-10 \text{ years}$), Bonds ($30 \text{ years}$).

• Regulation and Risks:     * Liquidity Coverage Ratio (LCR): Requirement to hold high-quality liquid assets to meet expected outflows during stress.     * Moral Hazard: The risk that government guarantees (like full deposit bailouts for SVB) encourage bank managers and large depositors to engage in riskier behavior.     * Systemic Risk: When a bank failure threatens the entire financial system, the FDIC may reimburse all deposits above the $250,000$ limit.

Shadow Banking and Securitization

• Commercial Banks: Primary role is accepting deposits and making loans.

• Securitization: Transforming loans (like mortgages) into tradeable assets (securities) starting in the 1970s.

• Shadow Banking Entities:     * Investment Banks: Do not take deposits; provide advice and trade securities like mortgage-backed securities.     * Money Market Mutual Funds: Buy short-term Treasury bills and commercial paper using investor funds.     * Hedge Funds: High-risk investments using money from wealthy investors.

• Financial Crisis of 2007-2009: Shadow banks were highly leveraged (using borrowed money) and unregulated (no FDIC). As housing prices fell, mortgage-backed securities lost value, causing bankruptcies and runs in the shadow system.

The Quantity Theory of Money

• Irving Fisher's Quantity Equation:     * $M \times V = P \times Y$     * $M = \text{Money Supply}$     * $V = \text{Velocity of Money}$ (average number of times a dollar is used per year for GDP goods/services).     * $P = \text{Price Level}$     * $Y = \text{Real Output}$

• Calculating Velocity (2022):     * $V = \frac{P \times Y}{M} = \frac{\text{Nominal GDP}}{M}$

• The Quantity Theory Assumptions: Assumes velocity (V) is constant.

• Inflation/Growth Rate Equation:     * $\text{Growth rate of } M + \text{Growth rate of } V = \text{Growth rate of } P \text{ (Inflation)} + \text{Growth rate of } Y$     * Assuming constant velocity ($\% \Delta V = 0$):     * $\text{Inflation Rate} = \text{Growth rate of } M - \text{Growth rate of } Y$

• Predictions of the Theory:     * Money supply grows faster than real GDP: Inflation.     * Money supply grows slower than real GDP: Deflation.     * Money supply grows at same rate as real GDP: Stable price level.

• Hyperinflation: Inflation exceeding $50 \%$ per month.     * Causes: Central banks printing money far in excess of GDP growth to fund government spending.     * Zimbabwe (2008): Inflation reached $15 \text{ billion percent}$.     * Venezuela (2019): Inflation over $2 \text{ million percent}$.     * Germany (1922-1923): Due to war reparations, the price index rose from $1,440$ to $126,160,000,000,000$.