financial system liquidity, asset prices and monetary policy

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Financial System Liquidity, Asset Prices and Monetary Policy. Hyun Song Shin 2005 Reserve Bank of Australia conference July 11-12, 2005. Background. Monetary policy works through financial markets Seen through lens of IS curve Central bank controls directly only overnight rate - PowerPoint PPT Presentation

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  • Financial System Liquidity,Asset Prices and Monetary PolicyHyun Song Shin

    2005 Reserve Bank of Australia conferenceJuly 11-12, 2005

  • BackgroundMonetary policy works through financial marketsSeen through lens of IS curveCentral bank controls directly only overnight rateBut can influence long rates through expectations of future path for short ratesAffects consumption, investment...

  • Tinbergen-style SeparationPrice/output stabilisationMonetary policy

    Financial stabilityPrudential/supervisory policies

  • Tinbergen-style SeparationPrice/output stabilisationMonetary policy

    Financial stabilityPrudential/supervisory policies

  • Tinbergen-style SeparationPrice/output stabilisationMonetary policy

    Price/output stabilisationPrudential/supervisory policies

  • Unwinding Financial ExcessOutput costs of financial crises

    Fiscal costs of financial sector restructuring

    Asymmetry of mechanismson the way upon the way down

  • Asset pricesDebtSpreadsBalance sheetstrengthMonetary Policy

  • Pricing claims in a system settingSome assets (e.g. loans) are claims on other partiesValue of my claim against A depends on value of As claims against B, C,...But B or C may have claim against me

  • Price of Debt/Claimface value

    price of debtassets

  • System

    Or, more simply

  • Pricing claimsTarskis fixed point theorem: increasing function on complete lattice has largest and smallest fixed point.

    ensures uniqueness

  • Indebtedness and SpreadsSuppose affects Spread can fall as debt rises De-leveraging can lead to rise in spreads

  • FeedbackBalance sheet strength determines lending capacity

  • FeedbackStrongerbalance sheetsIncreaseddebt

  • Simplified Financial SystemYoung HouseholdsOld HouseholdsBanks

  • Young Households Balance SheetAssetsLiabilitiesMortgagePropertyNet worth

  • Banks Balance SheetAssetsLiabilitiesNet WorthDepositsMortgage

  • Old Households Balance SheetAssetsLiabilitiesNet worthDepositsPropertyEquity

  • Duration of Assets and LiabilitiesTreasuryPricesValueDepositValueMortgageValueloose monetary policytight monetary policy

  • Property PriceProperty PriceSupply of propertyfrom oldproperty stockheld by young

  • Property Price as Function of Mortgage PriceProperty price, vMortgage pricepBank lendingBanks net worth

  • Mortgage Price as Function of Property Pricep(v)v

  • Define h(.) as inverse of v(p)pvh(v)p(v)

  • Step Adjustment:Fall in Treasury Yieldspvh(v)p(v)p(v)

  • Another Scenario...HouseholdsFannie MaePension Funds

  • HouseholdsAssetsLiabilitiesPropertyOther assetsNet WorthMortgage

  • Fannie MaeAssetsLiabilitiesMortgageOther AssetsNet WorthBonds

  • Pension FundsAssetsLiabilitiesBondsCashNet WorthPensionLiabilities

  • BondsBonds issued by Fannie Mae are perpetuities

    Price p, yield r

    Duration is

  • Pension LiabilitiesDuration of bondDuration of pension liabilityPrice of bondduration

  • Pension FundsPension funds mark their liabilities to market

    Pension funds match duration of liabilities with assets of similar duration

  • Pension funds demand for bondsPrice of bondsdemandfor bondsdurationof bondsduration of pension liabilities

  • Weight of Money into PropertyFannie Mae accommodates increased demand for bonds by new issues of bonds

    Cash proceeds lent out to households

    Money flows into property sector

    Property price rises...

  • Property Price as Function of Bond Pricep increase bond issue v increasev(p)p

  • Credit Quality

    Credit quality of bonds depends on household net worth

    v increase + net worth p increase

  • Bond Price as Function of Property Pricep(v)v

  • Define h(.) as inverse of v(p)pvh(v)p(v)

  • Step Adjustment:Fall in Treasury Yieldspvh(v)p(v)p(v)

  • Nature of Property WealthProperty PriceSupply of propertyfrom oldproperty stockheld by young

  • Nature of Property WealthIs housing net wealth?

    Suppose: increased debt reduction in spreads

    How is this possible without increase in net wealth?

    Culprit is marking to market

  • ReversalNew mechanisms on the way down

    Asymmetric nature of debtEasy to build upNot so easy to extinguishImportance of bankruptcy regime (Cf. Hong Kong)

  • ScenarioSuppose defaulting borrowers can return the keys and walk away...

    Banks hold property directly

    Banks mark property to market

  • Bank Balance SheetAssetsLiabilitiesNet WorthDepositsPropertyOther assets

  • Capital Adequacy Ratiotop: net worthbottom: marked-to-market assets, afters sale of property

  • Sales function s(p)When capital adequacy constraint binds, bank i sells property

  • vss(v)d(v)New equilibrium

  • What has changed?Strongerbalance sheetsIncreaseddebtShort term incentivesMarking to market

  • Changing Nature of Monetary PolicyMonetary policy works by manipulating asset pricesRepercussions for wider financial systemIs the IS view of monetary policy sufficient?Financial stability is also about output/price stabilisationCosts of getting it wrong are large

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