Macroeconomics II: Money, Monetary Policy and Banks PDF

Introduction Sidrauski’s Model Money Money Supply Assets and Banks Macroeconomics II Money, Monetary Policy and Banks Javier Fernández Universit...

Introduction Sidrauski’s Model Money Money Supply Assets and Banks Macroeconomics II Money, Monetary Policy and Banks Javier Fernández Universitat Autònoma de Barcelona Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money and Monetary Policy Complementary Readings: Monetary Theory and Policy, de Carl E. Walsh ☞ The courage to act, by Ben S. Bernanke ☞ Stress Test, by T. Geithner ☞ Economics for the commong good, by J. Tirole ☞ The Global Financial Crisis, by T. Geithner and A. Metrick, Coursera ☞ The curse of cash, by Kenneth S. Rogoff ☞ El Diluvio: The Spanish Banking Crisis, by Tano Santos ☞ Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money We have dealt with real variables so far: consumption, savings, production, wages, capital rental rates, real interest rate, etc. Prices were real in the sense that they were measured in units of the consumption good. Now, we will introduce money, and, hence, will talk about nominal variables, measured in currency units. That is, nominal wages, nominal interest rate, inflation, etc. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money We have dealt with real variables so far: consumption, savings, production, wages, capital rental rates, real interest rate, etc. Prices were real in the sense that they were measured in units of the consumption good. Now, we will introduce money, and, hence, will talk about nominal variables, measured in currency units. That is, nominal wages, nominal interest rate, inflation, etc. −→ First Order Questions: 1. Why is money relevant? 2. What are the macroeconomic effects of an expansionary monetary policy? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money We have dealt with real variables so far: consumption, savings, production, wages, capital rental rates, real interest rate, etc. Prices were real in the sense that they were measured in units of the consumption good. Now, we will introduce money, and, hence, will talk about nominal variables, measured in currency units. That is, nominal wages, nominal interest rate, inflation, etc. −→ First Order Questions: 1. Why is money relevant? 2. What are the macroeconomic effects of an expansionary monetary policy? You are surely familiar with the idea of the neutrality of money: Changes in money supply do not affect real variables (money is approximately neutral) in the long run. Recall the Quantity theory of money : PY = MV Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story () Q: How does a change in money supply affect the economy? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Q: How does a change in money supply affect the economy? Consider a simple closed economy: an old-fashioned amusement park -roller coasters, fun house, hot dogs. Let’s call it Tibidado. We are to use it as a lab to study the macro effects of a contractionary monetary policy Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Q: How does a change in money supply affect the economy? Consider a simple closed economy: an old-fashioned amusement park -roller coasters, fun house, hot dogs. Let’s call it Tibidado. We are to use it as a lab to study the macro effects of a contractionary monetary policy Tibidabo has its own monetary system. One cannot spend euros inside the park. Visitors use euros to purchase tickets at a fixed exchanged rate (say, 2 tickets per e), and then enter the park and spend the tickets (say, 3 tickets per ride) Rides and food in the park are priced in tickets. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Q: How does a change in money supply affect the economy? Consider a simple closed economy: an old-fashioned amusement park -roller coasters, fun house, hot dogs. Let’s call it Tibidado. We are to use it as a lab to study the macro effects of a contractionary monetary policy Tibidabo has its own monetary system. One cannot spend euros inside the park. Visitors use euros to purchase tickets at a fixed exchanged rate (say, 2 tickets per e), and then enter the park and spend the tickets (say, 3 tickets per ride) Rides and food in the park are priced in tickets. Business in the park fluctuates, e.g. Sundays are more popular than other days. This may cause the operators of the rides to call in some extra help on those days. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Suppose that for one Sunday we are in charge of the park and we decide to do some experiments. First experiment: - Each e gives you 4 tickets instead of 2 - Each ride now costs twice as many tickets (6 instead of 3). What happens? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Suppose that for one Sunday we are in charge of the park and we decide to do some experiments. First experiment: - Each e gives you 4 tickets instead of 2 - Each ride now costs twice as many tickets (6 instead of 3). What happens? Technically, there has been an inflation of 100% (money supply ↑). Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Suppose that for one Sunday we are in charge of the park and we decide to do some experiments. First experiment: - Each e gives you 4 tickets instead of 2 - Each ride now costs twice as many tickets (6 instead of 3). What happens? Technically, there has been an inflation of 100% (money supply ↑). Nobody really cares about the number of tickets in circulation. All that matters is the purchasing power of a ticket. Thus, most likely nothing will change. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Second experiment: - We increase the price of a ticket from 50 to 75 cents, without informing anyone in the park. - Prices of rides and food in tickets stay the same. What happens? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Second experiment: - We increase the price of a ticket from 50 to 75 cents, without informing anyone in the park. - Prices of rides and food in tickets stay the same. What happens? At the gate, customers may either decide to 1) turn around 2) buy 20 rather than 30 tickets from their 15e budget. 3) pay more and still buy 30 tickets. → Money supply, i.e. the number of tickets in circulation, will decrease. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Operators will notice that the park seems relatively empty and that people spend less than usual. The extra employees that were hired to help with the Sunday crowd are sent home early. Operators may become more pessimistic about their future business prospects. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Lucas’ Story ( ) Operators will notice that the park seems relatively empty and that people spend less than usual. The extra employees that were hired to help with the Sunday crowd are sent home early. Operators may become more pessimistic about their future business prospects. → We have created a recession (output and employment ↓). In a similar way, we can create a boom We cannot do that day after day! Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money How should we model the demand for money? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money How should we model the demand for money? There are basically three approaches: 1. (Real) money balances provide utility (Sidrauski, 1967) → We will study the relationship between money and prices and the neutrality of money (in more sophisticated versions, one could examine some of the central issues in monetary economics such as the optimal inflation rate). 2. Transaction costs of some form give rise to a demand for money by making asset exchanges costly (Baumol-Tobin, 1950s; Clower, 1967) or direct barter of commodities is costly when we live in a complex society (Kiyotaki and Wright, 1989) 3. Money is like any other asset used to transfer resources intertemporally (Samuelson, 1958). Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A pure-exchange economy that lasts 2 periods (no production) There are a large number N of identical consumers, allowed to save Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A pure-exchange economy that lasts 2 periods (no production) There are a large number N of identical consumers, allowed to save There is only one consumption good. yt : endowment in consumption good units at t. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A pure-exchange economy that lasts 2 periods (no production) There are a large number N of identical consumers, allowed to save There is only one consumption good. yt : endowment in consumption good units at t. A monetary authority gives M to each consumer at the beginnning of period 1; hence, money supply is NM. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A pure-exchange economy that lasts 2 periods (no production) There are a large number N of identical consumers, allowed to save There is only one consumption good. yt : endowment in consumption good units at t. A monetary authority gives M to each consumer at the beginnning of period 1; hence, money supply is NM. pt : price of the consumption good at t p2 −p1 π : inflation rate, π = p1 i : nominal interest rate of a bond (credit market) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A pure-exchange economy that lasts 2 periods (no production) There are a large number N of identical consumers, allowed to save There is only one consumption good. yt : endowment in consumption good units at t. A monetary authority gives M to each consumer at the beginnning of period 1; hence, money supply is NM. pt : price of the consumption good at t p2 −p1 π : inflation rate, π = p1 i : nominal interest rate of a bond (credit market) Consumers’ preferences: ln c1 + ln m1 + β (ln c2 + ln m2 ) mt : real money holdings at t Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model Consumer’s problem:   max ln c1 + ln m1 + β (ln c2 + ln m2 ) c1 ,c2 ,s,m1 ,m2 s. to p1 c1 + p1 s + M1 = p1 y1 + M̄ p2 c2 + M2 = (1 + i)p1 s + p2 y2 + M1 Mt ≡ pt mt is the money the consumer wants to have at the end of period t. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model Consumer’s problem:   max ln c1 + ln m1 + β (ln c2 + ln m2 ) c1 ,c2 ,s,m1 ,m2 s. to p1 c1 + p1 s + M1 = p1 y1 + M̄ p2 c2 + M2 = (1 + i)p1 s + p2 y2 + M1 Mt ≡ pt mt is the money the consumer wants to have at the end of period t. After some manipulations to write the intertemporal budget constraint, we have   max ln c1 + ln m1 + β (ln c2 + ln m2 ) c1 ,c2 ,m1 ,m2 1+π i 1+π 1+π M̄ s. to c1 + c + m + m = y1 + y + 1+i 2 1+i 1 1+i 2 1 + i 2 p1 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A consumer’s problem:   max ln c1 + ln m1 + β (ln c2 + ln m2 ) c1 ,c2 ,m1 ,m2 1+π i 1+π 1+π M̄ s. to c1 + c + m + m = y1 + y + 1+i 2 1+i 1 1+i 2 1 + i 2 p1 The Lagrangian: L = ln c1 + ln m1 + β (ln c2 + ln m2 )   1+π i 1+π 1+π M̄ − λ c1 + c2 + m1 + m2 − y1 − y2 − 1+i 1+i 1+i 1+i p1 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model A consumer’s problem:   max ln c1 + ln m1 + β (ln c2 + ln m2 ) c1 ,c2 ,m1 ,m2 1+π i 1+π 1+π M̄ s. to c1 + c + m + m = y1 + y + 1+i 2 1+i 1 1+i 2 1 + i 2 p1 The Lagrangian: L = ln c1 + ln m1 + β (ln c2 + ln m2 )   1+π i 1+π 1+π M̄ − λ c1 + c2 + m1 + m2 − y1 − y2 − 1+i 1+i 1+i 1+i p1 Eliminating the multiplier from the set of necessary (first order) conditions, we obtain 1+i 1+i 1+i m1 = c1 , c2 = β c , m2 = β c i 1+π 1 1+π 1 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model Now, after replacing them in the budget constraint, we have 1+π M̄ c1 + β c1 + c1 + β c1 = y1 + y + 1 + i 2 p1 That is,   1 1+π M̄ c1 = y1 + y2 + (1) 2(1 + β ) 1+i p1   1+i 1 1+π M̄ m1 = y1 + y2 + (2) i 2(1 + β ) 1+i p1   β 1+i 1 + i M̄ c2 = y + y2 + 2(1 + β ) 1 + π 1 1 + π p1   β 1+i 1 + i M̄ m2 = y1 + y2 + (3) 2(1 + β ) 1 + π 1 + π p1 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Sidrauski’s Model Definition Given the monetary policy M,
a competitive equilibrium consists of quantities c1∗ , m1∗ , c2∗ , m2∗ , s∗ and prices (i ∗ , p1∗ , p2∗ ), such that: 1. given prices, c1∗ , m1∗ , c2∗ , m2∗ , s∗ is solution to the representative
consumer’s problem. 2. All markets clear: Money Market: Np∗ m∗ = Np∗ m∗ = N M̄ 1 1 2 2 Credit Market: Ns∗ = 0 Goods Market: Nc ∗ = Ny1 , Nc ∗ = Ny2. 1 2 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Equilibrium From the market-clearing conditions, c1∗ = y1 , c2∗ = y2 , s∗ = 0 From equations (1), (2) and (3), 1 m1∗ = y1 (1 + β ), m2∗ = y2 , i ∗ = β From the consumer’s Euler equation, 1 + i∗ ∗ y c2∗ = β c ⇐⇒ 1 + π ∗ = β (1 + i ∗ ) 1 1 + π∗ 1 y2 Finally, from the money market-clearing conditions, M̄ M̄ M̄ M̄ p1∗ = = , p∗ = = m1∗ (1 + β )y1 2 m2∗ y2 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Equilibrium From the market-clearing conditions, c1∗ = y1 , c2∗ = y2 , s∗ = 0 From equations (1), (2) and (3), 1 m1∗ = y1 (1 + β ), m2∗ = y2 , i ∗ = β From the consumer’s Euler equation, 1 + i∗ ∗ y c2∗ = β c ⇐⇒ 1 + π ∗ = β (1 + i ∗ ) 1 1 + π∗ 1 y2 Finally, from the money market-clearing conditions, M̄ M̄ M̄ M̄ p1∗ = = , p∗ = = m1∗ (1 + β )y1 2 m2∗ y2 Conclusions: Neutrality of money. Neither the equilibrium real variables nor interest rate nor inflation rate depends on the money supply N M̄. Only do prices p1∗ and p2∗ increase one-to-one with money supply. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks (Super) Neutrality of Money Definition We say that the model exhibits neutrality of money if proportional changes in the level of nominal money balances, N M̄, have no effects on the real variables of the equilibrium allocation. Definition We say that the model exhibits superneutrality of money if changes in the rate of growth of nominal money balances, N M̄, have no effects on the real variables of the equilibrium allocation. (Q. 2 of PS#6) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks (digression) i: Nominal Interest rate: A nominal bond is an asset that is sold for one unit of money in period t, and pays 1 + i units of money in t + 1. Real Interest rate is measured in terms of the consumption good. Fisher Equation: 1 + i = (1 + r )(1 + π e ) ⇒ r ≃ i − π e pt : price of the consumption good in money units in period t pte+1 : expected price in period t of one unit of the consumption good in period t + 1 π e : expected inflation over the bond lifetime. 1 1+i 1+i 1+i (1 + r ) = e ⇒ 1 + r = pe = pt pt+1 t+1 1 + πe pt Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Figure: US Interest Rates Note: The nominal interest rate is the 3-month US Treasury Bill. The real interest rate is the nominal rate net of realized inflation. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks What is money? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks What is money? What is money? → is a medium of exchange is a store of value (to transfer income intertemporally) is a unit of account (metric for prices) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks What is money? What is money? → is a medium of exchange is a store of value (to transfer income intertemporally) is a unit of account (metric for prices) Consider Bitcoins. Does it satisfy these conditions? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks What is money? What is money? → is a medium of exchange is a store of value (to transfer income intertemporally) is a unit of account (metric for prices) Consider Bitcoins. Does it satisfy these conditions? 5 transactions per second (credit cards process thousands) very volatile (whales control it, Elon Musk’s tweets appear to affect its value) is it a store of value? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Modern economies are quite complex: large number of different goods. As a result, very rarely do we see double coincidence of wants (William S. Jevons) The first difficulty in barter is to find two persons whose disposable possessions mutually suit each other’s wants. There may be many people wanting, and many possessing those things wanted; but to allow of an act of barter there must be a double coincidence, which will rarely happen. → Time and resource costs associated to exchange. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Modern economies are quite complex: large number of different goods. As a result, very rarely do we see double coincidence of wants (William S. Jevons) When trade began in the history of mankind, people used goods (money) that were easily transportable (Yap stones, Micronesia) divisible in smaller units widely accepted Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Modern economies are quite complex: large number of different goods. As a result, very rarely do we see double coincidence of wants (William S. Jevons) When trade began in the history of mankind, people used goods (money) that were easily transportable (Yap stones, Micronesia) divisible in smaller units widely accepted → Money is a human construction that relies on trust (Sapiens, by Y. Haradi) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Types of money Commodity money: The commodity itself constitutes the money; for most of history, almost all money was commodity money. Ex.: shells, barley, gold and silver coins, cigarettes (prisons, concentration camps - recall The Shawshank Redemption starring T. Robins and M. Freeman) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Types of money Commodity money: The commodity itself constitutes the money; for most of history, almost all money was commodity money. Ex.: shells, barley, gold and silver coins, cigarettes (prisons, concentration camps - recall The Shawshank Redemption starring T. Robins and M. Freeman) Fiat Money: it’s worth zero. Ex.: bitcoins (Satoshi Nakamoto); notes came out first in Kublai Kahn China (1260s, Marco Polo; removed by 1500) What’s the cost of producing a 100-dollar bill?  Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Types of money Commodity money: The commodity itself constitutes the money; for most of history, almost all money was commodity money. Ex.: shells, barley, gold and silver coins, cigarettes (prisons, concentration camps - recall The Shawshank Redemption starring T. Robins and M. Freeman) Fiat Money: it’s worth zero. Ex.: bitcoins (Satoshi Nakamoto); notes came out first in Kublai Kahn China (1260s, Marco Polo; removed by 1500) What’s the cost of producing a 100-dollar bill?  Other types: commercial bank notes, paper money backed by some commodity, demand deposits,... Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply Money supply is the amount of money circulating in the economy, M. Monetary policy controls money supply. It is increasingly delegated to (partially) independent institutions, Central Banks. For ex., BoE was created in 1694, and granted independence over monetary policy in 1997. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply Money supply is the amount of money circulating in the economy, M. Monetary policy controls money supply. It is increasingly delegated to (partially) independent institutions, Central Banks. For ex., BoE was created in 1694, and granted independence over monetary policy in 1997. The Eurosystem has defined three monetary aggregates for the euro area (that differ in the liquidity of the assets considered): M1: comprises currency, i.e. banknotes and coins, and checking accounts. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply Money supply is the amount of money circulating in the economy, M. Monetary policy controls money supply. It is increasingly delegated to (partially) independent institutions, Central Banks. For ex., BoE was created in 1694, and granted independence over monetary policy in 1997. The Eurosystem has defined three monetary aggregates for the euro area (that differ in the liquidity of the assets considered): M1: comprises currency, i.e. banknotes and coins, and checking accounts. M2: M1 plus deposits with an agreed maturity of up to two years or redeemable at a period of notice of up to three months. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply Money supply is the amount of money circulating in the economy, M. Monetary policy controls money supply. It is increasingly delegated to (partially) independent institutions, Central Banks. For ex., BoE was created in 1694, and granted independence over monetary policy in 1997. The Eurosystem has defined three monetary aggregates for the euro area (that differ in the liquidity of the assets considered): M1: comprises currency, i.e. banknotes and coins, and checking accounts. M2: M1 plus deposits with an agreed maturity of up to two years or redeemable at a period of notice of up to three months. M3: M2 plus certain marketable instruments issued by the resident MFI sector. For example, repurchase agreements (repo), money market fund shares/units and debt securities with a maturity of up to two years.  → In billions of euros.... M3 is the more stable aggregate ⇒ it’s the reference for money growth in the Eurosystem Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy The primary objective of the ECB is to maintain price stability (ECB  tasks ) → The Governing Council of the European Central Bank aims to keep inflation below, but close to, 2% over the medium term. Mandate and independence of the Eurosystem Article 127(1) of the TFEU (...) states that the primary objective of the ESCB is to maintain price stability and that, without prejudice to the objective of price stability, the ESCB will support the general economic policies in the EU with a view to contributing to the achievement of the objectives of the EU as laid down in Article 3 of the TEU. Article 3 of the TEU sets out the objectives of the EU, which include, among other things, the sustainable development of Europe based on balanced economic growth and price stability, and a highly competitive social market economy, aiming at full employment and social progress. Price stability is therefore not only the primary objective of the ECB’s monetary policy, but also an objective of the EU as a whole. The Treaties thus establish a clear hierarchy of objectives for the Eurosystem, which clarifies that price stability is the most important contribution that monetary policy (...) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy  The dual mandate of the Federal Reserve (☞) is to keep inflation under control (2% target ) AND maximize employment. Trump is back and aims at 1% inflation  Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy Why 2% inflation?  Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy Why 2% inflation?  1) Why should there be any target? Convergence in inflation rates since 1989 (New Zealand); ECB since its creation in 1998; Board, January 2012 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy Why 2% inflation?  1) Why should there be any target? Convergence in inflation rates since 1989 (New Zealand); ECB since its creation in 1998; Board, January 2012 2) Alternatives? - We do not want a high inflation rate (pros of price stability): it would lead to higher volatility/uncertainty, less investment. it would create more distortions as not all prices adjust equally fast. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Supply and Monetary Policy Why 2% inflation?  1) Why should there be any target? Convergence in inflation rates since 1989 (New Zealand); ECB since its creation in 1998; Board, January 2012 2) Alternatives? - Neither a too low inflation rate: deflation risks (more saving/less spending) The CPI could be overestimating the actual inflation (measurement errors) in the EA, we’d like to have some margin due to the inflation differentials across regions real wages could not adjust to save employment/reduce layoffs (harder to reduce nominal wages) lower seigniorage revenue (inflationary tax) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Why the difference between the ECB and the Fed mandates? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Why the difference between the ECB and the Fed mandates? ECB After WWI, Treaty of Versailles imposed war reparations on Germany  (Keynes , MacMillan )  The Weimar government missed a reparations payment late in 1922 leading to the occupation of the Ruhr by France and Belgium, followed by German workers refusing to cooperate and the German govt printing more money to pay those wages, and then hyperinflation (a loaf of  bread valued 250 marks in January 1923, and 200,000 million marks in November) (A princess in Berlin ) US Fed After the happy 1920s... the stock market collapsed: stock market crash  of October 29, 1929 (The Great Gatsby , The Grapes of Wrath )  the Great Depression: unemployment rate soared to 23%, GDP fell by 15% in 1929-32 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply Central Bank controls the supply of money by buying and selling government securities in open-market operations M1: currency+deposits (M = C + D) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply Central Bank controls the supply of money by buying and selling government securities in open-market operations M1: currency+deposits (M = C + D) Households but also banks determine the demand deposits Table: Balance Sheet of a Commercial Bank Assets Liabilities Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply Central Bank controls the supply of money by buying and selling government securities in open-market operations M1: currency+deposits (M = C + D) Households but also banks determine the demand deposits Table: Balance Sheet of a Commercial Bank Assets Liabilities Loans Other Assets (bonds, etc.) Reserves (R) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply Central Bank controls the supply of money by buying and selling government securities in open-market operations M1: currency+deposits (M = C + D) Households but also banks determine the demand deposits Table: Balance Sheet of a Commercial Bank Assets Liabilities Loans Equity (and preference shares) Other Assets (bonds, etc.) Deposits (D) Reserves (R) Debt Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply To understand the role of commercial banks, let’s consider three different scenarios for an economy wherein currency C = 1.000e: 1. Banks/depositary institutions are nonexistent 2. 100-percent-reserve Banking 3. Fractional-reserve Banking Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply To understand the role of commercial banks, let’s consider three different scenarios for an economy wherein currency C = 1.000e: 1. Banks/depositary institutions are nonexistent → Currency is the only form of money, C = 1000e, and the supply of money is M = C = 1000e. 2. 100-percent-reserve Banking 3. Fractional-reserve Banking Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The second scenario: 100-percent-reserve Banking. Suppose that there is only one bank, called Bank A. Table: Bank A’s Balance Sheet A L R 1000 D 1000 Initially, C = 1.000e, D = 0e, and M = 1.000e. If households deposit their 1.000e in Bank A, then Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The second scenario: 100-percent-reserve Banking. Suppose that there is only one bank, called Bank A. Table: Bank A’s Balance Sheet A L R 1000 D 1000 Initially, C = 1.000e, D = 0e, and M = 1.000e. If households deposit their 1.000e in Bank A, then C = 0 and D = 1000e =⇒ M = 0 + 1000 = 1000e → A 100-percent-reserve Banking system has no impact on money supply. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The third scenario: Fractional-reserve Banking. Consider a reserve ratio (defined as the fraction of total deposits that a bank holds as reserves) equal to 20% =⇒ banks loan out the remaining Rmk: The reserve ratio is determined by a combination of banking regulation (reserve requirement) and bank policy (excess reserves). Initially, C = 1.000e, D = 0e, and M = 1.000e. Households deposit all their money holdings in Bank A. Table: Bank A’s Balance A L R 200 D 1000 Loans 800 Money supply M = Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The third scenario: Fractional-reserve Banking. Consider a reserve ratio (defined as the fraction of total deposits that a bank holds as reserves) equal to 20% =⇒ banks loan out the remaining Rmk: The reserve ratio is determined by a combination of banking regulation (reserve requirement) and bank policy (excess reserves). Initially, C = 1.000e, D = 0e, and M = 1.000e. Households deposit all their money holdings in Bank A. Table: Bank A’s Balance A L R 200 D 1000 Loans 800 Money supply M =C + D = 800 + 1000 = 1800e −→ Banks create money by holding only a fraction of deposits in reserve. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The creation of money does not stop with Bank A. Suppose the borrower from Bank A uses the 800e to buy something from someone who then deposits the currency in Bank B. Table: Bank B’s Balance A L R 160 D 800 L 640 And so on and so forth. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks The role of commercial banks in Money Supply The creation of money does not stop with Bank A. Suppose the borrower from Bank A uses the 800e to buy something from someone who then deposits the currency in Bank B. Table: Bank B’s Balance A L R 160 D 800 L 640 And so on and so forth. Money supply: M = 1000 + 800 + 640 + 512 +... = 1000(1 + 0.8 + 0.82 + 0.83 +...) 1 = 1000 = 5000 1 − 0.8 1 More generally, M = rr C. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Multiplier The amount of money the banking system generates with each euro of reserves is called the money multiplier. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Multiplier The amount of money the banking system generates with each euro of reserves is called the money multiplier. The Central Bank only directly controls the monetary base, B = C + R. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Multiplier The amount of money the banking system generates with each euro of reserves is called the money multiplier. The Central Bank only directly controls the monetary base, B = C + R. We have seen that commercial banks create money (not wealth!). Define the reserve ratio as rr = R/D Households also create money as may decide to hold more currency or more deposits depending on their preferences. Define the ratio of cash to deposits as the currency ratio, cr = C/D. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Money Multiplier The amount of money the banking system generates with each euro of reserves is called the money multiplier. The Central Bank only directly controls the monetary base, B = C + R. We have seen that commercial banks create money (not wealth!). Define the reserve ratio as rr = R/D Households also create money as may decide to hold more currency or more deposits depending on their preferences. Define the ratio of cash to deposits as the currency ratio, cr = C/D. Therefore, C +D cr + 1 M = C + D = m · B, where m ≡ = is the money multiplier B cr + rr Rmk: Previously cr = 0, and hence m = rr1. In the previous example, m = 5. How much was m in the 100-percent-reserve banking case? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks 2019 Final Exam Question Determine the monetary base, deposits and the money multiplier if money supply M = 100, currency C = 10 and the reserve ratio rr = 0.2 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Assets and Banks Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: 2. Risk: 3. Maturity: 4. Liquidity: Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: the ratio of the payoff on the asset over some period of time to the initial investment q +d rta = t+1 −1 qt qt : asset price in period t d: payoff/dividend at t 2. Risk: 3. Maturity: 4. Liquidity: Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: the ratio of the payoff on the asset over some period of time to the initial investment q +d rta = t+1 −1 qt qt : asset price in period t d: payoff/dividend at t 2. Risk: volatility of the rate of return of an asset (st. dev.) −→ Diversified portfolio. How about the pandemic? 3. Maturity: 4. Liquidity: Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: the ratio of the payoff on the asset over some period of time to the initial investment q +d rta = t+1 −1 qt qt : asset price in period t d: payoff/dividend at t 2. Risk: volatility of the rate of return of an asset (st. dev.) −→ Diversified portfolio. How about the pandemic? 3. Maturity: the time it takes for an asset to pay off. Example: 3-month U.S. Treasury bill 4. Liquidity: Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: the ratio of the payoff on the asset over some period of time to the initial investment q +d rta = t+1 −1 qt qt : asset price in period t d: payoff/dividend at t 2. Risk: volatility of the rate of return of an asset (st. dev.) −→ Diversified portfolio. How about the pandemic? 3. Maturity: the time it takes for an asset to pay off. Example: 3-month U.S. Treasury bill 4. Liquidity: how long and how costly is to sell an asset for its market value. Important b/c of the uncertainty about the timing of transactions Example: fiat money vs real estate Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Main Properties of Assets 1. Rate of return: the ratio of the payoff on the asset over some period of time to the initial investment q +d rta = t+1 −1 qt qt : asset price in period t d: payoff/dividend at t 2. Risk: volatility of the rate of return of an asset (st. dev.) −→ Diversified portfolio. How about the pandemic? 3. Maturity: the time it takes for an asset to pay off. Example: 3-month U.S. Treasury bill 4. Liquidity: how long and how costly is to sell an asset for its market value. Important b/c of the uncertainty about the timing of transactions Example: fiat money vs real estate Eveything else equal, (risk-averse) consumers prefer high rates of return, low risk, short maturities and high liquidity. −→ What are the properties of cash? Q12 PS#6 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Financial Intermediation Financial markets play an important role: reallocation of resources from savers to households and firms that borrow to buy and invest. This process is the so-called financial intermediation. A financial intermediary1 is defined by the following characteristics: It borrows from one large group of economic agents and lends to another large group −→ very diversified! It transforms assets. That is, the properties of its liabilities are different from the properties of its assets. It processes information (expertise). 1 insurance companies, mutual funds, and depository institutions Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Nobel Prize in Economics 2022 "for research on banks and financial crises" Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model2 There are 3 periods: 0, 1 and 2. Free entry in the banking sector =⇒ expected profits of banks = 0. 2 (JPE, 1983 ) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model2 There are 3 periods: 0, 1 and 2. Free entry in the banking sector =⇒ expected profits of banks = 0. There are a mass N of risk-averse consumers. CRRA Preferences: u(c) = c 1−σ 1−σ , regardless of when consumption takes place, with elasticity σ > 1. Each consumer is endowed with 1 unit of a production input at t = 0 2 (JPE, 1983 ) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model2 There are 3 periods: 0, 1 and 2. Free entry in the banking sector =⇒ expected profits of banks = 0. There are a mass N of risk-averse consumers. CRRA Preferences: u(c) = c 1−σ 1−σ , regardless of when consumption takes place, with elasticity σ > 1. Each consumer is endowed with 1 unit of a production input at t = 0 Investment/Production Technology: converts one production input at t = 0 into 1 + r units of the consumption good at t = 2 the production process can be interrupted at t = 1 to obtain 1 unit of the consumption good 2 (JPE, 1983 ) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consumers become either early or late consumers; however, they do not know their type until period t = 1. p: probability of (being an early consumer and) having to consume at t = 1. Late consumers choose whether to consume at t = 1 or at t = 2 Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consumers become either early or late consumers; however, they do not know their type until period t = 1. p: probability of (being an early consumer and) having to consume at t = 1. Late consumers choose whether to consume at t = 1 or at t = 2 The mass of early consumers is pN and of late consumers is (1 − p)N (Law of large numbers) Because consumers make decisions under uncertainty, they maximize the expected utility pu(c1 ) + (1 − p)u(c2 ) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consider 3 different scenarios: 1. Economy with no banks 2. Economy with an insurance market (with free entry, and no banks) 3. Economy with Diamond-Dybvig banks (free entry in the banking sector and no insurance market) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 1. Economy with no banks. Consumers invest their unit of the production input. If early consumer, (s)he consumes c1 = 1 at t = 1; If late consumer, (s)he consumes c2 = 1 + r at t = 2. So to speak, she obtains contract (c1 , c2 ) = (1, 1 + r ). Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 1. Economy with no banks. Consumers invest their unit of the production input. If early consumer, (s)he consumes c1 = 1 at t = 1; If late consumer, (s)he consumes c2 = 1 + r at t = 2. So to speak, she obtains contract (c1 , c2 ) = (1, 1 + r ). 2. Economy with an insurance market (with free entry, and no banks). If a consumer could insure away the risk of being an early consumer paying x, her problem would be max pu(c1 ) + (1 − p)u(c2 ) c1 ,c2 s. to pc1 + (1 − p)c2 = x Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 1. Economy with no banks. Consumers invest their unit of the production input. If early consumer, (s)he consumes c1 = 1 at t = 1; If late consumer, (s)he consumes c2 = 1 + r at t = 2. So to speak, she obtains contract (c1 , c2 ) = (1, 1 + r ). 2. Economy with an insurance market (with free entry, and no banks). If a consumer could insure away the risk of being an early consumer paying x, her problem would be max pu(c1 ) + (1 − p)u(c2 ) c1 ,c2 s. to pc1 + (1 − p)c2 = x p Solution: c1 = c2 (the marginal rate of substitution is 1−p at c1 = c2 ) = Social planner’s allocation Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 3. Economy with Diamond-Dybvig Banks a DB bank is a depositary institution that offers deposit contracts. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 3. Economy with Diamond-Dybvig Banks a DB bank is a depositary institution that offers deposit contracts. In exchange for one unit of the production input, such contracts offer c1 units of the consumption good if the consumer withdraws at t = 1, and c2 units at t = 2, otherwise. −→ Consumers willing to withdraw their deposits at t = 1 will be lined up. the bank cannot tell apart the early consumers and the late consumers. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model 3. Economy with Diamond-Dybvig Banks a DB bank is a depositary institution that offers deposit contracts. In exchange for one unit of the production input, such contracts offer c1 units of the consumption good if the consumer withdraws at t = 1, and c2 units at t = 2, otherwise. −→ Consumers willing to withdraw their deposits at t = 1 will be lined up. the bank cannot tell apart the early consumers and the late consumers. Let’s compare with the allocation in the no-banking economy. All consumers deposit their endowment in the bank at t = 0, which ends with N units of the input to invest in the technology. x: fraction of the investment to be interrupted at t = 1 to provide c1 units of the consumption good to those who withdraw their deposits early. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Let’s determine the equilibrium deposit contract (c1 , c2 ). −→ Assume that only do early consumers show up at the bank to withdraw at t=1. Recall: there is a representative bank, which behaves competitively Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Let’s determine the equilibrium deposit contract (c1 , c2 ). −→ Assume that only do early consumers show up at the bank to withdraw at t=1. Recall: there is a representative bank, which behaves competitively Free-entry into banking implies 0 profits: Period 1: Npc1 = Nx Period 2: N(1 − p)c2 = N(1 − x)(1 + r ) Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Let’s determine the equilibrium deposit contract (c1 , c2 ). −→ Assume that only do early consumers show up at the bank to withdraw at t=1. Recall: there is a representative bank, which behaves competitively Free-entry into banking implies 0 profits: Period 1: Npc1 = Nx Period 2: N(1 − p)c2 = N(1 − x)(1 + r ) By eliminating x, obtain the equation that characterizes all possible deposit contracts: (1 − p)c2 pc1 + =1 1+r Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Let’s determine the equilibrium deposit contract (c1 , c2 ). −→ Assume that only do early consumers show up at the bank to withdraw at t=1. Recall: there is a representative bank, which behaves competitively Free-entry into banking implies 0 profits: Period 1: Npc1 = Nx Period 2: N(1 − p)c2 = N(1 − x)(1 + r ) By eliminating x, obtain the equation that characterizes all possible deposit contracts: (1 − p)c2 pc1 + =1 1+r Consumers choose the deposit contract to maximize expected utility Consumer’s Problem: max pu(c1 ) + (1 − p)u(c2 ) c1 ,c2 (1 − p)c2 s. to pc1 + =1 1+r Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consumer’s Problem: max pu(c1 ) + (1 − p)u(c2 ) (1 − p)c2 s. to pc1 + =1 1+r Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consumer’s Problem: max pu(c1 ) + (1 − p)u(c2 ) (1 − p)c2 s. to pc1 + =1 1+r c1 < c2 =⇒ late consumers have incentives to consume in t = 2. 1 < c1 < c2 < 1 + r =⇒ banks increase aggregate welfare. Banking increases welfare by offering insurance for the case in which the individual needs liquidity in period 1. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Diamond-Dybvig Banking Model Consumer’s Problem: max pu(c1 ) + (1 − p)u(c2 ) (1 − p)c2 s. to pc1 + =1 1+r c1 < c2 =⇒ late consumers have incentives to consume in t = 2. 1 < c1 < c2 < 1 + r =⇒ banks increase aggregate welfare. Banking increases welfare by offering insurance for the case in which the individual needs liquidity in period 1. Q9 PS#6: what if log preferences? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Multiplicity of Equilibria and Bank Runs We have assumed that only the early consumers withdraw their deposits in period 1. Late consumers have no incentives to stop by the bank at t = 1 because c2 > c1. This is the good equilibrium. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Multiplicity of Equilibria and Bank Runs We have assumed that only the early consumers withdraw their deposits in period 1. Late consumers have no incentives to stop by the bank at t = 1 because c2 > c1. This is the good equilibrium. Suppose now that a late consumer believes that all other late consumers will go to the bank in period 1. What’s the best this consumer can do? Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Multiplicity of Equilibria and Bank Runs We have assumed that only the early consumers withdraw their deposits in period 1. Late consumers have no incentives to stop by the bank at t = 1 because c2 > c1. This is the good equilibrium. Suppose now that a late consumer believes that all other late consumers will go to the bank in period 1. What’s the best this consumer can do? Notice that (N − 1)c1 > N for N large enough b/c c1 > 1 (i.e., withdrawal demand > value of all assets when liquidated) Thus, this late consumer will run to the bank in period 1 =⇒ Bank panic This is the bad equilibrium. The bank goes bankrupt even if solvent! (self-fulfilling expectations) Multiple equilibria are used here to explain why bank runs have occurred historically. Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks (a) (b) (c)  Bank run on SVB: on March 9, 2023, depositors withdrew almost 25 percent of the total deposits Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks Multiplicity of Equilibria and Bank Runs A potential solution to the problem of bank runs is government-provided deposit insurance. In the Diamond-Dybvig model, if the government guarantees each depositor c2 given by the banking contract at point A, then no late consumer would have a reason to run to the bank. Rmk 1: This leaves aside the question of who the government will tax if it has to make good on its deposit insurance guarantees. Rmk 2: The main cost of deposit insurance is that it creates a moral hazard problem: deposit insurance encourages the depository institution to take on more risk Javier Fernández UAB & BSE Introduction Sidrauski’s Model Money Money Supply Assets and Banks (d) (e) (f) Deposit Insurance (Fondo de Garantía de Depósitos ☞) -until 100.000e in the Eurozone- to avoid bank runs (FDIC -until $250.000- in the US ☞) Javier Fernández UAB & BSE