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Home / Publications / Research / Economic Brief / 2022

Economic Brief
January 2022, No. 22-02

Market Freezes, Shadow Bank Runs and More: A Recap of
the Monetary Economics Conference
By Tim Sablik

What features of an economy make money a useful social construct? Why did
over-the-counter markets freeze during the 2007-2008 financial crisis? How do
changes in monetary policy get transmitted to the broader economy?
Researchers explored these questions and more at a recent conference hosted
by the Richmond Fed.
Economists from the Federal Reserve System and research universities met in Richmond for
a conference on monetary economics in December. This Economic Brief summaries the
research presented at the conference.

Is Money Essential?
What features of an economy make money socially useful? Economists classify money as
"essential" if more desirable outcomes are feasible with it than without it. This requires
frictions in the economy that make trade through bartering suboptimal. But many
economic models feature frictionless economies where money doesn't improve outcomes
and may even make things worse.
Bruno Sultanum of the Richmond Fed discussed results from an experiment seeking
evidence of money's essentiality under various conditions. The paper he presented, "Is
Money Essential? An Experimental Approach," was co-authored with Janet Hua Jiang of the
Bank of Canada, Peter Norman of the University of North Carolina, Daniela Puzzello of
Indiana University, and Randall Wright of the University of Wisconsin-Madison. In their
experiment, they sought answers to four questions:
Do agents use money when there is a monetary equilibrium?
Do agents use money when there is no monetary equilibrium?

Do recommendations about strategy from the experimenters help when a monetary
equilibrium exists?
Do recommendations from the experimenter matter when there isn't a monetary
To answer these questions, Sultanum and his co-authors designed an experiment with
three players who meet to trade twice. In the first meeting, player 1 meets with player 2,
then player 2 meets with player 3, after which the game ends. In each meeting, a player is
either a consumer or a producer. A consumer chooses whether to make an offer for a good
from the producer. The consumer can offer money or ask for the good for free. The
producer then chooses whether to accept the offer. The experimenters tested two models:
one in which all the players knew their roles from the start and one in which only player 1
did. They also varied whether player 1 began with money.
They found evidence that money is essential when theory would predict it should be.
Through exit surveys, they concluded that play deviating from theory mostly resulted from
player confusion.

Market Freezes
During the financial crisis of 2007-2008, markets with centralized trading continued to
operate, but trading in over-the-counter (OTC) markets came to a halt. In an OTC asset
market, traders must find counterparties and negotiate the terms of trade. During the
financial crisis, OTC markets for mortgage-backed securities froze. This raises two questions
for researchers:
Why does trade break down despite potential gains from trade?
Can the government intervene to restore normal market functions?
Despite the importance of answering these questions, there is no consensus economic
model for studying market freezes. Randall Wright of the University of Wisconsin-Madison
presented his paper "Market Freezes" — co-authored with Chao Gu of the University of
Missouri, Guido Menzio of New York University, and Yu Zhu of the Bank of Canada — which
modeled recurrent OTC market freezes as self-fulfilling prophecies.
Under standard assumptions, market freezes cannot happen. So, Wright and his co-authors
looked at three variations of a standard model:
There are assets with negative dividends, or so-called "toxic assets," which have lost
significant value and for which there is no longer any functioning market.
Agents pay a verification or sanitation cost to determine the value or safety of assets.
Agents pay fixed entry costs, or the model features other nonconvexities.

Using these models, Wright and his co-authors were able to show how to generate
temporary market freezes as an equilibrium phenomenon. They also showed how one
asset market can affect other asset markets, as well as how a low inflation rate can help
prevent market freezes.

Bargaining Under Liquidity Constraints
How do self-interested parties bargain to achieve mutually beneficial outcomes? Daniela
Puzzello of Indiana University presented her paper on this topic, "Bargaining Under
Liquidity Constraints: Nash vs. Kalai in the Laboratory (PDF)," co-authored with John Duffy of
the University of California, Irvine, and Lucie Lebeau of the Dallas Fed.
Puzzello and her co-authors studied bargaining solutions in a laboratory experiment.
Typically, such experiments involve a fixed pie for players to bargain over, an explicit
extensive form for the bargaining process, and no liquidity constraints. In contrast, the
authors of this paper studied bargaining in situations where the players simultaneously
decide both the size of the pie and how to split it. (An example would be negotiations
between a firm's workers and management.) The authors also examined the role liquidity
constraints play in bargaining solutions.
The experiment consisted of 30 rounds, with 10 participants per session. Half of the
participants were assigned the role of consumer, and the other half were producers.
Consumers and producers were randomly paired each round, and they had two minutes to
bargain over production and payoff. The experimenters first studied this bargaining in an
unconstrained environment and then in environments where consumers' money holdings
were constrained.
In an unconstrained environment, theory predicts that parties will split the pie 50-50
through negotiation, which is what Puzzello and her co-authors found in their
unconstrained experiment.
In the presence of liquidity constraints, theory offers two solutions, formalized by John Nash
and Ehud Kalai. Nash predicted that a larger surplus would accrue to the buyer relative to
the seller and the total gains from trade would be larger than those predicted by Kalai, who
argued that surpluses would be equal between buyer and seller.
Puzello and her co-authors found strong support for Kalai's prediction in their experiments:
Players effectively agreed to share a smaller pie to achieve greater equality.

A Model of Retail Banking
Economists debate the role of banks in transmitting monetary policy. One theory holds that
monetary policy affects the real economy through the supply of bank deposits. When the
federal funds rate increases, the spread between it and the deposit rate widens. As a result,

deposits flow out of the banking system, and this outflow induces a contraction in lending
Guillaume Rocheteau of the University of California, Irvine, presented a paper, "A Model of
Retail Banking and the Deposits Channel of Monetary Policy," in which he and co-author
Michael Choi, also of the University of California, Irvine, examined this theory. They
developed a model to explore several questions:
Is bank market power necessary and/or sufficient for the deposit channel of monetary
policy to operate?
Does the origin of bank market power matter for transmission?
How do fintech advances — such as mobile banking and crypto payments — affect the
transmission of monetary policy?
What are the distributional effects of monetary policy across consumers with different
liquidity needs?
In their model, banks have market power in deposit and loan markets. They found that
when consumers have private information about their liquidity needs, a deposits channel
for monetary policy emerges naturally. This channel isn't uniform across consumers and
operates through those on the bottom of the distribution of deposit holdings. Allowing for
both private information and two-sided bargaining powers, Rocheteau and Choi showed
that the strength of the deposits channel is higher in more concentrated markets.
They also found that fintech innovations in the banking industry can both reduce and
increase bank market power. Innovations that reduce market power by improving
consumers' outside options weaken the transmission of monetary policy. However,
innovations that reduce bank market power by limiting their information about consumers
strengthened the transmission of monetary policy.

Q-Monetary Transmission
Another way monetary policy may impact the aggregate economy is through stock prices.
An unexpected increase in the monetary policy rate causes stock prices to fall. According to
the theory of Tobin's q, this implies that corporate investment should also fall. Thus,
monetary policy can affect the economy through a decline in investment.
Ricardo Lagos of New York University presented a paper — "Q-Monetary Transmission," coauthored with Priit Jeenas of Universitat Pompeu Fabra — which examined whether such
asset-price monetary transmission can happen in theory, as well as whether it has
happened in practice. The authors first estimated how monetary policy impacts stock
prices, using well-established empirical evidence on how a surprise increase in the Fed's
policy rate causes stock indexes to fall. Second, they estimated how changes in stock prices
affect firm investment. This would then allow them to estimate how changes in monetary
policy affect the aggregate economy through changes in investment.

The challenge with estimating monetary policy transmission through asset price changes is
that monetary policy can affect firms' investment decisions and stock prices in unrelated
ways. For instance, a monetary shock that lowers demand for a firm's output could
decrease both the firm's investment and stock price, but that doesn't necessarily mean that
the company reduced investment because its stock price fell.
To meet this challenge, Lagos and Jeenas used cross-sectional evidence of stock price
changes that were only correlated with a monetary policy shock. They then used this to
estimate the effect of stock price changes on firms' investment decisions.
Using this approach, Lagos and Jeenas found that an unexpected, 25-basis-point increase in
the federal funds rate resulted in a 0.25 percent drop in aggregate investment three
quarters later through the asset price monetary transmission channel. This suggests that
the transmission of monetary policy shocks through stock prices accounts for a
nonnegligible amount of the overall impact of monetary policy on aggregate investment.

Shadow Bank Runs
In the financial sector, short-term debt is often used to fund illiquid assets. For example,
traditional banks use short-term deposits to make long-term loans. A conventional view in
economics is that these arrangements are prone to runs in part because redemptions must
be processed on a first-come, first-served basis. If a financial firm only has enough liquidity
to pay a fraction of its creditors at any given moment, then all creditors will rush to redeem
their contracts if they lose confidence in the firm to avoid being left with nothing. The
wholesale (or shadow) banking sector lacks this sequential service protocol and yet appears
to still be vulnerable to runs, as seen during the 2007-2008 financial crisis. In the
conventional Diamond and Dybvig banking model, such arrangements should not
necessarily be prone to runs.
David Andolfatto of the St. Louis Fed presented a paper — "Shadow Bank Runs," coauthored with Ed Nosal of the Atlanta Fed — which featured a model to show that
sequential service is not necessary to render banking arrangements run-prone when the
investments financed by banks are subject to fixed costs of production. The returns on
investments with fixed costs decline if production is scaled back, such as because of a
sudden lack of funding. Using short-term debt to finance this type of investment is
potentially unstable. If creditors lose confidence and call in their loans, production collapses
as financing vanishes, driving down the return on the investment and justifying the initial
loss of confidence.
Given that financial arrangements outside the traditional banking sector can be prone to
runs even absent sequential servicing, should policymakers do anything to reduce run risk?
Any financial arrangements can be made run-proof, but doing so may come at a cost.

The conventional view in economics is that banks provide a valuable service by
transforming liquidity from short term to long term, even though that arrangement is
vulnerable to runs. Andolfatto and Nosal examined how policies designed to prevent runs
vary under different conditions and compared them to recent policy interventions by the
Security and Exchange Commission and the Fed. They found that not all policies that render
financial arrangements in the shadow banking sector run-proof necessarily improve
depositor welfare, but they acknowledged that it was difficult to make conclusive
statements about the merits of any particular policy intervention.

Disintermediating the Fed Funds Market
Banks and government agencies borrow and lend reserves overnight on the federal funds
market to maintain necessary reserve levels at the Fed. The Fed implements monetary
policy in part by adjusting the interest rate in this market. But for more than a decade, the
volume of trading in the fed funds market has been declining. There are several possible
explanations for this development, including:
Higher trading costs because of new regulations
A composition effect resulting from banks being displaced by government-sponsored
enterprises, which trade less on the fed funds market
Abundant reserves in the banking system since the 2007-2008 financial crisis
Russell Wong of the Richmond Fed presented a paper in progress — "Disintermediating the
Federal Funds Market," co-authored with Mengbo Zhang of the Shanghai University of
Finance and Economics — which examines the decline of intermediaries in the fed funds
market as a possible explanation for the decline in trade volume. Intermediaries in the fed
funds market are banks that buy and sell funds on the same day. Wong and Zhang found
that the activity of these intermediaries declined substantially over the same period that
overall trading declined in the market. This was because both the number of intermediary
banks operating in the market fell and trading by the remaining intermediaries accounted
for less of overall market activity.
Wong and Zhang used a search model to identify why this disintermediation had occurred
as well as what effect it may have had on the fed funds market. They concluded that
disintermediation has occurred because of changes in the way the Fed has conducted
monetary policy since the 2007-2008 financial crisis. There are now abundant reserves in
the banking system, and the Fed implements monetary policy primarily by changing the
interest it pays on reserves and through reverse repo operations. But Wong and Zhang also
concluded that the fed funds market featured excessive intermediation prior to these
Tim Sablik is a senior economics writer in the Research Department at the Federal Reserve
Bank of Richmond.

This article may be photocopied or reprinted in its entirety. Please credit the author, source,
and the Federal Reserve Bank of Richmond and include the italicized statement below.
Views expressed in this article are those of the author and not necessarily those of the Federal
Reserve Bank of Richmond or the Federal Reserve System.

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