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Welcome to the money and banking video series. What makes an economy vulnerable to a financial crisis? How can a small shock trigger a large-scale crisis? How to manage a crisis? How to prevent it? And who should be in charge of it? In this video series you will learn about money creation by banks, liquidity spirals and the debt disinflation spiral as well as the paradox of prudence. You will study macro-prudential policy and monetary policy, contrasting the money view with the credit view. You will become familiar with monetary dominance, fiscal dominance and financial dominance. In addition, you will be exposed to various stability concepts and to the diabolic or doom loop between banking and sovereign risk. This video series is based on two articles I wrote with Yuliy Sannikov, titled the "I Theory of Money" and "Redistributive Monetary Policy". Our research sheds new light on these questions and studies the interaction between monetary policy, financial regulation and fiscal policy. Part one of this video series studies how the financial sector works. Let's start by setting up a simple economy with a financial sector. In our simple economy there is a bank and someone we call end-borrower who might want to buy a house. He goes to a bank and takes out a mortgage, let's say a million dollars. The bank which grants him a mortgage will credit the end-borrower one million dollars as deposit as soon as the mortgage is agreed upon. This creates credit on the asset side of the bank's balance sheet and deposits on the liability side of the bank's balance sheet. When the end-borrower finally buys a house and makes a payment to the seller he transfers his deposit to the seller of the house. As long as the seller holds a deposit he essentially, through the bank, lends funds to the end-borrower. Notice that after the purchase of the house the credit, the mortgage to the end-borrower, is risky to the bank while the saver's deposit is supposedly risk-free. Second, the mortgages are long-term commitments to the bank while the savers deposits are short term. For these reasons the bank faces two risks. First, on the asset side there is a possibility that the end-borrower does not pay back his debt. The bank faces credit or default risk, represented graphically by the fluctuating curve. Second, the bank faces liquidity funding risk or run risk which stems from the fact that the credit is long term while deposits are short term. If suddenly all savers withdraw their deposits the bank will not be able to repay them. In order to cover default risk the bank should have an equity cushion to protect the depositors, savers in our example. In order to fend off liquidity run risk some of these funds are invested in safe assets, for example reserves. The bank's balance sheet now has reserves on the asset side in addition to credit. On the liability side it has the equity of the bank in addition to savers own deposits, IOU's against the bank. Of course, the bank has many end-borrowers on the asset side and many savers, deposit holders, on the liability side. Granted these risky loans to the end-borrowers do not default all at the same time. The risks of each end-borrower partially offset each other. The bank diversifies risk across various end-borrowers. And putting various credits together into a single portfolio which is like merging the fluctuating curves into a single one, fluctuations are largely averaged out. Also, notice that although the bank grants many forms of credit the bank issues standardized IOU's in form of deposits. So on the asset side there are long-term assets which are risky and illiquid, while on the liability side there are standardised deposits, IOU's, issued by the bank, the latter which are much more liquid. In a sense, liquid deposits are one of the outputs of the bank's production function. These standardized deposits, IOU's, are inside money that is created by the banking sector. Since they are short term they are readily available. Due to the protection from the equity of the bank the default probabilities are low, that is, credit risk is limited. Hence, there is little asymmetric information about the value of these IOU's because of this it is easy to net IOU's across the whole financial system and hence it serves as a means of payment. Now let's add the government with the central bank. The reserves that we have introduced earlier on the asset side of the bank's balance sheet are provided by the government, more precisely by the central bank. Putting the picture together with the banks we can now see that savers have the option to hold either inside money in form of standardized deposits, IOU's, or outside money in form of physical cash issued by the central bank. In addition, savers can also directly lend to end-borrowers. However, direct lending is more risky for two reasons. First, savers cannot diversify as well as banks. Second, banks are better at enforcing the repayment from end-borrowers. Therefore, direct lending is much more risky compared to holding inside money. In addition, as mentioned before, standardization of inside money allows some netting, which is not the case for direct lending claims since the default risk might differ from end-borrower to end-borrower. To sum up, part one of this video series illustrated how the banks create money in normal times. In part two we study how the financial economy copes with an adverse shock. We focus on two spirals: the liquidity spiral and a disinflation spiral. We will also introduce the paradox of prudence. Click on part two for the next video