Transcript Lecture 8: Macro: The Financial System

Economics for CED
Noémi Giszpenc
Spring 2004
Lecture 8: Macro:
The Financial System
May 25, 2004
Growth and Investment
• Recall from N.W. Senior that
– investment in capital raises labor productivity
(& thus output) and that
– return on investment must overcome
other preferences of lenders of capital.
• This led R. Harrod to posit that
– rate of economic growth depends on
the growth of capital (directed toward investment)
• Whatever influences practice of lending and
borrowing affects the whole economy.
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Every country’s system is unique
• Countries differ widely in number and types of
banks, relationships among financial
institutions, regulation, etc.
• Basic functions of a national system:
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Keep savings safe
Put money to work through loans
Ease transactions
Create money
• Whoah, really? Yes. Amount of money needs to increase
as population and economy grow
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First, what is money?
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Something that people generally accept in exchange
for a good or a service.
Money performs four main functions:
1.
2.
3.
4.
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a medium of exchange for buying goods and services;
a unit of account for placing a value on goods and services;
a store of value when saving;
a standard for deferred payment when calculating loans.
Any item which is going to serve as money must be:
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acceptable to people as payment
scarce and in controlled supply
stable and able to keep its value
divisible without any loss of value
portable and not too heavy to carry.
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Ex: cowrie
shell
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Types of money
• Commodity moneys
– Have value in non-monetary uses equivalent to
the monetary value of the commodity.
• Ex: gold, silver, copper, shells, tobacco, oxen
• Fiat money
– A monetary standard (usually paper) that people
are required by law to accept as a medium of
exchange and/or a standard of deferred payment.
• Money by the "fiat"--the command--of the sovereign.
• Fiduciary money
– Based on transferable promises by bank to pay.
• Ex: bank notes, checks
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In the ancient world
• Division of labor and trade lead to
necessity of money for settling accounts
• In kingdom of Lydia, hunks of metal
stamped with picture of king
– First coins
– To ensure stability & quality control
• China, 1000 A.D.: innovation of printing
paper money
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In medieval Europe: Fred’s Bank
• Fred is a goldsmith who keeps his gold in a vault.
• Other people pay him a small fee to keep their gold in
his vault.
– This makes Fred’s vault a bank of deposit
• Fred gives his customers receipts for deposits.
• Customers begin to use receipts to settle accounts.
• Receipts begin to circulate as fiduciary money.
– People have faith (fides) that Fred will repay on demand.
– This makes Fred’s vault a bank of issue.
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Money creation & fractional reserves
• Fred notices that only some customers ask for gold
back in any given period.
• This means Fred can write more bank notes than he
actually has gold in bank.
• Writes notes as loans from bank; charges interest.
• Must be careful not to create so much money that if
depositors wanted gold back, vault would be emptied.
• So adopts reserve ratio: amount needed in bank for
every banknote (e.g.: 1/3)
• In fiduciary money system, amount of money in
circulation is generally a multiple of bank’s reserves.
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Problems faced by private banks
• If faith in bank falters, depositors and noteholders rush in and demand gold
– Hoping to collect before gold runs out
• Banks that failed this way not necessarily
insolvent, just illiquid
– Solvency: being owed more than one owes
– Liquidity: speed and certainty with which assets
can be turned into cash and transferred.
• Coin & banknotes very liquid: already cash
• Steel mill very illiquid: may take a while to sell, for
unknown amounts of cash.
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More problems of private banks
• Confidence
– Honest and prudent banks could fail due to panic
– Incompetent banks could fail from too many loans to
bad borrowers
– Dishonest banks could steal or conceal losses easily
• Competition
– To get business, banks could raise interest paid,
lower interest asked, and lend to riskier borrowers
• Each of these practices reduce safety & increase risks
• Needed help from government: regulation,
auditing, and ready source of emergency cash
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Prudential regulation
• Prudential: rules to ensure banks’ safety
– Private banks licensed by government
– Required to be audited, publish regular accounts,
submit to Central Bank supervision
– Kinds of business can and can’t do
– Minimum reserve ratio & form of reserves
• Notes, coins, Central Bank deposits, government bonds
and Treasury notes main forms
• Central Bank acts as lender of last resort
– Fact that it exists usually enough to prevent runs
• Some CBs can force sale of insolvent banks
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Economic regulation
• Measures to keep banks safe can also affect:
– Investment, employment, inflation, balance of
foreign payments, total supply of money and credit
• So governments do regulate banks and other
financial institutions for economic and social
purposes, by influencing:
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Rates of interest
Quantities and directions of lending
Amounts banks can borrow, how & from where
Dealings with foreign currencies, including
• rates of exchange, rights to buy or borrow foreign funds...
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Why credit markets don’t “clear”
• Rate of interest is the price of credit
– Price of using borrowed funds
• If rate of interest rises, demand tends to decline-but so does supply
– The lower the rate of interest, the more borrowers can afford
to pay it.
– The more sound borrowers there are, the more banks are
willing to lend.
• Credit rationing: At any rate of interest, there are
some borrowers lenders won’t trust.
– There is no market-clearing price
– So loan officers allocate loans administratively
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The central bank of the U.S.
• Federal Reserve System (the ”Fed")
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Established by Congress in 1913
Consists of 12 banks, one for each of 12 regions
Legally, cooperatively owned by member banks
Practically, governors appointed by Congress and
excess profits go to Treasury--so, branch of gov’t
– ”Member" banks have deposits in the Fed
• These deposits are part of the member banks' reserves.
– Bank reserves, federal reserve notes and deposits in
the Federal Reserve system are fiat money;
checking accounts are fiduciary money.
• Creation of fiduciary money is limited by the supply of bank reserves
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More about banks and reserves
• Bank reserves are obligations of the Federal
Reserve, including deposits and vault cash
• A bank that has excess reserves may be able to
create money and loan it
– by establishing a checking account in the amount of the loan
– Nevertheless, banks have to limit their lending to allow for
"clearing" through the Federal Reserve.
– Checks are "cleared" by the Fed by transferring deposits
from the issuing bank to the bank that deposits it
• An increase in reserves, for example by importing currency
from abroad, increases the total money supply by a
multiple of the increase in reserves
– The multiple is the inverse of the required reserve ratio.
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The Feds and the Money supply
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Money supply controlled by Open Market
Committee of the Federal reserve system:
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Increase in money supply:
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3.
4.
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The FOMC buys bonds.
It pays for the bonds with a check on the Fed.
The check is an addition to bank reserves.
With more reserves, banks create more money.
Decrease in money supply:
1.
2.
3.
4.
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The FOMC sells bonds.
The check written to pay for bonds is cleared through Fed.
This reduces bank reserves.
With less reserves, banks must cut back on money creation.
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Why control quantity of money?
• Price levels should be stable
• Quantity of money affects price levels:
– “quantity theory of money”
– Identity: M*V = p*RGDP
• Where M is money, V is velocity
– Velocity is defined as p*RGDP/M
– V is roughly constant--demand for money (M) is
proportional to nominal income (p*RGDP)
• Can also be written: p = M*V/RGDP
– So p is proportional to M, supply of money
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Money, the price level, & output
• Where the red line
intersects the green
curve is the equilibrium
price level, p.
• If M goes up without
fundamentals of
economy going up, only
result is that p goes up
(to p’).
– This is essentially
inflation.
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Velocity not quite constant
• 1/V is the amount of money people want to
hold, per dollar of purchases, for convenience
• Demand for money--convenience--balanced
against costs of holding money--opportunity
to earn interest.
• If interest rates go down, less costly to hold
money instead.
• The demand for liquidity (convenience) rises
when the interest rate (on non-liquid assets
such as bonds) drops.
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This helps Feds set interest rates
• Say Fed sets the total
quantity of money at Ma.
• Then people will try to shift
assets out of less liquid
accounts into liquid money
accounts as long as the rate
of interest is less than Ra…
• or in reverse, buy nonliquid
assets (bonds) whenever the
rate of interest is greater
than Ra.
• Competition pushes interest
to equilibrium rate of Ra.
• If Feds want rate of Rb,
expand money supply to Mb.
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(on bonds)
liquidity
preference
curve
(cash &
checking)
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Same slide, different words
• Bonds and money are
substitutes
• If bonds become more
attractive, money becomes less
attractive (and v.versa)
• Higher interest rates make
bonds more attractive
• If money supply is at Ma but
interest rate is at Rb, people
don’t find bonds that attractive
• So they try to sell their bonds
• To sell bonds, they attempt to
make the bonds more attractive
• This drives the interest rate up
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(on bonds)
liquidity
preference
curve
(cash &
checking)
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A liquidity trap?
• In the diagram, the demand for money increases
without any limit as the interest rate falls toward Rt.
(No one wants bonds.)
• Thus, no matter how much the Fed increases the
money supply, it could never push the interest rate
below Rt.
– Rt is called a "liquidity trap."
– In any case, interest rates can never go lower than zero
– Japanese economic system in late 1990's behaved like it
was at the "liquidity trap" interest rate level.
• Japanese interest rates in late 1990's were sometimes so low
that the zero lower limit would be relevant.
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Some historical notes of interest
• Plato and Aristotle reckoned that charging interest
was "contrary to the nature of things.”
• Cato considered it on a par with homicide.
• For many centuries, the Catholic Church regarded as
sinful the charging of any interest by lenders and it
was not allowed in Catholic countries.
– Jews were exempted, provided they did not charge
excessive rates.
– According to Pope Benedict XIV, in 1745, interest should be
regarded as a sin because "the creditor desires more than
he has given".
• England in 1545 removed the prohibition on interest
charges and fixed a legal maximum interest
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Marxist critique
• Marx distinguished between:
simple commodity exchange
– where people used markets to meet their needs in
use, and
capitalist commodity exchange
where the aim was to increase the stock of money
through profit.
•
•
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C-C’: Barter
C-M-C’: Simple Commodity Exchange
M-C-M’: Capitalist Commodity Exchange
M-M’: A modern extension of Marx: paper economy
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What is capital?
• Capital is wealth used to make more wealth.
• Wealth is all resources having economic value.
• Value is worth in general, but it tends to be measured
in a universal equivalent, that is,
• money.
– So the essence of capital is that it is wealth (usually money
in some form) capable of increasing its value.
• The modern term capital derives from a medieval
banking expression implying an amount of money
which grows through accumulating interest.
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Other financial systems: Islamic
• The core: prohibits the receipt and payment of
interest
– riba: predetermined, guaranteed rate of return
• Other principles of Islamic doctrine:
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risk sharing (suppliers of funds are investors, not creditors),
individuals' rights and duties,
property rights,
the sanctity of contracts (information sharing a sacred duty),
money as “potential” capital--actual only when joined with
other resources for productive activity
– prohibition of speculative behavior; only shariah-approved
investment activities
• Can’t make investment in alcohol, casinos, etc.
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Islamic financial instruments
• Trade with markup or cost-plus sale (murabaha)
– Incorporate mutually-negotiated markup
– Account for around 75% of Islamic financial transactions
• Leasing (ijara)
– Accounts for 10% of transactions; can lease-to-own
• Profit-sharing agreement (mudaraba)
– Investment fund; manager has incentives but limited liability
• Equity participation (musharaka)
– Analogous to a classical joint venture
• Sales contracts
– Deferred-payment sale (bay' mu'ajjal) and deferred-delivery
sale (bay'salam)
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Other systems: local currency
• Local communities can issue their own currency
(scrip)
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Popular during Great Depression of 1930s
Backed by local community
Must be used locally
Stimulates local production and trades
Creates new short-term credit for productive purposes
Can provide jobs for the underemployed
Legal as long as it is exchangeable for dollars so that
transactions can be recorded for tax purposes
– Decentralization and diversity have the benefit of preventing
large-scale failure
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