Transcript The function of financial markets

INTRODUCTION TO MONEY,
FINANCIAL INTERMEDIATION
AND FINANCIAL CRISES
Professor Lawrence Summers
October 1, 2015
Agenda
• The function of financial markets
• International capital flows
• Banking crises game
Function of financial markets: flow of
funds from savers to borrowers
• There are people who want to save to meet subsequent
needs (smooth their consumption)
• And there are businesses that have the opportunity to take a
dollar today and turn it into more than a dollar tomorrow
• The function of the financial system is to bring them together
• There are risks: financial markets help share and pool the
risks
Function of financial markets: flow of funds
Direct Finance
Funds
•
•
•
•
Lenders/Savers:
Households
Firms
Government
Foreigners
Financial Markets
(e.g. Stock exchange)
Returns
Borrowers/Spenders:
• Firms
• Government
• Households
• Foreigners
Indirect Finance
Deposit
Deposits
+ Interest
Financial
Intermediaries
(e.g. Bank, Insurance
co., Mutual fund,
Venture Capital co.)
Loans
Interest
++++
Interest
Inter-temporal optimization
MRS = Marginal rate
of substitution
r = interest rate
Future consumption
The optimal (C1,C2)
is where the
budget line
just touches
the highest
indifference curve.
C2
At the optimal point,
MRS = 1+r
O
Present consumption
C1
Source: Macroeconomics, N. Gregory Mankiw
Now, considering inter-temporal production
Intertemporal Production Possibility Frontier
Future
consumption
Represents trade-off between present and
future production of a consumption good.
Present
consumption
Source: International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld
Future consumption
Production and consumption are both
affected by changes in interest rates
Intertemporal
indifference curve
Intertemporal PPF
Intertemporal budget line
Present consumption
Slope determined
by interest rate
Why do we need financial intermediaries?
Why can’t those with savings just lend directly to borrowers?
• Pooling Savings: Most savers deposit small amounts; banks pool savings to
make large loans.
• Risk Diversification: Savers lending to individual borrowers face risk of total
loss if borrower defaults. Bank spreads risk and ensures return to saver.
• Liquidity Transformation: Banks make long-term loans, knowing that only
some depositors will want their money back during each short-term period.
• Asymmetric Information: Banks specialize in screening borrowers for
creditworthiness, processing and sharing information.
Examples of financial intermediaries
Intermediary
Primary Liabilities
Primary Assets
Commercial banks
Deposits
Business and consumer loans,
mortgages, US government securities,
municipal bonds
Savings and loans
Deposits
Mortgages
Mutual savings banks
Deposits
Mortgages
Credit Unions
Deposits
Consumers loans
Life insurance companies
Policy premiums
Corporate bonds and mortgages
Fire and casualty insurance companies
Policy premiums
Municipal bonds, corporate bonds,
stocks, US government securities
Finance companies
Commercial paper,
stocks, bonds
Consumer and business loans
Mutual funds
Shares
Stocks and bonds
Money market mutual funds
Shares
Money market instruments
Deposit-taking institutions (banks)
Contractual savings institutions
Investment Intermediaries
Fractional reserve banking
• Most of the time, only a small fraction of bank’s total
deposits will be demanded on given day.
• Banks lend out some of the deposits and keep just enough
cash reserves on hand to deal with day-to-day demands.
• Advantages:
• Bank income from loan interest can reduce depositor fees
• Provides financial intermediation
Agenda
• The function of financial markets
• International capital flows
• Banking crises game
Capital will flow from places where it is abundant to
places where it is scarce
• International capital flows are driven by expected (risk-adjusted) returns that can
be earned.
• As a result, capital should flow where it will be the most productive.
• Diminishing marginal product of
Marginal Product
of Capital
capital  investing a unit of capital
is more productive where it is scarce
than where there is already a lot of
capital.
• So capital will flow from places
where it is abundant to places
where it is scarce.
Capital
Multinational corporations play a major
role in international capital flows
• International capital flows can take the form of borrowing and lending, or of
foreign direct investment: where a firm in one country creates or expands a
subsidiary, production facility etc. in another country.
• Why do multinational corporations exist?
• Location: Why is a good produced in many different countries rather than one?
Resource abundance, economies of scale, transport costs, trade barriers are all factors
that help determine where it is most efficient for a good to be produced.
• Internalization: why is production in different locations done by the same firm, rather than by
different firms?
If transaction costs between different firms are too high then it is more profitable to carry
out transactions within one firm. Particularly important with technology transfer and vertical
integration.
In a Closed Economy:
National Savings equals National Investment (S = I)
1.
Y = C+I+G
National Income =
Consumption (C) + Investment (I) + Government Spending (G)
2.
Y–C–G=I
3.
Define National Saving (S) = Y – C – G
S= I
National Savings = National Investment
In a closed economy: what is not consumed (i.e. what is saved) is
invested.
Closed Economy: all goods and services
are produced and consumed domestically
Production
Producer Income
Spending and
Saving
Consumer Spending
and Saving
Closed Economy: What is not Consumed
(i.e. Saving) is Invested
Investment
National Savings
=
National Investment
Saving
Production
Spending and
Saving
Sales
Consumption
Producer Income
Consumer Spending
and Saving
Open Economy: Can borrow from/lend to rest of world.
Trade Balance = National Income – National Spending
National Income = Y = C + I + G + X – M
X – M = Trade Balance in Goods and Services
= Current Account
“Strictly, Current Account includes factor incomes and
transfers but we will mean X - M”
National Expenditure (Spending) = E = C + I + G
National Income – National Expenditure = X – M
Open Economy:
Trade Surplus is Income that is not Spent
Net Exports = X – M
Trade Surplus
Exports
Imports
Domestic Sales
of Domestic
Products
Income
Domestic
Purchases of
Domestic
Products
Expenditure
Income exceeds Expenditure by the Current Account Surplus = Net Foreign Lending
Difference between National Income and
Expenditure change in Net Foreign Assets
• Country with a deficit is spending more than its income by
either increasing its net foreign debt or reducing its net
foreign assets.
• Country with a trade surplus is either reducing its net
foreign debt or increasing its net foreign assets.
Trade Balance = Saving - Investment
Y=C+I+G+X–M
Y–C–I–G =X–M
(Y – C – G) – I = X – M
Define national saving S = Y – C – G
S–I=X–M
National Saving – National Investment = Trade Balance
S = Sp + Sg
National Saving = Private plus Government Saving
Agenda
• The function of financial markets
• International capital flows
• Banking crises game
An illustrative game:
Strategy A:
Win $1 if all play A,
Lose $10 otherwise
Strategy B:
0
Which strategy do you choose, A or B?
A. Win $1 if all play
50%
50%
W
in
$1
if
a
ll
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fo
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$0
pl
a
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, lo
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in
A, lose $10
otherwise
B. $0 for certain
Strategy A or B?
A. Win $1 if more
50%
50%
W
in
$1
if
m
or
e
su
r
fo
r
$0
th
an
90
%.
..
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than 90% of the
class plays A.
Lose $10
otherwise
B. $0 for sure
Strategy A or B?
A. Win $1 if more
50%
50%
W
in
$1
if
m
or
e
su
r
fo
r
$0
th
an
80
%.
..
e
than 80% of the
class play A.
Lose $10
otherwise.
B. $0 for sure