Economics for CED Noémi Giszpenc Spring 2004 Lecture 8: Macro: The Financial System May 25, 2004

Economics for CED

Noémi GiszpencSpring 2004

Lecture 8: Macro: The Financial System

May 25, 2004

Spring 2004 Economics for CED: Lecture 8, Noémi Giszpenc

2

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:– 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?• Something that people generally accept in exchange for a

good or a service. • Money performs four main functions:

1. a medium of exchange for buying goods and services; 2. a unit of account for placing a value on goods and services; 3. a store of value when saving; 4. a standard for deferred payment when calculating loans.

• Any item which is going to serve as money must be: – 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. 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 note-holders 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: – 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")

– 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

• Money supply controlled by Open Market Committee of the Federal reserve system:

– Increase in money supply:1. The FOMC buys bonds. 2. It pays for the bonds with a check on the Fed. 3. The check is an addition to bank reserves. 4. With more reserves, banks create more money.

– Decrease in money supply:1. The FOMC sells bonds. 2. The check written to pay for bonds is cleared through Fed. 3. This reduces bank reserves. 4. 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.

liquiditypreferencecurve

(on bonds)

(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

liquiditypreferencecurve

(on bonds)

(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 exchangewhere the aim was to increase the stock of money through profit.

• 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:– 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)– 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

Documents

Economics for CED Noémi Giszpenc Spring 2004 Lecture 8: Macro: The Financial System May 25, 2004