Economics for CED

1
Economics for CED

• Noémi GiszpencSpring 2004Lecture 8 Macro The
  Financial System
• May 25, 2004

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 countrys 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
• 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
• 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 cowrieshell
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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 Freds 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 Freds 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 Freds 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 banks
  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 cant 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 dont 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 wont 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
  govt
• 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
  moneychecking 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
• 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
• 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 MV pRGDP
• Where M is money, V is velocity
• Velocity is defined as pRGDP/M
• V is roughly constant--demand for money (M) is
  proportional to nominal income (pRGDP)
• Can also be written p MV/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.

(on bonds)
liquiditypreferencecurve
(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 dont 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

(on bonds)
liquiditypreferencecurve
(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.
• 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
• Cant 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