Economics for CED

Economics for CED Noémi GiszpencSpring 2004Lecture 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. Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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... Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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) Economics for CED: Lecture 8, Noémi Giszpenc

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 (on bonds) liquiditypreferencecurve (cash & checking) Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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. Economics for CED: Lecture 8, Noémi Giszpenc

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) Economics for CED: Lecture 8, Noémi Giszpenc

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 Economics for CED: Lecture 8, Noémi Giszpenc

Economics for CED