Economic Analysis for Business

Economic Analysis for Business Chapter 16 The Financial System

The financial system • financial system is designed to: • provide a haven for those who wish to save • transfer those savings to investors • attempts to offer a safe harbour for that part of each person’s income whose expenditure is to be postponed • postponed present consumption constitutes saving

Saving is postponed consumption • the postponement of present consumption allows part of the productive apparatus of an economy (land, labour, capital) to be used to produce – that is, it is for commercial use • if all incomes were immediately spent by those who earned those incomes to buy goods and services for immediate consumption, no part of the productive structure of an economy would be available to produce investment goods

Saving flows • aim of saving for the saver is to postpone the decision to purchase consumption goods • during each period: • there are individuals adding to the savings pool by not consuming • there are others adding to consumer demand by drawing on their savings • savings are incomes earned but not spent by those who have earned those incomes • funds are instead placed into savings institutions who lend those funds to others

Incomes Saving Investment Basic saving/investmentframework Purchasing power moves in and out of saving

Saving is Investment • everyone receives money for their productions, but the money represents a share of the goods and services produced • in exactly the same way, the act of saving by an individual appears to be nothing other than placing money into a financial institution • from a global economic point of view, saving means the use of the economy’s productive capabilities by individual other than the person who earned the income

To save is to spend • to save is to spend, but on a different set of goods chosen by someone other than the person who had originally earned the income • where savings are borrowed by business, those savings are made up of the capital goods that the existence of savings has allowed business firms to create

For an economy saving is production • saving is production • those who are doing the saving only see the money side of it • just as those who produce anything are seldom if ever paid with the products they have produced

Savings can be borrowed by consumers and governments • savings can also be borrowed by others besides investors which include: • those who wish to borrow to buy consumer goods and • governments who may wish to invest themselves

Incomes Consumers Saving Investment Government Flow of Saving to All Potential Users Direction of savings

Government productivity • government use of funds is in theory potentially as productive as the monies spent by private sector investors • funds borrowed by governments are seldom repaid out of the revenues earned on the projects themselves but from general revenue • general economic expansion is how governments justify borrowing the nation’s savings

Market testing of government projects • no market test of value or productiveness of government projects • in private sector, firms that cannot repay debts disappear • in public sector, result is higher tax and higher inflation • the more government has use of a nation’s savings, the less available for use by private sector • that is, the more government has use of the nation’s resources, the less for private sector

Interest rates are a price • interest rates are a price • in the first instance the price of borrowed money • but money represents command over goods and services • when one borrows money, one is actually gaining access to a proportion of the goods and services produced within the economy

Why interest? • interest is a payment for the use of someone else’s purchasing power • a price paid just as for any other item of property used by another • interest is similar to rent • lending money gives others access to goods and services they would not otherwise be able to make use of themselves

Interest represents competition for capital • need to ensure those who use borrowed funds are the optimal users of those fund from an economy wide perspective • willingness to pay higher interest if matched against a proper assessment of the uses for which the funds will be put will tend to allow money and capital to flow to those who will make the greatest economic return

Interest and risk • embedded into each interest rate charged a risk premium • this risk premium takes into account • the likelihood that the money will be repaid • or the length of time over which the money is to be borrowed • the less risky the lender or the shorter the period of time, the lower the interest rate will tend to be, all other things being equal

Many interest rates - not just one • there is not just one interest rate in an economy but a great many • a different process of interest rate setting for just about every form of borrowing • the greater the perceived risk, ceteris paribus, the higher the interest rate charged

Interest rates and inflation • the aim in lending money out is to receive in return • at least as much in purchasing power as was lent out • plus the interest earned which itself will contain a risk premium • inflation reduces the purchasing power of money

Effect of inflation • when inflation is running at 5%, if lenders are to receive in return at least as much in value as was lent out, the interest rate must include that 5% inflation premium • it is the expected rate of inflation that matters

Factors determining interest rates • the scarcity (supply) of available savings • the competing demands for those savings • the time period during which the funds are to be borrowed • the risks involved and the probability of being repaid in full • the expected rate of inflation

Natural Rate of Interest S r D Q (resources ) Q Natural rate of interest Supply and demand for real resources (land, labour, capital)

Assume a single rate of interest • the assumption of a single rate of interest is made to simplify the analysis • the rate can be seen as the representative rate

Market rate of interest • market rate of interest is determined by the financial system • no one trying to borrow is unaware of what this rate is • directly received are sums of money which can be used to buy capital

Banks and money • banks create money • have an ability to increase the supply of money and credit well beyond the increase in the actual level of savings • banks can create an account where none had existed before or add money to an existing account

Determining market rate of interest • determination of interest rates in the market for credit and money • demand curve may not be much different either in shape or concept from the demand for savings generally • supply curve is different • more important, the ceteris paribus conditions of supply are potentially very different

Money Rate of Interest S i D Q (money and credit) Q The market rate of interest Supply and demand for money and credit

Determination of the money supply • supply of money and credit determined jointly by central bank in collaboration with the economy’s banking system • two elements determine the extent an economy’s money supply may grow: • the level of base money in an economy • the reserve ratio imposed on the banks by either law or central bank regulation

Base money • banks compelled by law to maintain a particular proportion of its funds in liquid form • Liquid - in a form easily convertible into the medium of exchange or is in fact the medium of exchange • extremely liquid forms are the base money of an economy • most important parts of base money are: • notes and coins in the local currency or • deposits by the banks with the central bank

Reserve ratio • banks hold only a small fraction of the value of their deposits in highly liquid form • most of the assets of a bank are in the form of loans • proportion of loans a bank is compelled by law to hold in liquid form is the reserve ratio

Effect of reserve ratio on money supply • suppose banks compelled to hold 10% of their deposits as liquid assets • for every $100 of deposits, they would be compelled to hold only $10 in cash or other reserve assets • if ratio falls, the amount of deposits can increase • if ratio rises, the amount of deposits will fall

Size of the money supply • size of the money supply depends on: • the amount of base money entering the economy • the money placed in banks and other financial institutions by depositors • the reserve ratio of the banking system which determines the maximum extent a bank can lend relative to its deposit base • the amount of money lenders wish to borrow

Increasing the money supply • raising the supply of money can occur in any of the following situations: • an increase in base money • an increase in deposits • a fall in the reserve ratio • an increase in the amount of money borrowed

Open Market Operations • central banks can manipulate the flow of base money using open market operations • to put more cash into the hands of the public through buying bonds • the public ends up with fewer bonds but more money • to reduce money supply can sell bonds • public has more bonds but less money

Government spending and deficits • amount of base money is also affected by government spending and tax policy • high spending, low taxes and budget deficits increase the amount of base money • less spending, high taxes and a budget surplus pull money out

Varying the deposit ratio • central bank can influence the level of loans through variations in the deposit ratio • to increase the money supply, the ratio can be lowered • to diminish the money supply, the ratio can be raised

State of the economy • amount of money lent out depends on willingness of banks to lend and the relative optimism or pessimism of those who might be inclined to borrow • as an economy slows and pessimism spreads less desire to borrow and the banks become more reluctant to lend • when conditions improve there is an increase in the demand for loans and financial institutions become more willing to lend their funds out

Supply of money not a fixed constant • the notion that there is some amount of money that is “the” money supply is untenable • money supply continues to change all the time through design or the ebb and flow of economic activity • manipulation of money supply to vary interest rates one of the most important causes of economic instability • policies to bring stability into the financial system and discipline monetary authorities remain elusive • business cycle certain to remain

Saving and Investment Market Rate of Interest Natural Rate of Interest S Saving r i D Invest Q I Q I1 Market Rate and Natural Rate together Equilibrium

Saving and Investment Market Rate of Interest Natural Rate of Interest S S2 Saving i i2 r r2 D Invest I Cr Cr2 Sv Inv q Increasing the Supply of Money Excess Demand for Real Resources of the Economy

Consequences when market rate below natural rate • Consequences of natural rate below real rate: • higher inflation • slower economic growth • inefficient investments • inflation of asset prices (the “bubble” economy)

Government demand for savings • part of the demand for savings comes from governments • an increased demand by government • pushes outwards the demand curve for savings and • pushes upwards the rate of interest

Crowding out • higher interest rates lead to a lower private investment • the effect of a higher level of public sector expenditure is a fall in the level of private sector business investment • this process is referred to as crowding out

Crowding out includes deficit financing • crowding out includes outlays by government that require public sector deficits • any part of available capital absorbed by governments the less available for others • perfect crowding out occurs where every dollar of increased public borrowing leads to a fall of one dollar in private sector investment

Government spending and deficit finance • the great inflations due to large increases in liquidity caused by increases in public spending unfunded either by taxation or borrowing from the public • governments can spend monies they do not have • governments can therefore create inflation • firstly through their own spending • secondly, through their ability to create the liquidity • difficult to sustain inflation without deficit finance

Consumption Saving C Investment I Production Possibility Curve with consumption and investment Saving is Non-Consumed Production

Consumption Taxation Saving C Investment plus Government I+G Production Possibility Curve with C, I and G Government spending absorbs savings

Private Investment I1 I2 Government G1 G2 Private investment versus government spending Business and government compete for savings

Natural Rate of Interest S2 S r2 r D Q (saving) I2 I Effect of Crowding Out Available savings for private investment falls

Effect on growth • government spending far less productive than private sector investment • government spending often unproductive, wasting resources under its control and creating less value than used up in its productions • one of the serious flaws of Keynesian economics is that it treats public spending as an equivalent to private

Economic Analysis for Business