How is Saving Allocated?

1
How is Saving Allocated?
2
Direct versus Indirect Financing

• Direct Savers and borrowers link directly
• Indirect An intermediary channels funds from
  saves to borrowers.
• Bank Borrowing
• UK 70
• Japan 65
• US 30 (Over 50 through foreign banks!)

3
Efficient Financial Intermediation

• An efficient system reduces x-inefficiency costs.
• Intermediaries make pooling of funds possible
  and, therefore, economies of scale and risk
  pooling.
• Intermediaries can reduce information asymmetries
  and other market failures.

4
Potential for Misallocation of Capital

• There is a potential for unfettered capital
  markets to misallocate capital
• Intermediaries undermine domestic policy
• Financial market shocks increase
• Greater potential for contagion.
• Loss of Economic Growth
• Evidence on the latter

5
Market Failures

• Asymmetric Information Possession of
  information by one party that is not available to
  a another party of the transaction. Can lead to
• Adverse Selection Those least worthy most likely
  to borrow.
• Herding Behavior Savers follow someone they
  feel is better informed.

6
Market Failures

• Moral Hazard Borrower engages in riskier
  activity once the financing is in place.
• Moral hazard can result from information
  asymmetries or from national government or
  international organization guarantees.
• Policy Created Distortions
• Differential taxes, regulations, tariffs
• Regulatory Arbitrage

7
Conclusion

• Potentially large allocative and efficiency gains
  to be enjoyed from capital market liberalization.
• Policy-created distortions and market failures
  must be addressed.

8
Payments Systems Risks

• Liquidity Risk The risk of loss that may occur
  when a payment is not received when due.
• Credit Risk The risk of loss that may occur when
  one party fails to abide by the terms of an
  agreement.
• Systemic Risk The possibility that liquidity
  risk or credit risk may affect a third party.

9
System Risk

• Systemic Risk involves a negative externality.
• Herstatt Risk Liquidity, credit, and systemic
  risk across international borders.
• Term comes from the events surrounding the
  failure of the Herstatt bank in 1974.
• G10 nations developed a netting arrangement to
  minimize Herstatt risk (early 1990s).

10
Central Bank Functions

• Fiscal Agents
• Bankers Bank
• Lenders of Last Resort
• Macroeconomic and Monetary Policy Makers
• Exchange market intervention
• Monetary policy

11
The Monetary Base and the Money Stock
12
The Monetary Base

• A nations monetary base can be measured by
  viewing either the assets or liabilities of the
  central bank.
• The assets are domestic credit (DC) and foreign
  exchange reserves (FER).
• The liabilities are currency in circulation (C)
  and total reserves of member banks (TR).

13
Simplified Balance Sheet of the Central Bank
Assets
Liabilities
Currency (C)
Domestic Credit (DC)
Foreign Exchange Reserves (FER)
Total Reserves (TR)
Monetary Base (MB)
Monetary Base (MB)
14
Money Stock

• There are a number of measures of a nations
  money stock (M).
• The narrowest measure is the sum of currency in
  circulation and the amount of transactions
  deposits (TD) in the banking system.

15
Money Multiplier

• Most nations require that a fraction of
  transactions deposits be held as reserves.
• The required fraction is determined by the
  reserve requirement (rr).
• This fraction determines the maximum change in
  the money stock that can result from a change in
  total reserves.

16
Money Multiplier

• Under the assumption that the monetary base is
  comprised of transactions deposits only, the
  multiplier is determined by the reserve
  requirement only.
• In this case, the money multiplier (m) is equal
  to 1 divided by the reserve requirement,
• m 1/rr.

17
Relating the Monetary Base and the Money Stock

• Under the assumptions above, we can write the
  money stock as the monetary base times the money
  multiplier.
• M m?MB m(DC FER) m(C TR).
• Focusing only on the asset measure of the
  monetary base, the change in the money stock is
  expressed as
• ?M m(?DC ?FER).

18
Example - BOJ Intervention

• Suppose the Bank of Japan (BOJ) intervenes to
  strengthen the yen by selling 1 million of US
  dollar reserves to the private banking system.
• This action reduces the foreign exchange reserves
  and total reserves component of the BOJs balance
  sheet.

19
BOJ Balance Sheet
Assets
Liabilities
C
DC
FER
TR
-1 million
-1 million
MB
MB
-1 million
-1 million
20
BOJ Intervention

• Because the monetary base declined, so will the
  money stock.
• Suppose the reserve requirement is 10 percent.
  The change in the money stock is
• ?M m(?DC ?FER),
• ?M (1/.10)(-1 million) -10 million.