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Finance and Banking NAKEcourse Robert Lensink and Elmer Sterken RuG


Bank supply loans and loan demand may suffer from net-worth problems (the balance sheet effect) ... R=tD. Reserves. Central bank. Households. Firms. Banks ... – PowerPoint PPT presentation

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Title: Finance and Banking NAKEcourse Robert Lensink and Elmer Sterken RuG

Finance and BankingNAKE-courseRobert Lensink
and Elmer SterkenRuG
  • Lecture 1
  • The Credit View

Course outline
  • Two sections Micro (RL) and Macro (ES)
  • Micro-section (1) equilibrium and rationing in
    credit markets, (2) adverse selection and
    signaling, (3) collateral as a sorting device,
    (4) financial contracting control, (5) the
    optimal number of creditors and duration
  • Macro-section (a) the credit view a special
    role for loans, (b) credit frictions in general
    equilibrium, (c) the financial accelerator, (d)
    banking and monetary transmission, (e) finance
    and growth

Finance and Banking in Macro
  • Arrow-Debreu world no relevance of financial
    structures (think of Modigliani-Miller), no role
    for banks, no money
  • Macro quest for relevant imperfections
    information problems (missing markets, stickiness
    of prices) or imperfect competition and improper
  • This lecture information problems (credit
  • Both imperfect information and imperfect
    competition issues lead to the relevance of
    finance, financial structures, and theory of
    financial intermediation

Macro General Outline
  • The Credit View loans are special!
  • General equilibrium models of net worth
  • The Financial Accelerator
  • Is private bank behavior itself relevant for
    monetary transmission?
  • Empirics of the credit view
  • Banking, finance, and growth

Basic Macro Hicksian IS-LM
  • Economy can be described by the goods market
    (savings and investment), money market (money
    supply by the central bank and private banks and
    money demand), and the bond market
  • Equilibrium is obtained via adjustment of output
    and the rate of return on bonds
  • Money is special it can be controled by monetary
    authorities. There are no near-monies of any
    importance, so adjustment of the money stock is a
    strong instrument
  • All long-term assets are perfect substitutes
    bonds, equity, private placements, loans. We can
    simply use one interest rate
  • We will depart from this view and show that
    financial assets are special in particular loans

Critique on IS-LM McCallum and Nelson (JMCB,
  • Fixed price level ? today there are micro
  • No distinction between the nominal and expected
    real interest rate ? we need an explicit role for
  • No recognition of enough distinct assets ? one of
    the subjects of this lecture
  • Only short-run analysis permitted ? we will see a
    DSGE model based on the financial accelerator
  • The capital stock is fixed ? we will see models
    that focus on capital decisions
  • Not derivable from explicit maximizing analysis
    by rational economic agents ? we follow a New
    Keynesian strategy

Tobins General Equilibrium Approach to Monetary
  • Why would agents substitute out of money into
    bonds only? Why not in real capital (Tobin)? Or
    in consumer durables (Friedman)?
  • Agents do, so money stimulates capital, see
    hereafter for a short outline of the so-called
    Tobin model
  • Why are some assets perfect substitutes and
    others not? Start from the idea that assets are
    imperfect substitutes
  • Is financial behaviour modelled consistently? Are
    adding-up constraints and balance sheet
    conditions guaranteed?

Is money neutral? The
Tobin effect
  • The idea is simple agents hold portfolios of
    real money and capital. If the growth rate of
    money supply increases, inflation rises, reducing
    the return on money and shifting the portfolio
    from money to capital
  • It is simply money in the Solow growth model, but
    with strong implications
  • There is no optimizing behavior of agents
    savings are exogenous. The Tobin model yields
    neutrality of money, but not superneutrality.
    Note money in the Ramsey growth model yields
    superneutrality, see Sidrauski, 1967

Tobin effect (2)
  • Household wealth in money m or capital k (all
    lower case symbols represent per capita
  • There is a savings and a portfolio decision
  • Production per capita y f(k)
  • a ? k m is total wealth
  • In the steady state sf(k) (1 - s)?1nk,
    derivation skipped, where ? m/k is the
    portfolio composition, s the savings ratio, n the
    growth rate of population and n n/(1 n)

Tobin effect (3)
  • The share of real money in the portfolio is
    assumed to be negatively related with inflation
    inflation is the net negative return on money.
    Higher inflation therefore leads to a higher
    steady state capital stock
  • Money M is neutral, since M does not affect the
    steady state, but not superneutral, since
    inflation does have an impact on the real

Effects of money growth
? 0.4
? 0.2
Tobin effect
  • ? m/k depends negatively on the yield on k
    (which is fk r) and positively on the yield on
    m (which is -?/(1 ?)), so negatively on ?. A
    higher inflation therefore implies a lower ?
  • This will lead to a higher k in the steady state,
    so money stimulates capital (assuming savings are
  • One can see this as a basic model of imperfect
    substitution between money, bonds, and equity
  • Main disadvantage no micro foundation of savings
    behavior s

Tobin, JMCB (1969)
  • General equilibrium approach to monetary theory
    real decisions should be integrated with
    financial decisions. Financial structure is
  • Start from an accounting framework that embeds
    balance sheets per sector and market clearing
  • Assume behaviour by various sectors, constrained
    by adding-up constraints and clearing conditions
  • The Tobin framework provides a first idea of the
    credit view through imperfect substitution,
    although Tobin still gave a special role to money
    (and its impact on capital)
  • The crucial assumption is imperfect
    substitutability of assets. But what are the
    foundations of these low degrees of
    substitutability? Problems in deriving expected

Accounting framework
Net total holdings
Consistency and adding-up restrictions on
portfolio models For each interest rate the
portfolio equations add up to 0 For wealth to
1 Across assets imperfect substitution
National wealth
Net worth
Money and output
  • The Money view is in the core of IS-LM changes
    in money supply lead to changes in bond prices
    and so affect investment finance. Money is
    special, while loans are indistinguishable from
    other long-term assets
  • Imperfect substitution with other assets leads to
    additional channels e.g. via equity or loans
  • The credit view builds on the special properties
    of loans most importantly the private nature

A further appraisal of the money view Inside The
Black Box
  • It is hard to find a quantitatively important
    effect of the neo-classical cost of capital
    variable e.g. on investment. This troubles the
    IS-LM model
  • Monetary policy has an impact on short-term
    interest rates, but the main transmission (e.g.
    housing) is via the long-term rate. This seems to
    be in contradiction with basic IS-LM thoughts

Inside The Black Box The Four Empirical Facts
  • Unanticipated monetary tightening has a
    transitory impact on interest rates, but
    sustained influence on real output and the price
  • Final demand falls quickly, but production
    follows with a lag, so inventories increase
  • After a contraction residential investment falls
    sharply, followed by consumption
  • Fixed business investment decreases, but it does
    so with a lag (and after housing and consumer
  • So how to deal with these stylized facts?

Inside The Black Box
  • Information problems lead to a wedge between cost
    of funds raised externally and the opportunity
    costs of internally generated funds. Wedge
    External Finance Premium (EFP)
  • Two channels (1) the balance sheet channel the
    role of net worth in setting the EFP, (2) the
    bank lending channel banks cannot replace lost
    deposits with other sources of funds
  • In all cases there is special interest in private
    contracts. Probably the private character of
    these financial products also explains the time
    lags found in the empirics

The Credit View in general
  • Equilibrium rationing in loan markets is likely
    this makes assets of banks even interesting as
    liabilities (money)
  • Adverse selection, moral hazard, and costly state
    verification are the micro-foundations of the
    rationing problems
  • Money versus credit the Bernanke-Blinder model
    is a simple illustration

Equilibrium credit rationing
  • Some borrowers demand for credit is turned down,
    even if this borrower is willing to pay all the
    price and non-price elements of the loan contract
    (Baltensperger, 1978)
  • The price ( interest rate) mechanism works at
    all times
  • Contrast to disequilibrium rationing, like in the
    Availability Doctrine (Radcliffe report)

Two types of rationing
  • Type I An agent cannot borrow the amount she
    wants at an existing interest rate. An entire
    group of applicants is excluded redlining
  • Type II Some borrowers from an observationally
    identical group are able to get a loan, while
    others are not

Backward bending supply curve
  • Expected return on a bank loan is not a monotonic
    function of the nominal rate of the loan
  • Monopolistic bank offers the maximum interest
    rate R
  • Monopolistic bank may decide to ration credit
    above a certain level of the interest rate the
    pool of applicants might get too risky

Backward bending supply
Supply curve
Information asymmetry in the credit market
  • Ex ante adverse selection the contract design
    affects the group of loan applicants screening
    might help
  • During the contract moral hazard the behavior
    of the applicants changes after signing the
    contract monitoring helps
  • Ex post costly state verification. Auditing is
    an instrument

Simple example of credit in macro
Bernanke-Blinder (1988)
  • IS-LM assumes money is special. Money has no
    close substitutes and can be isolated in policy.
    The bond market is redundant by Walras Law.
  • Bonds include also loans and all kinds of private
    contracts and must so be considered to be a very
    rough capital market asset
  • The Stiglitz-Weiss literature demonstrates that
    credit deserves more attention. So there is a
    further analysis of the bond market what is the
    role of private versus public contracts?

Bernanke-Blinder (2)
  • Credit view credit is special loans! Bank
    supply loans and loan demand may suffer from
    net-worth problems (the balance sheet effect)
  • Information problems in financial markets make
    credit special
  • Credit-GNP relationship is more stable than
  • There is no direct assumption on credit rationing
    (see for this type of literature the credit
    availability doctrine (Radcliffe report in the

Bernanke-Blinder (3)
  • There is a choice between bonds and loans, r is
    the interest rate on loans, i on bonds
  • Loan demand Ld L(r, i, y), with y being GNP
  • Bank balance sheet Reserves (R) loan supply
    (Ls) required reserves (t D) excess reserves
    (E) deposits (D)

Tobinesque overview
Bernanke-Blinder bank behavior
  • Loan supply Ls l (r, i) D(1 - t)
  • Bond demand Bb b (r, i) D(1 - t)
  • Excess reserves demand E e(i) D(1 - t)
  • with adding-up restrictions on l, b, and e
  • Loan equilibrium L(r, i, y) l(r, i) D(1 - t)
  • Deposit supply is 1 / (e(i) (1 - t) t) R
    m(i) R
  • R tD

Money and goods market equilibrium
  • Deposit demand D D(i, y)
  • Equilibrium D(i, y) m(i) R, where m(i) is the
    money multiplier
  • Bond market is the Walrasian market
  • Goods market y Y(i, r)

Solution of the model
  • Substitute the equilibrium solution of
    D(i, y) m(i) R into the loan market
    equilibrium L(r, i, y) l(r, i) D(1 - t) and
    solve for r r f(i, y, R)
  • fi gt 0 as long as the money multiplier is not
    too interestelastic, fy gt 0, fR lt 0
  • Substitute r f (.,.,.) into the IS-curve to get
    y Y (i, f (i, y, R) )
  • Yi lt 0 the Commodities and Credit (CC)-curve

CC-LM model monetary expansion
  • CC-curve is affected by changes in reserves R,
    while the IS-curve is not
  • CC-curve becomes the IS-curve again, if loans
    and bonds are perfect substitutes, or if
    commodity demand is insensitive to the loan rate
  • If money and bonds are perfect substitutes the
    LM-curve is horizontal (liquidity trap), but
    monetary policy still effective in CC!

Comparative statics
  • Expenditure shock shifts CC like IS
  • Money demand shock shifts LM
  • Rise in bank reserves is expansionary through LM
    and CC! But this creates an identification
    problem (see hereafter)
  • Increase in credit supply shifts the CC-curve

The effectiveness of the credit channel implicit
  • Prices do not adjust instantaneously to offset
    changes in the nominal quantity of money. This is
    the problem of inflation persistence see the
    notes on Taylor, Calvo and Fuhrer-Moore hereafter
  • The Central Bank can directly influence the
    volume of credit through R
  • Loans and bonds are imperfect substitutes for
    both borrowers and banks

Inflation persistence Taylor (1)
  • xt log contract wage set at t
  • wt (xt xt-1)/2 is average wage faced by the
    firm it is assumed that wages are set for two
    periods. With a mark-up pt wt ?
  • Assume a constant mark-up ( 0) pt wt
  • Average expected real wage over the life of the
    contract is xt - (pt Etpt1)/2
  • Real wage is assumed to be increasing in the
    level of economic activity xt - (pt
    Etpt1)/2 k yt

Inflation persistence Taylor (2)
  • Use ?t Et-1pt - pt, one can show that
  • pt pt-1 Etpt-1 k(yt yt-1) ?t/2
  • Use ?t pt - pt-1, and we get
  • ?t Et?t1 2k(yt yt-1) ?t
  • So the price level is sticky, but inflation is
    not (the coefficient for Et?t1 is equal to

Calvo staggered price setting intuition (1)
  • 1- ? is the proportion of firms able to change
    their price in a period
  • ? is the proportion of firms unable to change
    their price
  • Aggregate price level
  • pt (1- ?) xit ? pt-1

Price non-setters
Price setters
Calvo intuition (2)
  • xit optimal price setting
  • xit (1- ??) pt ??Et xit1
  • ? 0 implies perfect price flexibility and so
    xit pt
  • ? 1 implies inflexibility xit Et xit1

Price set at t
Myopic price
Desired price at t1
Calvo intuition (3)
  • Myopic price is the price that would prevail in a
    flexible price equilibrium pt k pt mct, wher
    mc are marginal costs
  • The price is a constant mark-up k over marginal
  • In loglinear form pt pt mct
  • Suppose that marginal costs mct are related to
    the output gap yt, for instance via wages mct

Inflation persistence Calvo (1)
  • Firms adjust prices infrequently. Opportunities
    arrive by a Poisson process each period there is
    a constant probability 1 - ? that the firm can
    adjust the price. The expected time between price
    adjustments is 1/(1 - ?)
  • The firm minimizes ½? ?j ?j Et(pit - ptj)2
  • pit is the actual price in period t, pt is the
    optimal target price. We use that pitj ?j pit
    these prices remain constant!

Inflation persistence Calvo (2)
  • Optimization of the loss function with respect to
    pit. Note that ? ?j?j is an infinite geometric
    series, so 1/ ? ?j?j (1 - ??). So minimization
    gives the optimal price xt
  • xt (1 - ? ?) ? ?j?j Etptj or
  • xt (1 - ? ?) pt ?? Etxt1
  • Suppose that pt pt ?yt ?t, where ?t is a
    disturbance, and yt is output

Inflation persistence Calvo (3)
  • xt (1 - ??) (pt ?yt ?t) ? ? Etxt1
  • pt (1 - ?)xt ?pt-1. A large number of firms 1
    - ? will adjust their price each period
  • Using ?t pt - pt-1 we get
  • ?t ? Et?t1 (1 - ?)(1 - ??)/? (?yt ?t)
    ? Et?t1 ?yt ?t
  • So this model is quite close to Taylors model
  • An increase in ? decreases ? if the average
    time between price adjustments increases, output
    has less influence on inflation

Inflation persistence Fuhrer-Moore
  • Main point inflation might be sticky instead of
    the price level
  • Wage negotiations are conducted in terms of the
    wage relative to an average of real contract
  • Real value of contracts negotiated at time t as
    xt - pt ?t. Define the index of average
    real contract wages in effect at time t
    vt (?t ?t-1)/2. remember
    two-period contracts

Inflation persistence Fuhrer-Moore
  • Setting ?t agents (1) want at least a wreal
    contrac wage equal to (vt Etvt1)/2, and (2)
    compensation for the business cycle kyt
  • Setting the real contract wage at the level
    ?t (vt Etvt1)/2 kyt (?t-1
    Et?t1)/2 2kyt
  • We can rewrite this equation into
  • ?t (?t-1 Et?t1)/2 2k(yt yt-1) ?t
  • So now we have sluggishness in inflation

Evidence of the balance sheet channel
  • Firms loan demand depends on collateral
    especially for small firms
  • Firms financial position affects investment (in
    cash flow or investment Euler models for
  • External finance premium increases during a
    slump business cycle dependent

Bank lending channel
  • One of the empirical problems is identification.
    It can be supply and/or demand effects
  • Monetary policy might affect the supply of
    credit, but lower output can also decrease demand
  • Bank-dependent borrowers might be rationed for
    instance small firms
  • Crucial banks must meet some kind of
    imperfection to attract additional funds
  • We turn to this issue in Lecture 5

Conclusions credit view
  • Information asymmetry makes credit special
    probably a low substitution of loans with bonds
  • Credit view includes the bank lending channel and
    the balance sheet channel
  • Credit view affects both firms, households and
    banks behavior
  • The real impact depends on the degree of price
    stickiness (e.g. Calvo staggered price setting)
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