Title: Finance and Banking NAKEcourse Robert Lensink and Elmer Sterken RuG
1Finance and BankingNAKE-courseRobert Lensink
and Elmer SterkenRuG
- Lecture 1
- The Credit View
2Course 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
3Finance 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
regulation - This lecture information problems (credit
view) - Both imperfect information and imperfect
competition issues lead to the relevance of
finance, financial structures, and theory of
financial intermediation
4Macro 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
5Basic 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
6Critique on IS-LM McCallum and Nelson (JMCB,
1999)
- Fixed price level ? today there are micro
foundations - No distinction between the nominal and expected
real interest rate ? we need an explicit role for
inflation - 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
7Tobins General Equilibrium Approach to Monetary
Theory
- 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?
8Is 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
9Tobin effect (2)
- Household wealth in money m or capital k (all
lower case symbols represent per capita
variables) - 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)
10Tobin 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
equilibrium
11Effects of money growth
f(k)
? 0.4
? 0.2
sf(k)
0
k
12Tobin 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
exogenous) - 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
13Tobin, JMCB (1969)
- General equilibrium approach to monetary theory
real decisions should be integrated with
financial decisions. Financial structure is
relevant - Start from an accounting framework that embeds
balance sheets per sector and market clearing
conditions - 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
returns?
14Accounting framework
Sectors
Net total holdings
1
2
n
Assets
1
2
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
n
National wealth
Net worth
15Money 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
16A 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
17Inside 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
level - 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
durables) - So how to deal with these stylized facts?
18Inside 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
19The 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
20Equilibrium 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)
21Two 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
22Backward 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
23Backward bending supply
L
L2
Supply curve
L1
R
0
R
24Information 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
25Simple 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?
26Bernanke-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
Money-GNP-relationship - There is no direct assumption on credit rationing
(see for this type of literature the credit
availability doctrine (Radcliffe report in the
UK))
27Bernanke-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)
28Tobinesque overview
29Bernanke-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
30Money 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)
31Solution 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
32CC-LM model monetary expansion
i
LM
CC(?R)
CC
0
y
33CC-LM-model
- 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!
34Comparative 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
outward
35The effectiveness of the credit channel implicit
assumptions
- 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
36Inflation 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
37Inflation 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
unity)
38Calvo 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
39Calvo 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
40Calvo 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
costs - In loglinear form pt pt mct
- Suppose that marginal costs mct are related to
the output gap yt, for instance via wages mct
?yt
41Inflation 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!
42Inflation 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
43Inflation 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
44Inflation persistence Fuhrer-Moore
(1)
- 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
wages - 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
45Inflation persistence Fuhrer-Moore
(2)
- 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
adjustment
46Evidence 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
instance) - External finance premium increases during a
slump business cycle dependent
47Bank 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
48Conclusions 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)