Money and Banking 2009 Spring

8/8/2019 Money and Banking 2009 Spring

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MONEY AND

BANKINGDR. Sleyman Yaar


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The program : The focus of the program

is on the design of strategies for money

and banking management. There will bean emphasis on learning practical

concepts and techniques of policy

analysis and management.


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SCHEDULE OF PROGRAM

1. Why study Money and Banking

An Owerview of the Financial System

The Defination and Role of Monetary Authorities What is the new principles of the global economy?

2. What is Money

Functions of Money

Medium ofExchange

Unit of Account

Store of Value

Evoluation of the payment system

Electronic Money


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3. Measuring Money

Theorical and Empirical Definations of Money

Federal Reserves Monetary Agregates

Money supply M1, M2, M2Y, M3

4. Monetary Analysis

Analytical Balance Sheet of the Banking System

Balance Sheet ofCentral Bank

Balance Sheet ofDeposit Money Bank


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5. The Quantity Theory and the Demand

for Money

The concept of the Money Multiplier

Financial innovation and deregulation

Currency substitution


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6.Exchange rate regimes and monetaryanalysis

Monetary equiblirium

The evaluations of exchange rate regimes

Exchange rate regimes monetary autonomy

7. Interest Rate and Rates of Return Financial Assets and Rates of return

Nominal and reel interest rate


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8. The Mundel Fleming Model

IS/LM in the closed economy

IS/LM in the open economy

9.The instruments of monetary policy Seignorage

Real interest rate and tight money paradox

Inflation target and fiscal consistency

Inflation and disinflation

The cost of disinflation Central bank independence

Lessons from Inflation TargetingExperiences


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10. Banking Industry

Historical Development of the Banking System

Basic Operation of a Bank

General Principles of Bank Management Liquidity Management and the Role of Bank

Management

Assets Management

Liability Management

Capital Adequacy Management


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11. Managing Credit Risk

Screening and Monitoring

Long term Customer Relationship

Loan Commitments Management Interest rate risk

12.Asymmetric Information and Bank Regulation

Deposit Insurance

Bank supervision

Consumer protection


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13. International banking

Eurodollar Market

Currency crises Speculative attack under fixed exchange

rates

The role of expectations

Banking sector vulnerability andcurrency crises


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14. Financial liberalisation and capitalflows

Financial reforms and capital accountsliberalisations

Lending booms and banking crises

Using the simple monetary model

IMF Financial Progranmming andMonetary Model


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What is the new principles of the global economy? John Willliamsondefined the new principles of global economy in the 10 topics.

The Washinton Consensus 1.FISCALDISIPLINE

Consolidated public sector deficit should be financeable withoutrecourse to the inflation tax.

2.PUBLICEXPENDITURE PRIORITIES

Redirect public spending towards areas with high economicreturns and potential to improve income distrubution.

3.TAX REFORM

Broaden tax base and cut marginal tax rates to improveincentives and horizontal equity without lowering realizedprogressivity.


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4.FINANCIALLIBERALIZATION

Abolish preferential interest rates for priviliged

borrowers and achive moderately positive realinterest rate with eventual goals of market-

determined interest rate.

5.EXCHANGE RATES It should be competitive.


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The Washinton Consensus 6.TRADELIBERALIZATION

Reduce tariffs progresivelly to 10 percent

range.

7.FOREIGN DIRECT INVESTMENT

Abolish barriers to entry of foreign firms.


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8.PRIVATIZATION

Privatize SEE.

9.DEREGULATION

Abolish regulations that impede entry of new firm orrestric competition.

10.PROPERTY RIGHTS The legal system should provide secure property

rights without excessive cost.


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Augmented Washington Consensus 11. Corporate governance 12.Anti-corruption 13.WTO agreements

14.Financial codes and standarts 15.Prudent capital account opening 16.Non-intermediate exchange rate regimes 17.Independent central bank/inflation targeting 18.Social safety nets 19.Flexible labor market 20. Targeted poverty reduction


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Three financial markets deserve particular attention,

-the bond market,

-the stock market

-the foreign exchange market.

On the other hand,financial markets can beclassified as

-debt and equity markets, -primary and secondary market,

-exchange and over the counter market.


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An Owerview of the Financial System

A market economy based on money, the financial systemprovides intermediation for the resources flowing among the

economic sectors.

The monetary sector serves as a clearing house for all finacialflows, the monetary accounts provide unique insigth into thebehavior of these flows,which mirror the flows of realresources among sectors.

Monetary accounts focus on variables ( such as Money, credit,and foreign assets and liabilities) that play a central role in themacroeconomic analysis of an open economy.


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The Defination and Role of

Monetary Authorities

The term monetary authorities is a fuctionalrather than an institutional concept.

In most countries, the monetary authoritiesare represented by the central bank, but theconcept can include agencies of the

government, such as the treasury,thatperform some of the functions of a centralbank.


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The monetary authorities,

-issue currency,

-hold the countrys foreigns Exchange

reserves, -borrow for balance of payments purposes,

-act as banker to the government,

-oversee the monetary system, and

-serve as the lender of last resort to the

banking system.


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-In many countries, the treasury,issues coins and holds the official

reserves.

-In some countries, a treasurycontrolled Exchange stabilisation fund

instead holds the countrys officialreserves.


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THE SYSTEM OF NATIONAL ACCOUNTS (SNA)

The System of National Accounts was developed as anaccounting framework within which macroeconomic data canbe compiled and presented for economic analysis.

The Key Macro economic Aggregates

Gross Output (Q) is the value of all goods and servicesproduced in the economy.

Value Added (VA) is the value of gross output less the value of

intermediate consumption.

Gross Domestic Product (GDP) is defined as the sum of valueadded across all sectors in the economy.


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Investment, in macroeconomic terms, refer to

additions to the physical stock of capital in an

economy.

Depreciation is used to differentiative net from

gross investment and is sometimes call the

consumption of fixed capital.

Net investment = Gross investment Depreciation


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Net exports, which are equal to the value of export

of

goods and services less the value of imports of

goods and services, are used to measure the impactof foreign trade on aggregate demand.

Absorbtion (A), also called aggregate domestic

demand, is defined as the sum of total finalconsumption (C) and gross investment (I)

A= C + I


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MACROECONOMIC

CONSISTE

NCY FRAME

WORK

Y - A = CAB = ( A Y)*

+ + +

Bs - Bd = KA = ( Bd Bs)*

+ + +

Ms - Md = R = ( Md Ms)* 0 0 0


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MACROECONOMIC CONSISTENC Y FRAMEWORK

CAB= TB + NFP + NFT

A= C+ I

KA = FDI + NFB

TB= Trade balance

NFP= NET FACTOR PAYMENT ( Remittence)

NFT= NET FOREIGN TRANSFER (Grand)

FDI= FOREIGN DIRECT INVESTMENT

NFB= NET FOREING BORROW

* = REST OF THE WORLD

CAB= CURRENT ACCOUNT BALANCE

A = ABSORPTION

KA= CAPITAL ACCOUNT BALANCE

R = CHANGE IN RESERVES

B= BOND

M= MONEY


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AGGREGATEINCOME AND ABSORBTION AND THEEXTERNALCURRENTACCOUNT BALANCE

GNI= GDP +Yf

GNDI= GNI + TRf

S= GNDI C

GNDI A= CAB

CURRENT ACCOUNT DEFICITS MIRROR AN EXCESS OFABSORPTION OVER INCOME.

S - I = CAB

CAB= X M + Yf+ TRf

ECONOMY WIDESAVING INVESTMENT = CAB= USE OF FOREIGNSAVING.

Yf= Net factor income from abroad

TRf= Net transfer from abroad


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OVERVIEW

Production Possibility Frontier :

Productivity or GDP perHour Worked : how much an avarage

worker produces per hour, calculated by dividing real GDPby hours worked in the economy.

How Choice Are Made :

Market Mechanism . Market determinant prices signalsurpluses and shortages, and owners allocated resources totake advantage of highest monetary rewards.

Command Economy. Central authority allocates resourcesto achive goals.

Mixed Economy. An economy that uses both market andnon-market signals to allocate goods and resources.


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OVERVIEW

LAW OF DEMAND : Increase in price ( P )

causes decrease in quantity ( Q ) demanded. LAW OF SUPPLY : Increase in price ( P )

causes increase in quantity ( Q ) supplied.


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Inflation : A sustained rise in the general price level.

Cost - Push inflation : inflation whose initial cause is a rise inproduction cost.

Demad Pull inflation : inflation whose initial cause is

aggregate demand execeding aggregate supply at the currentprice level.

Very High Inflation : we define as an annual inflation rate of100 percent or more .

Hyperinflation : an inflation of more than50 percent per month.

Disinflation : the process of eliminating or reducing inflation. Deflation : a sustained fall in the general price level.


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OVERVIEW

Stagflation : a situation in which high inflation iscombined with low growth and high unemployment.

Aggregate demand curve : a curve relating the totaldemand for the economys good and services ateach price level, given the level of wages.

Aggregates expenditures schedule : a curve thattraces out the relation ship between expenditures

the sum of consumption, investment, governmentexpenditures, and net exports - and nationalincome, at a fixed price level.


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Consumption expenditure : aggregate

expenditures on goods and services to

satisfy current wants.

Savings : all income not spent on goods and

services which are used for current

consumption.


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Taxatation : compulsory levies on private induviduals andorganizations made by government to raise revenue to financeexpenditure on public goods and services, and to control thevolume of private expenditure in the economy. Taxes areclassified in various way. Some are called direct taxes. Others are

called indirect taxes.

Tariff : a tax imposed on a good imported into a country .

Privatization : reduce the government economic activites in thewhole economy.

Horizontal Equity: the principle that says that those who are inidentical or similer circumcitances should pay identical or similaramount in taxes.


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ALTERNATIF APPROACHTO

DETE

RMINING GDP

The GDP can be determined using three basic approaches :

1. The production approach

2. The income approach

3. The expenditure approach

These alternative approaches yield equivalent results.

The production approach

GD

P = VA VA = sum of value added across all sectors in the economy.

NDP = GDP D

D= depreciation or cosumption of fixed capital


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The Income Approach

GDP can also be considered as equel to the sum ofincomes generated by resident producers.

GD

P = W + OS

+ TS

P

W = wages, salaries, other labor cost ( employerssocial security contributions and plus employeessocial security contributions)

OS

= gross operating surplus of enterprises (including profits, rents, interests, and depreciations)

TSP = taxes less subsidies on products


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2.What is money ?

Money is the stock of assets that can be readily used tomake transactions.

The Functions of Money

Money has three functions. A medium of exchange. This function corresponds to the

transactions motive for holding money.

A store of value. Money is an asset that can be used totransfer purchasing power from the present to the future.

This function corresponds to the portfolio (speculative)motive for holding money.

A unit of account. Prices of goods, services and assetsare typically expressed in term of money.


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What is the Money Supply

The quantity of money avaliable is called the money supply.

The control over the money supply is called monetary policy.

Monetary Policy is delegated to a partially independent institutioncalled the central bank.

The central bank controls the supply of money is through open-market operations the purchase and sale of government bonds.


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Analytical Balance Sheet of the Monetary Authority(the Central Bank)

Assets Liabilities

Net foreign assets Reserve money

Net Claims on the Government - Reserves of deposit Money Banks

Net claims on the Private Sectors - Currency held by the public

Other items net Total Assets Total Liabilities


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Analytical balance sheet ofDeposit Money Bank

Assets Liabilities

Net foreign assets Deposits

Reserves -D

emand - Required reserves - Time

- Excess reserves - Foreign currency

Domestic Credit - Liabilities to monetary authority

- Claims of government Other less liquid liabilities

- Claims on other domestic sector

Other items

Total assets Total liabilities


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Consolidated Banking System

Analytical Balance Sheets of the Banking System : Monetary Survey

Assets Liabilities

Net Foreign assets (NFA) Broad Money (M2) Net Domestic Assets(NDA) Narrow Money (M1)

Net Domestic Credit (NDC) -Currency in Circulation

-Net Claims of Government (NDCg) -Demand deposits( DD)

-Claim on the private sector (NDCp) Quasi money

Other items (net) Time deposits (TD)

Foreign currency deposits

Total assets Total Liabilities


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Reserve Money (RM) = CY + R

Narrow Money (M1) = Currency in circulation (CY)+Demand Deposits (DD)

Broad Money (M2) = Narrow Money (M1) + QuasiMoney (QM)

Or

M2 = CY + DD+ TD M2 = NFA + NDA

NFA= M2 - NDA


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The Quantity Theory and the Demandfor Money

The earliest monetary theory is based on the link between thestock of money (M) and the market value of output that itfinances (PY). The so- called quantity equation equates thestock of money in real terms with real output, with

aproportionality factor, ( k ). Thus, M /P = k.Y

If (k ) is assumed to be constant, this expression provides thequantity theory of money.

This theory postulates a direct link between the stock of money (M)

and the price level (P) whenever the economy is assumed to be at fullemployment. Thus, so long as ( k ) remains constant, there is aproportional relation between ( M ) and ( P ).


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M x V = P x Y where V = 1 / k is the income velocity of money, whichis the ratio of the money income (nominal GDP) to the money stock.

The nominal demand for Money is the demand for a given numberspecific currency units, such as Lira orDollar.

The real demand for money, or the demand for real money balances,is the demand for money expressed in terms of the number of unitsof goods that the Money can buy.

Therefore, the demand for real money balances is the quantity ofmoney (M) expressed in real terms (M/P), that is , deflated by theindex for the general level of prices. The demand for money isfundementally a demand for real money balances, because peoplehold money for what it can buy.


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Money and Inflation

Milton Friedman : Inflation is always

and everywhere a monetaryphenomenon.

V = PY / M Inflation ( T ) = ( M / M - g + ( V / V


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6.Exchange rate regimes and monetary analysis

Exchange rate regimes

-Fixed or managed exchange rate

commitment to intervene in forexmarket to limit movement ofExchange

rate (E)

-Floating Exchange rate no commitment to forex intervention


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Exchange rate Exogenous Endogenous

regimes variable variable

Fixed or

Managed path to E NFA

Band path of upper E within bands,

and lower band NFA at bounds

Floating path of NFA E


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Continuum of exchange rate regimes:Fr

om flexible torigid

FLEXIBLECORNER

1) Free float 2) Managed float

INTERMEDIATEREGIMES

3) Target zone/band 4) Basket peg5) Crawling peg 6) Adjustable peg

FIXED CORNER

7) Currency board 8) Dollarization

9) Monetary union Reference:Jeffrey A. Frankel


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Of185 economies, the IMF at end-1999 (the last de jure list) classified: 51 independent floaters 45 have given up currencies -- of which:

11 member of EMU 2009 (The eurozone (officially the euro area is a currency union of16European Union (EU)

states which have adopted the euro as their sole legal tender. It currently consists ofAustria,Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, theNetherlands, Portugal, Slovakia, Slovenia and Spain.)

14 members of the CFA Franc Zone TheCFA franc (in French: franc CFA, "c fa", or just franccolloquially) is a currency used in

twelve formerly French-ruledAfrican countries, as well as in Guinea-Bissau (a formerPortuguese colony) and in Equatorial Guinea (a formerSpanish colony).

89 intermediate regimes -- of which: 30 pegs to a single currency (China) 13 pegs to a composite 5 crawling pegs 7 horizontal bands (minor Slovakia)

7 crawling bands 26 managed floats

Fischer (2001): Intermediate pegs, at 34%, down from 62% in 1991

But: there are as many currencies as in 1991


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Advantages of fixed rates

1) Encourage trade


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2) Encourage investment


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New popularity of

institutionally-fixed cor

ner

in 1990s currency boards(e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina,1991-2001; Bulgaria, 1997- ; Estonia 1992- ; Bosnia,1998- ; )

dollarization(e.g, Panama, El Salvador, Ecuador)

monetary union(e.g., EMU, 1999)


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Advantages of floating rates

1)Monetary independence 2) Automatic adjustment to trade shocks

3) Retain seignorage 4)Retain landing of last resort ability 5) Avoiding crashes that hit pegged

rates, particularly if origin of speculative attacks is multiple equilibria,

not fundamentals.


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Which dominate: advantages of fixing or

advantages of floating?

Answer depends on circumstances, of course:

No one exchange rate regime is right for all

countries or all times.


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On what criteria should a country

base its choice of regime? Traditional criteria for choosing - Optimum

Currency Area.

Focus: trade and stabilization of business cycle.

1990s criteria for choosing

Focus: financial markets & stabilization of speculation.

The return of two neglected criteria --

Terms of trade volatility

Financial development


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Optimum Currency Area criteria

for fix

ing the ex

change rate: Definition: An optimum currency area is a region

that should have its own currency and ownmonetary policy

This definition can be given more content byobserving that smaller units tend to be more openand integrated.

Then an OCA can be defined as: a region thatis neither so smalland open that it would be

better off pegging its currency to a neighbor,nor so large that it would be better off splittinginto subregions with different currencies


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On the other hand we can explain anoptimum currency area or bloc refers to a

group of nations whose national currenciesare linked through permanently fixedexchange rates and the conditions thatwould make such area optimum.


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The currencies of member nations could thanfload jointly with respect to the currencies ofnonmember nations.

The formation of an optimum currency area alsoencourages producers to view the entire area as a

single market and to benefit from greatereconomies of scale in production.


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The formation of an optimum currency areais more likely to be beneficial on balance

under the following conditions: (1) thegreater is the mobility of resources among

the various member nations, (2) the greatertheir structural similarities, (3) the more

willing they are to closely coordinate theirfiscal, monetary, and other policies.


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An optimum currency area should aim atmaximizing the benefits from permanently fixedexchange rates and minimizing the costs.

According to Economist Paul R.Krugman,Europeis not an optimum currency area. Therefore,

asymmetric economic development withindifferent countries of the euro zone will be hard tohandle through monetary policy.


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Optimal currency areas

Economists typically cite four criteria, often called theoptimum currency area (OCA) criteria, to evaluate thevalue of switching to a single currency. There are three

economic criteria (labour and capital mobility, productdiversification, and openness) and one political criterion(fiscal transfers). Robert A. Mundell formulated the ideathat perfect capital and labour mobility would mitigatethe adverse consequences of asymmetric shocks in a

currency area. While capital is quite mobile in theEurozone, labour mobility is relatively low, especiallywhen compared to the U.S. and Japan.


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Ronald McKinnon formulated the idea that areas which are veryopen to trade and trade heavily with each other form an optimumcurrency area. This is because the high trade intensity will lower thesignificance of the distinction between domestic and foreign goodsas competition will equalize the prices of most goods,

independently ofexchange rates.

The Eurozone members trade heavily with each other (intra-European trade is greater than international trade), and all evidenceso far seems to indicate that the monetary union has at leastdoubled trade between members.

So while Europe scores well on some of the measurescharacterizing an OCA, it has lower labour mobility than the UnitedStates and similarly cannot rely on Fiscal federalism to smooth outregional economic disturbances.


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Optimum Currency Area criteria

for fix

ing the ex

change rate:Small size and openness

Symmetry of shocks Labor mobility

Fiscal cushions


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New proposal: Peg the Export Price (PEP)

Combines the best of both worlds:

The advantage of automatic accommodation to terms of tradeshocks (as floating rates promise, but fail to deliver in the case ofextraneous volatility), together with the advantages of a nominalanchor and integration (which exchange rate pegs promise, but failto deliver in the case of currency crashes).

How would it work operationally, say, for oil-exporter Iraq?

Each day, after noon spot price of oil in London S($/barrel), thecentral bank announces the days exchange rate, according to theformula:

E (dinar/$) = fixed price P (dinar/barrel) / S($/barrel).


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6 proposed nominal target and

Achilles heel of each:

Targeted

variableulnerability Exa ple

onetarist rule 1 Velocity shocksUS 1982

Inflation targetingCPI Import price

shocksil shocks of

1973, 1980, 2000

o inal inco etargeting

ominal Peasurement

problemsLess

developedcountries

old standardPrice

of gold

Vagaries oforld goldmarket

1849 boom;1873-96 bust

o oditystandard

Price of agr. &

mineralbasket

Shocks in

impor

tedcommodity il shocks of1973, 1980, 2000

Fixed

exchange rate

$(oreuro)

Appreciation of$ (orother)

1995-2001


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T

he imposiple tr

inity The hypothesis in international economics that it is impossible to have all three of the

following at the same time:

A fixed exchange rate

Free capital movement

An independent monetary policy.

Fix exchange rate


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Why is Peg the export price betterthan CPI-targeting?

Better response to adverse terms of trade shocks:

If the $ price of imported commodity (say, oil) goes up, CPI targetsays to tighten monetary policy enough to appreciate currency.

Wrong. If the $ price of the export commodity goes down, PEP says to ease

monetary policy enough to depreciate currency. Right.


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More moderate versions of PEP Target a broaderExport Price Index (PEPI).

1st step for any central bank dipping its toe in these waters:compute monthly export price index.

2nd

step: announce that it is monitoring the index

. Target a basket of major currencies ($, , )andminerals.

A still more moderate, still less exotic-sounding, version ofPEPI proposal: target a producer price index (PPI).

Key point: exclude import prices from the index,& include export prices. Flaw of CPI target: it does it the other way around.


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7. Interest Rate and Rates of Return

Reel interest rate r= i- r=reel interest rate i= nominal interest rate = inflation rate

The after tax reel interest rate r = i ( 1- tax rate) -

Sensitive reel interest rate 1+ r = 1+i / 1 +


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Measuring interest rate

A) Current yield of the bond= Yearlycoupon payment / Price of the coupon bond

I c= TL 10/ TL 100 = 0.10%


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C) Yield on the discount basis On our one year bill, which is selling for TL 900 and has

a face value of TL 1000, the yield on a discount basiswould be as follows:

db= 1000 900/ 1000 . 360/365 = 0.099= 9.9%

D) Present value of bondPV= R/ (1+i)n

Par value = TL1000

i= 10% for one year PV= 1000/1.10=TL 909


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E) Future value

FV= P . (1+i)npar value TL 100

i= 10%

FV= TL 100 . ( 1+ 0.10)= 100. 1.10= TL110


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F) Interest rate calculation for days

i= 10%

Time = 30 daysYield= TL 1000. 10. 30 / 36500 = TL 8.21


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Interest rate changes is so important that ishas been given a special name, interestrate risk


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8. The Mundel Fleming Model

Explaining Fluctuations With the IS-LM Model

The IS (Investment- saving) curve represents theequilibrium in the market for goods and services.

The LM ( liquidity- money ) curve represents theequiblirium in the market for real money balances.

The intersection of IS curve and LM curve determines thelevel of national income. When one of these curvesshifts, the short - run equilibrium of the economychanges, and national income fluctuates.


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Mundel- Fleming Model is an open-economy version of the IS-LM model.

The Mundel Fleming Model makes one important and ex

tremeassumption ; it assumes that the economy being studied is asmall open economy with perfect capital mobility.


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In addition, for some economies, such as

Belgium and the Netherlands, the

assumption of a small open economy with

perfect capital mobility is a good one. Onelesson from the Mundell Fleming model is

that the behavior of an economy depends on

the exchange rate system it has adopted.


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9.The instruments of monetary policy

The control over the money supply is called monetary policy.

The objective of monetary policy are high employment, stable pricelevel (no inflation), steady growth in the nations productive capacity,

and a stable foreign exchange value for national money.

The chain of reactions in the economy that transmits cahange inmoney growth to the levels of unemployment and inflation is referredto by economists as the transmission mechanism.

Monetary Policy is delegated to a partially independent institutioncalled the central bank.


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C) Central bank discount rate

Liquidity Trap

Liquidity trap refers to a state in which the nominal interest rate isclose or equal to zero and the monetary authority is unable tostimulate the economy with monetary policy.

In such a situation, because the opportunity cost of holding moneyis zero, even if the monetary authority increases money supply tostimulate the economy, people hoard money.Consequently, excessfunds may not be converted into new investment.


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11. Managing Credit Risk

To be profitable, financial institutions must overcome theadverse selection and moral hazard problems that makeloan defaults more likely.

The attempts of financial institutions to solve theseproblems help explain a number of principles formanaging credit risk: screening and monitoring,establishmnet of long-term customer relationships, loancommitments, colleteral, compensating balance

requirements, and credit rationing.


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Screening and Monitoring

Screening, adverse selection in loan marketrequires that lenders screen out the bad

credit risks from the good ones so that loansare profitable to them.

To accomplish effective screening, lendersmust collect reliable information from

prospective borrovers.


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Long term Customer Relationship

Long term relationships benefit the customers

as well as the bank. A firm with a previous

relationship will find it easier to obtain a loan

at a low interest rate because the bank has an

easier time determining if the prospective

borrower is a good credit risk and incurs

fewer costs in monitoring the borrower.


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Loan Commitments

A loan commitment is a banks commitment toprovide a firm with loans up to a given amount

at an interest rate that is tied to some marketinterest rate.

Management Interest rate risk

If a bank has more rate-sensitive liabilities

than assets, a rise in interest rates will reducebank profits and a decline in interest rates willraise bank profits.


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12.Asymmetric Information and Bank Regulation

Asymmetric information analysis explains what types ofbanking regulations are needed to reduce moral hazard andadverse selection problems in the banking system.

Regulators are continually playing cat and Mouse withfinancial institutions- financial institutions think up cleverways to avoid regulations which then causes regulators tomodify their regulation activities.

Because of financial innovation, deregulation and a set of

historical accidents adverse selection and moral hazardproblems increased in the 1980s and resulted in huge lossesfor the US savings and loan industry and for taxpayers.


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13. International banking

Why international banking

A) The rapid growth in international trade andmultinational corporations

B) The desire to escape burden some regulation

Euro dollar market

Euro dollars are created when deposits in accounts in

the USA are transferred to a bank outside the country.The main center ofthe eurodollar market is London,


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Currency crises

Contemporary macroeconomic management focuses increasingly onmanagement of volatile capital flows.

We look at the basies on of balance of payment crises. A BOP crisescan emerge if a country ignores the restraint on monetary policy that

is imposed by commitment to a managedEx

change rate. Few if any crises, however, are predictable with exactitude- in their

timing or severity- on the basis of fundamentals. The problem is notonly the constant arrival of news.

Of equal or greater importance is that market psychology can be selfconforming.

Acting on expectations of devaluation, market participants withdraw

foreignexchange from the centralbank, thereby increasing theprobability of a devaluation.


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BOP crises can emerge, therefore, even when thefundamentals are sound.

-Fist generation models:

Mocro policy fundamentals are incosistent with

maintanence of the peg. Forward-looking speculatorsbring about an earlier and more spectucular demise thanwould be implied by the central banks steady lossreserves.

-Second generation models:

Collapse is not inevitable based on the fudamentals,

but there are multiple self confirming sets of marketexpectations, at least one of which involves a crises andcollapse of peg. Reserve limits not necessarily key.


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First generation models (Krugman 1979):

-The structure of the economy is given by our simple monetarymodel, with Y fixed at Fixed Exchange Rate (FE).

-A transition to floating occurs when the NFA of the centralbank reach a lower bound.

-Speculators have perfect foresight. -There is an underlyng fiscal deficit that is financed trought

steady increases in DC from the central bank.

Krugman showed that reserves would fall steady until aspeculative attack occured that would wipe out the remainingreserves overnight.

Second Generation Sepeculative Attack Models:Self fulfillingpanics.


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Second Generation Sepeculative Attack Models: Self fulfilling panics.

Consider 2 sets of expectations regarding the nominal Exchange rate:

GOODEXPECTATIONS : The peg will continue to hold.

BADEXPECTATIONS: The authorities will devalue by some knownpercentange >0

PROBLEM : Both expectations may be correct, self conforming. In the good case:

- (E/E )e =0, so i=i* and the economy stays at FE with nospeculative activity in the forex market: so no pressure on the peg.

In the BAD case:

(E/E )e = so the domestic interest rate rises to i* +.


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If inflation expectations rise by less, the real interest rate, r, hasrisen. This exerts a contra dictionary effect on aggregate demandand a slump in the Non tradable goods market. Putting pressure onthe public authorities to devalue the nominal Exchange rate andcreate demand and supply switching. If they do devalue,

expectations are confirmed. While E is still pegged, inflation is zero (P=EP* and = 0) and wehave assumed Y is fixed and since E / E = 0, velocity is fixed atv(i*). There fore M is constant, so the steady rise in DC is ofset 1 for1 by a steady loss of reserves.

-Once is floating, Rising DC will cause a steady rise in H and treforesteady depreciation of E . Since this deprecitaion is expected, thedomestic interest rate rises from i* to i*+ (E / E). Therefore velocityis higher, the demand for real Money balance is lower, once thefloat is underway.

14 Fi i l lib li ti d


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14. Financial liberalisation andcapital flows

Financial repression and liberalization

FINANCIAL REPRESSION: The government decides on the allocationand price of credit.

FINANCIALLIBERALIZATION entails:

Elimanating credit controls

Deregulating interest rate Banking sector reformsAllowing free entry into banking and

financial

services

Allowing bank authonomy in management

Privatizating bank ownership Liberalizing the capital account


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OBJECTIVE OF FINANCIAL LIBERALIZATION - increasing quantity and quality of domestic

investment

- financial market development Note: The evidance suggests that growth benefits

come mainly from increased investment quality,financial deepening occurs ( M2 / GDP rises), but

the effect of financial liberalization on nationalsaving is general weak.


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Managing the transition

Secquencing of reforms : Ideally

Fiscal stabilization Trade liberalization

Banking reform

Capital account liberalization


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Banking sector weakness and capital flows

-Inadequate bank supervision complicates themanagement of inflows

*Especially under fixed Exchange rates with a

convertibility guarantee, financial liberalization canproduce a lending boom with declining assets qualityand increasing foreign Exchange exposure of banks and/or firms. The implicit the insurance to foreign currencylenders (moral hazard) is greater for shorter term

inflows. and may increase vulnerability to currency crises.


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*Foreign lending subject to rapidreversal on fears of devaluation orExchange control.

*High interest rate strategies becomeless credible in supporting theExchange rate commitment becausematurity mismatch and poor assetsquality means they can produce bankfailures.


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Reducing vulnarability

_Stronger prudential regulation of riskness of

bank portfolios to reduce moral hazard,

-Increased capital requirements

-Depeosit rate ceiling at Treasury-bill rate

-Control on capital inflows, paticularly short

term higher marginal reserve requirements -GreaterExchange rate flexibility.


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Source of inflow: domestic pull factors

-Tightening of domestic credit policy orincrease in administered interest rates,

without fiscal adjustment (in anti inflationprogram. Effects E-Led disinflation programs.)

-An improvement in domestic policies.Structural changes that improve investmentproductivity or reduce public sector deficit.

- Domestic financial liberalization


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Sources of inflow: push external factors.

A fall in world interset rates. Without fiscal adjustment

-Bandwagon effects.

So the dangers are those associated with overheating

-Lending boom with declining assets quality.

-Aggregate demand and output up, impliying inflationarypressure, CAB deterioration.

-Domestic inflation means real Exchange rateappreaciation, compettivenes, furtherCAB deterioration.


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-Discourage gross inflows or promote

gross outflow.

- mpose tax

or direct control on inflows -Liberalize outflows

-Increase exchamge rate risk facing

speculators by widening currency

bands.

A small macro model : monetary policy and exchange rate


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A small macro model : monetary policy and exchange rateregime

A small macro model : monetary policy and exchangerate regime

1 . M / P = Y / V Money demand = Money supply

2 . P = E P * PPP ( all goods traded)

3. i = i* + ( E/E Uncovered interest parity (perfect

capital mobility)

4. ( M = mm . ( RM = mm ( Ex NFA* + ( DC)Determines

next periods money supply.

The IMF Financial Programming Model


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The IMF Financial Programming Model

There are two targets and two Projections.

Two targets : low inflation ( T t ) and a sustainable BOP ( NFAt )

Two projections : real growth ( g) pr and the change invelocity ( (v / v)pr.

- We have T = ( M/ M - g + ( v / v, so the growth andvelocity projections tie down the money growth rate that isconsistent with the T target:

(M /Mpr = T t + (g) pr - ( v / v

But the central banks balance sheet says

( M = mm ( E. ( NFA + ( DC )

So we are stuck. To achive the BOP target, we must place aceiling on ( DC.

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Money and Banking 2009 Spring

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