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INTRODUCTION TO MONEY, FINANCIAL INTERMEDIATION AND FINANCIAL CRISES Professor Lawrence Summers October 1, 2015 Agenda • The function of financial markets • International capital flows • Banking crises game Function of financial markets: flow of funds from savers to borrowers • There are people who want to save to meet subsequent needs (smooth their consumption) • And there are businesses that have the opportunity to take a dollar today and turn it into more than a dollar tomorrow • The function of the financial system is to bring them together • There are risks: financial markets help share and pool the risks Function of financial markets: flow of funds Direct Finance Funds • • • • Lenders/Savers: Households Firms Government Foreigners Financial Markets (e.g. Stock exchange) Returns Borrowers/Spenders: • Firms • Government • Households • Foreigners Indirect Finance Deposit Deposits + Interest Financial Intermediaries (e.g. Bank, Insurance co., Mutual fund, Venture Capital co.) Loans Interest ++++ Interest Inter-temporal optimization MRS = Marginal rate of substitution r = interest rate Future consumption The optimal (C1,C2) is where the budget line just touches the highest indifference curve. C2 At the optimal point, MRS = 1+r O Present consumption C1 Source: Macroeconomics, N. Gregory Mankiw Now, considering inter-temporal production Intertemporal Production Possibility Frontier Future consumption Represents trade-off between present and future production of a consumption good. Present consumption Source: International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld Future consumption Production and consumption are both affected by changes in interest rates Intertemporal indifference curve Intertemporal PPF Intertemporal budget line Present consumption Slope determined by interest rate Why do we need financial intermediaries? Why can’t those with savings just lend directly to borrowers? • Pooling Savings: Most savers deposit small amounts; banks pool savings to make large loans. • Risk Diversification: Savers lending to individual borrowers face risk of total loss if borrower defaults. Bank spreads risk and ensures return to saver. • Liquidity Transformation: Banks make long-term loans, knowing that only some depositors will want their money back during each short-term period. • Asymmetric Information: Banks specialize in screening borrowers for creditworthiness, processing and sharing information. Examples of financial intermediaries Intermediary Primary Liabilities Primary Assets Commercial banks Deposits Business and consumer loans, mortgages, US government securities, municipal bonds Savings and loans Deposits Mortgages Mutual savings banks Deposits Mortgages Credit Unions Deposits Consumers loans Life insurance companies Policy premiums Corporate bonds and mortgages Fire and casualty insurance companies Policy premiums Municipal bonds, corporate bonds, stocks, US government securities Finance companies Commercial paper, stocks, bonds Consumer and business loans Mutual funds Shares Stocks and bonds Money market mutual funds Shares Money market instruments Deposit-taking institutions (banks) Contractual savings institutions Investment Intermediaries Fractional reserve banking • Most of the time, only a small fraction of bank’s total deposits will be demanded on given day. • Banks lend out some of the deposits and keep just enough cash reserves on hand to deal with day-to-day demands. • Advantages: • Bank income from loan interest can reduce depositor fees • Provides financial intermediation Agenda • The function of financial markets • International capital flows • Banking crises game Capital will flow from places where it is abundant to places where it is scarce • International capital flows are driven by expected (risk-adjusted) returns that can be earned. • As a result, capital should flow where it will be the most productive. • Diminishing marginal product of Marginal Product of Capital capital investing a unit of capital is more productive where it is scarce than where there is already a lot of capital. • So capital will flow from places where it is abundant to places where it is scarce. Capital Multinational corporations play a major role in international capital flows • International capital flows can take the form of borrowing and lending, or of foreign direct investment: where a firm in one country creates or expands a subsidiary, production facility etc. in another country. • Why do multinational corporations exist? • Location: Why is a good produced in many different countries rather than one? Resource abundance, economies of scale, transport costs, trade barriers are all factors that help determine where it is most efficient for a good to be produced. • Internalization: why is production in different locations done by the same firm, rather than by different firms? If transaction costs between different firms are too high then it is more profitable to carry out transactions within one firm. Particularly important with technology transfer and vertical integration. In a Closed Economy: National Savings equals National Investment (S = I) 1. Y = C+I+G National Income = Consumption (C) + Investment (I) + Government Spending (G) 2. Y–C–G=I 3. Define National Saving (S) = Y – C – G S= I National Savings = National Investment In a closed economy: what is not consumed (i.e. what is saved) is invested. Closed Economy: all goods and services are produced and consumed domestically Production Producer Income Spending and Saving Consumer Spending and Saving Closed Economy: What is not Consumed (i.e. Saving) is Invested Investment National Savings = National Investment Saving Production Spending and Saving Sales Consumption Producer Income Consumer Spending and Saving Open Economy: Can borrow from/lend to rest of world. Trade Balance = National Income – National Spending National Income = Y = C + I + G + X – M X – M = Trade Balance in Goods and Services = Current Account “Strictly, Current Account includes factor incomes and transfers but we will mean X - M” National Expenditure (Spending) = E = C + I + G National Income – National Expenditure = X – M Open Economy: Trade Surplus is Income that is not Spent Net Exports = X – M Trade Surplus Exports Imports Domestic Sales of Domestic Products Income Domestic Purchases of Domestic Products Expenditure Income exceeds Expenditure by the Current Account Surplus = Net Foreign Lending Difference between National Income and Expenditure change in Net Foreign Assets • Country with a deficit is spending more than its income by either increasing its net foreign debt or reducing its net foreign assets. • Country with a trade surplus is either reducing its net foreign debt or increasing its net foreign assets. Trade Balance = Saving - Investment Y=C+I+G+X–M Y–C–I–G =X–M (Y – C – G) – I = X – M Define national saving S = Y – C – G S–I=X–M National Saving – National Investment = Trade Balance S = Sp + Sg National Saving = Private plus Government Saving Agenda • The function of financial markets • International capital flows • Banking crises game An illustrative game: Strategy A: Win $1 if all play A, Lose $10 otherwise Strategy B: 0 Which strategy do you choose, A or B? A. Win $1 if all play 50% 50% W in $1 if a ll ce fo r $0 pl a yA , lo se .. . rta in A, lose $10 otherwise B. $0 for certain Strategy A or B? A. Win $1 if more 50% 50% W in $1 if m or e su r fo r $0 th an 90 %. .. e than 90% of the class plays A. Lose $10 otherwise B. $0 for sure Strategy A or B? A. Win $1 if more 50% 50% W in $1 if m or e su r fo r $0 th an 80 %. .. e than 80% of the class play A. Lose $10 otherwise. B. $0 for sure