Download Chapter 1. On the Role of Financial Markets and Institutions

Chapter 1. On the Role of Financial
Markets and Institutions
• 1.1 Finance: The Time Dimension
• 1.2 Desynchronization: The Risk Dimension
• 1.3 The Screening and Monitoring Functions of the Financial System
• 1.4 The Financial System and Economic Growth
• 1.5 Financial Intermediation and the Business Cycle
• 1.6 Financial Markets and Social Welfare
• 1.7 Conclusions
NOTE: This chapter is available online (our course webpage)
Ch.1: Main message
• Worth stepping back and asking yourselves
(again):
– Does finance make sense on social grounds?
– What functions does financial
markets/instruments really fulfill?
Ch. 1: Main tool
• General equilibrium theory:
First and Second Welfare Theorems (section 1.6)
1.4 The Financial System and Economic
Growth
• Performance of financial markets matter at
several levels.
– Important welfare determinant
• One important characteristic is in channeling
resources from savers to investors is very
important.
• Whenever new technologies allow for a lower cost
to perform this task, welfare increases.
1.4 The Financial System and Economic
Growth
Figure 1.2: Savings and Growth in 90 Developing Countries
0,35
0,3
0,29
0,27
0,25
0,2
0,2
0,18
Real GDP grow th (% increase)
Total savings (% GDP)
0,15
0,1
0,08
0,07
0,04
0,05
0,02
0
Highgrow th
countries
Middlegrow th
countries
Low grow th
countries
* East
Asia
* Hong Kong, Singapore,
Taiw an,S.Korea,Indonesia,
Malaysia, Thailand
Source: IMF World Economic Outlook, May 1993 (Annual data, 1971-92)
Savings and Growth
• In a broad sense we see that saving rates are quite
correlated with general GDP growth.
• A closer look shows that this is not so simple.
– Soviet Union was an example
– Basic level of potential investment as important as
where to invest your money.
Extreme case
• One can think of the process of transferring funds
from savers to investors as a matching process.
• Least efficient system: all investment made by
savers themselves.
– Why is it worst: investment only happens with a double
coincidence of cash and project for the same agent.
• Situation when savers don’t trust banks with their money
(Argentina at certain points in time is an example)
• Let FS/S represent the fraction of aggregate
savings (S) on hands of Financial System
(FS)
Variables (1)
• Think of BOR as some amount that is borrowed
from institutions among FS
– Note BOR can be bounded by several factors:
legislation; quality of bank service provided (it
can be costly to operate a bank)
• BOR/FS is the ratio of funds transferred
from FS to borrowers and entrepreneurs.
• Let I/BOR be the fraction of borrowed
funds actually invested.
Variables (2)
• Finally let EFF represent the efficiency of the
investment project undertaken, normalized to 1.
– EFF>1 above average project
– EFF<1 bellow average project
– EFF = 0 a bridge to nowhere
• K is the aggregate capital stock that is
depreciated at rate Omega.
• Finally, let S/Y be the savings rate
1.4 The Financial System and Economic
Growth
  EFF  I  K
K
(1.1)
  EFF  ( I / BOR )  ( BOR / FS)  ( FS / S)  (S / Y)  Y  K
K
(1.2)
• A well functioning Financial System will perform its
matching function efficiently will positively affect
S/Y and FS/S.
• Bottom-line: well function FS permits and
promotes growth.
1.6 Financial Markets and Social Welfare
• A timeless economy (consumption today only )
• Consumers - firms - n goods – markets
• Thanks to the action of the price system, order will
emerge out of this uncoordinated chaos, provided
certain conditions are satisfied.
– Note: this is a general description of an economy. For a
a more formal definition of an economy, check Theory
of Value (page 75).
1.6 Financial Markets and Social Welfare
• H1. Complete Markets.
• There exists a market, on which a price is established, for each
of the n goods valued by consumers.
• H2. Perfect competition.
• Agents behave as price takers
• The number of consumers and firms is large enough so that no agent
is in a position to influence market prices.
• H3. Consumers’ preferences are convex (a.k.a concave
utility)
• Agents have preference for mixtures.
• H4. Firms’ production sets are convex as well.
• Technical
1.6 Financial Markets and Social Welfare
• Definition: a General Competitive Equilibrium
A price vector p* and an allocation of resources, resulting
from the independent decisions of consumers and
producers to buy or sell each of the n goods in each of the
n markets, such that, at the equilibrium price vector p* ,
supply equals demand in all markets simultaneously and
the action of each agent is the most favorable to him or her
among all those he/she could afford (technically or in
terms of their budget computed at equilibrium prices).
« In other words: given current price, each agent "solves his
problem at current prices", and markets clear »
1.6 Financial Markets and Social Welfare
• Definition: a Pareto Optimum
An allocation of resources, however arrived at, with the
property that it is impossible to redistribute resources, i.e.
to go ahead with further exchanges, without reducing the
welfare of at least one agent. In a Pareto efficient
allocation of resources, it is thus not possible to make
someone better off without making someone else worse
off.
« Such a situation may not be just or fair, but it is certainly
efficient in the sense of avoiding waste. »
1.6 Financial Markets and Social Welfare
1. The Existence of a competitive equilibrium: Under H1-H4,
a competitive equilibrium is guaranteed to exist.
2. 1st Welfare theorem: Under H1-H2, a competitive
equilibrium, if it exists, is a Pareto-optimum.
3. 2nd Welfare theorem: Under H1-H4, any Pareto efficient
allocation can be decentralized as a competitive
equilibrium.
1.6 Financial Markets and Social Welfare
1. The Existence of a competitive equilibrium: Under H1H4, a competitive equilibrium is guaranteed to exist.
2. 1st Welfare theorem: Under H1-H2, a competitive
equilibrium, if it exists, is a Pareto-optimum.
3. 2nd Welfare theorem: Under H1-H4, any Pareto efficient
allocation can be decentralized as a competitive
equilibrium.
• And?
• These two theorems, taken together, are the
major source of govermental policies.
BlackBoard Picture
* Edgeworth Box example.
Time and Risk Dimensions
• Revisiting H1
Goods are defined by date and state of nature at
which they are available: « contingent
commodities ».
Complete Markets
• One distinct Arrow-Debreu security for each and
every future date/state configuration
• Ch. 8: There is no single way to make markets
complete
• In reality, different needs are met by alternative specialized
instruments
• Time dimension: personal loans, bank loans, money
market, bonds, pensions, etc.: « non contingent
instruments ».
• Individual contingencies:
– insurance contracts
– probably incomplete because of information asymmetries
• Most other available assets are contingent on collection of
states of nature defined on collective basis:
– e.g. stocks, derivatives
Conclusions
–
•
TOBIN:
" New financial markets and instruments have proliferated over the last decade, and it
might be thought that the enlarged menu now spans more states of nature and moves us
closer to the Arrow–Debreu ideal. Not much closer, I am afraid. The new options and
futures contracts do not stretch very far into the future. They serve mainly to allow
greater leverage to short-term speculators and arbitrageurs, and to limit losses in one
direction or the other. Collectively they contain considerable redundancy. Every
financial market absorbs private resources to operate, and government resources to
police. The country cannot afford all the markets the enthusiasts may dream up. In
deciding whether to approve proposed contracts for trading, the authorities should
consider whether they really fill gaps in the menu and enlarge the opportunities for
Arrow–Debreu insurance, not just opportunities for speculation and financial arbitrage.”
Chapter 1: Key concepts
• Preference for smoothness –Utility
representation: concave utility
• Desynchronizing across time and states of
nature
• Screening and monitoring functions
• Savings rate is important, but not all, for
growth
• Financial accelerator
Key concepts (cont’ed)
•
•
•
•
•
•
A competitive equilibrium
A Pareto optimum
Welfare Theorems
Contingent commodities
Arrow-Debreu securities
Complete markets