Download Explanation for Financial Crisis from Monetary Perspective

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Explanation for Financial Crisis from Monetary Perspective
LI Xiaohong
School of Banking, Xinjiang University of Finance and Economics, China, 830012
[email protected]
Abstract: Using deductive researching approach, this paper studies the causes for financial crisis. As the
economy developed into the era of commodity economy, money has played a more and more important
role in social economy. By constructing simple models, this paper analyses how money acts upon
economy through commodity market, stock and bond market and derivative market. Furthermore, this
paper studies the relationship between money and economic growth. The result shows that when the
supply of money in a certain market exceeds the potential demand for money, there will be the threat of
crisis.
Keywords: Money, Market, Financial Crisis
1 Introduction
1.1 Review on the main theories on financial crisis
In Marx’s view, the key reasons for real crisis are the poverty and limited consumption of the majority
and the endeavor to develop productivity by the capitalist production.
In others’ view, the social Darwinism featured by New Liberalism in economics and New Conservatism
in politics supports Law of the Jungle and Survival of the Fittest, which is the spiritual sources for crisis.
Krugman (1979) created the model for money crisis. The first generation model of money crisis is
adapted from Krugman’s theory. Its background is the money crisis in Mexican (1973-1982) and
Argentina (1978-1981). It emphasizes the relationship between speculation attack in foreign exchange
market and macroeconomic variables.
When the 1992-1993 European Money Crisis took place, some countries had large amount of foreign
reserves, and there was no contradiction between macroeconomic policies and the stable exchange rate
policies. Obstfeld(1994,1996), Sachs, Tornell and Velasco(1996) put forward the second generation
model of money crisis, which emphasizes multi-equilibrium and self-fulfilling of the crisis, that is, the
speculators’ believes and expectations can make the government stick to or discard the fixed exchange
rate policy.
In order to explain the 1997-1998 Asian Financial Crisis and the related crisis, the third generation
model of money crisis came into being. This theory studies beyond the macroeconomic analysis scope
of exchange rate mechanism, monetary policy, fiscal policy, public policy and focuses on financial
intermediaries and the change in asset prices. It also emphasizes the roles of financial intermediaries in
the process of the crisis. According to the different study angles, the third generation model of money
crisis can be divided into three types: economic basic variables propelling models, financial panic
propelling models and models emphasizing the relationship between the expectation and economic basic
variables.
While accepting the fact that Marx’s theory can explain the economic crisis, some Chinese economists
emphasize the contradiction between real economy and fictitious economy.
1.2 Comment on the present theories
For all the crisis theories and models from home and abroad, none of them could abstract the common
features of economic crisis. What they can do is to explain the crisis of a certain period and they are of
little applicability. For example, the scope of the third generation theory changes compared with the
second generation theory, but still is only partial explanations for certain crisis or crisis of certain period.
They didn’t reveal the gist of the crisis.
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1.3 Theory introduction
The 2007 subprime financial crisis has great influence on world economy. To study the financial crisis in
the post-crisis period and put forward theories to explain the crisis can provide basis for the prevention
before the crisis, active treatment during the crisis and timely remedial after the crisis.
What is the relationship between money and real economy? What effect does economic growth has on
money? How does financial crisis come into being?
As the economy developed into the era of commodity economy, money has gradually become a kind of
commodity that is independent of other commodities and has indispensible effects on the development
of real economy. The development stage of the real economy decides the money stock of that period,
and the economic growth decides the increment of money. This paper has divided the economy into
three markets-commodity market, stock and bond market and derivative market. Money moves inter or
across the three markets. When the supply of money of one or several of the markets exceeds or is less
than the potential demand for money, there will be financial crisis.
2 Theory for Financial Crisis
2.1 General Model
Suppose
1. The resource is a constant. Here resource refers to natural resource, human resource and technique
resource.
2. The economy can be divided into three markets: commodity market, stock and bond market and
derivative market.
3. The economy is divided into two stages: Production Stage and Circulation Stage.
4. Money in reservation form is constant
Resource is allocated through stock and bond market during Production Stage, income is allocated
through commodity market during Circulation Stage. Risks are allocated through derivative market.
Stocks and bonds are issued in the stock and bond market and the economy starts its Production
Stage. In commodity market, through buying and selling of commodities, income is allocated. The
derivative market allocates risks from the two stages. Relations of the two stages and three markets
can be described in the following figure. Money in reservation form is also considered.
Stock and
Market
、
Commodity Market
Bond
Derivative Market
Reservation
Money
Figure: Economy Structure
In the figure, the ellipse stands for the whole economy, the arrows stand for money flow. Suppose
money in circulation in the commodity market is M1, the velocity is V1, money in circulation in the
stock and bond market is M2, the velocity is V2, money in circulation in the derivative market is M3, the
velocity is V3, and money in reservation form is Mc. Money supply M is thus
M=M1V1+M2V2+M3V3+Mc. When pricing is reasonable, if money issued in the whole economy is more
than the potential necessary amount, the excess money will go into certain market. When money supply
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exceeds money demand, the price will go up. In commodity market, there will be inflation, in stock and
bond market and derivative market, there will be bubbles. When pricing is unreasonable, if the price in
certain market is too high, money will be attracted to flow in. when the price goes higher than the
critical value that the economy could stand, there will be crisis. If money supply is less than enough,
there will also be crisis.
2.2 Models for certain market
Take commodity market as an example:
2.2.1. Model for Money and the Economy
Suppose
1. MV=PT. M stands for money in circulation, V stands for velocity of money, P is price level, T is total
level of transaction
2. The supply of commodity G is constant
3. The demand for commodity G declines
4. In short term, the money stock is unchanged
(Other economic situations could be achieved by changing the assumptions)
As demand for goods declines, T, which is the total level of transaction, also declines. As the supply of
goods is now larger than the demand for goods, P declines. In the above equation MV=PT, the right side
declines, so the left side should also decline. There are several routes: M declines with V unchanged; V
declines with M unchanged; M together with V decline; M declines more than V increases, or V declines
more than M increases so that MV declines.
Suppose V is unchanged (For a certain development stage, people are used to a certain level of V). Then
M should decline. As assumption 4 shows, in short term, the money stock is unchanged, so the money
supply of markets other than the commodity market increases. This M goes into the stock and bond
market or derivative market. In a certain stage of economy, money demand of different market is
constant. When the M goes into one or two of the two markets and causes money supply to exceed the
potential money demand, there will be the possibility of crisis.
In my opinion, the equilibrium in the market includes the act of governmental behavior. It means that
government is also a participant of the economy, and it acts to promote the equilibrium of the economy.
If the regulation from the government for the superfluous money to the real economy is not efficient,
there will be a threat of crisis in the economy.
2.2.2. Model for Money and the Economic Growth
Suppose
1. There is an economic growth in the economy, pushed by technology progress.
2. The increases in demand for and supply of commodities match
3. MV=PT is also used here.
Now PT increases either because T increases or because P increases so that the total value of trade goods
increases as a result for the technology progress. The situation of an increase in P will be explained later
(Usually P is not changed for the time being, but is pushed to change for reasons explained below). For
this new stage of economy, an increment in money stock is needed (There may also be an increase in V,
but as people get used to the present level of V, there may be a time lag for the change of V. Or, in
general, the increase in V is usually not enough to meet the demand for money for the new stage of
economy). If the present stage of economy is in equilibrium, and the increment in money stock is
suitable enough to put the economy in another new equilibrium, there will be no problem. However, if
the increment in money stock is not suitable to the economy stage, there should be a change in the
general price level. If it is more than enough, the price will generally go up, which is just the situation in
most of the history of economy with a higher price level as the economy develops. And if the price goes
beyond the critical value that the economy could stand, there may be crisis explained in model 2.1
If the changes in supply of and demand for commodities don’t match, there will be a change in the
general price level, which may cause relative changes in both sides of the equation. For example, if
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supply of commodities is larger than demand for commodities, P will goes down, the change in PT
depends. If PT declines, then MV declines. As V is stable, to some extent, M should declines. This will
require a change in money, which will follow the first model in part 2.2.1.
3 Reality Test for the Theory
3.1 1673 Tulpenmanie.
In this crisis, as the tulip was priced too high, large amount of money was attracted into tulip market and
finally the amount of money in the tulip market exceeded the critical value of the market and crisis took
place.
3.2 1720 South Sea Bubble.
Too much money flew into the stock market and the stock price went to above 1,000 pounds.
3.3 1837 Panic.
The panic in 1837 happened in the U.S.A. and caused the banking system to shrink. The management of
money in reservation form is out of order and caused the panic.
3.4 1907 Banking Crisis.
More than half of the bank loans in New York City were put into the stock and bond market, which led
to the result that the money supply in the stock and bond market exceeded the potential demand and
crisis took place.
3.5 1929 Economic Crisis.
Money in large amount had been put into the stock and bond market for speculation and caused bubble
in the market and finally induced crisis.
3.6 1987 Black Monday.
S&P index dropped 20%, the bubble cracked and crisis happened.
3.7 1994 Mexican Financial Crisis and 1997 Asian Financial Crisis.
Money flew into the stock market and caused price to go up. Then price went down and crisis took
place.
3.8 2007 Subprime Financial Crisis.
According to the statistics from NAR, the spot median price for houses went from $139,000 in 2000 to
$185,200 in 2004, 33% up in five years with annual increasing rate of 6.7% (9.3% in 2004 and more
than 12% in 2005). The scale of housing mortgage loan also expanded quickly, from 4.8 trillion dollars
in 2000 to 9.7 trillion dollars in 2006, among which the balance of subprime loan went from 140 billion
dollars in 2000 to 640 billion dollars in 2006, with average annual increasing scale of 36%. The excess
money inflow into the two market-housing market and derivative market has caused the crisis.
4 Conclusion
Nowadays, the world hasn’t formed an international integrated, mature market. But still we can suppose
that there is an international market for world economy. According to the above models, as the US dollar
is world money, from world angle, the American derivative market is the derivative market for the
international market, which means that the derivative market is centered in the U.S.A. According to
the above theory, the price for houses went up and caused the demand for other commodities went down.
What’s more speculation prevailed, and M went into the housing market and derivative market. The
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attack from this amount of money led to the result that the supply of money in the two markets exceeded
the potential demand for money, the bubble cracked and crisis took place.
Acknowledgement:
I thank my advisor LI Jigang for his advice and help during my writing of the paper.
References
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14(2009):46~47, 68(In Chinese)
[2]. ZhuBo, FanFangzhi, Review of Financial Crisis Theories and Models, World Economy Study,
6(2005):28~35 (In Chineses)
[3]. Carmen M. Reinhart and Kenneth S. Rogoff, Is the 2007 US sub-prime Financial Crisis So
Different? An International Historical Comparison, American Economic Review, 98:2 (2008)
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