Money, Banking and The Macro-Economy - Answers: 5.1 Checklist Questions

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The key takeaways from the passage are that banks play an important role in facilitating lending between savers and borrowers by addressing issues of maturity transformation, risk pooling, information asymmetry, and aggregation of small savings. Banks also help achieve monetary policy goals through their impact on money supply and credit conditions.

There are four main reasons why saver household do not lend directly to borrower households, and banks can address each of these issues. First of all, savers want access to their savings at short notice, but borrowers want to finance long-term projects including mortgages. Banks assist in this maturity transformation in the economy. In addition, typical sav- ings quantities (e.g. regular savings by households) are much smaller than typical loan requirements (e.g. for lumpy investment projects such as house purchase or building a new production facility). Banks ensure ag- gregation, aggregating small savings and giving large loans. Third, banks provide risk pooling. Indeed, some borrowers will default, and if it is a single saver household that takes up the entire risk this may imply an additional default. Banks, instead, can withstand a certain proportion of defaulting, and hence offer little or no risk to savers. Finally, banks can assess the riskiness of loans, which savers typically cannot.

The money demand curve will then be shifted back to the left. This does not necessarily alter the central bank’s ability to achieve its desired output gap. By keeping the policy rate unchanged, any shift in the money demand function affects the money supply but does not feed back to influence real economic activity.

Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Chapter 5

Money, Banking and the


Macro-economy – Answers

5.1 Checklist questions


1. Why do saver households not lend directly to borrower households? How
can banks help solve this problem?
ANSWER:
There are four main reasons why saver household do not lend directly to
borrower households, and banks can address each of these issues. First
of all, savers want access to their savings at short notice, but borrowers
want to finance long-term projects including mortgages. Banks assist in
this maturity transformation in the economy. In addition, typical sav-
ings quantities (e.g. regular savings by households) are much smaller than
typical loan requirements (e.g. for lumpy investment projects such as
house purchase or building a new production facility). Banks ensure ag-
gregation, aggregating small savings and giving large loans. Third, banks
provide risk pooling. Indeed, some borrowers will default, and if it is a
single saver household that takes up the entire risk this may imply an
additional default. Banks, instead, can withstand a certain proportion of
defaulting, and hence offer little or no risk to savers. Finally, banks can
assess the riskiness of loans, which savers typically cannot.

2. What happens to the money supply and to aggregate demand when con-
fidence in financial markets is boosted? Assume the policy interest rate
stays the same throughout. Illustrate your answer using a 3-equation
model diagram (as in Fig. 5.5).
ANSWER:
The 3-equation model is represented in Fig. 5.5 in the chapter together
with the demand for money. The return of confidence to financial markets

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

2CHAPTER 5. MONEY, BANKING AND THE MACRO-ECONOMY – ANSWERS

in the aftermath of a credit crunch feeds into the structural parameter


Φ, which comprises all the shifters of money demand other than output.
The money demand curve will then be shifted back to the left. This does
not necessarily alter the central bank’s ability to achieve its desired output
gap. By keeping the policy rate unchanged, any shift in the money demand
function affects the money supply but does not feed back to influence real
economic activity. However, if in addition, the bank mark up is reduced,
then rP has to be raised to keep rS constant at y = ye .
3. Why are loans to households and firms considered risky? Make sure you
refer to and explain the following terms in your answer:
a. Uncertainty
b. Moral hazard
c. Asymmetric information.
ANSWER:
Bank lending is risky because there is no guarantee that interest payments
on a loan will be repaid or that the principal will be paid back in full
when repayment is due. This risk is called credit risk, and will be present
even when bank lending is backed by collateral, because banks may incur
transaction and legal costs when seizing the collateral in relation to non
performing loans. Uncertainty will affect the riskiness of a loan. If, for
instance, we consider that firm’s future profitability is very uncertain,
then its ability to repay the loan will be too. This will raise the risk of
default of such loan. Even more important than the fact that the future is
unknown, however, is the way information problems can affect behaviour.
The problem of possible default by the borrower for reasons other than
bad luck is an example of moral hazard and it affects the willingness of
banks to lend and why that is affected by the wealth of the borrower.
The more of its own wealth a firm is able (and prepared) to invest in the
project, the easier it is to borrow. When your own funds are at stake,
your incentives are better aligned with those of the lender. Besides moral
hazard, firms and households have better information about the expected
future earnings of a project than the bank. Such situation of asymmetric
information increases credit risk and may result in a problem of adverse
selection. As a consequence, borrowers with insufficient wealth to invest
in their project may be denied credit.
4. Are the following two statements both true or is only one of them true?
Justify your answer.
S1. The bank lending rate will increase the more risky loans are perceived
to be
S2. Given S1, the more risk that banks can tolerate, the higher the bank
lending rate will be.
ANSWER:

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

5.1. CHECKLIST QUESTIONS 3

Statement S1 is true. The riskier the loan, the higher the banking mark-
up that banks will charge on top of the policy rate. This stems from
the considerations explained in the previous answer. With greater credit
risk, banks insure themselves from borrower’s default by charging a higher
lending rate. Statement S2, in contrast, is false. Indeed, the lending rate
depends negatively on risk tolerance. Banks that are more willing to take
up higher risk will charge a lower lending rate, for a borrower of the same
risk, compared to a less risk tolerant bank. By doing so, they are able to
attract a higher share of risky borrowers.
5. The following four borrowers are categorised according to their level of
wealth and the quality of their proposed investment project. Which of the
borrowers will receive a loan from the bank for their project and why?
a. low wealth, low quality project
b. low wealth, high quality project
c. high wealth, low quality project
d. high wealth, high quality project
ANSWER:
To answer the question, we assume that the only difference across bor-
rowers and projects is their wealth, which is known to the bank and the
quality of the project, which is not. Based on these assumptions, of the
four borrowers, (d) will receive a loan. Higher wealth signals to the bank
the borrower’s ability to repay the loan. Higher wealth also allows the
borrower to signal the quality of the project by the borrower’s willingness
to contribute equity, which better aligns the borrower’s incentives with
those of the lender. In presence of asymmetric information, borrowers (a)
and (b) look alike and will not receive a loan. Because borrower (c) is
able to provide an equity contribution to the project and or provide col-
lateral, they are likely to receive a loan for a lower quality project than it
is possible for borrower (b) to finance.
6. Is deposit insurance always a ‘good thing’ ?
ANSWER:
Such schemes are beneficial in avoiding "coordination failures" and liquid-
ity risk stemming from self-fulfilling bank runs. However, they need to be
designed in order to avoid moral hazard. Such schemes dampen the incen-
tive for banks to take due care in their loan decisions and more broadly, in
their prudential behaviour. They also reduce the incentives for households
to be prudent. If a household knows their deposits are guaranteed up to
a certain amount, they may, for example, be less sceptical of the business
model of banks offering very attractive deposit rates. It is more likely that
bad management of banks will escape the notice of depositors.
7. Set out a simple balance sheet for a single commercial bank (as in Fig.
5.9). Define each item in turn and discuss why that item has been labelled

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4CHAPTER 5. MONEY, BANKING AND THE MACRO-ECONOMY – ANSWERS

as an asset or a liability. Why is net worth on the liabilities side of the


balance sheet?
ANSWER:
Use Fig. 5.9 in the chapter as the guide.
The bank’s net worth is defined as the difference between bank’s assets
and liabilities. This is on the liability side because it is also referred to
as the bank’s equity, which is owed to its owners. A bank is insolvent if
the value of its liabilities exceeds the value of its assets; its net worth is
negative.
8. What are the channels through which banks can fund their lending? In the
model presented in this chapter, can banks influence the level of aggregate
demand in the economy?
ANSWER:
Banks can fund their lending through the different types of liabilities listed
on their balance sheet. The most typical channel is represented by de-
posits. As well as unsecured borrowing in the money market, banks can
also raise funds through Wholesale repo borrowing secured with collateral.
The term repo stands for sale and repurchase agreement and is a very
common form of short-term secured borrowing by banks. This is the way
banks fund their everyday activities – they borrow from the money mar-
ket by selling assets to another bank (the lending bank) and promising to
buy them back in a few weeks or months. The repurchase price is always
higher than the sale price, providing interest for the lending bank. The
banking system facilitates the transformation of new savings into new in-
vestment. Banks can only influence aggregate demand in the short run
(e.g. by lowering the lending rate). In the case where the economy is
initially at equilibrium output, the central bank will then raise the pol-
icy rate. The banks will respond by restoring r = rS , and thereby keep
aggregate demand is once again equal to ye .
9. What are the key differences between the way that monetary policy is
conducted in the 3-equation model (from Chapter 3) and in the 3-equation
model with the banking system? Does this change the policy implemented
by the central bank following economic shocks?
ANSWER:
The central bank reacts in exactly the same way as it does in the core 3-
equation model, by adjusting the interest rate to stabilize the economy at
equilibrium output and target inflation. The key difference relates to the
instrument through which monetary policy is conducted. In Chapter 3 we
simplied by assuming that the central bank directly sets the lending rate,
whereas in this chapter the central bank sets the policy rate to achieve
their desired lending rate (taking into account the banking mark-up). The
central bank uses its control over the policy interest rate to affect the
funding costs of banks, inducing them to change their lending rate.

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

5.1. CHECKLIST QUESTIONS 5

A
rS
Initial banking B
mark-up Z
r′S r P
r0
C IS
IS′
r P′
Period 1
banking y
mark-up
π
PC(π 0E = π T )
PC(π tE = π 0 )
A, Z
πT
π1 C
π0 B y
MR

y0 ye y1

Figure 5.1: 3-equation model - reduction in consumer confidence

10. Use the 3-equation model to show the impact of a reduction in consumer
confidence on the economy. Make sure you show the period 1 mark-up
on your diagram and discuss what happens to both the policy rate and
the lending rate (as in Fig. 5.13). How would you expect a reduction in
competition in the banking sector due to mergers between banks to affect
the macro-economy?
ANSWER:
A reduction in consumer confidence is modelled as leftward shift of the
IS curve, as in fig. 5.1. Aggregate demand is depressed and output goes
below the equilibrium level; inflation falls too. The central bank responds
by cutting the policy rate to rP ′ in order to achieve their desired lending
rate of r0 – the period one mark-up is shown on the figure. The decrease
in the lending rate boosts aggregate demand and raises inflation. The
central bank then gradually increases the policy rate over the following
periods until the lending rate reaches its new stabilising rate at rS′ . For
all types of market structure, the factors influencing the banking mark-up
are the same and work in the same direction: bank’s perception of loan
riskiness, bank’s risk tolerance and bank’s capital cushions. The market
structure simply affects the size of the mark-up. When banks have market
power they are able to charge a higher lending rate, holding everything

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

6CHAPTER 5. MONEY, BANKING AND THE MACRO-ECONOMY – ANSWERS

else constant. In the example in this question, a reduction of competition


it is likely to require a sharper cut in policy rates by the central bank in
order to achieve the same desired level of lending rate.

5.2 Problems and questions for discussion


1. Collect the annual report of a US commercial bank from 2006. Find
the consolidated balance sheet and condense it into a form similar to
the Barclays’ balance sheet shown in Fig. 5.10. Answer the following
questions:
a. What proportion of customer deposits does the bank hold with the
central bank as reserves?
b. How much of the bank’s loans are funded through customer deposits?
c. What is the bank’s leverage?
ANSWER:
Left as an activity for students.
2. Use central bank websites to collect data on monthly policy rates and
mortgage rates in two developed economies between 2000 and 2012. Plot
the data on graphs, as per Fig. 7.9. Answer the following questions:
a. How do the banking mark-ups compare in the two countries?
b. Do the banking mark-ups change over time?
c. Use the chapter and the appendix to discuss possible reasons for any
differences observed over time and across countries.
ANSWER:
Left as an activity to students.
3. In the wake of the global financial crisis, there has been a lot of discus-
sion about whether banking is ‘socially useful’. Use the simple model of
the macro-economy and the financial system to explain the benefits to
the economy of the banking system and its role in stabilization policy.
What factors are not considered in the basic model which could lead to
the banking system destabilizing the economy? Could these activities be
considered socially useful?
ANSWER:
The simple model highlights the role of the banking system in supplying
payments services that allow spending decisions to be carried out. When
looking at bank balance sheets as we modelled them, loans represent the
largest item and can be considered a bank’s core activity. This highlights
why the banking system is so crucial to the functioning of the economy.
The model shows how the banking system provides maturity transfor-
mation facilitating the shift of new savings into new investment. When

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

5.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 7

output and income go up as a result of higher investment spending, sav-


ings also go up. Under the assumptions of the model, households must
decide how to allocate their new savings between deposits in the banking
system and the purchase of financial assets – neglecting the purchase of
bank’s shares. Banks will transform such savings into loans that finance
investment: both directly, through deposits, and indirectly, issuing new
loans financed through the money market. The central bank is able to
achieve its stabilization objectives through the link between the policy in-
terest rate and the lending rate set by the banking system. The presence
of deposit guarantee schemes and the role of the central bank as lender of
last resort prevent a liquidity crisis from creating a disruptive banking cri-
sis. The model simplifies the layers of complexity that exist in the global
financial system and, in particular, does not consider the role of invest-
ment banking activities (see Chapters 6 and 7 for more discussion). When
a financial crisis hits the economy, lending to business and the household
sector may be perceived as too risky by banks, which may increase the
degree of credit rationing. This is easier to do if the bank’s business model
includes activities other than lending. Typical examples could be trading
portfolio assets and investing in derivative financial instruments. Such
activities are less socially useful the less they are related to investment in
the real economy.
4. The UK government introduced lending targets for the five major UK
banks after the global financial crisis. Use the simple model of the macro-
economy and the financial system to discuss this policy. Make sure you
refer to:
a. Whether you think the policy makes economic sense.
b. Are there any potential pitfalls with the policy?
c. How could it affect stabilization policy?
ANSWER:
A policy aimed at introducing lending targets for the major banks seeks
to bring them back towards what is generally deemed as the core activity
for a banking system: providing loans to households and to small and
medium sized firms. The financial crisis worsened bank balance sheets and
saw a reduction of lending, perceived by banks as too risky. In principle,
therefore, a policy of lending targets could be effective. Being obliged to
increase the share played by loans in their balance sheets, banks would
regain the role of stabilising the economy that is typical of the model
considered here. There are two factors that limit the effectiveness of a
policy of lending targets. The first relates to the incentives of the banks
and the second to the demand for loans by firms. When the regulatory
authorities are trying to improve the safety of the banking system by
requiring banks to have larger equity cushions, there will be a tendency
for banks to reduce their lending. Setting higher lending targets is an
attempt to prevent this reaction by banks. This highlights the difficulties

© Wendy Carlin and David Soskice 2015. All rights reserved.


Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

8CHAPTER 5. MONEY, BANKING AND THE MACRO-ECONOMY – ANSWERS

for the government in inducing the banks to contribute to stabilization in


a recession by raising their lending at a time when the authorities are also
attempting to ensure a safer financial system by requiring banks to reduce
leverage. Reducing their lending is a direct way of reducing leverage (see
Chapter 13 for further discussion). The second factor that may limit the
effectiveness of policy relates to the demand for credit. In particular, firms
may reduce their demand for loans because they have low confidence in
the future profitability of their own business. If it is credit constrained
firms that represent the main driver of the slowdown in investment during
a recession, increasing bank lending may improve their external financing
position and help the economy to recover, inducing a virtuous cycle. If,
on the other hand, credit is depressed mainly because of weak demand for
loans due to the lack of confidence of firms in the future of their business,
a policy of setting lending targets may be ineffective.

© Wendy Carlin and David Soskice 2015. All rights reserved.

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