6 - Money, Banking and the Macroeconomy

Question 1

Why do saver households no lend directly to borrower households?

Answer 1

1. Savers want access to their savings at short notice, but borrowers want to finance long-term projects (mortgages).
   - banks assist in this maturity transformation in the economy
2. Saving quantities are much smaller that typical loan requirements.
   - banks ensure aggregation, aggregating small savings and giving large loans
3. Some borrowers will default.
   - banks provide risk pooling - offer little to no risk to savers
4. Banks can assess the riskiness of loans, which savers typically cannot.

Question 2

Why are loads to firms and households considered risky?

Answer 2

Credit risk
-no guarantee that loan or interest payments will be repaid
Uncertainty
-firm’s future profitability is uncertain, then so will its ability to repay the loan
Moral hazard
-problem of possible default by the borrower for reasons other than bad luck
-affects the willingness of banks to lend and why that is affected by the wealth of the borrower
Adverse selection
-firms and households have better information about the expected future earnings of a project than the bank

Question 3

Is deposit insurance always a good thing?

Answer 3

Such schemes are beneficial in avoiding ‘coordination failures’ (expectation of a bank collapsing) and liquidity risk stemming from self fulfilled bank runs. However, they need to be designed in order to avoid moral hazard.
Such schemes reduce incentives for banks and households to be prudent.
-households may be less sceptical of the business model of banks offering very attractive deposit rates

Question 4

What are the channels through which banks can fund their lending?

Answer 4

They can fund their lending through the different types of liabilities listed on their balance sheet.
-deposits m, unsecured borrowing, and wholesale repo borrowing secured with collateral

Question 5

How do banks fund their everyday activities?

Answer 5

They borrow from the money market by selling assets to another bank, promising to buy them back in a few weeks or months.

Question 6

Aggregate demand and banks

Answer 6

Banks can only influence aggregate demand in the short run (by lowering the lending rate).

Question 7

What are the key differences between monetary policy and the banking system?

Answer 7

The CB ready in exactly the same way, by adjusting the interest rate to stabilise the economy at equilibrium output and target inflation.

Monetary policy: assume that the CB directly sets the lending rate.
Banking system: CB uses its control over the policy interest rate to affect the funding costs of banks, inducing them to change their lending rate.

Question 8

Reduction in consumer confidence

Answer 8

A reduction in consumer confidence is modelled as a leftward shift of the IS curve.

• aggregate demand is depressed and output goes below the equilibrium level, inflation falls too.
• CB cuts policy rate to achieve desired lending rate
• decreases lending rate boosts aggregate demand and raises inflation
• CB then gradually increases policy rate until lending rate stabilises