Macro Unit 6 Flashcards
How can we set up a model for bilateral debt?
There are 2 actors, A and B, and 2 periods, now and later. There is one good, grain, which can be eaten, stored or used to produce more grain.
We assume A has wealth (a pile of grain). He can consume it now but wants to ensure he can also consume later.
We assume B has no wealth but if she can borrow grain, she could consume some now and grow more for consumption later.
Land is freely available so grain production requires 2 inputs; grain itself and labour.
A has no wish to spend any time working but B is willing and able to work.
If A were to lend some grain to B, she could invest some of it (by planting it now) and pay A back in the future.
This requires B to take on debt (liability).
What is a bilateral debt contract and what do both parties gain?
When someone borrows an agreed amount from someone else and promises to repay a fixed amount in the next period.
In the model example, A lends some grain to B who promises to repay a fixed amount of grain in the next period.
The benefit to B of entering the contract is that without it she cannot consume.
A needs to consume in the second period so needs a store of value. Or he can save by lending to B, in the expectation that she will repay him later, which acts as an alternative store of value.
An added incentive for A is if B pays back more grain in the future than she borrows now (interest)
Explain a balance sheet and apply it to the bilateral debt model
A balance sheet is a record of all current assets and liabilities. A difference between a person’s assets and liabilities is their net worth/wealth.
Net worth measures the amount you could consume now if all your debts were paid.
For A and B, assets, liabilities and net worth are all measured in terms of grain (the unit of account)
Suppose A starts with 100 units of grain and lends 50 units to B.
Before loan:
A’s total assets are 100 and total liabilities are 0, NW=100
B’s total assets are 0 and total liabilities are 0, NW=0
After loan:
A’s total assets are still 100 and total liabilities are 0, NW=100
B’s total assets 50 and total liabilities are 50, NW=0
The loan has not changed A or B’s net worth, ie debt cancels out
How is interest incorporated into the bilateral debt model?
Suppose the contract specifies an interest rate of 10% so that if A lends 50 units of grain to B, B must repay 55 units.
Rate of interest = extra amount borrower promises to repay/loan
For A, the effect of the loan is that he can consume his remaining 50 units of grain now and 55 units in the second period. Thus he can consume more than he could have without the loan.
B must invest some of the loan to grow more grain for her future consumption and to repay A.
Suppose B consumes 20 units now and plants/invests 30 units. After dedicating labour to growing grain, at beginning of the second period, B pays 55 units back to A and consumes the remainder.
The loan has enabled B to consume and invest in the first period, and because the investment led to grain production, she can consume in the second period.
What are financial intermediaries and financial markets?
Economic agents such as banks or pension funds that borrow from savers and simultaneously lend to borrowers. Intermediation provides an alternative to bilateral loan contracts as a way of channelling savings from people who want to lend to those who want to borrow.
In financial markets, large borrowers, like large companies and governments, trade directly with investors (pension funds or insurance companies who act on behalf of households).
Companies and governments are able to borrow directly by selling bonds or can raise funds by issuing shares of the company.
Bonds and shares are then traded in bond and stock markets - secondary trading.
How can a bank be incorporated into the bilateral debt model?
There are now 3 actors, A, B and the bank owner. There are still two periods. Initially, A has 100 units of grain and B has no wealth.
The bank accepts deposits and makes loans in the form of grain.
Additionally, the bank has 10 units of grain stored, this is the owner’s initial equity in the bank.
A can save 50 units of grain by depositing it at the bank in period 1 at the rate of interest it offers and withdraw it for consumption in period 2.
B can borrow 50 units of grain from the bank in period 1 at the rate of interest at which the bank lends. She can consume, invest and produce grain and then repay the bank in period 2.
The bank owner acts as an intermediary between A and B and will make a profit if the interest rate B pays is higher than the interest rate on A’s deposit.
What is the bank’s balance sheet in the bilateral debt model?
Initially, the bank has one asset, 10 units of grain in reserves and no liabilities. Its net worth is 10.
After A deposits 50 units of grain and the bank loans out 50 units to B, the bank’s total assets are now 60 (10+50) and total liabilities are 50.
This is because A’s deposit is a liability to the bank as the bank owes this to A. The loan to B is an assets as B must repay it back.
Again, the net worth of the bank remains unchanged (60-50=10) because the assets and liabilities have risen equally.
Banks’ net worth are typically small compared to their assets
How does a bank make profit?
Using the bilateral debt model, in period 2 B harvest the grain they have produced from their investment and repays the bank with interest and consumes the remaining grain.
The bank pays interest to A and A withdraws the original deposit and consumes the grain.
Suppose the bank offers 6% interest on deposits and lends at 10%.
We assume B invests 30 units of the grain she borrows and produce 90 units in period 2 and then fulfils the promise to pay 55 units back to the bank.
A withdraws 53 units (deposit+interest).
The bank’s profit is 2 grains (difference between interest received and paid out)
The bank’s revenue on a loan = interest rate on loan x total lending, and the payments to depositors (costs) = interest rate on deposits x total deposits
Profit = revenues form lending - payments to depositors
Since a bank’s liabilities are almost as high as its assets, total deposits are approximately equal to total lending so:
Profit ~ (interest rate on loans - interest rate on deposits) x total lending
Banks increase their profits the more they lend and the bigger the gap between the interest rates on assets and liabilities
What are reasons banks are preferred to a 2-way bilateral debt contract?
- Without banks lenders may not meet borrowers who want to borrow the exact amount the lender wishes to lend
- Even if a bilateral debt contract for the exact amount were available, there is risk involved in making a loan
For any loan, there is always a risk the borrower will default (fail to pay the loan or repay less than specified).
When there is a risk of default, the profit on the loans depends on how much the borrower actually repays
Rate of return on loans = total amount borrower actually pays back - loan/loan
If the borrower repays the loan in full, with interest, the rate of return on the loan is equal to the interest rate on lending, but otherwise is lower.
Revenues from lending = rate of return x loan
Banks are able to spread the risk by diversifying, ie lending to many borrowers knowing most will repay.
Given a rate of interest, the higher the profitability of default is, the lower the expected return is. So when banks make risky loans to borrowers whose probability of default is high, lenders set a higher interest rate by adding a default premium.
What is insolvency and bank run?
Insolvency is when a bank does not have enough assets to repay its liabilities.
The main source of risk to savings in banks is that the bank’s borrowers may default. Although diversified lending reduces this risk, banks cannot be certain on the proportion of loans that will be repaid.
Banks are obliged by law to have sufficient equity/net worth (capital adequacy requirements) to meet their liabilities if the return on loans is lower than expected
Bank run is when depositors withdraw funds from a bank as they fear it may go bankrupt and not repay its liabilities
This arises due to a liquidity issue where lenders can withdraw whenever they want, hence liabilities are liquid, but the bank cannot demand loan repayments instantly, hence assets are illiquid
What are the functions of money?
- means of exchange: something buyers and sellers are willing to exchange for goods and services
- store of value: people can store their wealth in this firm until they want it use it to buy goods ans services
- unit of account: facilitates the exchange of goods and services by enabling everyone to use the same units for valuing them
What is commodity money and bank money?
In economies without a well-developed banking system, people may use a particular commodity such as gold, as money. The commodity is typically a basic good that is widely valued and acts as a medium of exchange, store of value and unit of account.
Commodity Money historically was preferred to barter.
In wealthy economies, (still assuming no notes, coins or legal tender) bank deposits are used as a medium of exchange.
Extending the bilateral debt model to include other goods and services, rather than A carrying around grain to pay for other goods, ie groceries at a supermarket, he can deposit 50 units of grain into a savings account and 50 into a current account for consumption.
When A makes a 5 unit of grain purchase of groceries, the bank owes 5 units to the supermarket, and now owes 95 units to A,the remainder of the liability.
This is bank money, money in the form of deposits in commercial banks
What is base money?
Base money/central bank money is a liability of the central bank. In modern banking systems, base money has replaced commodity money like gold and silver.
The central bank supplies two forms of base money, currency (notes and coins) and reserves (deposits that commercial banks have in their accounts at the central bank)
Reserves can be converted to currency on demand at the central bank and vice versa. Commercial banks must use its reserves to carry out transactions with other banks.
When a customer of bank A spends money at a business that has an account with bank B, the customer’s money (deposit) is transferred from bank A to B, along with a corresponding amount of reserves.
Most money is circulation in economies is bank money (bank deposits in commercial banks) and the rest is currency (notes and coins)
What are banknotes?
Physical currency that serves as legal tender, ie must be accepted in exchange for goods or services.
Banknotes are a liability of the central bank
Banknotes and base money fulfill the same role, but bank money is a liability of commercial banks (commercial banks promise to transfer deposits from one person to another and to repay the deposit-holder on demand) whereas banknotes are a liability of the central bank (whenever there are used, the central bank’s liability is transferred from one person to another
What are the central bank’s liabilities?
Banknotes and reserves (commercial bank deposits).
Reserves come in the form of two complements:
1. Commercial banks’ reserve account balances which are deposits by the commercial banks in their accounts at the central bank. Ie the central bank acts as a banker to commercial banks, enabling individual banks to pay each other
2. Cash ratio deposits: central banks may regulate the minimum level of reserves commercial banks must hold at the central bank to ensure they have adequate liquidity to meet demands for withdrawal of deposits by customers
Banknotes and reserves together form the monetary base (base money) which is a form of government debt
What is quantitative easing (QE)?
In the financial crisis of 2008, when policy interest rates hit the zero lower bound, many central banks boosted AD by pushing down long term interest rates in a policy called quantitative easing.
The central bank did this by buying government bonds from financial institutions like pension funds and insurance companies.
The increased demand for bonds caused the price of bonds to increase in the bond market. The higher price meant that the fixed payments to bond holders corresponded to a lower interest rate. While the short term policy rate was stuck at zero, the longer-term interest rates hit on bonds fell (inverse relationship between the price and interest rate on bonds)
These bonds are an asset for the central bank but liability for the government
How is money created?
- Banks create bank deposits when they make loans. Suppose bank A makes a $1000 loan to a firm X who wishes to buy a computer from firm Y. A $1000 deposit is created and credited to the firm’s current account which produces an asset (loan) and liability (deposit of $1000) for the bank. To make the loan, bank A did not require a deposit from the firm. If the two firms have accounts at the same bank, the $1000 deposit is transferred from company X to company Y’s account. If the two firms have accounts at different banks, ie firm X banks with A and Y banks with B. The $1000 deposit leaves A and goes to B. A’s reserve account falls by $1000 and B’s rises by $1000. New bank money has again been created as B’s deposit liabilities have increased.
- Central banks create bank deposits when they buy bonds, increasing reserves.
What are constraints to the amount of loans a bank can make?
- demand for loans. There must be a demand for bank loans from households and firms on the terms the bank is willing to offer. The central bank’s monetary policy will directly impact the amount of lending by commercial banks because it affects the demand for loans. A higher policy rate will be passed on by commercial banks as a higher lending rate which will dampen demand for loans.
- capital adequacy requirements. The bank is required by the government to have enough equity relative to assets to meet requirements. When banks make loans, the net worth doesn’t change but assets and liabilities both increase, so the capital adequacy ratio has fallen
- reserve requirements. Banks must have enough reserves to be able to respond to depositors’ requests for withdrawals of deposits.
What are some common financial assets?
Financial assets offer a form of saving for households.
In financial markets, savers and borrowers buy and sell assets called traded securities, particularly bonds and shares.
When companies want to raise funds to invest, they can sell shares, reinvest profits, borrow or (for large companies) issue corporate bonds the same way the government does.
Bonds are tradeable forms of debt unlike loans.
The company makes coupon payments to the bond owner until the bond reaches maturity.
Raising funds by borrowing is debt finance.
When shares are issued by companies for the first time, this is an IPO. Shareholders are not entitled to regular payments but the company may pay out some of its profits in dividends. Profits not paid out (retained earnings) are reinvested into the business. If reinvested profitably, the net worth of the business increases and the share price rises.
When companies raise finance by selling new shares or via retained earnings, this is equity finance.
Most trading on bond and stock markets is of existing shares and bonds.
What is the rate of return on loans?
The choice between different financial assets for an investor depends on their rate of return
Rate of return on loans = total amount borrower actually pays back - loan/loan
The rate of return is only equal to the interest rate if the loan is fully repaid
Rearranged this gives: 1+rate of return = total amount borrower pays back/loan
This expression is a particular case of a general formula for the rate of return on any asset or investment:
1+rate of return = what you get back/what you put in
Capital gain or loss is the change in value, ie the difference between future and current price
Rate of return (%) = capital gain or loss (%) + income (%)
Capital gain/loss and income (annual income) are expressed as a percentage of what you put in, ie the current price
Real rate of return ~ nominal rate of return - inflation rate
What is leverage/gearing?
The process of increasing investments or asset purchases by borrowing. When a firm borrows to invest, it will have to pay interest on the loans, but if it can achieve a higher rate of return on its investment than the interest rate it must pay, the difference can enable shareholders to make higher rates of return.
The leverage ratio is debt/capital where capital = debt + equity, thus leverage ratio measures the proportion of financing funded by debt
The higher a firm’s leverage, the greater the potential return on equity if return on capital is positive, but also the greater the loss on equity if the return on capital is 0 or negative
