topic 6- the banking sector Flashcards
what are the macroeconomic policy and macroeconomic modelling implications of the financial crisis that we will examine?
the dangers of deflation ie negative inflation
the existance of zero lower bound (ZLB) in the nominal interest rate set by the central bank
the problem of having ignored the mechanics of the banking sector as in the case in the 3 equation model and in all DSGE models used by the central banks and treasury departments before the crisis
unconventional and conventional policies adopted to deal with the crisis and its aftermath
explain using the 3 equation model a way to represent the crisis?
you can use a massive permanent negative demand shock which shifts the IS curve to the left. the effect would be so great to shift inflation into the negative territory in the lower quadrant (inflation-output). the next periods phillips curve is forecast and the central bank works out the necessary interest rate to achieve C. however this interest rate is negative and therefore not attainable according to the fisher relationship r = i - expected inflation. the nominal interest rate i can only be pushed down to zero and as inflation is negative then r will be postive and not negative as required. the real interest rate is therefore rc. the economy therefore remains in a deep recession and the inflation is further pushed into the negative territory at inflation c. a similiar process is now gone through. the desired postion would be D’ which is still negative and not attainable. the economy will therefore find itself at D. the real interest rate will now be rd which is greater than rc. the process repeats itself again and again as the economy spirals down into a deep deflation with further losses of output and the interest rate has lost all ability to restore equillibrium
what are the advantages of the deflation diagram?
the diagram is useful and intutitive characterisation of why deflation is considered such a danger and why the limits of the interest rate as an instrument of monetary policy can be quickly reached
the above justifies the adoption of uncoventional policies once the conventional one of varying the interest rate is a spent resource
what are the problems of the delfation diagram?
a natural disaster of covid 19 pandemic would be represented largely in the same way so that there is nothing inherently financial about it
this is consistent with the 3 equation model having ignored the functions of the banking and financial sector. a more refined representation needs to address this explicititly.
the mechanical backward rule of the IAPC creates something visually intutitive but also implausible as it necessarily requires that unions bargain for nominal wage deflation. it is an empircally estabilished fact instead that very rarely cuts to the nominal wage accepted.
whilst the detrimental effects would persist, it is therefore difficult to imagine that a certain floor would not be found preventing the uncontrolled spiral downward
this is an unavoidable limitation of having adopted a mechanical rule in place of some model of expectation formation. such a rule may be plausible and viable in normal times but it is subject to becoming implausible and misleading in extraordinary circumstances
why does the 3 equation model ignore the functions of the banking sector?
it ignores the function of the banking and financial sector because it argues in a closed economy the liabilities of some agents are exactly mathced by the assets of other agents so that the net effect can be considered nil as a first approximation. the mechanics of commercial banking sector may be seen as an unnecessary complication provided that the transmission of any policy change is transmitted smoothly and reliably
why can you no longer avoid the banking and financial sector in macroeconomic models?
- that the interest rate measured on the vertical axis of the top quadrant (IS curve)is set by commercial banks and not directly by the central bank;
- that we need to have a model of how bank credit (loans) are demanded and supplied;
- that a consensus now exists that loans generate deposits and not the other way round, as often taught in introductory textbooks (Gärtner included);
- that once deposits are taken, as short-term liabilities, commercial banks seek liquid reserves in order to cope with sudden surges in demand for liquidity by their depositors.
- that Central banks provide such liquid reserves at the policy rate.
explain the stages of the banking circuit?
commercial banks supply loans at a lending rate higher than r0 by a given mark up
the equillibrium new loans are made and used by housholds and firms to pay for investment and services
loans return to the banking sector in the form of deposits
commerical banks choose to keep a small percentage of received deposits in liquid form, thereby demanding liquid reserves
the central bank supplies liquid reserves to commerical banks at the policy rate r0.
why is the extended model (Howells 2019) useful?
- It is consistent with modern banking practices and dispenses with a number of implausible theoretical links that have long been known to have no counterpart in practice.
- It successfully captures a recession that is generated within the banking sector and spills over on to the private non-banking sector;
- It is a pedagogically simple and intuitive representation of the challenges of the zero lower bound;
- It can be modified to include the challenges of a deflationary trap.
- It is susceptible to extensions and qualifications.
why is the extend model (Howells 2019) wrong?
- To be precise the policy rate and the lending rate are stated in nominal terms but the interest rate affecting the IS curve is the real one. A complex feedback mechanism would need to be put in place to take into account changes in inflation on to the vertical axis of quadrants I and II.
- It ignores bond and other asset markets.
- It is a single period analysis diagram in the sense given to the term by Hicks (1956) whereby the analysis holds for as long as no change in behaviour is expected or enacted.
- But to analyse the complex repercussions of the financial crisis, a continuation analysis (Hicks 1956) model is needed.
- A continuation analysis can be done but some movements are potentially ambiguous without additional statement as to the relative magnitude of certain effects, particularly when the demand for new loans shifts. This makes the diagram complex and more difficult to follow.
- Ideally we would want to be able to show on the diagram the effect of the unconventional policies adopted, but this is not easy at all on any diagram actually.
what are examples of uncoventional monetary policy tools?
negative interest rate policies
lending operations
asset purchase programmes
forward guidance
what are negative interest rate policies?
some central banks decided to set negative policy rates. They found that, overall, this strategy was effective in dealing with Effective Lower Bound events: long-term yields adjusted downwards in line with expectations of future short-term rates, thus providing the desired expansionary stimulus
what are lending operations?
Central banks expanded their liquidity facilities to deal with both Disrupted Transmission Chain (in the early stages of the crisis, abundant liquidity to financial intermediaries was crucial in bypassing impairments in the interbank and money markets) and problems related to the Effective Lower Bound. Interventions included extending the maturity of the typical lending operations, expanding the set of eligible collateral and the set of counterparties, changing the lending terms (eg fixed rate full allotment) and imposing explicit conditions on loans to ensure the desired ultimate outcome (eg bank lending to non-financial private firms).
what are asset purchase programmes?
which accounted for large increases in central banks ’balance sheets aimed mainly at lowering long-term yields and thus easing broad financial conditions. In some cases (mainly relating to the purchase of private assets),they supported asset valuations affected by fire sales, or provided additional funds to ultimate borrowers by incentivising the securitisation of loans. Overall, APPs proved to be very effective tools.
what is forward guidance?
In a period of heighted uncertainty about the economic outlook and the ability of central banks to deal with the challenges Forward Guidance served to clarify central banks’ intentions with respect to future policy rate settings and to communicate their commitment to the pursuit of their mandates.
