topic 8- financial instability

Question 1

show a technological bubble on the three equation model?

Answer 1

a technological improvement eg IT, raises productivity and shifts right the equillibrium level of output as a supply side shock. this is also however a demand side shock as technological shocks and shares start on a boom shifting the IS right. by assumption the supply shift is bigger than the demand one. the economy is therefore at B. the inflation targetting central banks seeks to restore equillibrium and inflation to the target level. which implies lowering the interest rate to rc in the usual mechanics of the 3 equation model. in so doing the bubble developed in the technological stocks and shares is validated and accommodated by easy monetary conditions that prolong it and let it progress further. to note also that the outcome is a permanently lower stablising rate . in this sense inflation targetting can be said to have promoted financial instability by accomodating the development of a bubble

Question 2

explain the minsky in diagram graphs?

Answer 2

it is made up of two quadrants which are left and right. one has the bank lending rate on the y axis and loans on x axis. it shows a downward sloping demand for loans and the supply of loans is a stepped function reflecting a revised upwards risk premium as the ratio of illiquid assets (loans) over liquid ones(equity capital, etc) increases.
on the right quadrant, the y axis is the interest rate and the x axis is investment. the investment demand curve for given expectations on the stream of profits is downward sloping .

Question 3

what shifts the demand for loans curve in the minsky diagram?

Answer 3

the expectations shift the demand for loans curve. if the expectations are optimistic then the demand for loans will shift to the right and the opposite is true when the expectations are pessimestic.

Question 4

what shifts the investment demand curve in the minsky diagram?

Answer 4

the expectations will shift the investment demand. if the expectations are optimistic then the ID curve will shift to the right and the opposite is true for the pessimistic expectations

Question 5

why is the supply of loans a stepped up function?

Answer 5

commerical banks need to pay attention to the ratio of liquid versus illiquid assets that they hold on their balance sheets. loans are obviously illiquid because recalling them takes time and some may default and not be repaid. other assets such as bonds and shares are liquid as they are constantly traded on deep and established markets so could be liquidated on short notice. commercial banks will expand their portfolio of illiquid assets relative to existing liquid assets if there is an increased risk premium to compensate for the increased illiquidity of their portfolio. it is stepped up under the assumption that once a certain number of loans has been extended, crucial liquidity thresholds are crossed and so loans can only be extended if the banks are compensated with an increased risk premium.

Question 6

what is the significance of the size of the steps and the steepness of the rise?

Answer 6

We are also in a position to discuss the significance of the size of the steps: we canenvisage that the shorter the steps and the steeper their rise, the more ‘conservative’ or ‘liquidity-prudent’ the bank is. Conversely the longer each step and the shallower their rise, the more thebank’s lending policy can be considered aggressive and less concerned by the liquidity ratios on its balance sheet

Question 7

what was the crucial role that was emphasised by minsky?

Answer 7

The crucial role emphasised by Minsky is that of current asset valuations in financial markets (e.g. thestock exchange and bonds markets). These will affect positively the expectations of future returns andwill therefore shift right the investment demand schedule

Question 8

why do the current asset valueations in financial markets positively affect the expectations on future returns and therefore shift right the investment demand schedule ?

Answer 8

1) firms need to bear in mind their own ratio of liquid to illiquid assets in the same way that commercial banks do. in this case investment in productive capacity are illiquid whereas the marked to market value of financial assets (NOT THEIR OWN SHARES_ THEY ARE LIABILITY) represent what firms may consider to be their liquid assets. the higher the current marketable value of these, the more the firms may feel to be in a good liquid position that warrants their expanding the illiquid assets as they feel they can afford to do so
2) the current price of investment that firms pay in order to increase their productive capacity has to be compared with what firms would pay if they opted instead for buying existing capacity from other firms. the two obviously arent going to be identical as new investment takes time before it becomes remunerative(profitable) whereas existing capacity may be a lot sooner. the cost of a possible takeover will be higher, the higher the shares of the firm to be taken over are currently value on the stock market. it follows therefore that the higher the current valuations on the stock markets of existing firms and production lines, the more it will become cheaper to expand productive capacity with genuinely new investment, even having taken into accountthe time lag before it becomes renumerative as expected.

Question 9

where does the minsky diagram start from?

Answer 9

it starts in an economy that is currently doing well, although it is not used to doing so in the distant past. as the booming economy expands, firms revise their profit expectations upwards shifting the ID right. they can finance this expansion in productive capacity from retained earnings and from a feeling of greater solidity because the market value of owned assets is currently up. the demand for new loans may go up but proportionally not by as much as investment is currently increasing.

Question 10

what is hedge finance according to minsky?

Answer 10

be described as a prudent attitude, whereby any new outflows are planned to be covered primarily, by existing and reliably predictable cash inflows

Question 11

what occurs in the first stage of an investment boom to those firms which were more aggressive in expanding compared to the rest of the economy?

Answer 11

although the economy is doing well in a boom, those firms that have been more aggressive in their expansion are now better off than those that have maintained a more prudent outlook. in other words, being more highly leveraged has paid off. this is the same on the banks side for those who have lent more have profited more than those which remained prudent.

Question 12

what occurs on the minsky diagram when the boom continues?

Answer 12

there will be further expansion in investment with still more optimistic expectations. however this time, more and more of the expansion has to rely on external finance ie loans which shift the ID right and in the demand of loans can be deemed to be equi-proportional. the supply of loans will remain a stepped up function but the steps have become smaller in magnitude as the risk premia is revised downwards as bank feels they can afford to expand the illiquid portion of their assets because the market valuation of liquid assets is increasing. banks and firms have short memory and disregard the distant past where the economy was not doing well and asset valuations would not go up all the time.

Question 13

what are financial innovations and when are they most prevalent?

Answer 13

financial innovation allow the banks to edxpand their credit regardless of the prudential regulations or individual policy actions that may take place by monetary and supervisory authorities.

Question 14

why does minsky assume that the banks will have short term memory?

Answer 14

it is because the bank managers and corporate directors who do take into account the long term memory and be more prudent will be deemed to have timidly held back the profitable opportunities that were coming their way, losing market share to their competitors. as a result, they have an incentive to act precisely towards having short memory and riding with the flow of rising leverage investment.

Question 15

what is speculative finance?

Answer 15

This is where firms borrow more on the expectation of further rises in asset prices,which would enable them to repay the principal of the newly incurred debt. What is happening is therefore that the continuing rise of the boom leads firms into greater and greater exposure to what the current mood of financial markets is. In other words, under hedge finance, firms only have to cope with whatever conditions are prevalent in factor markets in order to buy labour and new capital. In the speculative stage they also have to rely on financial markets

Question 16

what was minsky third stage of ponzi finance?

Answer 16

firms have to rely on financial markets in order to borrow more for the sake of paying the interest on already accrued debt. The logic is that, as the euphoric boom continues, firms that had been engaged in hedge finance are pushed into the speculative approach, whereas those that had been at the speculative stage already, are progressively pushed into the Ponzi stage. Again the point to be emphasised here is how these changes would endogenously arise because of the existing incentives that will reward more the more aggressive stance.

Question 17

what is the final stage of the minsky diagram?

Answer 17

a stage is reached when doubts can be entertained as to asset market valuations continuing on the upward trend or on a ratio of illiquid to liquid assets on the banks balance sheet having moved too high. this is the minsky moment when the prevailing conventional judgement is suddenly replaced by another equally conventional assessment of future prospects. banks revise upwards their risk premia and may shorten substantially the steps of supply of loans function in order to restore the liquidity of their assets. the economy enters a balance sheet recession where declining asset evaluations prompt banks and firm to re establish liquid positions that had been abandoned as too conservative in the boom.

Question 18

what is the minksy moment?

Answer 18

This is the Minsky moment, when the prevailing conventional judgment issuddenly replaced by another –equally conventional- assessment of future prospects, which this timetakes a negative outlook

Question 19

why is the minsky hypothesis useful?

Answer 19

It successfully incorporates financial consideration into a macro model so that investment cannot be undertaken without consideration of its financing options. Minsky described himself as a ”financial Keynesian” and the implications are evident. Keynes sought to construct a theory of a “monetary production economy” where money enters motives and means and could not be considered a mere veil. Minsky goes arguably a step further in stressing that in modern times money actually means credit and finance, and that, asa result, the nature of such an economy is inescapably CYCLICAL.
* It successfully incorporates financial innovation which is woven into the logic of the narrative instead of being a clumsily bolted add-on as in most recent attempts to take it into account.
* It justifies the endogenous development of each step without ad hoc assumptions at each stage.
* As an account of the recent financial crisis is unsurpassed even though it was formulated well before any notion that the crisis might hit when and as it did. This justifies Minsky being ‘cool’ as Krugman puts it. In some renditions the hypothesis is virtually prophetic.

Question 20

why is the minsky hypothesis wrong?

Answer 20

• Many (mainstream) economists would object to the conventional judgement andpostulate that agents would ‘rationally’ foresee the subsequent steps of the narrativeand take corrective action. Unfortunately if rational expectations had really beenapplicable the financial crisis would not have arisen at all, and instead it mostcertainly did. So this is an objection that mainly exposes how wrong and implausibleits own assumptions are rather than undermining Minsky’s hypothesis.
• As a corollary, many have tried to incorporate the financial instability hypothesis into DSGE models, but the results are unsatisfactory from a theoretical standpoint because too many ad hoc assumptions are required at each and every step.
• The actual timing of the Minsky moment is very arbitrary and by its very nature unpredictable. This may be seen as a drawback by some, but not by those who fully embrace that the future is fundamentally uncertain and the past never ever is a reliable guidance to what the future might bring.
• Minsky’s concern was always whether a Great Depression could happen again. He therefore only concentrated on the turning point at the top of the cycle, but never explained how things would unfold at the bottom of the cycle, when a negative outlook would give rise to a positive one. Schumpeterian technological innovations may bridge that gap, but such avenues are far from fully explored or explained.