Transcript Financial markets Regulation and monetary rule

ABC of Financial Markets
Savers/Lenders
Public, Private
Individuals or Corporate
Domestic
Foreigners
Intermediaries
Banks, Trusts and Funds and
Other financial Institutions
Stocks, Bonds, Exchange
Rate and Insurance Markets
Investors/Borrowers
Sectors and maturity
Risk categories
Local, National or Global
Sort sighted or far sighted
Macroeconomic Themes: 12
1
Saving and Investment Activities and Financial
Intermediation
Impact of financial intermediation cost in saving and investment
S1 (r )
I( r)
S0 (r )
Interest rate
r1

r0
0
S1= I1 S2=I2
Macroeconomic Themes: 12
2
Output, Consumption, Saving and
net Investment
Consumption:
Supply:
Labour Growth:
Aggregate demand:
Ct  bYt
1
Qt  Kt2 Lt
Lt  L  at
0
Yt  Ct  It
Model closure (saving –investment and change in the
St  sYt  It  dK
capital stock)
dt
1
1
Market clearing: Yt  Qt  It  Kt2 Lt  Ct  sK t2 Lt 
1
dKt
It 
 sKt2 Lt
dt
Macroeconomic Themes: 12
3
Capital Accumulation Over Time
1
dKt
It 
 sKt2 Lt
dt
Take the integral of both sides:
dKt
dKt

sL
dt
  s L  at dt 
 
 1  t
 0

1
Kt2
Kt2
1
2
2Kt2  ast  sL t  m
0
0
2
m
where 0 is a constant of integration.
2
sL
t
m


2
sL
t
m
2
K t  ast  0  0  K   ast  0  0 
4
2
2
t  4
2
2 

Macroeconomic Themes: 12

4
Financial markets Regulation and
monetary rule
Bank of England implements monetary rule through the
financial system.
Objectives: stability and growth
Means controlled discretion, credibility and transparency and
through pre-commitment.
Monetary rule in the UK are guided by
 Strategic ownership of policy by the Treasury
 A single symmetric inflation target
 Independent expert decision
 Built in flexibility
 Maximum transparency and accountability
Macroeconomic Themes: 12
5
Financial Services Authority (FSA)
http://www.fsa.gov.uk/
To create market confidence
To improve public awareness
Protection of consumers -such as CAT (fair Charges, easy
Access and decent Terms) - ISA system, stakeholder pensions.
Reduction of the financial crimes
Macroeconomic Themes: 12
6
Scope of FSA
600 banks, 850 insurance companies, 70 building societies, 270
friendly societies, 650 credit unions, 6000 self regulatory
organisations (SRO) ,
recognised investment exchange such as the London Stock
Exchange or London International Financial Futures and Options
Exchange (LIFFE) and Occupational Pensions Regulatory
Authority.
The SRO works through its three sister organisations such as
investment management regulatory organisation (IMRO), private
investment authority (PIA) and securities and future authorities
(SFA). About 15000 solicitors and accountants work in matter
relating to the FSA.
Macroeconomic Themes: 12
7
Financial sector policy at the EU level
Objectives : price stability among the member countries by ensuring “a year on year
Harmonised Price Index Of Consumer Prices (HICP) to remain below 2%.
This is ensured by quantitative reference and through regular observation. The
quantitative reference is reflected in the growth rate of M3 (currency plus demand
deposits plus the market securities) to remain at 4.5 percent.
The broad based assessment occurs through an analysis of price based on wage
development, exchange rates, debt, bond prices and yield curves, fiscal policy indicators,
price and cost indices, business and consumer confidence surveys and inflation forecasts.
The stability and growth pact among EU economies requires member states to limit the
fiscal deficit to not more than 3 percent of GDP and debt to not more than 60 percent of
GDP.
Macroeconomic Themes: 12
8
Multilateral Surveillance through ECOFIN
The ECB reports excessive deficits to the ECOFIN, council of the finance
ministers in the EU countries, which then can recommend adjustment
proposal to the concerned member government.
In addition EU policies are co-ordinated by multilateral surveillance under
the
Luxumbourg process on improving efficiency of the labour market,
Cardiff process on capital markets and
Cologne process about the non-inflationary growth in the EU.
Each member government need to submit stability programmes, which
should mention about the expected economic developments in the
programme with focus on its programme on inflation and growth.
G7 or G20 meetings and the multilateral organisations such as the IMF,
World Bank and the regional banks
Macroeconomic Themes: 12
9
Ramsey (1928)-Cass (1965)-Koopman (1965)
Save or die tomorrow problem
 t
0   1
Max U t    ln Ct 
t 0
Subject to:
Output and the technology : Yt  AK t
Capital formation:
Ct  I t  Yt
K  It
t 1
(100 percent depreciation)
Boundary (initial) condition
K K
0
0
Market clearing condition:
Macroeconomic Themes: 12
(1)
0    1 (2)
(3)
(4)
(5)
10
Dynamic Optimisation Conditions in
Ramsey (1928)-Cass (1965)-Koopman (1965) Model
Ct  Yt  I t  Ct  AKt  K
t 1
(6)

U t    t ln  AKt  K 
t 1 

t 0
(7)
Part of this infinite sum actually can be written as:
U t    t ln  AK t  K



t 1 
 t 1 ln  AK   K

t 1

  .. 
t 2 
First order conditions or the Euler equations ( here
consumption is a control and capital stock is the state
variable)
t
t 1
U t
  
AK 1  0 
t 1
Ct
Ct C
t 1
C
C
t 1
t 1  

AK  1  t 1  AK 1 (8)
t 1
t 1
Ct
Ct
t
Macroeconomic Themes: 12
11
Steady State in RCK model
..  K
t 1
 Kt  K
 ..  K and also
t 1
..  C  Ct  C  ..  C
t 1
t 1
Then (7) becomes
 t



U t  ln  AK  K    


t 0
C t 1 C
  AK  1
Ct
C
Y  AK 


1
  1
 1

K  

A


(9)
 A
1
1
(10)

Y  AA1
1

1
1
C  Y  I  AK   K  AA1  A1  A1  1    1

Macroeconomic Themes: 12

12
Convergence to the Steady State in RCK
model
Transition to the steady state in
B
C
C
A
D
time
When depreciation is 100 percent production in period t+1 is just is given by investment in period t. If
Macroeconomic Themes: 12
13
Intertemporal Budget Balance of the Household
A household can borrow and lend in the financial market,
but the life time budget should balance.
Borrowing: Bt  Bt 1  Yt  Ct  rBt 1 or
B  Y  Ct
B
 t t
t 1
1 r
(1)
B
Y
C
B
Y
C
t

1
t

1
t

1
t

2
t

2
t  2 (2)
Bt 
B

;
t 1
1 r
1 r
Substituting (2) in (1)
Ct  Yt Ct  1  Yt  1 Bt  1
B



t 1 1  r
2
1  r 
1  r 2
(4)
Ct  Yt Ct  1  Yt  1
B
B


 ... ..  t  n
t 1 1  r
1  r 2
1  r n  1
No-Ponzi condition implies that


Bt  n
Ct
Yt
0 
 1  r B  
0 t  0 1  r t  1
n   1  r n  1
t  0 1  r t  1
Lim
(5)
Macroeconomic Themes: 12
14
Firms Investment Decision
Y  F K  and K t  K t 1 1     I
t

1   P2K K
F K 
k

P K 
1  r 
1 r
K


1


P
 F ' K 
2  0 or MPK  1  r P1k  1   P2K

 Pk 
K 1  r 
1 r
k
P2K
K
MPK  1  r   1   1   K P1
, where   K  1 is the capital gain.
P1
k
K
MPK  r     P1
Value of the firms’ depends upon the expected profits


1
1

V  te  
 te 1 
1    te 1  .... 

1  rt 1  rte
1  rt



1
1
I V  te   I 
 te  1 
1    te  1  .... 



1  rt 1  rte
1  rt

 
 






Macroeconomic Themes: 12
 Yt




and t
 Kt



15
Intertemporal Optimisation Problem of a Firm
with Installation
Costs
I
Max
I,K
 t  F (Kt )  It

 I t  t
K
 t





s.t K t 1  1   K t  I t
where t is the profit, F(K) is the output, P F (K ) is the
revenue of the firm, assume P=1, I t is investment,
 I
It  t
K
 t
 I
 '' t
K
 t


 is


the installation cost with


0.


 I
 ' t
K
 t


  0 and


The law of motion of the capital stock is
 
Vt   t i
i0 1 r i
 t
 q
Lt  I t , K t , qt   
  t i  K
 1   K t i  I t 

i0 1  r i i0 1  r i  t i1
Macroeconomic Themes: 12
16
Derivation of Tobin’s q
Lt I t , Kt , qt 

I t i
qt i
 I
1    t i
K
 t i
 I

let   Kt i

 t i
qt i
 I
1    t i
K
 t i





I t i  I t i 
'
q
Kt i  Kt i  t i


0
i
1  r 
It i  It i 
'
Kt i  Kt i 

 I

 t i
 

K

 t i
 I
1   t i
K
 t i


 







;

It i  It i 
 '
Kt i  Kt i 







I t i
 1 qt i 1  investment occurs if q>1.


Kt i
Macroeconomic Themes: 12
17
Tobin’s q and value of the firm
Lt  It , Kt , qt  I
Kt i 1  qt i qt i1
t

i



0
i
i
i
Kt i
1 r 
1 r 
1 r 
It i Kt i 1   qt i qt i1



i
i
i
1 r 
1 r 
1 r 
It i Kt i 1   qt i
q

t i1
1 r   1 r 
From successive iterations
i


T
T

1   



1
q 
 1  r    t i 1    
 q
T 1  r  t T
  1  r  
t 0


T


T

1  1   
 t i 1  r 
 

t 0

Lim 1  
 0  q  1  r 

 q
t

T
T
n    1  r 
Macroeconomic Themes: 12





i
18
Intertemporal Balance if Government’s Account
Change in the government borrowing
Dt  D  Tt  Gt  rg D
t 1
t 1
(1)
Dt  Tt  Gt
Gt  Tt
Dt
D 
; D 
(2)

t 1
t 1 1 rg 1 rg
1 rt
By iteration forward
Gt  Tt Gt 1  Tt 1
Dt n
D 

 ...  .. 
No-Ponzi
t 1 1  rg
2
n

1




1  rg 
1  rg 




condition implies that
Dt n
Lim
0
n1
n

1  rg 


Tt
Gt





1

r
D

(5)


0
t

1
t

1
t 0 1 r 
t 0 1 r 
g
g


Macroeconomic Themes: 12
19
Consolidating the public, private and National
Budget constraints
Lim Bt n
0
n

1
n   1  r 


 Ct
 Yt  Tt  F  Kt 1   It
 1  r B  

0 t 0
t

1
t 0 1  r 
1 r t 1
(5)
 Ct
 Yt  Tt



1

r
B

 Vt


0
t

1
t

1
t 0 1  r 
t 0 1  r 
Define a primary current account deficit as:
PCAt   X t  M t 
The budget should balance over period
PCA 
1
PCA
2   F 1  r 
0
1 r
Macroeconomic Themes: 12
20
Consolidating the public, private and National
Budget constraints
Lim Bt n
0
n

1
n   1  r 


 Ct
 Yt  Tt  F  Kt 1   It
 1  r B  

0 t 0
t

1
t 0 1  r 
1 r t 1
(5)
 Ct
 Yt  Tt



1

r
B

 Vt


0
t

1
t

1
t 0 1  r 
t 0 1  r 
Define a primary current account deficit as:
PCAt   X t  M t 
The budget should balance over period
PCA 
1
PCA
2   F 1  r 
0
1 r
Macroeconomic Themes: 12
21
Effect of Financial Intermediation on Capital
Accumulation
Let  represent the fraction of savings 0    1 taken away
(wasted) by financial intermediaries while channelling
saving to investment.
As such a higher value represents more inefficiency in
the financial system.
Solutions is modified in this case as following
Ct  Yt  I t  C  AK     K  K 1   
t
t
t
 t 1


U t    t ln  AKt    K  K t 1   
 t 1


t 0
Part of this infinite sum actually can be written
as:
U    t ln AK    K
 K 1      t 1 ln AK    K
K
t
t
t 1
t
t 1
Macroeconomic Themes: 12
t 2

t 1 1     .. 
22
Financial Intermediation and Capital Accumulation
t
t 1 
U t

AK  1   1     0 
    
t 1
C
C
C
t
t
t 1 

C
t 1   AK 1   1    (8’)

t 1
Ct
 

steady state ..  Kt 1  Kt  Kt 1  ..  K
..  C  Ct  C  ..  C
t 1
t 1

U t  ln  AK   K  K  1      t


t 0
C
t 1  C   AK  1   1   


Ct

C 

AK  1   1  


  1 
1  
 K
 

 A 
K

 

       K  1   1A     1  



 1   
A
 1  


K



  


 1  
A

1
  1




1
1



(10’)
Macroeconomic Themes: 12
23
Output, Consumption and Investment in
Steady State With Financial Intermediation
Output in the steady state is given by steady state capital


1

A




stock: Y  AK Y  

   1   
Investment in the steady state
1

1

I  K  1   K I  K  I  K    A
   1   


Consumption in the steady state C  Y  I 

1

1

1

A


A





C 



   1   
   1   


Macroeconomic Themes: 12
24
Other Important Issues in the Financial Sector
Regulations
 Risk diversification and portfolio allocation by
households and corporate sector
 Under or over valuation of stocks or growing or
declining sectors and Tobin’s q.
 Convertibility and controls of capital account.
 Direct foreign in or outward investments and long and
short term interest rates
 Credit rationing, market segmentation and asymmetric
information
 Liberalisation of financial markets and economic
crises and contagion effects
 Speculative bubbles and attacks on financial and
exchange rate markets
 Monitoring, supervision and deposit insurance.
 Inter generational equity, Viability of pension funds
and pay as you go social
security system
Macroeconomic Themes: 12
25
References
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Macroeconomic
Themes: 12
26