INTRODUCTION TO MONEY, FINANCIAL INTERMEDIATION AND FINANCIAL CRISES Professor Lawrence Summers October 1, 2015

Agenda The function of financial markets International capital flows Banking crises game

Function of financial markets: flow of funds from savers to borrowers There are people who want to save to meet subsequent needs (smooth their consumption) And there are businesses that have the opportunity to take a dollar today and turn it into more than a dollar tomorrow The function of the financial system is to bring them together There are risks: financial markets help share and pool the risks

Borrowers/Spenders: Firms Government Households Foreigners Function of financial markets: flow of funds Lenders/Savers: Households Firms Government Foreigners Deposit ++ Interest Loans ++ Interest Funds Returns Financial Markets (e.g. Stock exchange) Direct Finance Financial Intermediaries (e.g. Bank, Insurance co., Mutual fund, Venture Capital co.) Deposits + Interest Indirect Finance

Inter-temporal optimization The optimal (C 1,C 2 ) is where the budget line just touches the highest indifference curve. MRS = Marginal rate of substitution r = interest rate C1C1 C2C2 O At the optimal point, MRS = 1+r Source: Macroeconomics, N. Gregory Mankiw Present consumption Future consumption

Now, considering inter-temporal production Intertemporal Production Possibility Frontier Present consumption Future consumption Represents trade-off between present and future production of a consumption good. Source: International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld

Production and consumption are both affected by changes in interest rates Present consumption Intertemporal indifference curve Intertemporal budget line Intertemporal PPF Future consumption Slope determined by interest rate

Why do we need financial intermediaries? Why can’t those with savings just lend directly to borrowers? Pooling Savings: Most savers deposit small amounts; banks pool savings to make large loans. Risk Diversification: Savers lending to individual borrowers face risk of total loss if borrower defaults. Bank spreads risk and ensures return to saver. Liquidity Transformation: Banks make long-term loans, knowing that only some depositors will want their money back during each short-term period. Asymmetric Information: Banks specialize in screening borrowers for creditworthiness, processing and sharing information.

Examples of financial intermediaries IntermediaryPrimary LiabilitiesPrimary Assets Deposit-taking institutions (banks) Commercial banksDeposits Business and consumer loans, mortgages, US government securities, municipal bonds Savings and loansDepositsMortgages Mutual savings banksDepositsMortgages Credit UnionsDepositsConsumers loans Contractual savings institutions Life insurance companiesPolicy premiumsCorporate bonds and mortgages Fire and casualty insurance companiesPolicy premiums Municipal bonds, corporate bonds, stocks, US government securities Investment Intermediaries Finance companies Commercial paper, stocks, bonds Consumer and business loans Mutual fundsSharesStocks and bonds Money market mutual fundsSharesMoney market instruments

Fractional reserve banking Most of the time, only a small fraction of bank’s total deposits will be demanded on given day. Banks lend out some of the deposits and keep just enough cash reserves on hand to deal with day-to-day demands. Advantages: Bank income from loan interest can reduce depositor fees Provides financial intermediation

Agenda The function of financial markets International capital flows Banking crises game

Capital will flow from places where it is abundant to places where it is scarce Capital Marginal Product of Capital Diminishing marginal product of capital  investing a unit of capital is more productive where it is scarce than where there is already a lot of capital. So capital will flow from places where it is abundant to places where it is scarce. International capital flows are driven by expected (risk-adjusted) returns that can be earned. As a result, capital should flow where it will be the most productive.

Multinational corporations play a major role in international capital flows International capital flows can take the form of borrowing and lending, or of foreign direct investment: where a firm in one country creates or expands a subsidiary, production facility etc. in another country. Why do multinational corporations exist? Location: Why is a good produced in many different countries rather than one? Resource abundance, economies of scale, transport costs, trade barriers are all factors that help determine where it is most efficient for a good to be produced. Internalization: why is production in different locations done by the same firm, rather than by different firms? If transaction costs between different firms are too high then it is more profitable to carry out transactions within one firm. Particularly important with technology transfer and vertical integration.

In a Closed Economy: National Savings equals National Investment (S = I) 1. Y = C + I + G National Income = Consumption (C) + Investment (I) + Government Spending (G) 2. Y – C – G = I 3. Define National Saving (S) = Y – C – G  S = I National Savings = National Investment In a closed economy: what is not consumed (i.e. what is saved) is invested.

Production Producer Income Closed Economy: all goods and services are produced and consumed domestically Consumer Spending and Saving Spending and Saving

National Savings = National Investment Production Spending and Saving Consumption Saving Producer Income Closed Economy: What is not Consumed (i.e. Saving) is Invested Investment Sales Consumer Spending and Saving

Open Economy: Can borrow from/lend to rest of world. Trade Balance = National Income – National Spending National Income = Y = C + I + G + X – M X – M = Trade Balance in Goods and Services = Current Account “Strictly, Current Account includes factor incomes and transfers but we will mean X - M” National Expenditure (Spending) = E = C + I + G National Income – National Expenditure = X – M

Domestic Sales of Domestic Products Domestic Purchases of Domestic Products Net Exports = X – M Imports Exports Open Economy: Trade Surplus is Income that is not Spent IncomeExpenditure Trade Surplus Income exceeds Expenditure by the Current Account Surplus = Net Foreign Lending

Difference between National Income and Expenditure change in Net Foreign Assets Country with a deficit is spending more than its income by either increasing its net foreign debt or reducing its net foreign assets. Country with a trade surplus is either reducing its net foreign debt or increasing its net foreign assets.

Trade Balance = Saving - Investment Y = C + I + G + X – M Y – C – I – G = X – M (Y – C – G) – I = X – M Define national saving S = Y – C – G S – I = X – M National Saving – National Investment = Trade Balance S = Sp + Sg National Saving = Private plus Government Saving

Agenda The function of financial markets International capital flows Banking crises game

An illustrative game: Strategy A: Win $1 if all play A, Lose $10 otherwise Strategy B:0

Which strategy do you choose, A or B? A. Win $1 if all play A, lose $10 otherwise B. $0 for certain

Strategy A or B? A. Win $1 if more than 90% of the class plays A. Lose $10 otherwise B. $0 for sure

Strategy A or B? A. Win $1 if more than 80% of the class play A. Lose $10 otherwise. B. $0 for sure