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Econ Abhinav Lse 2
Econ Abhinav Lse 2
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Macroeconomics Notes
Topic 1: Introduction to Economic Growth
Lecture 1
Definition of GDP: Value of all new goods and services produced within national borders in a given
time period.
Y = C + I + G + NX
Y national income C consumption I investment G government spending NX net exports
Real Vs. Nominal GDP: (i.e. how we can compare GDP over time)
PPP Vs. Market Exchange Rates: (i.e. how we can compare GDP between different countries)
Market exchange rates: Measure with local prices. Convert local prices (usually into USD)
using market exchange rates. Compare.
o Differences are due to different prices AND different quantities
Doesn’t completely account for inflation, cost of living etc.
Purchasing Power Parity (PPP): Measures using prices of a base country.
o Differences due to different quantities ONLY
1. Poor countries usually have higher PPP GDP compared to nominal (b/c low cost of living).
2. Key GDP figures I should know roughly: (World Bank 2015)
a. UK: Nominal = $2.8 trillion (or £1.8 trillion)
b. USA: Nominal = $18 trillion PPP: Int$18 trillion
c. China: Nominal = $11 trillion PPP: Int$19.5 trillion
d. EU: Nominal = $16.2 trillion PPP: Int$19.1 trillion
Solutions:
Key takeaway: These mechanisms do not require public policy market mechanisms work to
direct effort to solving bottlenecks in resources.
Zero-growth world:
More leisure
Less materialistic, less competitive, more focus on meaningful things
Pro-growth arguments:
1. Quantity of life: GDP/capita correlates with higher life expectancy (and adult literacy, lower
infant mortality)
2. Retrograde politics: Ben Friedman argues low/no growth associated with retrograde politics
3. Hurt poor countries: Zero growth in rich world may slow growth in poor countries
4. Arbitrary: Arbitrariness of picking consumption level; leisure already an option but not
taken.
1. GDP/capita has remained stagnant for most of human history; starting growing
exponentially after Industrial Revolution
2. GDP/capita today is 10X higher than in 18th century
3. Some African countries have GDP/capita lower than Britain’s 1000 years ago.
4. HDI facts: (2015)
a. Norway: 0.949; United States: 0.920 China: 0.738 UK: 0.909
Limitations of GDP:
i. Doesn’t account for externalities ii. Doesn’t account for underground economy
iii. Doesn’t account for household work iv. Doesn’t perfectly account for access to health/education
v. GDP =/= consumption vi. Includes ‘bad’ things e.g. cleaning up after environmental disaster
vii. Doesn’t account for leisure viii. Marginal utility of consumption is likely non-linear
+Many more reasons e.g. problems with non-PP/nominal measurements, inequality etc.
Summary: GDP necessary, but not sufficient, for welfare improvement
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1. Increasing function
a. Adding more capital per worker = more GDP per worker
2. Decreasing marginal productivity of capital
a. Each added bit of capital adds less and less to GDP
Investment:
Act of putting into place additional new pieces of equipment and structures.
Investment is ‘endogenous’ in this model.
Investment Rate, s: 𝑠 𝐷
so Investment = s X GDP
China: 45% USA: 20% UK: 17% World: 24% Malaysia: 25%
Depreciation:
Inevitably, capital stock ages and becomes less efficient and breaks down over time.
Depreciation is exogenous – we take it as given / cannot be influenced.
Law of motion for capital: (must always be expressed in per worker terms change variables you get if needed)
In mathsy terms: k = sy dk
k = capital per worker y = GDP per worker s = investment rate d= depreciation rate
Now we divide by k…
∆𝑘 𝑦
𝑠 𝑑
𝑘 𝑘
k/k = growth rate of capital per worker y/k = average product of capital
During transition (to steady state), growth rate keeps declining. Given the assumption of diminishing
marginal product of capital, average product of capital (y/k) will also diminish as we add more
capital.
Population Growth: Is akin to depreciation b/c as population grows, capital per worker gets diluted.
Hence why countries have fertility control policy e.g. China, India.
Conclusion: Growth through capital accumulation decreases over time and peters out eventually.
If increase s: Get an added period of growth, but it stops again (reaches a higher steady state). To
keep growing, must keep increasing share of GDP i.e. higher value of s.
GDP = C + G + I + NX
I = GDP – C – G – NX
s = 1 (C + G)/GDP NX/GDP
1 - (C+G)/GDP is National saving rate NX/GDP is net exports as a share of GDP rate.
Will still reach mathematical limit to savings rate [historical limit is 50% ish]
Politically costly – people may revolt if savings rate too high
Option 2: Increase imports, decrease exports [i.e. decrease NX, make it negative]
Yet barely any relationship between growth rate and capital per worker (should be downward
sloping [GDP per worker vs capital per worker should be concave as well]
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Two countries are at the same capital-labour ratio (i.e. both are at same point of k). If one
country has a steady state that is further away (i.e. higher), it will have a faster growth rate.
o Poor countries may actually grow slower than rich countries – the absolute level of
capital per worker is not important. Rather, it’s the distance between starting point
and destination (steady state) that dictates growth rates.
A country with a higher population growth rate will have a lower steady state (population
growth is akin to depreciation).
Total output is determined by both capital and labour. If the labour force falls, total output
will fall even though capital per worker is higher now.
Relationship between GDP/worker and Capital/worker should be concave given
diminishing marginal productivity of capital
o However, assumes countries use capital with same level of efficiency (i.e. doesn’t
account for TFP differences)
Example textile factory in India (Low TFP) – big mess. Has capital, but not used efficiently.
Focus of this lecture is Capital per worker + TFP = GDP per worker
Example of inefficient state: USSR
o Had lots of capital but poorly organised + did not allocate capital efficiently.
Total Factor Productivity, TFP: Efficiency with which factors of production are used.
[Not in lectures]
Gro th in total-factor productivty (TFP) represents output growth not accounted for by the growth in inputs."
Hornstein and Krusell (1996).
TFP can be measured b the Solo residual hat s left after ou ve accounted for labour capital gro th
Graphically: Increase TFP Entire production function shifts up (higher investment & GDP curve)
TFP growth is not subject to Diminishing Returns. It is the key to long-run growth.
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Not just ‘process’ innovation, but ‘product’ innovation as well i.e. creating variety. Important
because diminishing returns from existing products.
Characteristics:
Problem:
Solutions:
Patents
o Duration is usually 20 years (Europe/USA); USA has 15-year design patents
o Gives firms market power, can charge above marginal cost to recoup research costs
o Tradeoff: Give too long, lose consumer surplus. Give too short, cannot recoup costs
Subsidies
o Allow R&D to be tax deductible for corporate taxation
o Match spending – every dollar of R&D matched by dollar of subsidy
For countries behind the tech frontier, imitation makes more sense than innovation (long hanging
fruit). However, imitation isn’t that simple a lot of informal & implicit/tacit knowledge required. Hard
to communicate this knowledge except with experience.
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1. Foreign Direct Investment, FDI: Any cross-border investment that takes a form of a
plant/firm [In this context, firms in rich countries build/takeover firms/plants in developing
countries]. Generally quite effective way of increasing FDI.
a. Direct tech transfer: Build plant Plant embodies knowledge of origin firm. The
plant itself directly increases TFP (Least important mechanism)
b. Diffusion through imitation cluster: Employee of original plant learn tech, start own
plant. (e.g. textile FDI in Bangladesh from Japan)
c. Competition with inefficient local firms: Puts pressure on locals to increase efficiency
or cannot make profit. Good firms will respond and increase efficiency. Bad firms
will leave market (thus capital/labour that was trapped now gets reabsorbed into
more efficient firms)
2. Trade (decent evidence for this)
a. Imports
i. Get embodied technology (ideas/knowledge embodied in physical objects)
ii. Puts pressure on inefficient local firms (same analysis with FDI)
b. Exports
i. Learning by exporting (buyers teach sellers). If want to export, must raise
game. German etc. buyer will tell you how to make perfect product. They do
this because want cheaper product from developing country. Lots of evidence to support this.
ii. Market size. Imitation entails upfront costs as well. Can recover upfront cost
of becoming more efficient b/c got more scale. Scale also justifies upfront
cost of imitation
3. Education/work abroad (works to a point)
a. Worked well in Singapore, but only because they are good at getting people back
b. Other countries: people leave, loss of brightest talent.
c. Also little evidence of how much tech/knowledge actually transferred.
Examples: HIV/AIDS patents in South Africa. Chinese firms accused of violating patents; Chinese
government accused of being complicit. Same problem historically with Japan.
Big dispersion in TFP among firms within countries (particularly poor countries)
Why? Managers are heterogenous in ability
o Can make big gains from bringing up the ‘tail’ (i.e. the worst)
1) High entry costs for talented outsiders (So less competitive pressure for incumbents)
a. Upfront production costs required
b. Licenses permits required etc. (red tape cost)
2) Poorly developed financial markets (to borrow and overcome upfront costs)
a. Typically as result of inefficient contract enforcement (developed country: has
system of courts etc. to ensure repayment of debt)
3) Limited scope for buyouts (hard to go to incumbent and buy them out)
Human capital per worker: Intrinsic ability/skills to produce. Anything embodied in workers which
makes them more productive. Sourced from schooling and health (more energetic/focused, lose less
days to sickness etc.)
1) Direct effect on GDP per worker: produce more (b/c more knowledge/energy)
2) Indirect effect on investment: increases marginal product of capital (higher return on capital,
more incentive to invest because investment will have higher return)
3) Indirect effect on TFP: facilitate innovation/imitation (workers more receptive e.g. reading
manual)
Qualifier: Human capital not a panacea to growth. It is not a huuuge contribution to growth. TFP is
the true key.
Lecture 4
Industrial policy: The picking of particular industries to grow. Some industries need particular
attention from government (needs to be nurtured) e.g. cars, semiconductors, steel, IT.
Tools:
Tax breaks &subsidies
privileged access to currency/import channels,
suppression of labour regulations,
protection from imports.
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Rationale:
Economic fluctuations: Fluctuations in aggregate economic activity around its long-run growth path
[change in growth rate, not growth level]
Long-run economic growth in UK is around 2-2.5%. But growth fluctuates every year (shocks).
2 Kinds of shocks:
Expansionary (positive) shocks vs. Contractionary (negative) shocks. Use of positive/negative does not
imply value judgement – both booms and recessions are problematic.
Sources of AD Shocks:
G
o Wars (e.g. WW1/2 & Vietnam big positive shock to US economy)
o Ideology changes (e.g. UK conservative’s election – Osborne’s commitment to
austerity)
o Fiscal crises, gov. literally has no money (e.g. Greece)
I/C
o Chg in taxes (e.g. Donald Trump plans to drop corporate tax to 15%)
o Chg in wealth
o Psychological / animal spirits (e.g. Brexit; consumers spending went up)
NX
o Changes in exchange rates (e.g. depreciation of pound is positive shock)
o Foreign demand shocks (e.g. Euro area crisis)
Flexible Prices
Micro theory would lead us to think that shocks have very little effect on quantities, but big effect
on prices/wages.
Rough Illustration: AD decreases 10%. So as a shop you expect customers want to spend 10% less.
Instead of firing workers and having your machines idle (produce less), you just cut prices by 10% to
meet new level of demand. P=MC still achieved.
More technical (from exercises): AD drops by 10%. If I don t drop prices, I have to drop quantities by 10%. This reduces MC
without reducing P equivalently (therefore not optimal, P=MC not achieved). So I have to drop price (and wages) by 10%.
P=MC is satisfied because both P and MC are dropped by 10% (MC is linear function of factor prices, so if other factor prices
and wages fall 10%, MC falls 10%). Also, the physical production required to sustain the new level of AD will be the same as
the old level
Sticky Prices
Supply is determined by demand. Producers respond by adjusting quantities, not prices. That’s why
we have booms and shocks.
Menu costs – costs of physical act of changing prices – not the most important
Information costs – costs of figuring out new price (e.g. hiring consultant)
Consumer reaction – inertia; collective problem of being first to change price (lose market
share to competitor, perhaps even permanently)
Wage rigidity – social norms surrounding wages.
Fiscal Policy
o Changes in G spending (including transfers) and in taxes
o Run by Government (UK: Chancellor of the Exchequer)
Monetary Policy
o Purchases and sales of financial assets, setting of statutory interest rates
o Run by the central bank
Terminology:
Government spending
o = G (goods and services purchased by gov) + Transfers + Interest
o G i.e. goods and services purchased by gov
o Transfers
o Interest payments on debt
Government revenues
o = mostly taxes
Deficit
o = Spending – Revenues = chg in debt
o Most govs run deficits (like UK now)
Surplus
o = Revenues – Spending = (-) chg in debt
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2. Tool to counter other demand shocks e.g. fiscal stimulus policies in 2007-2009
Lecture 5
*Multiplier less than 1 (crowding out) not necessarily bad – allows you to support unemployment in
response to AD shock.
Limits of expansionary fiscal policy: Debtors stop lending to you when debt too high
Golden rule for fiscal policy: Run a deficit in recession, run a surplus in booms; keep budget
balanced on average. Germany is the main opponent against this – believes in always running
balanced budget. UK (Osbourne administration) says don’t run deficits ever, till now (abandoned due
to Brexit).
Done by Central Banks e.g. Fed, Bank of England, ECB, Bank of Japan
Example of arbitrage: i on gov bonds go up Demand for corporate bonds goes down i on
corporate bonds goes up. [corporate bonds need to raise interest rates to find lenders]
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Changing policy rates affects all other rates in the economy e.g. Interest rates on commercial bank
borrowing from central bank goes down financing for commercial banks becomes cheaper
commercial banks require lower interest rates to lend.
Cash poor firms: interest rate is cost of borrowing; high i deters borrowing to invest
Cash rich firms: interest rate is opportunity cost of investment project; if i is high, might as
well lend money rather than use it to invest.
Effective Lower Bound (ELB): The point below which conventional monetary policy is ineffective
Until recently, ELB was thought to be 0 (i.e. the Zero Lower Bound, ZLB)
ELB reflects the cost of storing cash
o Negative interest rates should give incentive to borrow and hoard infinite cash,
pushing up interest rate to 0% again [b/c creditor pays borrower]
o But this does not happen – hoarding cash costs money (security, storage costs,
insurance etc.)
o Therefore people still willing to rely on electronic deposits (ELB < 0%)
Estimated that negative interest rates are still feasible at -0.5%
Switzerland (Jan 2015): -0.75% UK (Aug 2016): 0.25% Sweden (Feb 2016): -0.5%
Japan (Jan 2016): -0.10% *ECB (March 2016): 0% USA (March 2017): 1.00%
[Extra info] *Deposit facility rate (interest banks receive for deposits with central bank overnight) is -0.4%. main refinancing operations
(MRO; cost for banks to borrow from central bank for one week, most important rate) is 0%. Marginal lending facility rate (cost of
borrowing from central bank overnight) is 0.4%
Getting around the ELB: (i.e. how to make monetary policy effective at low/negative interest rates)
Without cash, must hold deposits and face the negative interest rate
Problems:
o Poor rely depend on paper currency, may not have current accounts
o Some legitimate transactions hard to conduct w/out paper e.g. Yard sale
o [not in lectures] Individuals may turn to alternative currencies (Bank of Canada, 2016 paper)
Quantitative Easing:
Long term bonds usually have positive interest rates even when short-term ones are at zero
or negative. This ‘spread’ is a risk premium:
o Compensate lenders for locking-in money for long time
o Borrowers don’t mind locking in a fixed interest rate even if it’s slightly higher
These long-term interest rates are very important – involves big purchases like cars, houses
& most businesses concerned primarily with long-term rates
Central Banks may switch to buying long-term bonds in attempt to lower long-term interest
rates [Bypasses relationship with commercial banks – go straight to financial market]
1. Central Bank starts buying long-term assets (using newly created electronic money)
2. Therefore demand for long-term assets increases
3. This pushes down interest rates specifically on long-term assets
4. Long-term interest rates are most important for investment decisions
5. So low long-term rates can help foster growth/recovery
QE Facts/Examples:
Shape:
Usually upward sloping (i.e. long-term bonds have higher interest rate than short-term ones)
Reasons for upward sloping: [Not sure if examinable, was discussed in my class]
Why it might be downward sloping: Bad economic climate (I expect CB to lower short-term rates
soon to boost economy, therefore I’m willing to accept lower long-term rates to lock-in a decent
return)
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Movement:
Short-term and long-term rates move together (but long-term will be higher)
Action Movement
Central Bank increases policy Curve becomes shallower (‘flatter’) Short-term rates increase, but long-
rate term rates are less responsive to the policy rate, so the curve becomes flatter.
Short-term rates expected to Curve becomes steeper If I think short-term rates will increase in future, I want
increase in future better compensation for my long-term bond now.
Inflation expected to increase Curve becomes steeper If I think inflation will erode my purchasing power in the
future, I want better compensation for my long-term bond. Also, I expect CB may
in future increase short-term rates in future to combat inflation.
Curve becomes shallower Central bank buys long term bonds, increasing their
**Quantitative Easing** demand and decreasing their interest rate (intuition: if so many people want my bond,
why should I pay a high interest rate for it…?)
Lecture 6
Boost stock markets (b/c bond returns go down, holders of stocks feel richer as stocks
increase in price)
Make room for loans on commercial banks’ balance sheets (fewer bonds to buy)
Depreciate the exchange rate (b/c supply of currency increases e.g. euro)
Psychological boost to investors and consumers (seen to be doing something)
Does QE work? Who knows – only one data point (for now)
Helicopter money: Central Banks prints money and gives it directly to individuals
Topic 6: Inflation
From short-run to long-run: Prices not sticky forever. Economy gravitates back towards its
‘natural’ level of output
Booms are bad as well: when prices become unstuck, inflation occurs
Risk of expansionary monetary policy: may swing too far and generate inflation, or not
enough, then recovery takes too long
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 100 𝑋
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
i.e when nominal GDP grows faster than real GDP, the difference is inflation.
CPI vs Deflator:
Venezuela: 808% (2016) USA: 2.4% (March 2017) UK: 2.3% (April 2017)
Problems:
We don’t care about absolute prices -- relative prices convey information on scarcity and wants –
crucial so that producers/consumers respond efficiently.
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Firms change prices infrequently (sticky prices) -- different firms change prices at different times,
leading to relative price distortions – causes microeconomic inefficiencies in the allocation of
resources.
Consumers/firms mistake nominal price changes for relative price changes e.g. may feel purchasing
power is falling when it is not; see that broccoli is 30% higher but don’t realise their wage is also
higher. Consumers react differently to different price changes (monetary illusion).
3. Increased uncertainty
Higher inflation rate means more variability and unpredictability. Higher rate means inflation tends
to turn out different from expectations more often and differences tend to be larger (but not
systematically positive/negative).
Complicates financial planning. Harder to estimate correct inflation rate for use in contracts etc.
One benefit:
Nominal wages rarely get cut (downward rigidity), thus may make recessions worse.
Inflation allows real wage to fall without nominal wage cuts (product the firm sells becomes higher
priced relative to wages they pay out) – so moderate inflation may improve the functioning of labour
markets.
Bank of England: 2%
ECB: less than but close to 2% (problematic: Draghi thinks this means close to 2%, Germany thinks it means 0%)
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Examples of hyperinflation:
Lecture 7
Ending hyperinflation
Two-pronged strategy:
1. Fiscal reform
Without adjustment on fiscal side, root cause of hyperinflation will continue to exist. Requires gov to
do things like raise taxes, cut spending, sell public assets to reduce dependence on seigniorage.
Ppl expecting high inflation – ‘baked in’ expectations – Ppl don’t believe inflation will come down
Fiscal reform:
Monetary reform:
Brazil experienced high inflation in 1994 Government introduced a virtual currency called the URV
(unit of real value) all prices were to be quoted in URVs, but payments were to be made in cruzeiros
(the inflating currency) URV was pegged to USD and every day gov. would update value of cruzeiros
to URVs on July 1st 1994 Gov introduced new currency called the Real to replace the cruzeiro; had
same value as URV new currency was followed by contractionary fiscal/monetary policy inflation
eliminated URV functioned as nominal anchor; countered psychological inertia of inflation
Problems:
Supply shocks are simple: Something happened on firm side that made it more expensive/cheaper
for them to operate.
Topic 7: Unemployment
Part One: Basics + Terminology
Unemployed, U = not employed but looking for a job (serious about getting job)
Components of unemployment:
Separations
o Dismissals, redundancies, firm closures
o Quits
Search
o Of workers for firms
o Of firms for workers (vacancies)
Matches
o Search and matching process takes time and effort
Fraction of employed workers that become separated from their jobs in a given period
New unemployed = s X E
New employed = f X U
𝑠𝑋𝐸 𝑓𝑋𝑈
𝑠𝑋 𝐿 𝑈 𝑓 𝑋 𝑈 ; replaced E from U + E = L
𝑠𝑋𝐿 𝑠 𝑓 𝑋 𝑈; bring s X U to right, factorise
𝑼 𝒔
𝑳 𝒔 𝒇
Lecture 8
Pays part of a worker’s former wages for a limited time after the worker loses their job
Advantages:
Disadvantages:
Increases search length + unemployment, because reduces opp cost of being unemployed
o Studies: longer a worker is eligible for UI, longer the average spell of unemployment
o Gov’s problem: choosing level and duration of UI so to find right balance between
costs and benefits
UI Net Replacement Rates Ho much of the person s former income is covered b UI (European Commission 2013 paper)
Portugal: 90% Spain: 60% Germany: 60% Italy: 55% UK: 10%
[Not in lectures] Other active policies include Direct Job Creation (creates temporary nonmarket jobs e.g. France’s Job’s for
Young People), Supported Employment (subsidies for individuals with reduced working capacity), Job-Search Assistance
(covers employment agencies, but also subsidies to help workers relocate), and subsidies for hiring workers.
Analogy: Does forbidding divorce results in more/less unmarried people? Hard to tell – no flows
from married to unmarried, BUT fewer flows from unmarried to married. Low s, but low f.
OECD EPL Index (0 = Least Restrictions, 6 = Most Restrictive; P = Permanent, T = Temp. jobs):
Central wage setting amplifies EPL: Know you’re not going to be fired – have incentive to push for
higher wages (b/c unlikely you will be fired, also unlikely you will become an ‘outsider’) -- Creates
insider-outsider situation
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Category of jobs where EPL does not apply (Temporary Jobs). But to prevent employers using ONLY
temporary jobs, apply a time limit e.g. Italy 6 months then must hire permanently.
6. Payroll taxes
Example Payroll Tax Rates (W worker’s contribution as of salary, E Employer’s contribution as of payroll):
Spain: 6% W, 31% E Italy: 9% W, 32% E Germany: 20% W, 20% E USA: 5.5% W, 10% E
7. Minimum Wage
Conventional views:
o Minimum wage leads to decline in labour demand therefore few vacancies, lower f
o If minimum wage > marginal productivity of workers, firms won’t hire them
Unconventional views:
o If firm is monopsonist, they will artificially reduce demand for labour to squeeze
wages (Alan Manning)
Therefore, minimum wage may not actually increase unemployment (or
lower f)
o Higher minimum wage may decrease quits (lower s) (Brochu and Green, 2011)
Workers less keen on quitting
Layoffs may decrease. Replacements more expensive (coupled with search
costs/risk)
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Financial sytem: The set of institutions that allows savers to transfer funds to borrowers (i.e.
facilitates flow of funds)
Financial Markets
o Through which HH/firms directly provide funds to firms/gov
i) Bond market (corporate/gov bonds)
ii) Stock market
iii) Etc
Financial intermediaries
o Through which households/firms indirectly provide funds to firms/HH/gov
i) Banks
ii) Insurance companies
Asymmetric Information:
Need for screening (Adverse selection): investors who know their projects are less
likely to succeed are more eager to finance the projects with other people’s funds
Need for monitoring (Moral Hazard): entrepreneurs investing other people’s money
are not as careful as with their own funds. Bank may restrict how loan proceeds are
spent.
Maturity Transformation: Bank issues short-term debt (Deposits from savers) and transforms it into
a long-term asset (loans)
Share issuance
o Dilutes ownership – shareholders don’t like this
Reinvested retained earnings/asset appreciation
Borrow cheap (e.g deposits) and lend dear (e.g. bank loans).
Issue bonds: cheap because safe
Leverage:
The use of borrowed money (at cheap rates) to supplement existing funds for purposes of
lending/buying assets.
More leverage = more profits.
But leverage is a vulnerability
Insolvency:
Assets less < liabilities. Usually bank shuts down. Bankruptcy = cannot repay creditors.
Risk of insolvency is intrinsic to leverage
More capital = more cushion to cover losses.
o If everything is equity, you can never go insolvent.
Lecture 9
Insolvencies:
Problem in 2007:
Contagion:
Fire sales:
Hence firms and HH find it harder to get funding Recession AD falls, Unemployment rises
More people default (new round)
Vicious cycle that reduces profits, asset values and incomes with more defaults/bankruptcies.
Central bank makes direct loans to these banks (even gov may make loans) Solves issue of illiquidity.
3. Nationalisation
Can’t lend to an insolvent firm – or else will still be insolvent. So Gov injects capital, takes ownership
of company – Gov makes up difference in assets and liabilities. Gov owns whole bank because they
are the entire capital share.
Weaker form of nationalisation is recapitalisation form firms close to insolvency. Gov takes partial
control.
Examples:
4. Subsidies to lending.
Give top-up on interest + guarantees on loans. (e.g. UK lend-to-buy scheme subsidised mortgage
loans; however most economist thought ineffective because raised housing prices)
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Diagnosis 1: Over-optimism
Structure of compensation: asymmetric risks i.e. fully participate on upside, but sheltered on
downside
o Fixed pay + bonus contingent on profits you bring in
o Bonus cannot be negative.
o If bet goes wrong – shareholders, creditors lose but not CEO. Therefore take
excessive risk
Creditors need to do HW, ask for higher interest rate if find risky behaviour
However, reckless or safe, both types can borrow at same interest rate
o Because Implicit bailout guarantee (Too Big To Fail)
o Cheap bank funding encourages high leverage
o More I lever up, the more big become, the more important to gov that I don’t fail
Idea: Bail-Ins i.e. bond holders forced to take losses when gov. recapitalises the bank e.g. €10b
bail-in of Cyprus (Possible problem: Makes gov. reluctant to intervene and recapitalise banks)
2. Protection of deposits
Lecture 10
Minimum buffers that financial institutions must have. Most controversial / hard to pass regulation.
Examples metrics:
Trade-off
o Pro: Makes banks safer so less fail due to crisis.
o Con: [bank lobby] Increased cost of funding hence less lending in normal times.
IF Capital amount fixed + ceiling on leverage in place (i.e. capital requirements)
o Balance sheet constrained, cannot borrow more
o So indeed there will be limit on lending
BUT, if get more capital?
o More lending sourced not just from borrowing, but from capital.
o Don’t rely exclusively on borrowing – can still lend
Argument from banks: Equity more expensive than debt. Need to guarantee return akin to
other equity (7-8% return). It matters how we finance the marginal loans we make.
Firm owners have incentive to raise new equity when firm is overvalued. New equity
providers know this and ask for bigger share of pie
o Counterarguments:
If so, then use retained earnings to grow capital!
Less relevant if all banks are made to raise equity by regulators (new equity
not due to overvaluation but regulation)
Debt is cheaper because of implicit bailout guarantee (and tax advantages)
o But then equity is privately more expensive, but not socially more expensive
Difference between equity and debt financing large privately, but small socially
o Lending supported by implicit bailout guarantees should not happen [Risk taken on
by taxpayers] Maybe those additional loans aren’t worth the social cost.
4. Compensation reform
a. Level of compensation
Logically, should not impact risk-taking (but perhaps matters in other areas e.g. impact on inequality)
Made by Aaron Luke
aaluke16@gmail.com
b. Structure of compensation
Proposal: Clawback
5. Responsibility reform
Interest rate spreads: Difference in interest rates between countries. Differences due to risk
premiums [more risky = higher interest rate incurred]. Eurozone benchmark rate is Germany’s.
In 2008-2009, countries enacted fiscal stimulus and expensive bank rescues, leading to larger
government debts.
Severe crisis meant GDP fell (recession). This coupled with higher spending means debt/GDP ratio
went up, spooking investors.
Made worse by concerns of further problems in banking. If banks weak – maybe need to recapitalise
or bail them out, which will worsen fiscal situation for governments.
Enough reason for higher spreads? Probably not. Need another reason
Before crisis investors counted on implicit bailout guarantee from EU. Default of Lehman Brothers in
USA + general contentiousness of bailouts may have led to reconsideration. (“Maybe Germany
would let Greece go down?”) Political climate hostile to bailouts
Thus, investors demand higher interest rates from countries like Greece/Italy
Made by Aaron Luke
aaluke16@gmail.com
1. Gov risk of insolvency (not enough liquidity to pay back debts). Forced to cut spending and
increase taxes Austerity
2. High interest rates on benchmark gov bonds spread to rest of economy (Interest rates move
together) Credit Crunch
b. Recession weakens banks – increasing implicit gov liabilities – forcing further austerity
Increasing number of observers who believe fiscal multiplier is larger than 1 in eurozone periphery.
Therefore less G increase in debt/GDP ratios, even though gov. is shoring up spending
Greece (or others) defaults German banks lose money invested in periphery-country assets
o German banks not healthy – coming out of financial crisis
o Form of indirectly bailing out own banks (if not, may have to directly bailout in future)
May cause contagion – same with Lehman situation in USA
o Ppl terrified run on banks.
o When people see Germany as similar to Greece, Germany nicer to Greece.
o When not, tougher on Greece.
o In Greece’s incentive to make contagion look likely
Possible Eurozone breakup
o Creates a precedent
Solution to Sovereign Debt Crisis requires a balancing act between three parties:
3. Creditor-country tax payers: Stronger-countries may provide loans to crisis country, imposes
risk/loss to taxpayers there
2010 2012: Occasional secondary-market purchases of gov bonds (to contain spreads)
Mario Draghi becomes ECB Governor in Nov. 2011. Draghi more hands on
2012:
2014: QE starts
2015: QE, negative rates.
2016: QE, negative rates, free long-term loans to banks
There’s a school of thought in Germany that hates Draghi, claims ECB policy too expansionary.
Recent increase in inflation makes it harder to support economy (2% in February, 1.5% in March
2017)
Purchased large amount of Gov. bonds, reducing interest rates on these bonds
o Govs can borrow at cheaper rates
o Lower rates transmit to other sectors – less credit crunch
o Euro is kept relatively low
Provided cheap loans to banks
o Less liquidity pressure on banks/decreased risk of bank failure
o Banks can use loans to buy gov bonds, driving down interest rates further
o Banks use loans to lend to firms/households
__________________________________________________________________________________
Disclosure
I claim no liability for inaccuracy/incompleteness in these notes. Just know that if you mess up because of it, I
probably will too.
These notes won’t do you much good in understanding the material – at best it’ll help you outline and keep
track of it. Caselli is bae. Listen to his lectures. I recommend x1.8, or x1.9 if you’re feeling feisty.
Special thanks to Edward Kwan for helping fill in some gaps in Topics 1 & 2.
Peace out, and remember that LSE doesn’t mark on a relative scale (from my knowledge), so share the love.
Much love,
Aaron