Unit 10 - Part 1 - Student Version PDF

UNIT 10. BANKS, MONEY, AND THE CREDIT MARKET Economics for a changing world OUTCOMES Students need to be able to: distinguish between the important key concepts that are introduced in this unit (e.g. money, wealth, gross income, disposable in...

UNIT 10. BANKS, MONEY, AND THE CREDIT MARKET Economics for a changing world OUTCOMES Students need to be able to: distinguish between the important key concepts that are introduced in this unit (e.g. money, wealth, gross income, disposable income, etc.) discuss consumption smoothing (i.e., the moving of consumption to the future or to the present by lending or borrowing respectively) explain and graphically illustrate the concept of pure impatience identify and explain another way consumption can be moved to the future (by means of investment) recognise how central banks can affect spending in the economy through changes in the policy rate understand the credit market constraints in a principal-agent problem assess the level of inequality with respect to individuals excluded from the credit market and the rest of the lenders and borrowers in the economy understand income and substitution effects with respect to changes in the interest rate draw and explain the graphs that are presented in Unit 10. Note that you will not be asked to draw the income and substitution effects, but you need to be able to interpret these effects on a graph. 2 OUTLINE Introduction Income, borrowing and saving 10.1 Money and wealth 10.2 Borrowing: Bringing consumption forward in time 10.3 Impatience and the diminishing marginal returns to consumption 10.4 Borrowing allows smoothing by bringing consumption to present 10.5 Lending and storing: Smoothing and moving consumption to the future 10.6 Investing: Another way to move consumption to the future Balance sheet 10.7 Assets, liabilities, and net worth Banks and money 10.8 Banks, money, and the central bank 10.9 The central bank, the money market, and interest rates 10.10 The business of banking and bank balance sheets 10.11 The central bank’s policy rate can affect spending Credit rationing 10.12 Credit market constraints: A principle-agent problem 10.13 Inequality: Lenders, borrowers, and those excluded from credit markets 10.14 Conclusion 3 Introduction 4 The context for this unit Markets for goods and services allow parties to interact in mutually beneficial ways. (Units 6-9) In most markets, money is the medium of exchange. How do banking systems affect individual consumption choices and economic outcomes? What are the limitations of the banking system? 5 This Unit Model how individuals borrow, save, and invest Understand the role of commercial banks and the central bank in the economy Explain how commercial banks make money and the risks they face and pose 6  A roadmap for this unit Consumers want to smooth their consumption over time (between now and later) Access to credit (loans) can assist with this smoothing BUT everyone does not have equal access to credit (some people are credit constrained and can only borrow at high interest rates; while others are credit excluded and cannot borrow money at all)  A roadmap for this unit (continues) A consumer that does not have any money now, must borrow money if they need money to consume (and buy goods) [Julia] The amount of money that is borrowed depends on the following: ▪ the interest rate (how expensive it is to borrow money); and ▪ the extent to which the person (in this case Julia) is impatient (in other words, in a hurry to consume)  A roadmap for this unit (continues) A consumer that has money now (or an asset that they can sell for money), but will not receive any money in the next period must decide how they are going to manage their asset (or money) between now and later [Marco] Suppose Marco has an asset now (grain to the value of $100), but that he will not be receiving any money in the next period. How can he smooth his consumption over time?  A roadmap for this unit (continues) Marco’s options: ▪ Use a part of the grain now and store the rest [suffer losses due to pests that eat a part of the grain] ▪ Sell the grain for its value ($100) and then: o consume a part of the $100 now and store the rest under his mattress (to consume later); OR o consume a part of the $100 now and lend out the rest (receiving an interest return in the next period); OR o consume a part of the $100 now and invest the rest (plant the seed for a harvest return in the next period); OR o consume a part of the $100 now, invest the rest (plant the seed for a harvest return and borrow against this investment)  A roadmap for this unit (continues) By studying Julia and Marco’s different options, we can draw conclusions about which option will have the best outcome (i.e., which option will put a person in the best possible position). We will be making use of indifference curve analysis and feasible frontiers to study these different options. But first: let’s cover some theory. Two case studies (examples) Chambar, Pakistan Ireland (1970) 12 Pakistan has two cropping seasons, "Kharif" being the first sowing season starting from April-June and is harvested during October- December. Rice, sugarcane, cotton, maize, moong, mash, bajra and jowar are “Kharif" crops. 13 1. Chambar, Pakistan o City in Pakistan o Serves as financial centre for 2400 farmers from surrounding villages. o At the beginning of planting season, the farmers need to buy fertiliser and other inputs. o Only way they can do this is by borrowing and promising to repay when harvest comes in. o Other people in the community borrow to pay for healthcare. o They do not have the formal, large commercial banks that we are familiar with, o But they have around 60 moneylenders 14  Two case studies (examples) Chambar, Pakistan Money lenders No collateral “money and trust are more closely related than you might think” 15 2. Ireland (1970) On 4 May 1970 a notice appeared in the Irish Independent newspaper stating that, due to industrial action by the Irish Bank Official’s Association banks are closing off all their offices. The banks only reopened on the 18th of November; more than six months later. 16 2. Ireland (1970) Did this cause financial and economic ruin across Ireland? Surprisingly, no. Economic growth continued as before. How was this possible? IRISH PUBS.  2. Ireland (1970) At the time Ireland had 1 pub for every 190 adults. o Everyone in the villages used the pubs and was known by The cheques circulating the pub owners. during the six months amounted to approximately o The pub owners agreed to accept deferred payments in £5 billion. the form of cheques (even though it would not be cleared by a bank in the near future). o Soon they swapped one person’s cheque with another and the cheques became a financial intermediary (used as money). ❖ This system worked because of TRUST. The pub owners knew the patrons and judged them to be trustworthy. They knew that the patrons did have the money to back these cheques even though the money could not be cleared by a bank. 18 What is a cheque? A cheque is a printed form on which you write an amount of money and who it is to be paid to. Your bank then pays the money to that person from your account. 19  Two case studies (examples) Ireland (1970) Money Trust Money creation The essence of these two case studies: Money (or any item that is generally accepted for payment) only has its value because of trust 20 Income, borrowing and saving 21 10.1 Important concepts: Money Wealth Gross income Disposable income Expenditure 22 Money Money = A medium of exchange used to purchase goods or services bank notes, bank deposits, cheques, … Money allows purchasing power to be transferred among people. For money to do its work, everyone else must trust that others will accept your money as payment. 23 Wealth and gross income Wealth = Stock of things owned or value of that stock = buildings, land, machinery, capital goods – debts owed + debts owed to you Wealth is fixed (a "photo" of the things you own at a specific point in time) Gross income = The amount of money one receives over some period of time (flow). from market earnings, investments, government. Gross income is variable (taking a "video" of the things you own over a period of time) 24 Disposable income Disposable income = The amount of money left from your income after you have paid your taxes. 25 Expenditure Expenditure = The money flowing out of the bathtub is called consumption expenditure, which reduces wealth. 26 Other key concepts Depreciation Net income Earnings Consumption Savings Investment 27 Other key concepts Depreciation = Reduction in the value of a stock of wealth over time. Net income = The maximum amount that one could consume without running down wealth. Net income = gross income – depreciation Earnings = Wages, salaries, and other income from labour. Consumption = Expenditure on consumer goods Savings = Income that is not consumed. Investment* = Expenditure on newly produced capital goods. *This is not the same as financial investment (stocks, bonds, crypto etc.). More on Investment in Unit 13. 28  Saving in South Africa: Impact of COVID-19 1000000 800000 600000 400000 Rand million 200000 0 indv dont save and after 2005 they "dissave" after covid (2020) start saving as u couldnt spend money -200000 -400000 -600000 Net saving by general government Net saving by households Net corporate saving Consumption of fixed capital (Depreciation) Source of basic data: South African Reserve Bank 29 The impact of the COVID-19 pandemic on saving, investment and foreign direct investment in South Africa 1000000 800000 600000 Rand million 400000 200000 0 net captital flow negative-outflow -200000 Gross fixed capital formation Source of basic Balance of Payments: Change in gross gold & other foreign reserves data: South African Gross saving - Total Reserve Bank Net capital inflow from rest of the world 30 Foreign investment Questions and exercises Question 10.1 Question 10.2 31 Question 10.1 Which of the following statements are correct? a) Your material wealth is the largest amount that you can consume without borrowing, which includes the value of your house, car, cant meaure human capital therefore = false financial savings, and human capital. b) Net income is the maximum amount that you can consume and leave your wealth unchanged. true c) In economics, investment means saving in financial assets such as stocks and bonds. d) Depreciation is the loss in your financial savings due to unfavourable movements in the market. 32 Question 10.2 Mr Bond has wealth of £500 000. He has a market income of £40 000 per year, on which he is taxed 30%. Mr Bond’s wealth includes some equipment, which depreciates by £5 000 every year. Based on this information, which of the following statements is correct? 33 a) Mr Bond’s disposable income is £40 000. fasle as its income after tax b) Mr Bond’s net income is £28 000. net = gross-depreciation therefore 23000 c) The maximum amount of consumption expenditure possible for Mr Bond is £23 000. false as he can also spend the 500000 d) If Mr Bond decides to spend 60% of his net income on consumption and the rest on investment, then his investment is £9 200. 23000*60%=13800 left with 9200 ntherefore true  In the news (22 July 2024) https://businesstech.co.za/news/finance/783663/turn-for-interest-rates-in-south-africa-hits-the-rand/ 10.2 Consumption over time Consuming goods now or later? There is a trade-off between consuming goods now and later. The opportunity cost of having more goods now?... Is having fewer goods later. 36 Borrowing and lending allows us to reorganise over time our capacity to buy goods and services 37 Borrowing (example) Let’s say you want to buy a house of R2 million, but you don’t have the cash to buy it. You take out a mortgage and pay off the house over 20 years (monthly instalment = capital + interest). You get the opportunity to enjoy this asset (the house) from the moment the purchase goes through - you don't have to wait 20 years before you move into the house (this is the benefit of having access to credit in the economy). The most important question you need to ask yourself is: can you afford the monthly instalment? 38 Borrowing Borrowing allows us to buy more now at a cost of buying less in future. Interest rate (r) = The price of bringing some buying power forward in time. (1+r) = Tradeoff between current and future consumption (MRT) to have one unit of the good now you have to give up 1 + r goods in the future 39  Please note the calculations in the textbook Figure 10.2: Borrowing, the interest rate, and are rounded to 0 decimals the feasible set. repayment: principal amnt +principal amnt*(r)=Principal amount (1+r) if interest =10% r=0.1 Julia's endowment 100 Consumption later, $ 1 Julia has nothing Julia has no money now, but she knows that in the next period she will have $100. Note that we assume in this situation that Julia is able to borrow money. 0 0 Consumption now, $ Figure 10.2: Borrowing, the interest rate, and the feasible set. 2 Bringing future income to the present Julia could, for example, borrow $91 now and promise to pay the lender the $100 that she will have later. The interest rate would be Julia’s endowment 100 10%. Consumption later, $ Why $91? Repayment = Principal amount + Interest payment She can only repay $100 in the next period and the interest is 10%. $100 = Principal amount + Principal amount*i = Principal amount (1 + 10%) $100 Principal amount = = $90,91 1,10 = $91 0 0 91 Consumption now, $ Figure 10.2: Borrowing, the interest rate, and the feasible set. Julia’s endowment 100 Consumption later, $ 3a Borrowing even less At the same interest rate (10%), she could also borrow $30 67 to spend now, and repay $33 at the end of the year. In that case she would have $67 to spend next year. 3b Borrowing less At the same interest rate (10%), she could also borrow $70 to 23 spend now, and repay $77 at the end of the year. In that case she would have $23 to spend next year. 0 0 30 70 91 Consumption now, $ Figure 10.2: Borrowing, the interest rate, and the feasible set. If you are at a point below your feasible frontier, you are not consuming (spending) all your money. Given the current interest rate, you Julia’s endowment 100 cannot be at a point above your feasible frontier, since you cannot afford Consumption later, $ this point. 67 4 Julia’s feasible set The boundary of Julia’s feasible set is her feasible frontier, shown for the interest rate of 10%. 23 Feasible frontier (10% interest rate) 0 0 30 70 91 Consumption now, $ Figure 10.2: Borrowing, the interest rate, and the feasible set. Julia’s endowment 100 Consumption later, $ 67 5 Julia’s feasible frontier Julia can borrow now and choose any combination on her feasible frontier. 23 Feasible frontier (10% interest rate) 0 0 30 70 91 Consumption now, $ Figure 10.2: Borrowing, the interest rate, and the feasible set. Julia’s endowment 100 Consumption later, $ 6 A higher interest rate 67 If, instead of 10%, the interest rate is 78%, Julia can only borrow a maximum of $56 now. 23 Feasible frontier (10% interest rate) 0 0 30 56 70 91 Consumption now, $  Why $56? Figure 10.2: Borrowing, the interest rate, and Repayment = Principal amount + Interest payment the feasible set. She can only repay $100 in the next period and the interest is 78%. $100 = Principal amount + Principal amount*i = Principal amount (1 + 78%) Julia’s endowment $100 100 Principal amount = 1,78 Consumption later, $ = $56 7 The feasible set 67 The feasible set with the interest rate of 78% is the dark shaded area, while the feasible set with an interest rate of 10% is the dark shaded area plus the light shaded area. 23 Feasible frontier (10% interest rate) Feasible frontier (78% interest rate) 0 0 30 56 70 91 Consumption now, $ 10.3 Preferences for consumption Borrowing allows us to bring consumption forward How much consumption an individual will bring forward depends on: Consumption smoothing * Impatience * More detail in Unit 13 47 Consumption smoothing Diminishing marginal returns to consumption = The value of an additional unit of consumption declines, the more consumption the individual has. is it true for YOU? 48  Consumption smoothing Diminishing marginal returns to consumption = The value (or utility) that you receive from every extra unit of consumption decreases as the The marginal utility (extra utility) you receive individual consumes more. from every extra burger you consume decreases with every extra burger you consume. An individual smooths their consumption to avoid consuming a lot in one period and little in the other… 49 Figure 10.3a: Consumption smoothing: Diminishing marginal returns to consumption. 1 Julia’s choices The dashed line shows the combinations of consumption now and Consumption later, $ consumption later from which Julia can choose. 0 0 Consumption now, $ Figure 10.3a: Consumption smoothing: Diminishing marginal returns to consumption. Do you remember indifference curves from Economics 114? 2 Diminishing marginal returns to consumption Consumption later, $ Julia’s indifference curve is bowed toward the origin as a consequence of diminishing marginal returns to consumption in each period: the more goods she has in the present, the less she values an additional one now relative to more in the future. The slope of the indifference curve is the marginal rate of substitution (MRS) between consumption now and consumption later. Julia’s indifference curve (IC) 0 0 Consumption now, $ A quick recap from Economics 114 (Unit 3) The only difference now, is that instead of measuring two products (in this case soda and movies) on the two axes, we now measure “consumption now” on the x-axis and “consumption later” on the y-axis. Figure 10.3a: Consumption smoothing: Diminishing marginal returns to consumption. 3 What choices would Julia make? Consumption later, $ C The MRS at C is high (the slope of her indifference curve is steep): Julia has little consumption now and a lot later, so diminishing marginal returns mean that she would like to move some consumption to the present. The MRS at E is low: She has a lot of consumption now and less later, so diminishing marginal returns mean that she would like to move some consumption to the future. So she will choose a point between C and E. E Julia’s IC 0 0 Consumption now, $ Figure 10.3a: Consumption smoothing: Diminishing marginal returns to consumption. Consumption later, $ C 4 MRS falls We can see that the MRS is falling as we move along the indifference curve from C to E: the slope is steeper at C than at E - as illustrated by the slopes of the tangent lines at C and E. E Julia’s IC 0 0 Consumption now, $ Figure 10.3a: Consumption smoothing: Diminishing marginal returns to consumption. Remember that consumption smoothing does not mean you have to split the amount between now and later 50:50. Consumption smoothing simply means that you are trying a achieve a better balance between consumption now and consumption later Consumption later, $ C 5 Julia’s optimal choice Given the choice shown by the line CE, Julia will choose point F. It is on the highest attainable indifference curve. She prefers to smooth consumption between now and later. F E Julia’s IC (higher utility) Julia’s IC 0 0 Consumption now, $  10.3 Pure impatience Consumption smoothing may appear as being impatient. However, we differentiate it from pure impatience = being impatient as a person. Myopia (short-sightedness): People experience the present satisfaction more strongly than the same satisfaction later Prudence: People know that they may not be around in the future, and so they want to consume now How much more do you value a good now than later, if your endowments are the same in both periods? 56 Figure 10.3b: Pure impatience. purely impatient: value prensent value over future value To see pure impatience, you need to start at an initial endowment where consumption is the same in both periods (at Point A). A movement away Consumption later, $ from this point will indicate whether the consumer is purely impatient. Between Point A and Point B, Julia is willing to sacrifice $1,50 future consumption for $1 extra consumption now. 51,50 B A If you are purely impatient, you are literally willing to sacrifice $1,01 future 50 consumption for $1 more consumption now [i.e. the amount doesn’t even have to be $1,50 as on this graph]. Julia’s IC 0 0 49 50 Consumption now, $ Questions and exercises Exercise 10.1 Question 10.3 58 EXERCISE 10.1 THE CONSEQUENCES OF PURE IMPATIENCE 1. Draw the indifference curves of a person who is more impatient than Julia in Figure 10.3b, for any level of consumption now and consumption later. 2. Draw a set of indifference curves for Julia if she does not experience diminishing marginal returns to consumption but has pure impatience. Would she then want to smooth her consumption? 3. Draw a set of indifference curves for Julia if she does not experience diminishing marginal returns to consumption, has no pure impatience, and equally cares about consumption now and consumption later. 59  2) / 3draw straight indifference curve as we dont want a decreasing ANSWERS marginal return 1) Draw indiffernce curve that steeper;slope=level of impatience mrs>1: this is the exception future c willing to forgoe more of the future cosumption to gain 1 unit of current consumption currency c ANSWERS ANSWERS ANSWERS Question 10.3 Figure 10.3a depicts Julia’s indifference curves for consumption in periods 1 (now) and 2 (later). Based on this information, which of the following statements is correct? a) The slope of the indifference curve is the marginal rate of substitution between the consumption in the two periods. true b) The marginal return to consumption in period 1 is higher at E than at C. c) Julia’s consumption is more equal (more ‘smoothed’) at C than at E. Therefore, she prefers consumption choice C to E. cant say its mor smooth as they are just opposites if each other d) Consuming exactly the same amount in the two periods is Julia’s most preferred choice. Figure 10.3a  10.4 Optimal decision-making Remember: MRT = 1 + r Discount rate (ρ) = a measure of a person's impatience. Consumption smoothing Pure impatience Individual borrows as a rule at the point where Julia's optimal decision making occurs, when discount rate = interest rate MRS = MRT 1+ρ = 1+r 66  Figure 10.4: Moving consumption over time by borrowing. FF(10% interest rate) Julia’s 1 Julia’s feasible frontier endowment 100 Julia wishes to get to the highest indifference curve but is limited by her feasible frontier. Consumption later, $ Julia’s IC (higher utility) Julia’s IC Julia’s IC (lower utility) 0 0 91 Consumption now, $ 67  Figure 10.4: Moving consumption over time by borrowing. Borrow $58 to consume now. FF(10% interest rate) Consumption next period? Repayment = Principal amount + Interest payment = $58(1 + 10%) =$64 Julia’s Next period: $100 - $64 = $36 endowment 100 2 Julia’s best option When the interest rate is 10%, the highest attainable indifference curve will be Consumption later, $ the one that is tangent to the feasible frontier shown as point E. E 36 Julia’s IC (higher utility) Julia’s IC Julia’s IC (lower utility) 0 0 58 91 Consumption now, $ 68  Figure 10.4: Moving consumption over time by borrowing. FF(10% interest rate) Julia’s endowment 100 Consumption later, $ 3 MRS and MRT At this point, MRS = MRT. MRS = MRT E 36 Julia’s IC (higher utility) Julia’s IC Julia’s IC (lower utility) 0 0 58 91 Consumption now, $ 69  Figure 10.4: Moving consumption over time by borrowing. rho=p FF(10% interest rate) at f MRS>mRT Julia’s 1+Rho>1+r rho>r endowment 100 4 The decision to borrow Consumption later, $ At point F, her discount rate, ρ, exceeds r, the interest rate, so she would like to bring consumption forward in time. Similar reasoning eliminates all points on the feasible frontier except E. F E 36 Julia’s IC (higher utility) Julia’s IC Julia’s IC (through point F) Julia’s IC (lower utility) 0 0 58 91 Consumption now, $ 70  Figure 10.4: Moving consumption over time by borrowing: Let’s focus on the effect of the higher interest rate. FF (78% interest rate) Julia’s endowment 100 Consumption later, $ 5 An increase in the interest rate If the interest rate at which she can borrow increases, the feasible set gets smaller. 0 0 56 Consumption now, $ 71  Figure 10.4: Moving consumption over time by borrowing. FF(10% interest rate) FF (78% interest rate) Julia’s endowment 100 Consumption later, $ F E 36 Julia’s IC (higher utility) Julia’s IC Julia’s IC (through point F) Julia’s IC (lower utility) 0 0 56 58 91 Consumption now, $ 72  Figure 10.4: Moving consumption over time by borrowing. Calculation of Point G’s coordinates: FF(10% interest rate) If Julia borrows $35 to consume now, she will have to FF (78% interest rate) pay back $35(1+0,78) = $62,30 Later, when she receives the $100, she needs to pay Julia’s back the $62,30, which will leave her with: endowment 100 $100 - $62,30 = $37,70 = $38 Consumption later, $ 6 The effect of a higher interest rate F The best Julia can do now is to borrow less ($35 instead of $58), as shown by point G. G 38 E 36 Julia’s IC (higher utility) Julia’s IC Julia’s IC (through point F) Julia’s IC (lower utility) 0 0 35 56 58 91 Consumption now, $ 73 Questions and exercises Question 10.4 74 Question 10.4 Figure 10.4 depicts Julia’s choice of consumptions in periods 1 and 2. She has no income in period 1 (now) and an income of $100 in period 2 (later). The current interest rate is 10%. Based on this information, which of the following statements is correct? 75 Figure 10.4 a) At F, the interest rate exceeds Julia’s discount rate (degree of impatience). false as p>r at f b) At E, Julia is on the highest possible indifference curve given her feasible set. true c) E is Julia’s optimal choice, as she is able to completely smooth out her consumption over the two periods and consume the same amount. false, as its not equal and smoth. 3836 d) G is not a feasible choice for Julia. false as its in the feasible region