Financial Markets And Institutions Lecture Notes PDF

FINANCIAL MARKETS AND INSTITUTIONS Lecture: Introduction & Chapters 1&2 November 12th 2024 Bilge Karataş  Teaching team Dr. Bilge Karataş Dr. Győző Gyöngyösi Coordination, Lectures, Midterm Lecture 5, Seminars & F...

FINANCIAL MARKETS AND INSTITUTIONS Lecture: Introduction & Chapters 1&2 November 12th 2024 Bilge Karataş  Teaching team Dr. Bilge Karataş Dr. Győző Gyöngyösi Coordination, Lectures, Midterm Lecture 5, Seminars & Final Exams Specialization: Monetary Economics, Financial Crises Specialization: MacroFinance, Political Economy Dr. David-Jan Jansen (DNB) Prof. dr. Coen Teulings Guest (Lecture 7) (UU, ex-head CPB) Guest (Lecture 6) Specialization: Monetary policy, Specialization: Economic policy, Central bank communication Pensions, Post-crisis policymaking About Financial Markets and Institutions Tuesdays: Lectures (on-campus) (BB quizzes; deadline every Sunday before lecture) Thursdays: Seminars (on-campus) Book: Carlin, W., and D. Soskice (2015) “Macroeconomics: Institutions, Instability, and the Financial System” Guest Lectures: On-Campus Articles Assessment Midterm : 35% Endterm: 65%  How will sessions be organized? Week Tuesday: Lecture Thursday: Seminar 1 Carlin and Soskice: Chapters 1 & 2 Exercises on Chapters 1 & 2 2 Carlin and Soskice: Chapters 3 & 14 (parts 1,2&5) Exercises on Chapters 3 & 14 (parts 1,2&5) 3 Carlin and Soskice: Chapter 4 Exercises on Chapter 4 4 Midterm: Carlin and Soskice: Chapters 1 – 4 &14 (parts 1,2&5) 5 Carlin and Soskice: Chapters 5, 12 (parts 1,2) &13 Exercises on Chapters 5, 12 (parts 1,2) &13 6 7 Carlin and Soskice: Chapters 6 & 7 Exercises on Chapter 6 & 7 8 Guest Lecture by Coen Teulings Guest Lecture by David-Jan Jansen at 11:00 9 Endterm: Carlin and Soskice: Chapters: 1-7, 12.1, 12.2, 13-14 Papers discussed during the guest lectures Contents of The Course Macroeconomics Familiarize New Keynesian model or 3-equation model (IS-PC-MR) Step away from IS-LM AD-AS Closer to both current policy making & academia Monetary Policy Role of money in economy Financial Intermediaries Role of financial intermediaries Financial crisess and interpret academic papers Introducing: The Modern Monetary Framework The 3-Equation Model Demand Side (Aggregate Demand): Investment- Savings (IS) Curve Supply Side (Wage and Price Setting): Philips Curve (PC) Response of Inflation-Targeting Central Bank: Monetary Rule (MR) Integration of Financial System: Banking Mark-up Vulnerabilities of the Financial System leading up to Financial Crisis How to pass this course?  Keep up every week  Read chapters in advance  Do the BB quizzes  Do the homework exercises  Come to the seminars  Send us an e-mail if anything is unclear FINANCIAL MARKETS AND INSTITUTIONS Chapter 1: The Demand Side  Aggregate Demand The Demand side captures the spending decisions of: Households: Domestic (C) & Foreign (X – M) (Open Economy) Firms (I) The Government (G) Aggregate Demand (AD): 𝑦𝐷=𝐶+𝐼+𝐺+(𝑋−𝑀) Why study this? Fluctuations in AD affect unemployment and inflation Relevance to monetary and fiscal policy makers Understand the transmission mechanism of monetary and fiscal policy Demand side facts: Components of AD over time (UK) Investment is more volatile Business Cycle facts: Growth & Fluctuations (US) Recession Periods (Shaded Areas) Business Cycle facts: Volatility and Policy The Great Moderation: Did better policy-making reduce volatility?  The Model For Demand Side: The IS (Investment – Savings) Curve  The Model for Demand Side The IS Curve shows combinations of the Real interest rate (r) and Output (y) under goods market equilibrium. Goods Market Equilibrium: 𝑦 𝐷 = 𝑦 or, “Aggregate Demand = Output / Income”  Recall closed economy AD: 𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺  Consumption demand (C): Expenditure by individuals on goods and services; on durables and non-durables.  Investment demand (I): Firm expenditure on capital goods, Household expenditure on new houses, Government expenditure on infrastructure.  Government purchases (G): Government expenditure on salaries, goods and services.  The Model for Demand Side The IS (Investment -Savings) Curve Features: -Downward Sloping (high int. rate → lower AD) - Affected by expectations of the future (pessimistic expectations → lower AD at every int. rate) Deriving the IS Curve: Goods Market Equilibrium & the Multiplier First assume a Keynesian consumption function: 𝐶 = 𝑐0 + 𝑐1 1 − 𝑡 𝑦 Where 𝑐0 : autonomous consumption, not affected by income 𝑡 : tax rate 𝑦 : income 1 − 𝑡 𝑦 : disposable income 𝑐1 : marginal propensity to consume AD is given by: 𝑦 𝐷 = 𝑐0 + 𝑐1 1 − 𝑡 𝑦 + 𝐼 + 𝐺 𝐴𝐷 Goods Market Equilibrium & the Multiplier Goods market equilibrium is given by the 45° line: 𝑦 𝐷 = 𝑦 where AD = Output. The Multiplier effect: Δ G → Δ 𝑦𝐷 → Δ 𝑦 → Δ 𝐶 = 𝑐0 + 𝑐1 1 − 𝑡 ∆𝑦 → Δ 𝑦𝐷 → Δ 𝑦 → … The Multiplier The Multiplier determines the change in output due to a change in autonomous demand (ΔG in our example) ∆𝑦 1 = ∆𝐺 1 − 𝑐1 1 − 𝑡 ▪ The multiplier is greater than 1 since 0 < c1 < 1 and 0 < 𝑡 < 1. 1 ▪ If, the multiplier is k = , then ∆𝑦 = 𝑘∆𝐺 1−𝑐1 1−𝑡 ▪ If c1 = 0, then the 𝑦 𝐷 line is horizontal. The multiplier equals 1 and the effect of ΔG on output is not amplified. The Multiplier: Reality ∆𝑦 1 = ∆𝐺 1 − 𝑐1 1 − 𝑡  Theoretically Bigger than 1 (since 𝑐1 and 𝑡 are between 0 and 1)  Empirically disagreement on exact size (Empirics multiplier in Chp.14.2.2)  Realistically, probably somewhere between 0.8-1.5 (Ramey, 2011)  Larger in developed economies  Larger in closed economies  Larger during recessions  However: very hard to estimate…  Deriving the IS Curve Assume that Consumption is independent of 𝑟, while investment is given by: 𝐼 = 𝑎0 − 𝑎1 𝑟 Where 𝑟 is the real interest rate (although we don’t distinguish between the real and nominal interest rate until next week). Substitute this into the AD identity and solve so that 𝑦 becomes a function of 𝑟. Deriving the IS Curve In the r-y space, plot the Investment function. s Then add in 𝑐0 and 𝐺. Finally, factor in the multiplier to get the IS Curve.  IS Curve Properties Downward sloping ↓ 𝑟 → ↑ Investment (𝐼) → ↑ Output (𝑦) IS curve slope Changes with multiplier (𝑘) and hence MPC (c1 ) and 𝑡. Changes with interest sensitivity of investment (𝑎1 ). Shifts in the IS Curve: When autonomous consumption (c0 ), autonomous investment (a0 ), or government spending (G) change. the size of the multiplier (𝑘) will also impact the size of the shift.  Introducing Dynamics IS curve is static: Single point in time But, ▪ Spending decisions today are influenced by expectations of the future: Households adjust current spending based on expected future income; Consumption Smoothing. Permanent Income Hypothesis (PIH) Firms make investment decisions based on expected future profits Tobin’s q  Forward Looking Consumption ▪ People desire to smooth consumption  Diminishing marginal utility of consumption  Requires taking into account the future, and the ability to save and borrow. ▪ Permanent Income Hypothesis (PIH)  Individuals optimally choose consumption by allocating resources (assets & Present Value of future income) across their lifetimes.  Consumption is forward looking, as opposed to the Keynesian consumption function: (ie. depends on r, A0 , expected future income and taxes.)  PIH predicts that optimal C is smoother than income. (eg. consumers save when earning income and draw on savings when retired) Consumption Smoothing Behavior: Predictions of the PIH 1. Anticipated changes in income should have no effect on consumption when they occur 2. Unanticipated changes should affect consumption as permanent income needs to be recalculated Empirics ▪ Excess sensitivity: 𝐶𝑡 changes with anticipated changes in temporary income. ▪ Excess smoothness: 𝐶𝑡 changes too little with a change in permanent income. Why PIH might fail 1. Credit constraints: Inability to smooth consumption by borrowing 2. Impatience: Reluctance to save for consumption smoothing 3. Uncertainty about future income: Leads to precautionary savings above the level predicted by the PIH. Credit Constraints: “Excess Sensitivity” PIH households can increase C by borrowing, as soon as the news arrives. Credit-constrained households cannot do so, and can only increase C when actual income rises. Impatience: “Excess Smoothness” PIH households start saving as soon as the news arrives, allowing for smooth consumption when income falls. Impatient households do not do so, so consumption falls when income falls. Generally impatience is found in experiments  PIH and the IS Curve 1  Multiplier = 1−𝑐1 (1−𝑡)  Under the PIH, this implies:  Permanent income shocks: Multiplier> 1 𝑟  Temporary income shocks: Multiplier ≈ 1 (𝑐1 = 1+𝑟 , close to zero)  Credit constraints & Impatience: Multiplier > 1  Other factors affecting the slope of the IS:  Expected changes in lifetime wealth. Forward Looking Investment: Tobin’s q Theory of Investment 𝑀𝐵 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃𝑓𝐾 𝑞= 𝑀𝐶 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = δ+𝑟 (marginal 𝑞 model)  𝑞 = 1 (MB=MC): Investment is optimal  𝑞 > 1 (MB>MC): Firms should increase investment  𝑞 < 1 (MB less unemployment --> higher wages--> higher prices Note: Positive relationship output and inflation -> negative relationship inflation and unemployment Nominal rigidities, Inflation & the Business Cycle Cycle Next, we study movements away from the medium-run equilibrium (𝑤 𝑊𝑆 = 𝑤 𝑃𝑆 ) due to aggregate demand fluctuations. ▪ Demand-driven business cycles: output adjusts (instead of prices & wages) due to AD shocks. ▪ Price stickiness: Firms’ reluctance to change P when AD changes. ▪ Assume firms only adjust wages at the start of each ‘wage round’, so wages stay fixed throughout each ‘wage round’. ▪ Thus, an AD shock’s effects are modelled as follows: Graphical Derivation of the Phillips Curve (PC): ▪ Positive AD shock → Employment ↑ → ↑ Worker’s power in the labour market → Wage-setter sets higher wages to cover π𝑡−1 (2%) and the output gap (2%). ▪ Price setters set higher prices to cover higher wage costs (↑ by 4%) → ↑ Price Inflation (from 2% to 4%). ▪  A positive output gap causes Wage and Price Inflation to rise; Joining A and B in the π-y space gives us the PC. Phillips Curve (PC): Reality Phillips Curve (PC): Reality  Phillips Curve (PC): Reality Explanations of flattening PC curves can also help us understand it’s comeback: McLeay and Tenreyro (2018 CEPR WP)  When unemployment is high, central banks respond by lowering interest rates, pushing up inflation Pfajfar and Roberts (2018 US FED WP)  Inflation expectations are stickier than in the past, removing some of the amplifying effect of inflation expectations (more on expectations in week 3) Hooper, Mishkin, Sufi (2019 NBER WP)  The Phillips curve may be nonlinear, so that we’re currently just in a flat part of the Phillips curve where prices don’t respond to changes in the employment rate Ratner and Sim (2022 FEDS WP)  The loss of the worker’s collective bargaining power rather than stable inflation-targeting. Shocks in the absence of stabilizing policies Aggregate Demand Shock: Initial Equilibrium at A (𝑦𝑒 , 𝑟𝑒 , 𝑤𝑒 , 𝑁𝑒 , π = 2%) 1. Positive AD Shock: IS shifts right → 2. No stabilizing policy: 𝑟𝑒 is fixed → 3. Output increases to 𝑦𝐻 → 4. Persistent positive WS-PS gap (B) → 5. Wage setters try to set 𝑤𝐻 → 6. Price setters increase prices to keep the profit margin constant → 𝑤 7. π increases to 4%, while is still 𝑤𝑒 → 𝑝 8. Same process next period, since the WS-PS gap persists.  Positive AD Shock under no stabilising policy (𝑟𝑒 constant) → Continuously rising Inflation. Shocks in the absence of stabilizing policies Aggregate Supply Shock: (i) PS curve shifts: changes in productivity (λ), mark-up (μ) or price-push factors (𝑧𝑃 ) (ii) WS curve shifts: Changes in wage-push factors (𝑧𝑤 ) 1. Eg. ↓ U benefits: WS shifts down → 2. Equilibrium 𝑦𝑒 and 𝑁𝑒 rises → to 𝑦𝑒 ′ and 𝑁𝑒 ′ 3. No stabilizing policy maker: 𝑟𝑒 is fixed, and so is 𝑦 → 4. Negative WS-PS gap at 𝑦𝑒 → 5. W rises by 0%, Inflation falls by 2% → 6. π falls every period so long y < ye ′ (IS curve: y is pinned down by r)  Positive SS Shock under no stabilising policy → Continuously falling Inflation at 𝑦𝑒  Key points today and what’s coming next week One equation that relates output to interest rate (IS) 𝑦 = 𝑘 𝑐0 + 𝑎0 + 𝐺 − 𝑘𝑎1𝑟 or 𝑦 = 𝐴 − 𝑎𝑟 One equation that relates inflation to output (PC) 𝜋𝑡 = 𝜋𝑡−1 + 𝛼 𝑦𝑡 − 𝑦𝑒 Next week: Tying it all together with a policymaker (MR) to obtain the 3- equations model  End of Lecture 1…. Homework on BB for Seminars on Thursday…