Risk in Financial Markets & Monetary Policy in New Zealand

Table of contents

1. Risk in Financial Markets
1.1 Asymmetric Information.
1.2 Transaction Costs

2 Monetary Policy
2.1 The Role of Monetary Policy in an Economy
2.2 The Operation of Monetary Policy in New Zealand
2.3 The “Best Practice” in Monetary Policy
2.4 New Zealand’s Approach in Comparison to other Countries. 10 2.5 Concerns and Recommendations

3 References

1 Risk in Financial Markets

Risk in financial markets becomes a major issue regarding financial transactions between parties in the market. “Risk in finance relates to the uncertainty of both the amount and timing of the future cash flows of a business or project”. (Anonymous, no year)

It occurs when financial decisions have to be made with an amount of uncertainty about the pay-off of the financial transaction. This is because of insufficient knowledge about the other party involved in the transaction, which is called incomplete or asymmetric information. This lack of information makes it difficult to decide accurately and creates a problem on two fronts, before and after the transaction. (Mishkin, 2001, p. 34-35, 187)

1.1 Asymmetric Information

Adverse Selection is the problem created by asymmetric information that occurs before the transaction is initiated. It means that a potential borrower seeks out a loan but knows for himself that the outcome of his investment is most likely to be undesirable (adverse) for the lender. Due to the fact that these people are the ones who most actively seek out loans the probability is therefore very high that these will be selected. Since this problem leads to loans that may base on bad credit risks the lender is more likely not to make a loan even though if there might be a good credit risk available. (Mishkin, 2001, p. 35)

Countermeasures to avoid the problem of adverse selection exist. An option is to sell information about the businesses to people who want to supply them with their funds in order to minimize the inequality in information. But as soon as information is sold, other people not paying for the information will benefit from it as well and will adjust their actions

according to it too, eliminating any profit for the original purchaser of the information. This problem is called free-rider problem; as a result only little information is produced due to this problem. (Mishkin, 2001, p. 189)

The government can reduce the problem of adverse selection if it either produces information about the businesses itself or provides incentives for businesses to reveal honest information about themselves, so that investors can distinguish between bad and good firms. But government regulations do not eliminate the problem since businesses will make themselves appear to be a good company even though they might not be one. (Mishkin, 2001, p. 189-190)

In terms of financial intermediaries government allows only particular trustworthy institutes to enter the market in order to guarantee effective financial transactions. These intermediaries become experts in screening out good from bad credit risks, thereby reducing the loss of adverse selection. They then acquire funds (private non-traded loans) from depositors and lend them to good firms. Since the bank lends mostly to good firms, the return of the investments is so high that it is feasible to pay interests to the depositor and continue engaging in information production activity. As a result the financial intermediaries can lower the risk of ineffective financial transactions due to adverse selection and free-riding. (Mishkin, 2001, p. 37, 190-191)

The second front based on asymmetric information that bears a significant risk to financial transaction is the problem called moral hazard. It occurs after a transaction is made and describes the risk (hazard) that the borrower hides information or uses the money for activities that are undesirable from the lender’s point of view because these activities make it less likely to be able to repay the loan. Due to this reason lenders may decide not to make a loan. (Mishkin, 2001, p. 36)

Moral hazard has significant consequences when firms raise funds with equity contracts. This consequence is the principal-agent problem that

arises because of a lack of information and control what is done with the funds by the different equity-owner parties after the transaction. A small minority party may take advantage of this lack of information and uses the funds according to its self-interests rather than the interests of the whole business. (Mishkin, 2001, p. 192-193)

Countermeasure to defeat the principal-agent problem is the production of information (monitoring), but since it is costly in terms of money and time it makes equity contracts less desirable for financial transactions. Government regulation can help forcing companies to particular standards and thus making profit verification easier. But this is considered to be not that effective since there are still enough loopholes where people can make it hard for the government to find or prove fraud. (Mishkin, 2001, p. 194)

Financial intermediaries again can avoid the principal-agent as well as the moral hazard problem. These institutes verify and watch the firms’ activities they have financial transactions with, having their own people as members in the firms’ managing body. Since they claim non-tradable equity in the firm they provided with funds, they avoid the free-rider problem as well because nobody else can benefit from the firm’s monitoring activities. (Mishkin, 2001, p. 194)

To reduce the risk of moral hazard one can ensure that the borrower has a large financial involvement in the transaction, thus making minimizing the incentive to behave in a way that the lender does not expect or desire. Furthermore one can write provisions in a debt contract to restrict a company’s activities, but again this causes monitoring and enforcement costs and still suffers from the free-rider problem. (Mishkin, 2001, p. 196)

However, financial intermediaries have the ability to avoid both free-rider and moral hazard problems by making private loans with fund provider, which cannot be traded. Thus they can benefit from monitoring and

enforcement, shrinking these problems in debt contracts. (Mishkin, 2001, p. 198)

Moral hazard and adverse selection are crucial issues since a financial market will not work unless these problems are solved.

1.2 Transaction Costs

But asymmetric information is not the only risk for financial transactions. Again, financial intermediaries play a major role since they are the primary route in linking borrowers to lenders. This is due to the fact that financial intermediaries can reduce transaction costs because they have the expertise to lower them and can achieve economies of scale with bundling funds from many investors. (Mishkin, 2001, p. 34, 185-186)

This bundling allows individual persons to provide multiple small funds to multiple lenders and thus being able to diversify their portfolio and thereby reducing their own risk. In addition the low transaction costs and the expertise of the intermediary make it possible to offer services to the customer in order to make it easier for them to conduct transactions. (Mishkin, 2001, p. 185-186)

All in all asymmetric information and high transaction costs bear significant risks to participants in financial markets. These risks can be overcome by involving financial intermediaries. This process is called indirect finance. (Mishkin, 2001, p. 33-34)

2 Monetary Policy

2.1 The Role of Monetary Policy in an Economy

In an economy it is the ultimate aim to ensure and enhance the citizens welfare. This can be done by maximising the resource utilisation, guarantying full and stable employment, ensuring high economic growth, price stability, regional balance, environmental protection and the equitable allocation of wealth and income.

Monetary policy play a major role in the economic policy since it is a main part of it. It is conducted by the national central bank. Since monetary policy significantly affects only a limited number of variables which impact the economic welfare it is assigned particular goals. These goals declare a monetary framework which states an idealistic condition of monetary policy, whose effects contribute to the economic welfare at its full potential. To define goals it is essential to know the effects monetary policy can have on an economy in the long as well as in the short run. (Svensson, 2001, p. 1, 15-16)

In the long run monetary policy can on the one hand control nominal variables such as inflation or the nominal exchange rate. On the other hand instead, it is not able to increase the average level or the growth rate of real variables including the Gross Domestic Product (GDP), the employment or even the real exchange rates. However, it is able to impact these real variables to a small extent, but only to the expense of the economy. To intentionally affect real variables with monetary instruments will lead to ever-rising inflation; as a consequence, there is the evidence that high or variable inflation will harm the economy and economic growth since it makes the market mechanisms work less well and creates unnecessary uncertainty. (Svensson, 2001, p. 1, 15-16)

In the short or medium term monetary policy has effects on both nominal and real variables. But the complexity of its transmission channels and the difference in strength and time lags of each of these channels as well as the occurrence of unpredictable shocks or inherent uncertainty make it difficult to tune monetary policy to its full potential. (Svensson, 2001, p. 1)

Based on theory, empirical results and experience one has established an optimal monetary framework which is characterised by three main goals: price stability (in the sense of low and stable inflation), operational independence of the central bank and the clear accountability of the central bank for achieving the goal. (Svensson, 2001, p. 8)

For a stable environment a so called “nominal anchor” is essential, which anchors the nominal variables with the future expectations of the private sector for the future nominal variables. In many countries price stability is considered to be the best nominal anchor, since it keeps the inflation rate low and less variable, avoiding the impacts of the alternative high inflation on the economy as already mentioned above.

[...]