At least since the start of the last financial crisis in 2007, the analysis of financial stability is a broadly investigated field of research. Macroeconomic as well as microeconomic models try to evaluate the effects of distortions (liquidity shocks, substantial losses on equity good markets. . . ) on the financial markets to the stability of all or some areas of the economy.
Macroeconomic models mainly evaluate the impacts of such disruptions to benchmarks like GDP, unemployment or international trade and give recommendations regarding how institutions (central banks, governments. . . ) should react. As Blaug indicates, classical, neoclassical and new-classical models can be distinguished in this context. In contrary, microeconomic models are trying to quantify the welfare effects of such events on the level of individual economic participants like households, firms or banks. Most of this literature measure such losses via real-term variables, for example real wages or real consumption. Within such models, this causes instability on the banking/financial sector due to crashes in equity or bank-runs.
Just a small group of younger literature, such as Carletti et al. (2009) or Gersbach (2012), examines the question whether modeling nominal but non-contingent contracts instead of real ones improve financial stability in theory. Among this literature, the present article “Money, financial stability and efficiency”, written by Franklin et al. (2014), can be found. The authors consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks.
The aim of this term paper is to briefly describe relevant model specifications and main assumptions of the underlying model. Secondly, main findings and their implications regarding the proposed research question will be presented. Finally, this term paper will complete with some critical reflections about the applicability of the model in theoretic and empirical research.
Table of Contents
1 Introduction
2 Model specifications and assumptions
3 Main findings and their implications
3.1 Banks
3.2 Firms
3.3 Consumers
3.4 Market clearing and equilibrium
4 Conclusions and critical reflections
Research Objectives and Key Topics
This term paper examines the theoretical foundations of financial stability within a microeconomic framework, specifically investigating whether nominal, non-contingent financial contracts are sufficient to maintain an efficient equilibrium during periods of economic disruption and uncertainty.
- The role of fiat money and monetary policy in bank-intermediated economies.
- Theoretical modeling of banks, firms, and consumer behavior under time-dependent uncertainty.
- The interaction between market clearing conditions and the Quantity Theory of Money.
- Critical evaluation of the assumptions regarding labor markets and price flexibility in financial models.
- Analysis of bank-specific liquidity shocks and potential insurance mechanisms.
Excerpt from the Book
3 Main findings and their implications
Under the described setting of chapter 2, the economic participants face the following decision problems:
3.1 Banks
All banks give loans to firms and accept deposits from customers in the first period. These transactions are constrained by the required equality of in- and outflows. By reason of simplification, it is assumed that the total amount of loans will be 1, leading to the bank’s formalized decision problem: λD1 + (1 − λ) D2 = 1. (3.1)
In other words, banks just have to make sure that the inflows from deposits D in period two and three are equal to the total amount of loans paid out in the first period. If disruptions countermand this condition, the bank in question would plan to borrow the open amount of money on the interbank market. Pure competition and the zero interest rate assumption results in zero profits after achieving market equilibrium. Rewriting condition (3.1) to λ (D1 − D2) + D2 = 0 + 1 and regarding that this condition must hold for multiple values of λ, comparing the coefficients on both sides yields to D*1 = D*2 = 1. (see Franklin et al. (2014, pp 109)
Summary of Chapters
1 Introduction: Provides an overview of the research field, focusing on financial stability and the specific article by Franklin et al. (2014) regarding nominal contracts.
2 Model specifications and assumptions: Outlines the structural framework of the model, including consumer preferences, banking interactions, and the role of the central bank.
3 Main findings and their implications: Details the decision problems faced by banks, firms, and consumers, and illustrates how an efficient equilibrium is achieved.
3.1 Banks: Describes the constraints on bank loans and deposits, demonstrating how market competition ensures optimal conditions.
3.2 Firms: Explains the production problem of firms and their strategies for splitting capital into assets to meet consumer demand.
3.3 Consumers: Analyzes the optimal behavior of consumers based on their time-dependent consumption preferences for short or long assets.
3.4 Market clearing and equilibrium: Discusses the requirements for market clearing and how they relate to the Quantity Theory of Money to ensure an efficient economy.
4 Conclusions and critical reflections: Summarizes the study’s findings and discusses limitations, particularly regarding the absence of labor markets and the impact of price flexibility.
Keywords
Financial Stability, Monetary Policy, Fiat Money, Microeconomic Models, Banking Crisis, Nominal Contracts, Liquidity Shocks, Interbank Market, Economic Equilibrium, Quantity Theory of Money, Asset Allocation, Consumer Utility, Price Flexibility, Financial Regulation, Market Clearing.
Frequently Asked Questions
What is the primary focus of this paper?
The paper provides a summary and critical analysis of the academic article "Money, financial stability and efficiency" by Franklin et al. (2014).
What are the core thematic fields covered?
It explores macroeconomic and microeconomic perspectives on financial stability, specifically examining how banking models operate under liquidity shocks and nominal contracts.
What is the central research question?
The paper investigates whether modeling financial contracts as nominal and non-contingent is theoretically sound and sufficient for analyzing banking crises.
Which scientific methodology is employed?
The work utilizes a microeconomic model spanning three time periods, which integrates consumers, firms, commercial banks, and a central bank to determine equilibrium conditions.
What is the content of the main section?
The main section formalizes the decision problems for banks, firms, and consumers to show how an efficient, stable market equilibrium can be sustained.
Which keywords best characterize this work?
Key terms include Financial Stability, Monetary Policy, Nominal Contracts, Liquidity Shocks, and Microeconomic Models.
How does the model treat the role of the central bank?
The model defines the central bank as a passive supplier of fiat money that provides liquidity to commercial banks on an intraday basis at a zero interest rate.
What are the identified disadvantages of the model?
The primary drawbacks noted are the total exclusion of labor markets and the assumption that price flexibility is the only mechanism to absorb economic shocks.
- Arbeit zitieren
- Christian Summerer (Autor:in), 2016, "Money, financial stability and efficiency". A summary of the article by Franklin Allen, Elena Carletti and Douglas Gale (2014), München, GRIN Verlag, https://www.grin.com/document/458855
