"Money, financial stability and efficiency". A summary of the article by Franklin Allen, Elena Carletti and Douglas Gale (2014)

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

Appendix

References

List of Figures

4.1 The economic cycle

1 Introduction

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 GDP², unemployment or international trade and give recommendations regarding how institutions (central banks, governments...) should react. As Blaug (1997, pp. 278,651) 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, like Diamond(2007), Freixas et al. (2008) or Adams-Kane et al. (2004) 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.

2 Model specifications and assumptions

Regarding the basis model of this paper, the authors followed the ideas of Carletti et al. (2009), which assumed that an economy possesses a central bank that issues fiat money to the economic participants (productive sector, banking sector and consumption sector) up to an extent which allows the private sector to carry out all necessary transactions. Therefore, it lends money to banks on an intraday basis with zero interest rate. As all financial contracts are indicated in money, it enacts as a unit of account and a medium of exchange. From a chronological point of view, it is designed as an intertemporal model consisting of three dates t = 0, 1, 2.

The model embraces a large number of consumers who command an initial endowment and follow a time-related consumption preference regarding just one feasible type of good. In this context, early and late type consumers can be distinguished. Whilst the first type transforms its initial endowment into consumption in the second period, the late type stores the good in order to exchange it in the third period following a distribution-based on the random variable λ. In order to be able to shift consumption into the correct period, two different assets are available: a short asset, which allows riskless storage for one period, and a long asset based on constant returns to scale technology with maturity of two periods and return R. (see Franklin et al. (2014, p 105)

As the consumption decision will be made under timely uncertainty, the representative consumption function is configured Von-Neumann-Morgenstern utility function. This type of function multiplies the probability of consumption in time period t to the utility in this period. Finally, the total utility with respect to the time-dependent consumption profile (c1, c2) can be derived as :

Abbildung in dieser Leseprobe nicht enthalten

(see Franklin et al. (2014, p 107)

Aside commercial banks are designated, which collect deposits from consumers transform- ing present payments Dtin one of the future periods. By reason of free market entry, a consumer-utility-optimal deposit will be offered, granting zero profit to the issuing banks. The available money of time period t will be converted into one-period loans to the pro- ductive sector, which uses the money to buy the initial endowments from consumers in time period 0 and produce the consumption goods in future. (see Franklin et al. (2014, p 107)

The complete economic cycle presented by Franklin et al. (2014, p. 108) is shown in figure 1 (see Appendix 4.1). Consumers sell their initial endowments in time period 0 to the firms and receive fiat money, which was transferred to them earlier from commercial banks via loans. Consumers contract deposits up to the preferred time period of consumption.

Firms invest initial endowments in order to produce the correct amount of consumption goods within each period. So the only task of the central bank in this model is to fulfill the demand for money of the commercial banks at each time period via intraday borrowing. (see Franklin et al. (2014, pp 107)

At this point, the Quantity Theory of Money by Milton Friedman (1968) comes into play. As the central bank lends fiat money at zero interest rate to commercial banks and just satisfies the net demand of money in each period, the neutrality of money is achieved and the expected inflation of each time period is 0.

The summarized framework and its core assumptions diverge significantly from other in- vestigations in this field of research. First, it completely ignores the existence of labor as a good and the labor market. As Mas-Collel et al. (1995,p.525) argue, most of the microeconomic models assume some initial endowment of consumers regarding existent goods and the possibility to exchange labor against them. The absence of labor leads to the question in which way consumption should be financed. Here, the model impli- citly assumes that the initial endowment of each consumer is high enough to cover the consumption over all three periods. This restriction prevents the model economy from achieving economic growth.

Furthermore, it seems to be unclear in which way a possible inflation might be generated. Due to the inexistence of the labor market, a higher demand for labor and the resulting increase of labor costs could not put pressure on consumer prices, as described within the traditional cost-push theories (Samuelson & Nordhaus, 2001, p. 692). Additionally, inflation cannot arise from an expansionary monetary policy, as the central bank is obliged to act passively or from outside as a closed economy is analyzed in this paper. As will be argued later, this constellation has remarkable impacts on presented findings.

Up to some extent, it remains unclear which items exactly are subsumed under the defin- ition of “goods”. First, the initial endowment, the only consumption possibility and the value storage are defined as goods, later long and short assets are excluded. Thus, in this summary, the consumption good and the initial stock will be treated as goods, whereas the two assets will be treated as investment cases. As a last disadvantage, the described model is not able to explain what private participants will consume during the earlier periods. Shifting their complete consumption in period two (early type) or three (late type) seems to be a little bit curious, as they should also consume in period one.

References

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[8] Freixas, X. Rochet, J.-C.: Microeconomics of Banking (2nd ed.). London: The MIT Press, 2008.
[9] Friedman, M.: The Role of Monetary Policy. In: The American Economic Re- view,Vol. 58, No. 1, 1968, pp. 1-17.
[10] Gersbach, H.: Can contingent contracts insure the economy against banking crisis. (12/2012)https://www.ethz.ch/content/dam/ethz/special-interest/mtec/cer- eth/macroeconomics-dam/documents/research/context/finpoli.pdf[accessed 23 May 2016].
[11] Mas-Colell, A., Whinston D. M., Green, J. R.: Microeconomic Theory. New York: Oxford University Press, 1995.
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² Gross domestic product