Chapter 1. On the Role of Financial Markets and Institutions

1. Chapter 1. On the Role of Financial Markets and Institutions • 1.1 Finance: The Time Dimension • 1.2 Desynchronization: The Risk Dimension • 1.3 The Screening and Monitoring Functions of the Financial System • 1.4 The Financial System and Economic Growth • 1.5 Financial Intermediation and the Business Cycle • 1.6 Financial Markets and Social Welfare • 1.7 Conclusions NOTE: This chapter is available online (our course webpage)

2. Ch.1: Main message • Worth stepping back and asking yourselves (again): • Does finance make sense on social grounds? • What functions does financial markets/instruments really fulfill? Ch. 1: Main tool • General equilibrium theory: • First and Second Welfare Theorems (section 1.6)

3. 1.4 The Financial System and Economic Growth • Performance of financial markets matter at several levels. • Important welfare determinant • One important characteristic is in channeling resources from savers to investors is very important. • Whenever new technologies allow for a lower cost to perform this task, welfare increases.

4. Figure 1.2: Savings and Growth in 90 Developing Countries Source: IMF World Economic Outlook, May 1993 (Annual data, 1971-92) 1.4 The Financial System and Economic Growth

5. Savings and Growth • In a broad sense we see that saving rates are quite correlated with general GDP growth. • A closer look shows that this is not so simple. • Soviet Union was an example • Basic level of potential investment as important as where to invest your money.

6. Extreme case • One can think of the process of transferring funds from savers to investors as a matching process. • Least efficient system: all investment made by savers themselves. • Why is it worst: investment only happens with a double coincidence of cash and project for the same agent. • Situation when savers don’t trust banks with their money (Argentina at certain points in time is an example) • Let FS/S represent the fraction of aggregate savings (S) on hands of Financial System (FS)

7. Variables (1) • Think of BOR as some amount that is borrowed from institutions among FS • Note BOR can be bounded by several factors: legislation; quality of bank service provided (it can be costly to operate a bank) • BOR/FS is the ratio of funds transferred from FS to borrowers and entrepreneurs. • Let I/BOR be the fraction of borrowed funds actually invested.

8. Variables (2) • Finally let EFF represent the efficiency of the investment project undertaken, normalized to 1. • EFF>1 above average project • EFF<1 bellow average project • EFF = 0 a bridge to nowhere • K is the aggregate capital stock that is depreciated at rate Omega. • Finally, let S/Y be the savings rate

9. (1.2) 1.4 The Financial System and Economic Growth (1.1) • A well functioning Financial System will perform its matching function efficiently will positively affect S/Y and FS/S. • Bottom-line: well function FS permits and promotes growth.

10. 1.6 Financial Markets and Social Welfare • A timeless economy (consumption today only ) • Consumers - firms - n goods – markets • Thanks to the action of the price system, order will emerge out of this uncoordinated chaos, provided certain conditions are satisfied. • Note: this is a general description of an economy. For a a more formal definition of an economy, check Theory of Value (page 75).

11. 1.6 Financial Markets and Social Welfare • H1. Complete Markets. • There exists a market, on which a price is established, for each of the n goods valued by consumers. • H2. Perfect competition. • Agents behave as price takers • The number of consumers and firms is large enough so that no agent is in a position to influence market prices. • H3. Consumers’ preferences are convex (a.k.a concave utility) • Agents have preference for mixtures. • H4. Firms’ production sets are convex as well. • Technical

12. 1.6 Financial Markets and Social Welfare • Definition: a General Competitive Equilibrium A price vector p* and an allocation of resources, resulting from the independent decisions of consumers and producers to buy or sell each of the n goods in each of the n markets, such that, at the equilibrium price vector p*, supply equals demandin all markets simultaneously and the action of each agent is the most favorable to him or her among all those he/she could afford (technically or in terms of their budget computed at equilibrium prices). « In other words: given current price, each agent "solves his problem at current prices", and markets clear »

13. 1.6 Financial Markets and Social Welfare • Definition: a Pareto Optimum An allocation of resources, however arrived at, with the property that it is impossible to redistribute resources, i.e. to go ahead with further exchanges, without reducing the welfare of at least one agent. In a Pareto efficient allocation of resources, it is thus not possible to make someone better off without making someone else worse off. « Such a situation may not be just or fair, but it is certainly efficient in the sense of avoiding waste. »

14. 1.6 Financial Markets and Social Welfare 1. The Existence of a competitive equilibrium: Under H1-H4, a competitive equilibrium is guaranteed to exist. 2. 1st Welfare theorem: Under H1-H2, a competitive equilibrium, if it exists, is a Pareto-optimum. 3. 2nd Welfare theorem: Under H1-H4, any Pareto efficient allocation can be decentralized as a competitive equilibrium.

15. 1.6 Financial Markets and Social Welfare • The Existence of a competitiveequilibrium: Under H1-H4, a competitiveequilibriumisguaranteed to exist. • 1st Welfaretheorem: Under H1-H2, a competitiveequilibrium, if itexists, is a Pareto-optimum. 3. 2nd Welfaretheorem: Under H1-H4, any Pareto efficient allocation canbedecentralized as a competitiveequilibrium. • And? • Thesetwotheorems, takentogether, are the major source of govermentalpolicies.

16. BlackBoard Picture * Edgeworth Box example.

17. Time and Risk Dimensions • Revisiting H1 Goods are defined by date and state of nature at which they are available: « contingent commodities ».

18. Complete Markets • One distinct Arrow-Debreu security for each and every future date/state configuration • Ch. 8: There is no single way to make markets complete

19. In reality, different needs are met by alternative specialized instruments • Time dimension: personal loans, bank loans, money market, bonds, pensions, etc.: « non contingent instruments ». • Individual contingencies: • insurance contracts • probably incomplete because of information asymmetries • Most other available assets are contingent on collection of states of nature defined on collective basis: • e.g. stocks, derivatives

20. Conclusions • TOBIN: • "  New financial markets and instruments have proliferated over the last decade, and it might be thought that the enlarged menu now spans more states of nature and moves us closer to the Arrow–Debreu ideal. Not much closer, I am afraid. The new options and futures contracts do not stretch very far into the future. They serve mainly to allow greater leverage to short-term speculators and arbitrageurs, and to limit losses in one direction or the other. Collectively they contain considerable redundancy. Every financial market absorbs private resources to operate, and government resources to police. The country cannot afford all the markets the enthusiasts may dream up. In deciding whether to approve proposed contracts for trading, the authorities should consider whether they really fill gaps in the menu and enlarge the opportunities for Arrow–Debreu insurance, not just opportunities for speculation and financial arbitrage.”

21. Chapter 1: Key concepts • Preference for smoothness –Utility representation: concave utility • Desynchronizing across time and states of nature • Screening and monitoring functions • Savings rate is important, but not all, for growth • Financial accelerator

22. Key concepts (cont’ed) • A competitive equilibrium • A Pareto optimum • Welfare Theorems • Contingent commodities • Arrow-Debreu securities • Complete markets