research university financial markets and growth
TRANSCRIPT
FinancialMarketsandgrowth
UniversitéParis-DauphineInternationalOffice
2017-2018By
R E S E A R C HU N I V E R S I T Y
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Introductiontothiscourse• Outlineofthecourse:
– Ch1:Introduction,keydefinitionsandsomehistory– Ch2:Financeandgrowthnexus– Ch3:Growth,inequality,povertyandfinancialdeepening– Ch4:TheStructureofthefinancialsector– Ch5:Financialrepressionand liberalization– Ch6:Thedomesticfinancialsystem
• Evaluation:50%Finalexam,50%presentation(yourattitudeintheclasscanplayarole!)
• Theslidesareavailableathttp://forouheshfar.com/course-fmg/
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Readingsuggestions• “DevelopmentFinancedebatesdogmasandnewdirections”-
StephenSpratt(2009)
• “FinancialMarketsandInstitutions”- FredericS.Mishkin &StanleyEakins(8thEdition-2015)
• Worldbank:Globalfinancialdevelopmentreport– annually
• IMF&OECD:workingpapersandreports
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Chapter1:Introduction,keydefinitionsandsomehistory
FinancialMarkets andGrowth2017-2018
ByYeganehForouheshfar
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Outlineofthechapter
• WhatarefinancialMarkets• Definingkeyterms• Classificationoffinancialmarkets• Howdofinancialmarketsdifferfromothermarkets
• Majorrolesofthefinancialsystem• Marketorgovernment:Somehistory
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WhatarefinancialMarkets?• Financialmarketsperformtheessentialfunctionofchanneling
fundsfromeconomicplayersthathavesavedsurplusfundstothosewithashortageoffunds.
• Exchangebetweenthesetwogroupsofagentsissettledinfinancialmarkets.
• Thefirstgroupiscommonlyreferredtoaslenders,thesecondgroupiscommonlyreferredtoastheborrowersoffunds.
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Featuresofaneffectivefinancialsystem
• Financialtransactionsarebasedontrust
• Stronglegalinfrastructure
• Safe,reliableandefficientpaymentsystem
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Definingkeyterms• Thereexisttwodifferentformsofexchangeinfinancial
markets.Thefirstoneisdirectfinance,inwhichlendersandborrowersmeetdirectlytoexchangesecurities.
• Thesecondtypeoffinancialtradeoccurswiththehelpoffinancialintermediariesandisknownasindirectfinance.Inthisscenarioborrowersandlendersnevermeetdirectly,butlendersprovidefundstoafinancialintermediarysuchasabankandthoseintermediariesindependentlypassthesefundsontoborrowers
Securities areclaimsontheborrower’sfutureincomeorassets.Commonexamplesarestock,bondsorforeignexchange
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Definingkeyterms (cont.)• Asset:Anypossessionthathasvalueinanexchange.
– Tangibleassets:Itsvaluedependsonparticularphysicalproperties:Ex.buildings,land,machinery,…
– Intangibleassets:Legalclaimstosomefuturebenefit(itsvaluebaresnorelationtotheform,physicalorotherwise,inwhichtheseclaimsarerecorded):Financialassets/instruments
• Issuer (ofthefinancialinstrument):Entitythathasagreedtomakefuturecashpayments.
• Investor:Ownerofthefinancialinstrument.
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ExamplesoffinancialinstrumentsContext Issuer Investor Termsoftheloan
AloanbyBNP Theindividualwhobuysacar
Commercialbank
Specifiedpaymentsovertime=repaymentoftheloan+interest
Abond issuedbytheFrenchgovernment
Frenchgovernment
Buyerofthebond
Interestpaymentseverysixmonth tillmaturitydate->amountborrowed
Abond issuedbyTotalInc.
Corporation Sameasabove!
Abond issuedbythegovernment ofAustralia
Acentralgovernment
Sameasabove!
AshareofcommonstockissuedbyL’Oréal
Corporation Receivedividends+aclaimtoaproratashareofthenetassetvalueincaseofliquidation
AshareofcommonstockissuedbyToyotaMotorCorporation
TheJapaneseCorporation
Sameasabove!
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Definingkeyterms(cont.)• Globallywecanidentify2typesofFinancialinstruments(identifiedbytypeofclaimthattheholderhasontheissuer):
1. Debtinstrument:Theissueragreestopayinterestandrepaytheamountborrowed
2. Equityinstrument:Obligatestheissuerofthefinancialinstrumenttopaytheholderanamountbasedonearnings,ifany,aftertheholdersofthedebtinstrumentshavebeenpaid.Ex:commonstock,apartnershipshareinabusiness
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Characteristicsofdebtinstruments• Debtinstrumentsinclude:loans,moneymarketinstruments,
bonds,mortgage-backedsecuritiesandasset-backedsecurities.
• Maturity:Thenumberofyearsoverwhichtheissuerhaspromisedtomeettheconditionsoftheobligation
• MoneymarketinstrumentàMaturity<1year• CapitalmarketdebtinstrumentàMaturity> 1 year
• Parvalue/principal/facevalue/maturityvalue:Theamountthattheissueragreestopaybythematuritydate.
• Couponrate/nominalrate/contractrate:Theinterestratetheissueragreestopayeachyear.Thefrequencyofinterestpaymentsvariesbythetypeofthedebtinstrument.
• Zero-coupon bonds:debtinstruments thatarenotcontractedtomakeperiodiccouponpayments
• Floating ratesecurities:coupon paymentsresetperiodicallyaccordingtosomereferencerate
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Definingkeyterms(cont.)• Financialmarkets:Wherefinancialinstrumentsareexchanged
3majoreconomicfunctions• Interactionofbuyerandsellersdeterminethepriceoftradedasset(pricediscoveryprocess)
• Amechanismforaninvestortosellafinancialinstrument(offeringliquidity)
• Reducingthetransactioncosts– Searchcost :Ex.advertising– Informationcost:tocalculatethemeritsofafinancialinstrument
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Classificationoffinancialmarkets1. Type offinancialclaim
• Debtmarkets• Equitymarkets
2. Maturity oftheclaim• Moneymarket• Capitalmarkets
3. Issuance:• Primarymarket (newlyissued)• Secondarymarket (previouslyissued)
4. Time ofthetransaction:• Cashmarket• Derivativesmarket(Thecontractholderbuysorsellsafinancial
instrumentatsomefuturetime)5. Organizational structure:
• Auctionmarket/organizedExchange• Over-the-countermarket 15
Debtvs.Equity• Debttitlesarethemostcommonlytradedsecurity.Inthese
arrangements,theissuerofthetitle(borrower)earnssomeinitialamountofmoney(suchasthepriceofabond)andtheholder(lender)subsequentlyreceivesafixedamountofpaymentsoveraspecifiedperiodoftime,knownasthematurityofadebttitle
• Debttitlescanbeissuedon:– shortterm(maturity<1yr.)– longterm(maturity>10yrs.)– intermediateterms(1yr.<maturity<10yrs.)
• Theholderofadebttitledoesnotachieveownershipoftheborrower’senterprise
• Commondebttitlesare bondsormortgages16
Debtvs.Equity(cont.)• Themostcommonequitytitleis(common)stock
• Anequityinstrumentsmakesitsbuyer(lender)anowneroftheborrower’senterprise
• Formallythisentitlestheholderofanequityinstrumenttoearnashareoftheborrower’senterprise’sincome,butonlysomefirmsactuallypay(moreorless)periodicpaymentstotheirequityholdersknownasdividends.Oftenthesetitles,thus,areheldprimarilytobesoldandresold
• Equitytitlesdonotexpireandtheirmaturityis,thus,infinite.Hencetheyareconsideredlongtermsecurities
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Debtvs.Equity(cont.)Twoformsofequitymarket:
1)Publicequitymarket(sharemarkets/stockexchanges):Wherecompanieslist theirsharesfortradingpurposes.Totalvalueofthecompany’soutstandingsharesàMarketCapitalization (Ex:acompanywith100millionshares&eachsharehasamarketvalueof10$àcap.=?) Investorsreceivedividends
2)Privateequity:Sharesarenotlistedonapublicmarket,theyaresolddirectlytotheinvestors
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Moneymarketsvs.capitalmarkets• Moneymarketsaremarketsinwhichonlyshorttermdebt
titlesaretradedEx:Banker’sacceptances,commercialpaper,governmentbills
withshortmaturities
• Capitalmarketsaremarketsinwhichlongerterm debtandequityinstrumentsaretraded:Bondmarkets:Ø EnableInc.orgov. toborrowdirectlyfrominvestorsinthecapital
markets)Ø Regularstreamofincomepaymentsthroughcoupons.(interest
payments)Ø Paymentofthedebt’sprincipal uponmaturity
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Primarymarketvs.secondarymarkets• Primarymarketsaremarketsinwhichfinancialinstruments
arenewlyissuedbyborrowersØ Theyarenotveryknowntothepublic(sellingbehindcloseddoors)Ø Animportantinstitution:investmentbanks
• SecondarymarketsaremarketsinwhichfinancialinstrumentsalreadyinexistencearetradedamonglendersØ Ex:TheNewYorkStockExchangeØ Ex:NASDAQ
Themagnitudeofthecouponissetatthetimeofissuanceà Fixedinterest
Inthesecondarymarkets,afallinthepriceofthebondresults inanincreaseintherateofinterest,oryield paid.
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Cashvs.Derivativesmarket
Derivativesmarkets:2typesofbasicinstruments:
» Futures/forwardcontract:transactionofafinancialinstrumentatapredeterminedpriceataspecifiedfuture.
»Optioncontract:Ownerofthecontracthastherightbutnottheobligationtobuy/sellafinancialinstrumentataspecificpricefromanotherparty.
• Toolsforhandlingoffinancialrisk:Derivativescanbeusedforanumberofpurposes,includinginsuringagainstpricemovements(hedging),increasingexposuretopricemovementsforspeculationorgettingaccesstootherwisehard-to-tradeassetsormarkets.
Timeofthetransaction!
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Exchangevs.over-the-countermarkets• Secondarymarketscanbeorganizedas:
Ø OrganizedExchange,inwhichbuyersandsellersofsecuritiesmeetinonecentrallocation,suchasastockexchange(Avisiblemarketplaceforsecondarymarkettransactions)
ØOver-the-counter(OTC)marketsinwhichdealersatdifferentlocationswhohaveaninventoryofsecuritiesstandreadytobuy&sellsecuritiestoanyonewhocomestothem.(Atelecommunicationnetwork)üTitlesaresoldinseverallocationsüVerycompetitivesinceOTCdealerareincomputercontactandknowthepricessetbyanother
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Nationalorinternational?
• Capitalandmoneymarkets National
• Forex andderivativesmarkets International
FXmarkets:(Foreignexchangemarket/Forex)Amarketfortradingcurrenciesinternationally
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• Internationalizationofthefinancialmarketsà importanttrend
• Americancorporationsarenowmorelikelytotapinternationalcapitalmarketstoraisefunds
• Foreignersbecomeimportantinvestors(inUS,France,…)
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InternationalBondMarket• Foreignbonds:aresoldinaforeigncountryanddenominatedinthatcountry’scurrencyEx:ifPorschesellsabondinUSdenominatedin$àforeignbond
• Foreignbondhavebeenanimportantinstrumentforcenturies:alargepercentageofUSrailroadsbuiltisthe19th centurywerefinancedbysalesofforeignbondsinBritain
• Arecentinnovationintheinternationalbondmarket:Eurobond 26
• Eurobonds:AbondissuedinacurrencyotherthanthecurrencyofthecountryormarketinwhichitisissuedEx:AbondthatisdenominatedinU.S.dollarsandissuedinJapanbyanAustraliancompany
• AvariantoftheEurobondàEurocurrencies:foreigncurrenciesdepositedinbanksoutsidethehomecountry
• ThemostimportantEurocurrenciesareEurodollars:US$depositedinforeignbanksoutsidetheUS
AbonddenominatedineurosiscalledaEurobondonlyif itissoldoutsidethecountriesthathaveadoptedtheeuro
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Commercialfinancialinstitutions• Commercialbanks:
• Investmentbanks:
• Universalbanks:
• Mortgagebanks:
• Contractualsavings:
• Assetmanagementcompanies:
• Venturecapitalists/Privateequitycompanies:
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Commercialfinancialinstitutions• Commercialbanks:Takedepositfrompublicandlendto
individualsandcorporateborrowers.ü Differencebetweentheinterestratepaidtosaversandthatchargedto
borrowers Spreadü Thesebankstransformshorttermliabilitiesintolongtermassets
• Investmentbanks:Financialservicesthataregenerallyrelatedtothebusinesses(findingandstructuringvariousformsoffinance,issuanceofcorporatebonds,arrangementofmergersandacquisitions,…)
• Universalbanks:Combinefunctionsofcommercialandinvestmentbanks
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• Mortgagebanks:Providefinanceforthepurchaseofproperty.
• Contractualsavings:Institutionssuchaspensionfundsandinsurancecompanies.
Assetmanagement:Ø In-houseØ Out-sourced
• Assetmanagementcompanies:provide“Portfoliomanagement”servicesbyaccessingpublicandprivatefinancialmarkets
• Venturecapitalists/Privateequitycompanies:ProvidecapitalforneworexpandingbusinessInthelast2decades,wehaveseenaconsiderabledestructionofthe‘functionalboundaries’betweendifferenttypesofbankandnon-bankfinancialinstitutions. 30
Quasi-commercialfinancial institutions
• Statedevelopmentbanks:Ownedbygovernments,directcredittoprioritiesofthegovernment.
• Mutualcooperativebanks:Collectivelyownedbytheirmembers.(higherinterest,lowercharges)
• Postofficesavingsbanks:Basicfinancialservices(lowincome)
• Creditunions:Ownedbytheirmembers,creditgrantedtomembersonlowincomes
• Microfinanceinstitutions:Providingthepoorwithaccesstofinancialservices,informofbank,cooperative,creditunionetc.
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Governmentalfinancialinstitutions• Centralbanks:Havethemonopolyoffiatmoney
issuance.– Provideliquidity(controlmoneysupply)– LOLR:actasalender-of-lastresorttothedomesticbankingsystem
Mainfeatures:ØNationalpaymentsandsettlementsystemØ Prudentialregulation/supervisionØ InsurancefordepositsØ Executemonetarypolicyà inflationtargetingØ Exchangeratepolicy
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TypesoffinancialIntermediaries
1. Depositoryinstitutions:Financialintermediariesthatacceptdepositsfromindividualsandinstitutionsandmakeloans.
2. Contractualsavingsinstitutions:Financialintermediariesthatacquirefundsatperiodicintervalsonacontractualbasis.
3. Investmentintermediaries
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Financial
Intermediaries
Contractual savings
Institutions
Investment Intermedari
es
Depository Institutions
Commercial Bank
Mutual Funds (Investment Funds)
Finance Companies
Pension Funds
Credit Unions
Insurance Companies
Savings and Loans Associations (S&L)
Mutual Saving Banks
Money market Mutual Funds
Specialized Banks
Howdofinancialmarketsdifferfromothermarkets?
Timeandmanagementofrisk• Deliveryinfutureasopposedtothepresent,futureis
uncertainà Riskyà interestpayment(timevalueofamoney)
• Transfersacrosstime:smoothingconsumptionandinvestment
• Transferandmanagerisk• Creditrisk:dangerofdefault• Marketrisk:lossbysuddenchangesinassetprices• Liquidityrisk:unabletosellassetsquicklywithoutloss• Systemicrisk:contagionfromanotherbank
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Risksassociatedwithinvesting• Definitionofrisk=hazard,peril,exposuretolossorinjury• Quantifyingriskà thevarianceofanasset’sexpectedreturn
• Criticisms oftheuseofthevariance:– Thepossibilityofreturnsabovetheexpectedvalue(favorableoutcomeviewedasunfavorable)• Propositionsàmeasuresofdownsiderisk:riskofloss,valueatrisk
– Varianceisonlyonemeasureofhowthereturnsvaryaroundtheexpectedreturnà variance+Skewness
What isavariance?
Skewness:measurestheasymmetryofadistribution38
Mainrolesofthefinancialsystem(Levine,2005)
1. Producinginformationandallocatingcapital:
Ø Largecostsof:Evaluatingfirms,managersandmarketconditionsàHighinformationcostsmaykeepcapitalfromflowingtoitshighestvalueuse
Ø Improveresourceallocation
Ø Leadstoamoreefficientallocationofcapital
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Mainrolesofthefinancialsystem(cont.)
2. Monitoringfirmsandexertingcorporategovernance:
Ø Shareholdersmayexerteffectivegovernancedirectly byvotingoncrucialissues(mergers,liquidations,…)orindirectly byelectingboardsofdirections.
Ø Wellfunctioningstockmarkets:Linkingstockperformancetomanagercompensationhelpsaligntheinterestofmanagerswiththoseofowners
Ø Debtcontracts:reducetheamountoffreecashavailabletofirmsà reducesmanagerialslackAcceleratestherateofadoptionofnewtechnologies
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3.Riskamelioration:Ø Cross-sectionalriskdiversification:high-returnprojectstendtoberiskierthanlow-returnprojectsà financialmarketsmakeiteasierforpeopletodiversifyriskandshiftportfoliostowardshigherexpectedreturns.
Ø Intertemporal risksharing:Someriskscannotbediversifiedataparticularpointintime,suchasmacroeconomicshocks,theycanbediversifiedacrossgenerations.Long-livedintermediariescanfacilitateintergenerationalrisksharingbyinvestingwithalong-runperspective.
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ØLiquidityrisk:Liquidityreflectsthecostandspeedwithwhichagentscanconvertfinancialinstruments intopurchasingpoweratagreedprice.Liquidityrisk uncertaintiesassociatedwithconvertingassetsintoamediumofexchangeLinkbetweenliquidityandeconomicdevelopment:High-returnprojectsrequirealong-runcommitmentofcapital,notsavors’favorite!(Ex.Industrialrevolutionandliquidcapitalmarketsin18thcenturyinEngland)
Anotherformofliquidity:accesstocreditduringtheproductionprocess
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4.Mobilizeandpoolsavings:
Ø Theprocessofagglomeratingcapitalfromdisparateinvestorsiscostly
Ø Financialarrangementsthatmobilizesavingsfrommanydiverseindividualsandinvestinadiversifiedportfolioofriskyprojectsfacilitatereallocationofinvestmenttowardhigherreturnactivitieswithpositiveeffectsoneconomicgrowth.
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5.Easetheexchangeofgoodsandservices
Ø Financialarrangementslowertransactioncost
ØMorespecializationrequiresmoretransactions,sinceeachtransactioniscostlyà financialdevelopmentleadstomorespecialization àpositiveimpactongrowth
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Roleoffinancialmarkets:aSummary
• Althoughinapureneoclassicalframeworkthefinancialsystemisirrelevanttoeconomicgrowthinpracticeanefficientfinancialsystemcan:
• Lowerthecostofexternalborrowing• Raisethereturntosavors• Ensurethatthesavingsareallocatedtoprojectsthatpromisehighestreturns
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Financialsectorandthegovernment
• Governmentsregulate theactivitiesofthefinancialsystem
• Governmentsborrowfromthefinancialsystem:issuanceofsovereignbonds
• Governmentsmaytakemoredirectroleinthesystem:Intervenedirectlyinthefunctioningofthesystem,e.g.directingtheallocationofcreditthroughdevelopmentbanks,owningorcontrollingasectionofacommercialbank
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Shouldit?Towhatextent?
Marketorgovernment:Somehistory• BeforeKeynes:Althoughmarketscanfailthesefailuresare
justanomalouseventsà PeriodoffreecapitalmovementsOptimismaboutthenatureandroleoffreemarkets
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• Keynes(1936):imperfectionsareinherentinmarketsandthereisnonaturaltendencytowardstheproductionofoptimaloutcomesà Toensurethedesirableoutcomesofhighlevelsofgrowthandemployment,governmentsshouldnecessarilyinterveneintheeconomy.
• (WithouttheGreatDepressionKeynesviewswouldnothavetheimpactthattheydid!)
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• IrvingFisher,thegreatdepressionandBrettonWoods:
Ø Anotherstrandofthoughinthisperiod:viewingfinancialcrisisasanintegralpartofthebusinesscycle(notanomaliesorrationalresponsetodeterioratingeconomiccircumstances)
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Ø Fisher(1933)attemptedtodeterminetherootcauseoftheGreatDepressionà Acrucialfactor:levelofdebtintheeconomy§ Upswingsintheeconomyencourageincreasingdebtlevels(appearanceofgreaterinvestmentopportunities)
§ Higherinvestmentà higherdebtà growthofspeculationinassetmarket(gainsthroughrisingassetprices)à raiseininflationrate(increaseinborrowingincreasesmoneysupply)àreducesthevalueofdebtàencouragingmoreborrowing
§ Atacrucialpoint:CRISISà borrowersarenolongertomeettheirliabilities,theyliquidatetheirassets(distressselling)à deflationà debtincreasesà fearofbankinsolvencyàbankrunsà activitydeclinesàunemploymentrises 52
• IrvingFisher,thegreatdepressionandBrettonWoods(cont.):
Ø TheGreatDepression(1929-1939),shookpeople’sfaithintheabilityoffreefinancialmarketstodeliveroptimaloutcomes.
Ø BrettonWoodsinNewHampshirein1944:§ Representativesof44countries§ Aim:toconstructaninternationaleconomicsystemthatwouldreduce
theinstabilityofthefinancialsystem§ Thesereformscausedlongperiodofstability§ Currenciesholdingtotheirpeg§ Internationalmovementofcapitalwasgreatlyrestricted§ Keynesarguedthatcapitalcontrolsshouldbeobligatoryonall
countriesà IMFwouldallowsuchcontrolsbutnotinsistsuponthem
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• Structuralism:
Ø Destructionofmarketswasnotlimitedtoindustrialcountries
Ø InLatinAmericathestructuralismdevelopedwithintheEconomicCommissionforLatinAmerica(ECLAC)in1947§ Structuralist approach:“center-periphery”paradigm:UnequalnatureoftheworldeconomicsystemTheindustrialrevolutionin“center”à increasetheproductivityofthefactorsofproductionDevelopingcountries,“periphery”,havetoexportmoreandmorethesefactors(commodities)tobeabletoimportthesamequantityofcapitalgoodsà trappedincommodityproductionandexporttoservethecenter
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• Structuralism(cont.):
§ “Import-substitutionindustrialization”/ISM:Hightariffsonindustrialimports,exceptforessentialhigh-techcapitalgoods
Aim:movetheeconomyontoavirtuouscircleofindustrialization,risingproductivity,wagesandemployment.
§ Encouragecapitalinflowstofundthisdevelopment§ Criticismin60s:keyindustrializingsectorscontrolledbyforeigninvestors
§ Sweptawayin70s:authoritarianmilitaryregimesandmonetaristpolicies
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• Monetarismandreturnoffaithinmarkets:Ø Kindleberger (1978)distinguished2differentschoolsofthoughts:modernschoolsofmonetarismandKeynesianism(Currencyschool vs.Bankingschool)
ØCurrencyschool:ControlthemoneysupplyØBankingschool:Expandit
Ø Monetarists:Moneysupply(M)isexogenoustorealincome(Y),prices(P)andinterestrate(R)i.e.anincreaseinMà increaseinPbutnochangetoYFaithinabilityoffreemarketsandpriceadjustmentmechanismandlittlefaithinstate’sabilitytotakethisrole
Ø Keynesians:“quantitytheoryofmoney”:increasingMcouldincreaseY,Misendogenousandaresponsetocreditneeds
ØDominanceofeachschoolindifferentperiodsØPost-war:BankingschoolØ1970s:collapseofthefixedexchangeratesàMonetarist
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• Neo-liberalism:Ø ChicagoSchoolofEconomics:efficiencyofmarketsandfree
competitionvs.governmentinterventionsinmarketsthatdistortmarketsandpreventoptimaloutcome
Ø Noneedforgovernmenttointerveneintheeconomytoensurefullemployment,inafreemarketsituationpriceswilladjusttoensurethatallfactorsofproductionareemployed
ØMarketsautomatically adjusttofullemploymentmonetaryorfiscalpolicymerelycreateinflation
Ø ElectionofMargaretThatcher(1979)andRonaldReagan(1980)à ideologicalperspectivecametothefore
Ø Neverthelessearlypuremonetaristpoliciessuchascontrolforthemoneysupplyweresoonabandoned 58
• Neo-liberalism(cont.)Ø Relevantdomesticpolicyproposals
Ø Thederegulation ofdomestic financialmarketsØ PrivatizationØ Reduction inthepoweroftradeunionsØ SmallergovernmentØ LowertaxratesØ Opening theinternationalgoodsandcapitalmarkets
Ø In1990,thebirthadriseofthe“WashingtonConsensus”:Ø PrivatizationØ FreetradeØ Export-ledgrowthØ FinancialcapitalmobilityØ Deregulated labormarketsØMacroeconomicprudence
Ø Interventioninmarketsisusuallycounterproductive;regulationsshouldbelightandmarketsshouldbefreed
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• Financialfragility,uncertaintyandasymmetricinformation
ØKindleberger (1978)distinguishedbetween“upswings”(maniabehavior)and“downturns”(panicbehavior)intheeconomy
ØInupswingà demandforcreditincreasesà riseinbankloansà assetpricesriseà encouragemoreborrowingà thebubble expands
ØDistinguish:ØInsiders:areawareofthesituation,selloutatthetopofthemarket
ØOutsiders:attractedbythemania60
• Financialfragility,uncertaintyandasymmetricinformation(cont.)
ØBubblecancontinuetoexpandifoutsidersoutnumberinsidersà atsomepoint:Periodof“distress”whennatureofbubbleisrecognizedandinfluxofoutsidersceaseà untilsometriggersetsoffapanicandinvestorsrushtowithdrawtheirfunds(likeabankrun)
ØE.g.dotcomboomoflate1990sortheDutchTulipmaniain1637(Atthepeakoftulipmania,inMarch1637,somesingletulipbulbssoldformorethan10timestheannualincomeofaskilledcraftsman!!!!)
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• Financialfragility,uncertaintyandasymmetricinformation(cont.)
Ø Keynes(1936):FutureisinevitablyuncertainThereisnowaytodeterminethevalueofatrueassetintoday’smarketà thetruevalueisthediscountedfutureprofitsàtheseprofitscannotbeknown
Ø Davidson(1998):Agentsanalyzepastandpresentmarketdatainformingrationalexpectationsasabasisformakingutilitymaximizingdecisionsà awaytoobjectivelyobtain“fundamentalprice”thatthemarketcanconvergeon
Ø Allnewinformationisinstantlydiscountedintothecurrentmarketpriceà nopossibilityofspeculativeprofit,boomsandcrashes! 66
• Financialfragility,uncertaintyandasymmetricinformation(cont.)
Ø Newstrandoftheoryin1980s:Asymmetricinformation(JosephStiglitz - Nobelprize):lendersandborrowersdonothaveaccesstoequalinformation(usuallyborrowersarebetterinformed!)
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• Financialfragility,uncertaintyandasymmetricinformation(cont.)
ØMishkin (1996):2problemsofasymmetricinformation:ØAdverseselection(beforethetransactionoccurs):Indebtandequitymarketslendershavenowaytodistinguishgoodborrowersfrombadonesà thepricetheyarewillingtopayrepresentsthequalityofthefirmbutlow-qualityfirmswillbeeagertoissuesecuritiesatapricethatinflatestheirvalueandhigh-qualityfirmsareunwillingtoissuesecuritiesataverageprice.
ØMoralhazard (afterthetransactionoccurs):Theborrowerhasanincentivetoengageinhigh-riskstrategies.
– Banksarelesssubjecttoasymmetricinformationproblemsthansecuritiesmarketsà relationshipwiththecustomersandknowledgeoflocalmarket
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• Returnofpsychologyandbehavioralfinance:Ø Foundationoffinancialtheory:assumptionofrational,utility-maximizingagentsà banishpsychologyfromthestudyofeconomicbehavior
Ø 1970sPioneersbehavioraleconomists:Ø AmosTversky,Ø DanielKahneman
ØActualbehaviorsystematicallyviolatesthepreceptofrationaloptimizingbehaviorà theseanomaliescouldbepredicted
Ø Supportersofmarketefficiency:deviationsfromrationalbehaviorarerandomanduncorrelated
ØNewschoolofthough“Behavioralfinance”:peopleemploypsychologicalshort-cutsintheirdecisionmaking.
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• Returnofpsychologyandbehavioralfinance(cont.)Ø Someconceptsofbehavioralfinance:Emotionsareakey
driverofaperson’sbehavior.Peoplehavebeenshowntobelossaverse,generallyappearingtodislikelosingsomethingroughlytwiceasmuchastheylikegainingit.
Ø Prospecttheory(Kahneman &Tversky):
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References• “DevelopmentFinancedebatesdogmasandnewdirections”-
StephenSpratt(2009)
• Financeandgrowth:theoryandevidence– RossLevine(2005)
• Financialmarketsandinstitutions– Mishkin&Eakins(8thedition,2015)
• Handbookoffinance(2008)Volume1- Chapter1
• Economix:HowOurEconomyWorks(andDoesn'tWork)byMichaelGoodwin
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