Which of the following statements is true about the spending potential index?

10.1 Introduction

• Money is a medium of exchange consisting of bank notes and bank deposits, or anything else that can be used to purchase goods and services. It is accepted as payment because others can use it for the same purpose.
• Commercial banks are firms that provide financial services including both short-term financial investment opportunities (interest on savings accounts for example) and long-term loans (mortgages for home purchases).
• These banks create money in the form of bank deposits when they make loans.
• A nation’s central bank lends to commercial banks at what is called the policy interest rate, which plays a critical role in how a central bank regulates the amount of spending in the economy as a whole.
• This works because the policy interest rate chosen by the central bank affects the interest rate charged by commercial banks on loans to firms and households, which in turn affects the demand for housing, cars and other durable goods.
• Housing and financial assets differ from other goods and services because they are valued not only for the services they provide (for example, a place to live), but also because their value may increase in the future.
• The price of an asset depends on the return expected from holding it, its riskiness, and how much people value a ‘sure thing’ over taking risks.
• Asset prices may be subject to bubbles when a price increase motivates people to purchase more of the asset in anticipation of future price increases, causing the price to rise further.
• Because governments sometimes bail out failed banks (generally citing the need to avoid a financial system collapse), banks often engage in overly risky practices, knowing that some of the downside of their risk-taking will be borne by taxpayers.
• The trust and social norms on which many transactions in financial markets depend cannot be guaranteed either by enforceable contracts, or by relying on competition to weed out ‘bad actors’.

On 4 May 1970, a notice titled ‘Closure of banks’ appeared in the Irish Independent newspaper in the Republic of Ireland. It read:

As a result of industrial action by the Irish Bank Officials’ Association … it is with regret that these banks must announce the closure of all their offices in the Republic of Ireland … until further notice.

Banks in Ireland did not open again until 18 November, six-and-a-half months later.

Did Ireland fall off a financial cliff? To everyone’s surprise, instead of collapsing, the Irish economy continued to grow much as before. A two-word answer has been given to explain how this was possible—Irish pubs. Andrew Graham, an economist, visited Ireland during the bank strike and was fascinated by what he saw:

Because everyone in the village used the pub, and the pub owner knew them, they agreed to accept deferred payments in the form of cheques that would not be cleared by a bank in the near future. Soon they swapped one person’s deferred payment with another thus becoming the financial intermediary. But there were some bad calls and some pubs took a hit as a result. My second experience is that I made a payment with a cheque drawn on an English bank and, out of curiosity, on my return to England, I rang the bank (in those days you could speak to someone you knew in a bank) and they told me my cheque had duly been paid in but that on the back were several signatures. In other words, it had been passed on from one person to another exactly as if it were money.1

The closure of the Irish banks is a vivid illustration of the definition of money—it is anything accepted in payment. At that time, notes and coins made up about one-third of the money in the Irish economy, with the remaining two-thirds in bank deposits. The majority of transactions used cheques, but paying by cheque requires banks to ensure that people have the funds to back up their paper payments.

In a functioning banking system, the cheque is cashed at the end of the day, and the bank credits the current account of the shop. If the writer of the cheque does not have enough money to cover the amount, the bank bounces the cheque, and the shop owner knows immediately that he must collect in some other way. People generally avoid writing bad cheques as a result.

Credit or debit cards were not yet widely used. Today, a debit card works by instantly verifying the balance of your bank account and debiting from it. If you get a loan to buy a car, the bank credits your current account and you then write a cheque, use a debit card, or initiate a bank transfer to the car dealer to buy the car. This is money in a modern economy.

So what happens when the banks close their doors and everyone knows that cheques will not bounce, even if the cheque writer has no money? Will anyone accept your cheques? Why not just write a cheque to buy the car when there is not enough money in your current account or in your approved overdraft? If you start thinking like this, you would not trust someone offering you a cheque in exchange for goods or services. You would insist on being paid in cash. But there is not enough cash in circulation to finance all of the transactions that people need to make. Everyone would have to cut back, and the economy would suffer.

How did Ireland avoid this fate? As we have seen, it happened at the pub. Cheques were accepted in payment as money, because of the trust generated by the pub owners. Publicans (owners of the pubs) spend hours talking and listening to their patrons. They were prepared to accept cheques, which could not be cleared in the banking system, as payment from those judged to be trustworthy. During the six-month period that the banks were closed, individuals and businesses wrote cheques to the value of about £5 billion, which were not processed by banks. It helped that Ireland had one pub for every 190 adults at the time. With the assistance of pub and shop owners who knew their customers, cheques could circulate as money. With money in bank accounts inaccessible, the citizens of Ireland created the amount of new money needed to keep the economy growing during the bank closure.23

Neither Irish publicans, nor the moneylenders in the market town of Chambar that we introduced in Unit 9, would recognize that, by lending in this way, they were creating money. They would also not know that, in doing so, they were providing a service essential for the functioning of their respective economies.

10.2 Assets, money, banks, and the financial system

In the bathtub model of Unit 9, the amount of water in the tub represents a household’s wealth. But wealth is not a homogeneous substance like water. Wealth is held in many forms, as both financial and non-financial assets. Money, shares, and bonds are financial assets. Non-financial assets include housing, cars, intellectual property (such as a trademark or a patent), and works of art.

In the sections that follow, we introduce the main actors and markets in which assets are traded, which are part of a model of the financial system.

Actors

The main actors in the financial system are commercial banks (called banks from here on), the central bank, pension funds, and other financial institutions. Households and non-bank firms are also part of the financial system when they buy, sell, borrow, lend, save, invest, and interact in other ways with banks and the central bank.

Like other firms, banks are predominantly privately owned and seek to make profits. Unlike other firms, they make profits by supplying loans; through this process, they create money, known as bank money. Banks set the lending rate. This is the interest rate—the nominal interest rate—that borrowers must pay on a loan. The way banks operate in a modern economy is explained in the next three sections.

As we shall see, banks need a different kind of money, called base money, in order to carry out transactions with other banks. The only supplier of base money is the central bank. This allows the central bank to set the ‘price’ for borrowing base money, which is the policy interest rate, and like the lending rate, this is a nominal interest rate.

Pension funds manage the contributions of employees and employers, purchase financial assets using those contributions, and pay out pension benefits at retirement.

Other financial institutions include insurance companies, investment banks, payday lenders, and specialist lenders, such as mortgage providers in the housing market.

Markets

Asset markets are the money market, the stock market, the housing market, and other financial markets.

The central bank and commercial banks lend to each other and other financial institutions in the money markets.

To see how secondary trading on the stock market works and how prices of shares are set through a continuous double auction, see Section 11.6 in The Economy.

Companies make what are called initial public offerings (IPOs), using the stock market. In an IPO, shares in a company are sold to the general public for the first time. After that, the shares are traded on the stock exchange. This is called secondary trading.

The housing market plays an important role in the economy. Houses are the main form of wealth of households (except for the very rich). Households borrow long term from banks or specialist mortgage lenders to buy houses.

There are many other financial markets: for government and corporate bonds, derivatives, and other financial assets.

Financial assets

Money is a financial asset and is the subject of the next section.

By selling bonds, a government or a firm can borrow money. The bond issuer promises to pay a given amount to the bondholder on a fixed schedule. Selling a bond is equivalent to borrowing, because the bond issuer receives cash today and promises to repay in the future. Conversely, a bond buyer is a lender or saver, because the buyer gives up cash today, expecting to be repaid in the future. Both governments and firms borrow by issuing bonds. Households buy bonds as a form of saving, both directly, and indirectly through pension funds. Although a bond is a way a firm can borrow, it is different from a bank loan because it can be bought and sold in secondary trading in the bond market. To learn more about bonds and how assets are priced, read the two ‘Find out more’ boxes at the end of this section.

Shares (stocks) are a part of the assets of a firm that may be traded on the stock market. The owner of a share has a right to receive a proportion of a firm’s profit (when dividends are paid out) and to benefit when and if the firm’s assets become more valuable.

As we saw in Unit 9, people whose incomes fluctuate want to smooth their consumption and they do so, in part, by saving. One factor that affects whether a household saves by holding money in a savings account, or by buying bonds or shares, is its attitude to risk. Holding shares, as we shall see, offers the potential for a higher return on savings, but because the price of shares goes up and down, there is a risk that the value of the asset itself will fall. We explain the trade-offs facing households choosing which assets to hold in Section 10.8; in Sections 10.9 and 10.11, we show why holding shares and other financial assets other than bonds may be risky.

Find out more Present value (PV) and the price of an asset

Assets, like shares in companies or bonds, typically provide a stream of income in the future. Since these assets are bought and sold, we must ask the question: ‘How do we value a stream of future payments?’ The answer is the present value (PV) of the expected future income.

To make this calculation, we must assume that people participating in the market to buy and sell assets have the capability to save and borrow at a certain interest rate. Imagine that you face an interest rate of 6% and are offered a financial contract that says you will be paid €100 in one year’s time. That contract is an asset. How much would you be willing to pay for it today?

You would not pay €100 today for the contract, because if you had €100 today, you could put it in the bank and get €106 in a year’s time, which would be better than buying the asset.

Imagine you are offered the asset for €90 today. Now you will want to buy it, because you could borrow €90 today from the bank at 6%, and in a year’s time you would pay back €95.40, while you receive €100 from the asset, making a profit of €4.60.

The break-even price or present value (PV) for this contract would make you indifferent between buying the contract and not buying it. It must be equal to whatever amount of money would give you €100 in a year’s time if you put it in the bank today. With an interest rate of 6%, that amount is:

We say that the income next year is discounted by the interest rate; a positive interest rate makes it worth less than income today.

The same logic applies further in the future, when we allow for interest compounding over time. If you receive €100 in t years’ time, then today its value to you is:

The present value of these payments obviously depends on the amounts of the payments themselves. But it also depends on the interest rate; if the interest rate increases, then the PV will decline, because future payments are discounted (their PV reduced) by more. Note that it is easy to adjust the present value formula to take into account different interest rates for years 1, 2, and so on.

Net present value (NPV)

This logic applies to any asset that provides income in the future. If a firm is considering whether or not to make an investment, it must compare the cost of making the investment with the present value of the future profits it expects from the investment. In this context, we consider the net present value (NPV), which takes into account the cost of making the investment as well as the expected profits. If the cost is c and the present value of the expected profits is PV, then the NPV of making the investment is:

If NPV is positive, then the investment is worth making, because the expected profits are worth more than the cost (and vice versa).

Question 10.1 Choose the correct answer(s)

Which of the following statements are correct?

• If the annually compounding interest rate is 5%, then the present value of £100 in two years’ time is £90.91.
• If you pay £96 for an investment that pays £100 in one year’s time when the interest rate is 5%, then your net present value is £0.76.
• If the annually compounding interest rate is 5%, then the present value of receiving £100 at the end of each year for two years is £185.94.
• £95 today is worth the same as £100 in one year’s time if the interest rate is 5%.

• The present value is .
• The present value of £100 in one year’s time at the interest rate of 5% is . If is the cost of the investment, then the net present value is given by , which in this case is £95.24 – £96 = –£0.76 (in other words, a negative present value).
• The present value is .
• The present value of £100 in one year’s time at the interest rate of 5% is . Therefore, £95.24 today is worth the same as £100 in one year’s time.

Find out more Bond prices and yields

Recall that a bond is a financial asset:

• Issuing or selling a bond is equivalent to borrowing.
• A bond buyer is a lender or saver.
• Governments and firms borrow by issuing bonds.
• Households buy bonds as a form of saving.

What do the holders of bonds receive? Bonds typically last a predetermined amount of time, called the maturity of the bond, and provide two forms of payment: the face value F, which is an amount paid when the bond matures, and a fixed payment every period until maturity (for example, every year or every three months). In the past, bonds were physical pieces of paper and when one of the fixed payments was redeemed, a coupon was clipped from the bond. For this reason, the fixed payments are called coupons and we label them C.

As we saw in the calculation of PV, the amount that a lender is willing to pay for a bond is its present value, which depends on the bond’s face value, the series of coupon payments, and also on the interest rate. No one will buy a bond for more than its present value because they would be better off putting the money in the bank. No one will sell a bond for less than its present value, because they would be better off borrowing from the bank. So:

Or, for a bond with a maturity of T years:

An important characteristic of a bond is its yield. This is the implied rate of return that the buyer gets on their money when they buy the bond at its market price. We calculate the yield using an equation just like the PV equation. The yield y solves the following:

If the interest rate stays constant, as we have assumed, then the yield will be the same as that interest rate. But in reality, we cannot be sure how interest rates are going to change over time. In contrast, we know the price of a bond, its coupon payments, and its face value, so we can always calculate a bond’s yield. Buying a bond with yield y is equivalent to saving your money at the guaranteed constant interest rate of i = y.

arbitrageThe practice of buying a good at a low price in one market to sell it at a higher price in another. Traders engaging in arbitrage take advantage of the price difference for the same good between two countries or regions. As long as the trade costs are lower than the price gap, they make a profit. See also: price gap.

Since a saver (a lender) can choose between buying a government bond, lending the money in the money market, or putting it into a bank account, the yield on the government bond is very close to the rate of interest in the money market (set by the central bank’s policy interest rate). If it weren’t, money would be switched very quickly from one asset to the other by traders until the rates of return were equalized, a strategy called arbitrage.

Let’s take a numerical example: a government bond with a face value of €100, yearly coupon of €5, and a maturity of 4 years. The nominal interest rate in the money market is 3%, and we use this to discount the cash flows we receive.

So the price of this bond is given by:

We would be willing to pay, at most, €107.43 for this bond today, even though it generates €120 of revenue over four years. The yield is equal to the interest rate of 3%. If the central bank raises the policy interest rate, then this will reduce the market price of the bond, increasing the yield in line with the interest rate.

Question 10.2 Choose the correct answer(s)

Which of the following statements regarding a bond are correct?

• The face value of a bond is how much you pay for the bond.
• The coupon is the certificate that you receive when you buy a bond.
• If the price of a bond with a face value of £100, yearly coupon of £4, and a maturity of 1 year is £100.97, then the bond’s yield is 4%.
• When the nominal interest rate is 3%, then the price of a bond with a face value of £100, yearly coupon of £5, and a maturity of 2 years is £103.83.

• The face value is the amount (the ‘principal’) that the buyer receives when the bond matures.
• The coupon is the (normally) fixed payment that the buyer receives periodically (for example, annually or semi-annually).
• The bond’s yield is such that . Solving for we have: or 3%.
• The price is .

10.3 Money and banks

For money to do its work, almost everyone must believe that, if they accept money from you in return for handing over goods or services, then they will be able to use the money to buy something else in turn. In other words, they must trust that others will accept your money as payment. Governments and banks usually provide this trust. As an indication of the centrality of trust to banking, the origin of the word ‘credit’ is the Latin credere—to believe, to trust.

The Irish bank closure shows that, when there is sufficient trust between households and businesses, money can function in the absence of banks. The publicans and shops accepted a cheque as payment, even though they knew it could not be cleared by a bank in the foreseeable future. As the bank dispute went on, the cheque presented to the pub or shop relied on a lengthening chain of uncleared cheques received by the person or business presenting the cheque. Some cheques circulated many times, endorsed on the back by the pub or shop owner, just like a bank note.

Money

Money is used for transactions—buying and selling—in the economy. When you pay for a train ticket on your smartphone linked to your bank account, by a cardless transfer, or by your debit card, the payment is made to the train company from deposits in your bank. There are many ways to activate the transfer between you and the vendor, but the money itself is the bank deposit. You can also pay by cash. Cash and bank deposits are the main forms of money in contemporary economies.

In a barter economy, I might exchange my apples for your oranges because I want some oranges, not because I intend to use the oranges to pay my rent. Money makes more exchanges possible because it’s not hard to find someone who is happy to have your money (in exchange for something), whereas unloading a large quantity of apples could be a problem. This is why barter plays a limited role in virtually all modern economies.4

Money allows purchasing power to be transferred among people so that they can exchange goods and services, even when payment takes place at a later date (for example, through the clearing of a cheque or settlement of credit card or trade credit balances). Therefore, money requires trust to function.

What does money do?

Some of the functions that money fulfils are also fulfilled by other things. But only money clearly fulfils all these functions (although even money may not fulfil them equally well in all times and places).

These functions are:

1. A medium of exchange: We can use money to pay for things. Note that, to be a true medium of exchange, money must be divisible, ideally into sufficiently small units that even the smallest value purchases are possible.
2. A store of value: We can hold money as a means of storing up future consumption of goods and services.
3. A unit of account: A more subtle (but nonetheless important) distinction, whereby we use money as a yardstick by which we can measure the value of anything we own or want to buy.

One reason for confusion around the use of the term ‘money’ is that what people have used to fulfil these functions has changed over the course of time.

If we look back far enough, to an era well before the Industrial Revolution, most people in most countries would have recognized only one form, namely commodity money. The commodity chosen was often (but by no means always) a precious metal—most commonly gold or silver—which had some kind of intrinsic value (because it could in principle be used for other purposes, like jewelry or gold teeth).

But commodity money did not fulfil the three functions very well and understanding its limitations helps explain the emergence of banks.

Someone attempting to pay for a loaf of bread with a gold coin would have severe problems getting change, thus failing the test of divisibility. The risk of theft detracted from commodity money as a store of value (gold was much easier to steal than houses or cattle, for example). And there have always been significant fluctuations in the value of gold and silver in terms of what people really cared about—consumption of goods and services—thus detracting from its usefulness both as a store of value and as a unit of account.

As a result, even in periods when commodity money was widely used, alternatives that could fulfil at least some of the functions of money were available. In due course, these alternatives evolved into forms that eventually supplanted commodity money (almost) entirely.

Money in the modern economy is an IOU

These new forms of money share with commodity money the defining characteristic that they are accepted by other people as a means of payment. They differ from commodity money and share the feature, whether bank deposits or currency, that they are created when a bank or the central bank as part of the government creates a liability.

A liability is just an IOU (‘I owe you’). To understand how money works based on IOUs rather than on a commodity like gold, recall the Irish bank strike. The cheques that circulated as money and were used for payments—endorsed on the back by the publicans—were the way in which IOUs were passed around in exchange for goods and services.

IOU-based money is nothing new. A famous example originated hundreds of years ago on the remote island of Yap, in the Pacific Ocean. As you can read in the article ‘The Island of Stone Money’, even when the giant stone ‘coins’ were lost overboard and remained on the bottom of the sea, the transfer of purchasing power in exchange for goods and services among different people went on. Find out more about the Yap stones and their use as money in a video by the Federal Reserve Bank of Atlanta:

What we call money today is IOU or liability-based money. To be more precise, if I own some form of liability money, it is because either a commercial bank or the central bank owes me that amount, and someone else will accept a transfer of all or part of that debt via electronic transfer or currency as a means of payment.

Even in the era of commodity money, the fear of theft often led wealthy individuals to deposit their gold coins with goldsmiths. The goldsmiths in turn would issue ‘promissory notes’, which were open commitments to return the gold whenever required. These IOUs in due course evolved into the first prototype banknotes, which were the liabilities of the goldsmith. If the depositor wanted to make a purchase, they did not need to retrieve the gold, but could make payments directly using the promissory notes, that is, the goldsmith’s liabilities. In due course, these forms of arrangements evolved into the modern banking system.

Money in bank accounts: IOUs of commercial banks

Today, in most countries, virtually all forms of money are liability-based money. But whose liabilities are they? Mostly, they are the liabilities of banks. If you have $1,000 in your current account, this means that the bank owes you $1,000. In your balance sheet as we saw in Section 9.9, your bank deposit would appear as an asset; in the bank’s balance sheet, it appears as a liability.

Money as coins and notes: IOUs of central banks

The other institution that issues liabilities that we call money is the government. While banknotes and coins are officially the liability of the central bank, in almost all countries the central bank is owned by the government, so the central bank is issuing liabilities on the government’s behalf.

Paul Krugman compares cryptocurrencies like Bitcoin to commodity money and fiat money, and asks what problems cryptocurrencies solve.

In earlier times, banknotes and coins issued by the central bank were exchangeable for gold, just like the promissory notes of the goldsmiths. In modern monetary systems, there is no gold-backing for currency and it is called ‘fiat currency’. The central bank promises to honour the debt printed on the bank note with the words: ‘I promise to pay the bearer on demand the sum of twenty pounds’ (signed by the Chief Cashier on behalf of the Governor of the Bank of England). On US dollar bills, it says the equivalent: ‘This note is legal tender for all debts, public and private’ and is signed by the Treasurer of the United States. Euro notes are signed by the President of the European Central Bank. If the design changes, for example, the central bank will swap the old note for a new one. Trust in fiat currency originates partly from the government’s commitment to accept it in payment of taxes.

Exercise 10.1 Money and its role in the economy

Using the following references, write a 400-word explanation of how economists can learn from anthropologists about what money is and does, in the style of ‘How economists learn from data’.

• the note above on the Yap stones
• William Henry Furness. 1910. Chapter 7 ‘Money and currency’. The Island of Stone Money, Uap of the Carolines.
• Felix Martin. 2013. ‘Chapter 1’. Money: the Unauthorised Biography. Bodley Head.

Looking for Questions 10.1 and 10.2? They are in the optional sections ‘Present value and the price of an asset’ and ‘Bond prices and yields’, and if you skipped those sections you don’t need to attempt them.

Question 10.3 Choose the correct answer(s)

Which of the following statements about money are correct?

• Money allows purchasing power to be transferred between consumers.
• In economics, money refers to the coins and notes in circulation.
• If I can exchange my apples for your oranges, then apples can be classified as money.
• Banks must exist for money to do its work.

• Money allows purchasing power to be transferred between people so that they can exchange goods and services, even when payment takes place at a later date (for example, through the clearing of a cheque or the settlement of credit card and trade credit balances).
• Money is a medium of exchange that includes bank notes, cheques, bank deposits, or whatever else that can be used as a means of payment; it is accepted because others can use it for the same purpose.
• Exchanging apples for oranges is barter. Apples are not money here because they cannot be used in other transactions, for example, to pay your rent. Cash or cheques are money because others can also use them as means of payment.
• For money to do its work, almost everyone must trust that others will accept your money as payment. Banks usually provide this trust. However, the economy in Ireland managed to operate in 1970 for six-and-a-half months using cheques as money, even though they could not be cleared in the banking system at that time due to banks being closed.

10.4 Banks, profits, and the creation of money

Among the moneylenders in Chambar, Pakistan and payday lenders in New York (in Unit 9), the profitability of their lending businesses depend on:

• the cost of their borrowing
• the default rate on the loans they extended
• the interest rate they set.

This provides the starting point for analysing banks as businesses.

Banks create money when providing payment services and making loans

A bank is a firm that makes profits through its lending and borrowing activities. The terms on which banks lend to households and firms differ from their borrowing terms. The interest they pay on deposits is lower than the interest they charge when they make loans, and this spread or margin allows banks to make profits.

To explain this process, we must first explore the concept of money in more detail.

Types of money

Money can take the form of bank notes, bank deposits, or whatever else one purchases things with.

• Base money: Cash held by households, firms, and banks, and the balances held by commercial banks in their accounts at the central bank, known as reserves. Base money is the liability of the central bank.
• Bank money: Money in the form of bank deposits created by commercial banks when they extend credit to firms and households. Bank money is the liability of commercial banks.
• Broad money: The amount of broad money in the economy is measured by the stock of money in circulation. This is defined as the sum of bank money and the base money that is in the hands of the non-bank public.

We saw that anything that is accepted as payment can be counted as money. Unlike bank deposits or cheques, base money or high-powered money is cash plus the balances held by commercial banks at the central bank, called commercial bank reserves.

Reserves are equivalent to cash because a commercial bank can always take out reserves as cash from the central bank, and the central bank can always print any cash it needs to provide. As we will see, this is not the case with accounts held by households or businesses at commercial banks; commercial banks do not necessarily have the cash available to satisfy all their customers’ needs.

Most of what we count as money is not base money issued by the central bank, but instead is created by commercial banks when they make loans. In the UK, 97% of money is bank money; 3% is base money. We explain how money is created using bank balance sheets.

Payment services

Our hypothetical Abacus Bank is not linked to the real-life Abacus Federal Savings Bank, which had an interesting role in the financial crisis of 2008.

Unlike our balance sheet example in Unit 9 in which a bank deposit arises from a loan to Julia, let us suppose that Marco has $100 in cash that he puts in a bank account with Abacus Bank. Abacus Bank puts the cash in a vault or deposits the cash in its account at the central bank. Abacus Bank’s balance sheet gains $100 of base money as an asset, and a liability of $100 that is payable on demand to Marco, as shown in Figure 10.1a.

Figure 10.1a Marco deposits $100 in Abacus Bank.

Marco wants to pay $20 to his local grocer, Gino, in return for groceries, so he instructs Abacus Bank to transfer the money to Gino’s account in Bonus Bank (he could do this by using a debit card to pay Gino). What happens immediately is that Abacus Bank transfers a liability to Bonus Bank, saying it owes Bonus Bank $20. However, it must only transfer what it owes at the close of business that day—so in the short term, no base money needs to be transferred.

This is shown on the balance sheets of the two banks in Figure 10.1b. Abacus Bank now owes $80 to Marco and $20 to Bonus Bank. Bonus Bank’s assets are increased by this promise of $20 owed by Abacus Bank, and its liabilities increase by $20 payable on demand to Gino. For both banks, net worth (assets minus liabilities) stays the same, although the net worth of their customers, Marco and Gino, changes.

Figure 10.1b Marco pays $20 to Gino.

To complete the story, at the close of business that day, Abacus Bank must transfer the base money it owes Bonus Bank. The balance sheets are shown in Figure 10.1c.

Figure 10.1c Marco pays $20 to Gino (end of transaction).

Note that both banks may make many other transactions in the same day, and the base money that must be transferred at close of business is the net value of those transactions. So suppose Marco pays $20 to Gino, but then another Bonus Bank customer transfers $5 to another Abacus Bank customer. Then at the end of the day Abacus Bank need only transfer $20 – $5 = $15 to Bonus Bank.

This illustrates the payment services provided by banks. You may have noticed in Figure 10.1b that the total amount of assets and liabilities of the two banks increased from $100 to $120; however, at close of business it was back down to $100 again (Figure 10.1c). The increase occurred because Abacus Bank created a new liability by effectively borrowing from Bonus Bank for the duration of the day. As long as it owed $20, that $20 was a new liability in the banking system and represented new bank money. When Abacus redeemed the loan at the end of the day by transferring base money, the loan disap­peared. But this mechanism also applies for longer-term term loans; when a bank lends money to a firm or a household, it increases the money supply. In this way, banks create money in the process of making loans, as we now show.

Making a loan

Suppose that Gino borrows $100 from Bonus Bank. Bonus Bank lends him the money by crediting his bank account with $100, so he is now owed $120 (taking into account the $20 Gino paid him earlier). But he owes a debt of $100 to the bank. So Bonus Bank’s balance sheet has expanded. Its assets have grown by the $100 owed by Gino, and its liabilities have grown by the $100 it has credited to his bank account, shown in Figure 10.1d.

Figure 10.1d Bonus Bank gives Gino a loan of $100.

Bonus Bank has now expanded the money supply. Gino can make payments up to $120, so in this sense the money supply has grown by $100—even though base money has not grown. The money created by his bank is called bank money.

Because of the loan, the total ‘money’ in the banking system has grown, as Figure 10.1e shows.

Figure 10.1e The total money in the banking system has grown.

While banks are free to create bank money when they make loans, they need base money to settle transactions at the end of each business day, as we saw above. In practice, banks perform many transactions among each other on any given day, most cancelling each other out. This means that the net that must be transferred at the end of each day is small compared with the amount of money flowing around in transactions. This means banks do not need to have sufficient base money available to cover all transactions.

The ratio of base money to broad money varies across countries and over time. For example, before the financial crisis, base money comprised about 3–4% of broad money in the UK, 6–8% in South Africa, and 8–10% in China.

Banks provide maturity transformation services, borrowing short term and lending long term

Creating money may sound like an easy way to make profits, but as we have seen, the money banks create is a liability, not an asset, because it must be paid on demand to the borrower. It is the corresponding loan that is an asset for the bank. Banks make profits out of the process that allows people to shift consumption from the future to the present by charging interest on the loans. So if Bonus Bank lends Gino $100 at an interest rate of 10%, then next year the bank’s liabilities have fallen by $10 (the interest paid on the loan, which is a fall in Gino’s deposits). This income for the bank increases its accumulated profits and therefore its net worth by $10. Since net worth is equal to the value of assets minus the value of liabilities, this allows banks to create positive net worth.

By taking deposits and making loans, banks provide the economy with the service called maturity transformation. Bank depositors (individuals or firms) can withdraw their money from the bank without notice. But when banks lend, they give a fixed date on which the loan will be repaid, which in the case of a mortgage loan for a house purchase, may be 30 years in the future. They cannot require the borrower to repay sooner, which allows those receiving bank loans to engage in long-term planning. This is called maturity transformation because the length of a loan is termed its maturity, so the bank is engaging in short-term borrowing and long-term lending. It is also called liquidity transformation—the lenders’ deposits are liquid (free to flow out of the bank on demand), whereas bank loans to borrowers are illiquid.

Maturity transformation, liquidity risk, and bank runs

While maturity transformation is an essential service in any economy, it also exposes the bank to a new form of risk (called liquidity risk), aside from the possibility that its loans will not be repaid (called default risk).

Banks make money by lending much more than they hold in base money, because they count on depositors not to need their funds all at the same time. The risk they face—liquidity risk—is that depositors can all decide they want to withdraw money instantaneously, but the money won’t be there. In Figure 10.1e, the banking system owed $200 but only held $100 of base money. If all customers demanded their money at once, the banks would not be able to repay. This is called a bank run. If there’s a run, the bank is in trouble. Liquidity risk is a cause of bank failures and explains why many governments provide automatic insurance for depositors against the risk that their banks will fail to meet payments. Protection limits and the extent to which banks contribute to the insurance fund vary across countries.

If people become frightened that a bank is experiencing a shortage of liquidity, there will be a rush to be the first to withdraw deposits. If everyone tries to withdraw their deposits at once, the bank will be unable to meet their demands because it has made long-term loans that cannot be called in at short notice.

Question 10.4 Choose the correct answer(s)

Which of the following statements are correct?

• Money is the cash (coins and notes) used as the medium of exchange to purchase goods and services.
• Bank money is the money deposited by savers in bank accounts.
• Base money in circulation is broad money minus bank money.
• Liquidity transformation occurs when the banks transform illiquid deposits into liquid loans.

• Money is a medium of exchange used to purchase goods and services, but it can also take the form of bank deposits, as well as coins and notes.
• Bank money is the money created by commercial banks when they extend credit to firms and households.
• Broad money is base money (created by the central bank) that is in the hands of the non-bank public plus bank money created by commercial banks.
• Liquidity transformation occurs when the banks transform liquid deposits into illiquid loans.

Question 10.5 Choose the correct answer(s)

Figure 10.2 shows a balance sheet of a bank.

Figure 10.2 A bank’s balance sheet.

The interest rate charged on loans is 10%. Based on this information, which of the following statements are correct?

• The possibility that the loans will not be repaid is called the liquidity risk.
• The bank holds £10 million of base money.
• In one year’s time, both assets and liabilities grow by £10 million.
• There is a bank run if depositors ask to withdraw more than £10 million of their deposits at the same time and the bank is unable to raise the difference.

• That is called the default risk. Liquidity risk is when the bank is unable to honour the promise to pay on demand when the depositors withdraw their deposits, as the money is tied up in illiquid assets.
• Here, cash is the base money while the loans are the bank money. Therefore, base money is £10 million.
• Only the asset side grows by £10 million, which is the interest charged on the loans. The balance of £10 million is the bank’s profit that increases its net worth.
• Banks make money by lending much more than they hold in legal tender because they count on depositors not to need their funds all at the same time. When they do, and the bank is unable to raise the difference, there is a bank run.

10.5 The central bank, banks, and interest rates

Commercial banks make profits from providing banking services and loans. To run the business, they need to be able to make transactions, for which they need base money. There is no automatic relationship between the amount of base money they require and the amount of lending they do. Rather, they need whatever amount of base money that covers the net transactions they make on a daily basis. The price of borrowing base money is the short-term interest rate.

Suppose, in the example of Gino and Marco, that Gino wants to pay $50 to Marco after borrowing $100. Also assume there are no other transactions that day. At close of business that day, Gino’s bank, Bonus Bank, doesn’t have enough base money to make the transfer to Abacus Bank, as we can see from its balance sheet in Figure 10.1f.

Figure 10.1f Bonus Bank does not have enough base money to pay $50 to Abacus Bank.

So Bonus Bank must borrow $30 of base money to make the payment. Banks borrow from each other in the money markets since, at any moment, some banks will have excess money in their bank accounts, and others not enough. They could try to induce a household or firm to deposit additional money, but deposits also have costs, due to interest payments, marketing, and maintaining bank branches. Thus, cash deposits are only one part of bank financing.

But what determines the price of borrowing in the money market (the interest rate)? We can think in terms of supply and demand:

• The demand for base money depends on the volume of transactions commercial banks must make.
• The central bank supplies base money.

Since the central bank controls the supply of base money, it can decide the interest rate. The central bank intervenes in the money market by saying it will lend (i.e. supply) whatever quantity of base money is demanded at the interest rate (i) that it chooses.

The technicalities of how the central bank implements its chosen policy interest rate vary among central banks around the world. The details can be found on each central bank’s website.

Banks in the money market respect that price; no bank borrows at a higher rate or lends at a lower rate, since they can borrow at rate i from the central bank. This i is also called the base rate, official rate or policy (interest) rate (often shortened to ‘policy rate’).

The base rate applies to banks that borrow base money from each other and from the central bank. The base rate matters in the rest of the economy because of its knock-on effect on other interest rates. The average interest rate charged by commercial banks to firms and households is called the bank lending rate. This rate is typically above the policy interest rate, ensuring that banks make profits (it is also higher for borrowers perceived as risky by the bank, as we saw earlier). The difference between the bank lending rate and the base rate at which they can borrow is the markup, or spread on commercial lending.

In the UK, for example, the policy interest rate set by the Bank of England was 0.75% in 2019, but few banks would lend at less than 3%. In emerging economies, this gap can be quite large, owing to the uncertain economic environment. In Brazil, for instance, the central bank policy rate in 2018 was 6.5% but the average bank lending rate was 53%.

The central bank does not control this markup, but generally the bank lending rate goes up and down with the base rate, in the same way that other firms adjust their prices as their costs rise and fall.

Figure 10.3 greatly simplifies the financial system. It does not include all the actors, financial assets, or markets introduced in Section 10.2. In this simplified model, we show household savers facing just two choices: to deposit money in a bank current account, which (for simplicity) we assume pays no interest, or buy government bonds in the money market. The interest rate on government bonds is called the yield.

Go back to the ‘Find out more’ box at the end of Section 10.2 for an explanation of these bonds, and why the yield on government bonds is close to the policy interest rate. We also give an explanation of what are called present value calculations, which are essential for you to understand how assets like bonds are priced.

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Figure 10.3 Banks, the central bank, borrowers, and savers.

Adapted from Figure 5.12 in Chapter 5 of Wendy Carlin and David Soskice. 2015. Macroeconomics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press.

Exercise 10.2 Interest rate markups

Use the websites of two central banks of your choice to collect data on the monthly policy interest rate and the mortgage interest rate between 2000 and the most recent year available.

1. Plot the data for both countries on a single line chart, with the date on the horizontal axis and the interest rate on the vertical axis.
2. How does the banking markup (difference between the mortgage interest rate and the monthly policy interest rate) compare between the two countries? Suggest possible reasons for what you observe. You may find it helpful to research characteristics of the economies of your chosen countries.
3. Do banking markups change over time? Suggest possible reasons for what you observe.

Question 10.6 Choose the correct answer(s)

Which of the following statements are correct?

• The supply of base money depends on how many transactions commercial banks must make.
• The central bank chooses the interest rate to charge on loans to banks, but not the lending rate.
• When savers buy bonds, they are lending money in the money market.
• The central bank sets the policy rate in order to maximize its profits.

• Demand for base money depends on how many transactions commercial banks must make. The supply of base money is simply a decision by the central bank.
• The bank lending rate is the interest rate charged by the commercial banks to firms and households. The rate charged by the central bank is the base rate (also called the official rate or policy rate).
• When savers buy bonds in the market, the issuers are borrowing the money from the savers.
• The central bank sets the policy rate to achieve the desired private sector spending. Commercial banks set the lending rate to maximize their profits.

10.6 The business of banking and bank balance sheets

Having introduced the banks and the central bank as actors in the economy, we can understand the business of banking better if we can look at a commercial bank’s costs and revenues:

• The bank’s operational costs: These include the administration costs of making loans. For example, the salaries of loan officers who evaluate loan applications, the costs of renting and maintaining a network of branches and call centres used to supply banking services.
• The bank’s interest costs: Banks must pay interest on their liabilities, including deposits and other borrowing.
• The bank’s revenue: This is the interest on and repayment of the loans it has extended to its customers.
• The bank’s expected return: This is the return on the loans it provides, taking into account the fact that not all customers will repay their loans.

As was the case for moneylenders, if the risk of making loans (the default rate) is higher, then there will be a larger gap (or spread or markup) between the interest rate banks charge on the loans they make and the cost of their borrowing.

The profitability of the business depends on the difference between the cost of borrowing and the return to lending, taking account of the default rate and the operational costs of screening the loans and running the bank.

A good way to understand a bank is to look at its entire balance sheet (Figure 10.4), which summarizes its core business of lending and borrowing.

• Bank borrowing is on the liabilities side: Deposits and borrowing are recorded as liabilities. Loans can be either secured (the borrower has provided collateral) or unsecured (the borrower has not provided collateral). See Section 9.10 for more on the role of collateral in lending.
• Bank lending is on the assets side.

Figure 10.4 A simplified bank balance sheet.

Adapted from Figure 5.9 in Chapter 5 of Wendy Carlin and David Soskice. 2015. Macroeconomics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press.

As we saw in the example of Abacus and Bonus Bank in Section 10.4:

Another way of saying this is that the net worth of a firm, like a bank, is equal to what is owed to the shareholders or owners. This explains why net worth is on the liabilities side of the balance sheet. If the value of the bank’s assets is less than the value of what the bank owes others, then its net worth is negative, and the bank is insolvent.

Like any other firm in a capitalist economy, banks can fail by making bad investments, such as by giving loans that do not get paid back. But in some cases, banks are so large or so deeply involved throughout the financial system that governments decide to rescue them if they are at risk of going bankrupt. This is because, unlike the failure of a firm, a banking crisis can bring down the financial system as a whole and threaten the livelihoods of people throughout the economy. Bank failures and the threat of bank failures played a major role in the global financial crisis of 2008.

Let’s examine the asset side of the bank balance sheet:

• (A1) Cash and central bank reserves: Item A1 on the balance sheet is the cash it holds, plus the bank’s balance in its reserve account at the central bank. Cash and reserves at the central bank are the bank’s readily accessible, or liquid, funds. This is base money and amounts to a tiny fraction of the bank’s balance sheet—just 2% in this example of a typical contemporary bank.
• (A2) Bank’s own financial assets: These assets can be used as collateral for the bank’s borrowing in the money market. As we have discussed, they borrow to replenish their cash balances (item A1, Figure 10.4) when depositors withdraw (or transfer) more funds than the bank has available.
• (A3) Loans to other banks: A bank also has loans to other banks on its balance sheet.
• (A4) Loans to households and firms: The bank’s lending activities are the largest item on the asset side. The loans made by the bank to households and firms make up 55% of the balance sheet in Figure 10.4. This is the bank’s core business.
• (A5) Bank assets such as buildings and equipment will be recorded on the asset side of the balance sheet.

On the liability side of the bank balance sheet, there are three forms of bank borrowing, shown in Figure 10.4:

• (L1) The most important one is bank deposits, making up 50% of the bank’s balance sheet in this example. The bank owes these to households and firms. As part of its profit-maximization decision, the bank makes a judgement about the likely demand by depositors to withdraw their deposits. Across the banking system withdrawals and deposits occur continuously, and when the cross-bank transactions are cleared, most cancel each other out. Any bank must ensure that it has cash and reserves at the central bank to meet the demand by depositors for funds, and the net transfers they have made that day. Holding cash and reserves for this purpose has an opportunity cost, because those funds could instead be lent out in the money market in order to earn interest, so banks aim to hold the minimum prudent balances of cash and reserves.
• (L2) and (L3) on the liabilities side of the balance sheet are what the bank has borrowed from households, firms, and other banks in the money market.
• Item (L4) on the balance sheet is the bank’s net worth. This is the bank’s equity. It comprises the shares issued by the bank and the accumulated profits, which have not been paid out as dividends to shareholders over the years. For a typical bank, its equity is only a few per cent of its balance sheet. The bank is a very debt-heavy company.

Equity is the difference between the value of an asset owned and the value of liabilities associated with that asset. (The term ‘equity’ is also used in an entirely different sense to mean the quality of being fair or impartial.)

We can see this from real-world examples illustrated in Figures 10.5 and 10.6.

Figure 10.5 shows the simplified balance sheet of Barclays Bank (just before the financial crisis) and Figure 10.6 shows the simplified balance sheet of a company from the non-financial sector, Honda.

Figure 10.5 Barclays Bank’s balance sheet in 2006 (£m).

Barclays Bank. 2006. Barclays Bank PLC Annual Report. Also presented as Figure 5.10 in Chapter 5 of Wendy Carlin and David Soskice. 2015. Macro­economics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press.

Figure 10.6 Honda Motor Company’s balance sheet in 2013 (¥m).

Current assets refer to cash, inventories, and other short-term assets. Current liabilities refer to short-term debts and other pending payments.

A way of describing the reliance of a company on debt is to refer to its leverage ratio, also known as gearing.

Leverage for non-banks is defined differently from leverage for banks. For companies, the leverage ratio is defined as the value of total liabilities divided by total assets. For an example of the use of the leverage definition for non-banks, see: Marina-Eliza Spaliara. 2009. ‘Do Financial Factors Affect the Capital–labour Ratio? Evidence from UK Firm-Level Data’. Journal of Banking & Finance 33 (10) (October): pp. 1932–47.

Unfortunately the term leverage ratio is defined differently for financial and non-financial companies (both definitions are shown in Figures 10.5 and 10.6). Here, we calculate the leverage for Barclays and Honda, using the definition used for banks (total assets divided by net worth). Barclays’ total assets are 36 times their net worth. This means that, given the size of its liabilities (its debt), a very small change in the value of its assets (1/36 ≈ 3%) would be enough to wipe out its net worth and make the bank insolvent. By contrast, using the same definition we see that Honda’s leverage is less than three. Compared to Barclays, Honda’s equity is far higher in relation to its assets. Another way to say this is that Honda finances its assets by a mixture of debt (62%) and equity (38%), whereas Barclays finances its assets with 97% debt and 3% equity.

Question 10.7 Choose the correct answer(s)

The following example is a simplified balance sheet of a commercial bank. Based on this information, which of the following statements are correct?

Figure 10.7 A commercial bank’s balance sheet.

• The bank’s base money consists of cash and reserves and financial assets.
• Secured borrowing is borrowing with zero default risk.
• The bank’s net worth is its cash and reserves of £2 million.
• The bank’s leverage is 33.3.

• The base money is cash plus reserves at the central bank. It does not include the financial assets.
• Secured borrowing is bank’s borrowing with collateral, using its financial assets. It has positive default risk (hence the use of collateral).
• The bank’s net worth is its assets – liabilities = £3 million.
• Leverage is net worth divided by assets; in this case £100 million/£3 million = 33.3.

Question 10.8 Choose the correct answer(s)

Which of the following statements are correct?

• The net worth of a bank belongs to its employees.
• A bank is insolvent if the value of its liabilities exceeds the value of its assets.
• The more a bank holds in cash and reserves, the higher its profits.
• A loan is secured if it is default-free.

• A bank’s net worth is its equity. This belongs to its shareholders or its owners.
• In this situation the net worth is negative, making the bank insolvent.
• Larger cash and reserves mean that the bank is more able to meet the demand by depositors for funds. However, holding cash and reserves has an opportunity cost, as they could instead be lent out in the money market to earn interest. Therefore, banks that hold more cash and reserves do not necessarily have higher profits.
• A loan is secured if the borrower has provided collateral. The borrower can still default on the loan.

10.7 How key economic actors use and create money: A summary so far

Here is a summary of how key economic actors use and create money in a modern economy.

Households

• Use money for transactions: Using deposit accounts and currency.
• Borrow short term: Often from a bank, using an overdraft or credit card debt.
• Borrow long term: Also often from a bank, to purchase durable goods such as a house or car, or from a specialized institution for a student loan.

Their income is wages, salaries, interest, rent, profits, government transfers, and gifts. From this, they:

• Pay taxes.
• Pay interest: On loans.
• Purchase goods and services: This is consumption.

• Save to add to their net worth: To do this, they:

  • use deposit or savings accounts
  • purchase assets (financial and non-financial)
  • repay debt.

Firms (other than banks)

• Use money for transactions.
• Borrow short term: Often from a bank, to allow payments ahead of sales.
• Borrow long term: Also often from a bank, to purchase new machinery and equipment and fund other investment projects. This is called bank debt financing of investment.

• Sell financial assets: To purchase new machinery and equipment and fund other investment projects. These are:

  • shares, called equity financing of investment
  • bonds, called market debt financing of investment.

Their revenue is the money taken in through sales of goods and services. From this, they:

• Pay taxes.
• Pay interest: On loans, coupons to corporate bondholders.
• Purchase inputs: These include wages and salaries.
• Replace depreciated machinery, equipment, and buildings.

They make profits. After paying tax, interest and depreciation, they:

• Make purchases: New machinery, equipment and buildings.
• Fund other investment projects: These include R&D. This is called financing investment from retained earnings.
• Pay dividends: To shareholders.
• Purchase assets: These can be financial or non-financial.
• Repay debt.

Banks

• Create bank money: By making loans.
• Lend money: To households and other firms.
• Borrow reserves (base money) from the money market: They pay the central bank’s policy interest rate. Borrowed funds are used to cover lending in excess of the expected level.

They have reserves accounts at the central bank. They use these to:

• Settle payments: With other banks.
• Convert into cash: To pay out to depositors.

Central bank

• Chooses the policy interest rate: It does this to influence:

  • the demand for loans
  • the level of borrowing and hence spending by households and firms in the economy.

• Meets the demand from banks for base money (that is, currency and reserves). The money supply is endogenous.

Government

• Uses money: For transactions.
• Sells financial assets: To cover its spending in excess of tax revenues. These assets are government bonds, which may, for example, promise to pay a fixed amount per year, called a coupon.

It also has revenues, primarily from taxes. From these, a government:

• Pays interest (for example, coupons) to bondholders.
• Purchases inputs: These include wages and salaries.
• Replaces depreciated machinery and equipment.
• Purchases new machinery, equipment, and buildings.
• Funds other investment projects: These include R&D and infrastructure.
• Repays debt.

Having explained the major actors in financial markets, we turn now to how individuals value financial assets.

10.8 The value of an asset: Expected return and risk

People buy fresh fish or clothes for their consumption value—to eat or to wear. But when people buy an asset—a house, a car, a work of art, a bond, or a share (a piece of ownership in a company)—they often have a second motive. Their objective is not only to benefit in some way while owning the asset (for example, living in the house), but also to be able to sell it later for more than they paid for it. Assets are distinguished from other goods because they are long-lasting in a particular sense; unlike fish or used clothes, asset owners care about the resale value of their assets in the future.

In Unit 7, we studied the factors that determine the price of ordinary goods and services. As in those cases, the interaction of supply and demand determines the price for assets, but the demand for an asset is not based only on how much the buyer wishes to have it, but also on the buyer’s estimation of how valuable it will be to other potential buyers in future years.

The fact that the value of an asset today depends on how much it will be worth to others in the future introduces an important new consideration: the uncertainty caused by the fact that an asset’s value may increase or decrease. As a result, unlike the clothes or the fish—where what you buy is what you get—buying an asset in most cases means taking a risk about its future value.

This assumption was brought into question in the Eurozone crisis that followed the global financial crisis. To find out about the Eurozone crisis, read this article.

To study how risk affects the price of an asset, we will contrast how a person might value a government bond, which is as close to a riskless asset as you can get, and shares in a company. A government bond is considered to be a riskless asset because it is a promise from the government to pay some fixed amount to the holder of the bond on a given schedule over a fixed period of time and because it is assumed that the government will not default on the payments.

Shares are literally a share in the ownership of a company. The holder owns some fraction of the company’s buildings, equipment, intellectual property, and other assets. As a part owner of the firm, the shareholder also owns a share of the profits of the firm. The value of a share depends on how profitable the firm is and is expected to be in the future. Shares thus differ from bonds in two important respects: there is no promised payment to the holder (it depends on how profitable the firm is), and there is no fixed maturity period for the ownership of a share (it may be held for a lifetime).

Safe bonds and risky shares

Now think about Ayesha, who is deciding whether to buy a government bond or a share in one of a large number of companies with publicly listed shares. What does she care about? Two things. The first is her best guess about what her wealth will be at some future date depending on what she buys, called the expected value of her wealth. The second thing she cares about is how much risk she is taking when she buys a particular bond or share. The expected value is her best guess but what actually happens could be very different, either much better or much worse.

In the case of the bond, there is no risk attached to holding the bond—the promise to pay a certain amount over a certain period can be counted on. But the value of the share that she purchases may go up or down. We will use a model to explain how Ayesha could decide what kind of asset to purchase, taking account of both expected value and risk.

To simplify things, suppose that in the future there are just two possible states of the world affecting the value of the share she has purchased. There is a ‘good’ state in which the price is higher than her expected value, and a ‘bad’ state in which the price is lower than her expected value. Ayesha does not know which will occur, and that is why purchasing shares is risky.

Some shares are much riskier than others. For some shares the difference in the good and the bad state is very small. Something close to the expected value (a bit higher or a bit lower) will definitely occur. But for other shares, the difference is substantial: the share may double in value or be reduced to a worthless piece of paper. The difference in the share’s value between the good and the bad state is the degree of risk that Ayesha will face, depending on which share she purchases, or if she purchases the bond.

To summarize so far: Ayesha prefers shares with a greater expected value and a lower degree of risk.

The trade-off between a higher expected return and higher risk

Ayesha would like, of course, to buy an asset that has a high expected value and a low degree of risk. But there is a hitch—low-risk assets typically have low expected values, and assets with high expected value are often associated with high levels of risk. In other words, Ayesha faces a trade-off, similar to the trade-offs faced by the student and the farmer in Unit 4, who wanted both more free time and also more of the other thing they valued—success in the exam and grain produced on the farm.

Facing this trade-off between expected value and risk, what will she buy? We have the two pieces of information necessary to describe the choice that will make her the best off—give her the maximum utility—of all the choices open to her, that is, we know her:

• feasible set and its boundary, the feasible frontier
• indifference curves, representing how Ayesha dislikes risk and values expected return.

Figure 10.8a explains how the combinations of risk and return associated with different assets are represented by a feasible set and feasible frontier.

• The level of risk associated with different assets is measured along the horizontal axis, and called Δ, the Greek letter, delta, denoting a difference, in this case between the good and the bad states.
• The expected value of the asset next year is measured on the vertical axis, denoted by w (for ‘wealth’).

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Figure 10.8a The trade-off between risk and return: The feasible set.

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The feasible set

Points A, B, C, and E represent combinations of risk and expected return associated with different assets that Ayesha can buy. The shaded area represents the feasible set of combinations of risk and expected return.

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The risk–return schedule

The only points of interest to Ayesha are those on the feasible frontier, called the risk–return schedule. Asset A is the risk-free bond. An asset like E inside the feasible frontier, is not worth considering, because there will always be some other asset (like C) which has both a higher expected return and a lower risk.

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Upward-sloping risk–return schedule

Ayesha can entirely opt out of risk-taking by purchasing the bond (point A). But she also has a large choice of shares with more or less risk. Notice that the risk–return schedule is upward sloping. Higher returns (greater expected values) are possible only by taking greater risk, for example, by purchasing the share indicated by point C, or—even more risky—point B.

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Marginal rate of transformation

The slope of the risk–return schedule is called the marginal rate of transformation of risk into return. For low levels of risk (near the vertical axis), the slope of the feasible frontier is steep, meaning that taking a little more risk yields large gains in expected return. However, the curve gets flatter (and may even slope downwards) when the level of risk is greater.

Each point in the figure represents some combination of these two aspects of an asset—risk and expected return.

From Figure 10.8a, we can see that not all the conceivable combinations of risk and return are possible by buying an asset. If Ayesha has $1,000 to purchase an asset, the ones that are available to her—the feasible set of combinations of risk and expected return—make up the shaded area in Figure 10.8a. The red curve is the familiar feasible frontier, which in this case is called the risk–return schedule (a ‘schedule’ is just a curve or function, and return refers to the expected value).

The risk-free bond is shown by point A where the feasible frontier intersects the vertical axis—the level of risk, Δ, is equal to zero. If Ayesha wishes to entirely avoid risk, she can purchase bonds. But the risk–return frontier shows that she can achieve a higher expected return (measured on the vertical axis, by w) if she purchases a risky asset such as the one shown by point C.

As highlighted in the figure, the feasible frontier is very steep near the vertical axis when risk is very low. By moving to a riskier asset, Ayesha can achieve large gains in expected return. As the frontier gets flatter, the riskier the assets become.

The slope of the risk–return schedule is called the marginal rate of transformation of risk into return.

Ayesha’s preferences about risk and return

To determine what choice would give Ayesha the greatest utility, we need a second piece of information—how much she values each of the outcomes (combinations of w and Δ). To do this, we introduce Ayesha’s preferences, which we represent by her indifference curves. Figure 10.8b explains the shape of Ayesha’s indifference curves. Two of these are shown in Figure 10.8b as the blue curves. To see what these mean, notice that point A (no risk, low expected value) is on the same indifference curve as point B (high risk, high expected return), meaning that, as far as Ayesha is concerned, these two outcomes are equally valued by her.

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Figure 10.8b The trade-off between risk and return: Ayesha’s preferences.

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Ayesha’s preferences

The blue curves show combinations of w and Δ) that give Ayesha the same level of utility. They are upward sloping, meaning that Ayesha needs to be compensated for risk-taking through a higher expected return.

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Marginal rate of substitution

The slope of Ayesha’s indifference curves is called the marginal rate of substitution between risk and expected value. A steep indifference curve means that taking on a given increase in risk would have to be compensated by a large increase in return. When comparing Ayesha’s indifference curves, notice that at a given level of risk such as Δ*, she is less risk averse when her expected wealth is higher: the slope is flatter at C than at F.

Notice about these risk–return indifference curves:

• They slope upwards: This reflects Ayesha’s trade-off. She values a high-risk, high-return share as much as some other low-risk, low-return share.
• The curves are flatter when the level of risk is low: This means that, when Ayesha is exposed to very little risk, taking a little more risk is not very costly to her; only a small increase in the expected value is required to offset the increased risk. But for higher levels of risk (further to the right), the curves are steeper, indicating that Ayesha will be willing to take on yet more risk only if compensated by a substantial gain in expected value.

The slope of Ayesha’s indifference curves is called the marginal rate of substitution between risk and expected value. The steepness of the indifference curve measures how much of a ‘bad’ risk is, compared to how much of a ‘good’ the expected value is. This is termed risk aversion, meaning how much the individual is averse to (does not like) risk.

Now notice a third thing about the indifference curves:

• For any given level of risk Δ, the higher-up curves are flatter than those lower down: This means that people who can expect greater wealth in the future are also less risk averse.

Wealthier people and those exposed to less risk are less risk averse

The three features of risk–return indifference curves discussed above mean that people tend to be more risk averse:

• when they are exposed to substantial risk
• when they are poor.

Ayesha’s choice: Trading off risk and return

In Figure 10.8c, we combine the indifference curves with the risk–return schedule to see how Ayesha makes her asset choice.

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Figure 10.8c Ayesha’s choice: MRS = MRT.

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MRS = MRT

We see that the best Ayesha can do is to select point C, that is, a share with an expected value of w* and a risk level of Δ*.

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Ayesha does better by buying a share

Point D is called the ‘certainty equivalent’ of point C, meaning it is the outcome with zero risk that would be just as good as the risky asset she chooses. But D is not feasible. This explains Ayesha’s choice of a risky share at C rather than the safe bond at A.

Putting together the indifference curves and the risk–return schedule, we see that the best Ayesha can do is to select point C, that is, a share with an expected value of w* and a risk level of Δ*.

We can compare Ayesha’s choice of this share with what she would have gained had she purchased the bond. Point D and point C (the point she chose) are on the same indifference curve, so they are equally good from Ayesha’s standpoint. Point D indicates the expected value with no risk that would have been just as good as point C (higher return, some risk).

Point D is called the certainty equivalent of point C, meaning it is the outcome with no risk that would be just as good as the risky point she chose. We can compare point D with point A because both are outcomes with no risk. Notice that point D, and hence also point C (on the same indifference curve), are preferred to point A, the purchase of a bond. Hence, taking on some risk can give Ayesha higher utility than buying a bond.

Exercise 10.3 Understanding Ayesha’s risk–return trade-offs

1. Using Figure 10.8b, show how high the value of the bond would have to be for Ayesha to choose to purchase it rather than the share C, whose expected value and risk level remains unchanged. Hint: look at the indifference curve through point C and recall that its vertical axis intercept is the certainty equivalent of C.
2. Redraw Figure 10.8b to illustrate the following situations:
   1. Draw a new indifference curve through point C to show that, if Ayesha were less risk averse, she would choose a riskier share than C. Hint: draw a less risk averse indifference curve through point C.
   2. Draw a set of indifference curves according to which Ayesha would choose to purchase share B.
   3. If all shares became riskier without affecting their expected value this would displace points C, F and B horizontally to the right. Show this in your figure by introducing new points C′, F′ and B′ to the right of the initial points.
   4. Show that though she initially preferred share C to share B (you showed this above) she now would choose share B over share C.

Question 10.9 Choose the correct answer(s)

Which of the following statements about assets and risk are true?

• All assets have a high level of risk involved.
• Risk aversion occurs because the value of an asset is determined in the future and people are impatient.
• The value of shares in a company varies according to the profits that people expect the firm to make in the future.
• Exposure to greater risk makes people more risk averse.

• While shares can have a high level of risk, bonds issued by stable governments that respect the rule of law usually have a very low (or virtually no) risk involved.
• While it is true that the value of an asset is determined in the future, the way that people evaluate risk is not related to impatience.
• Shareholders own part of the company’s profits and the value of the company’s shares is positively related to the company’s expected profits.
• As shown in Figure 10.8b, the indifference curves for a given expected value are steeper for greater risk.

How economists learn from data The wisdom of crowds: The weight of (live)stock and the value of shares

What is the right price for, say, a share in Facebook? Would it be better for the price to be set by economic experts, rather than determined in the market by the actions of millions of people, few of whom have expert knowledge about the economy or the company’s prospects?

Economists are far from understanding the details of how this mechanism actually works. But an important insight comes from an unusual source—a guessing game played in 1907 at an agricultural fair in Plymouth, England. Attendees at the fair were presented with a live ox. For sixpence (2.5p), they could guess the ox’s ‘dressed’ weight, meaning how much saleable beef could be obtained. The entrant whose answer, written on a ticket, came closest to the correct weight would win the prize.

The polymath, Francis Galton, later obtained the tickets associated with that contest. He found that a player, chosen at random, missed the correct weight by an average of 40 lbs. But what he called the ‘vox populi’ or ‘voice of the people’—the median value of all the guesses—was remarkably close to the true value, deviating by only 9 lbs (less than 1%).

The insight that is relevant to economics is that the average of a large number of not-very-well-informed people is often extremely accurate. It is possibly more accurate than the estimate of an experienced veterin­arian or ox breeder.

Galton’s use of the median to aggregate the guesses meant that vox populi was the voice of the (assumed) most informed player, but it was the guesses of all the others that picked out this most informed player. Vox populi was obtained by taking all of the information available, including the hunches and fancies that drove outliers high or low.

Galton’s result is an example of the ‘wisdom of the crowd’. This concept is particularly interesting for economists because it contains, in a stylized format, many of the ingredients that go into a good price mechanism.

As Galton himself noted, the guessing game had a number of features contributing to the success of vox populi. The entry fee was small, but not zero, allowing many to participate but also deterring practical jokers. Guesses were written and entered privately, and judgements were uninfluenced ‘by oratory and passion’. The promise of a reward focused the participants’ attention.

Although many participants were well informed, many were less so and, as Galton noted, were guided by others at the fair and their imaginations. Galton’s choice of the median value would reduce (but not eliminate) the influence of these less-informed guessers, preventing individual wild guesses (say, those 10 times the true value) from pulling the vox populi away from the views of the group as a whole.

The stock market represents another expression of vox populi, which sees people guessing at the value of a company, often (but not always) quite accurately tracking changes in the quality of management, technology, or market opportunities.

The wisdom of crowds also explains the success of prediction markets. The Iowa Electronic Markets, run by the University of Iowa, allows individuals to buy and sell contracts that pay off, depending on who wins an upcoming election. The prices of these assets pool the information, hunches, and guesses of large numbers of participants. Such prediction markets—often called political stock markets—can provide uncannily accurate forecasts of election results months in advance, sometimes better than polls and even poll-aggregation sites. Other prediction markets allow thousands of people to bet on events, such as who will win the Oscar for best female lead. It was even proposed to create a prediction market for the next occurrence of a major terrorist attack in the US.

10.9 Changing supply and demand for a financial asset

When a company sells new shares (or stocks) to the public for the first time, this is called an initial public offering (IPO). After that, the shares are traded on the stock exchange. This is called trading on the secondary market.

Prices in trading in secondary markets are constantly changing. The graph in Figure 10.9 shows how News Corp’s (NWS) share price on the Nasdaq stock exchange fluctuated over one day in May 2014 and, in the lower panel, the number of shares traded at each point. Soon after the market opened at 9.30 a.m., the price was $16.66 per share. As investors bought and sold shares through the day, the price reached a low point of $16.45 at both 10 a.m. and 2 p.m. By the time the market closed, with the share price at $16.54, nearly 556,000 shares had been traded.

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Figure 10.9 News Corp’s share price and volume traded (7 May 2014).

The flexibility demonstrated by News Corp share prices is common in markets for other financial assets, such as government bonds, currencies under floating exchange rates, commodities, such as gold, crude oil and corn, and tangible assets such as houses and works of art.

But share prices are not only volatile hour-by-hour and day-by-day. Figure 10.10 shows the value of the Nasdaq Composite Index between 1995 and 1999. This index is an average of prices for a set of shares, with companies weighted in proportion to their market capitalization. The Nasdaq Composite Index at this time included many fast-growing and hard-to-value companies in technology sectors.

The index began the period at less than 750, and rose to 2,300 over four years, reflecting strong demand for these shares, arising from the view that there were new profitable opportunities for firms in the technology sector.

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Figure 10.10 Information technology and rising prices for tech shares: Nasdaq Composite Index (1995–1999).

10.10 Asset market bubbles

The logic of market stability and bubbles

As well as reflecting long-term technology trends, share prices can also display large swings, often referred to as bubbles.

To see how this happens, we should distinguish between the so-called fundamental value of a share (based on the expectations of the firm’s profitability in the future), and the changes in value associated with beliefs about how much others would be willing to pay for the share in the future and therefore its future price trends.

To model markets for assets like shares, paintings, or houses, we need to allow for the effects of beliefs about future prices. Figure 10.11 contrasts two alternative scenarios following an exogenous shock of good news about future profits of a fictitious firm, Flying Car Company (FCC), that raises the share price from $50 to $60.

In the left-hand panel, beliefs dampen price rises; some market participants respond to the initial price rise with scepticism about whether the fundamental value of FCC is really $60, so they sell shares, taking a profit from the higher price. This behaviour reduces the price and it stabilizes—the news has been incorporated into a price between $50 and $60, reflecting the aggregate of beliefs in the market about the new fundamental value of FCC.

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Figure 10.11 Positive vs negative feedback.

By contrast, in the right-hand panel beliefs amplify price rises. When demand rises, others believe that the initial rise in price signals a further rise in future. These beliefs produce an increase in the demand for FCC shares. Other traders see that those who bought more shares in FCC benefited as its price rose, so they follow suit. A self-reinforcing cycle of higher prices and rising demand takes hold.

Question 10.10 Choose the correct answer(s)

Which of the following statements about asset prices are correct?

• A bubble occurs when beliefs about future prices amplify a price rise.
• When positive feedback occurs, the market is quickly restored to equilibrium.
• Negative feedback occurs when prices give traders the wrong information about the fundamental value.
• When beliefs dampen price rises, the market equilibrium is stable.

• When beliefs amplify a price rise, the price moves further away from the fundamental value, causing a bubble.
• Positive feedback occurs when an initial price change sets in motion a process that magnifies the initial change, so the market moves further away from equilibrium.
• Negative feedback occurs when an initial price change is dampened by other market participants selling the asset, in the belief that the price is now above the fundamental value.
• If beliefs about the fundamental value dampen a price rise, the market moves back to equilibrium.

Example: The tech bubble

Figure 10.12 extends the series in Figure 10.10 through to 2004. The rise in the index—from less than 750 to more than 5,000 in less than five years at its peak—implied a remarkable annualized rate of return of around 45%. It then lost two-thirds of its value in less than a year, and eventually bottomed out at around 1,100, almost 80% below its peak. The episode has come to be called the tech bubble.

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Figure 10.12 The tech bubble: Nasdaq Composite Index (1995–2004).

Bubbles, information, and beliefs

The term ‘bubble’ refers to a sustained and significant departure of the price of any asset (financial or otherwise) from its fundamental value.

Sometimes, new information about the fundamental value of an asset is quickly and reliably expressed in markets. Changes in beliefs about a firm’s future earnings growth result in virtually instantaneous adjustments in its share price. Both good and bad news, (such as information about patents or lawsuits, the illness or departure of important personnel, earnings surprises, or mergers and acquisitions) can all result in active trading—and swift price movements.

Three distinctive and related features of markets may give rise to bubbles:

• Resale value: The demand for the asset arises both from the benefit to its owner and because it offers the opportunity for speculation on a change in its price. A landlord may buy a house, both for the rental income and also to create a capital gain by holding the asset for a period of time and then selling it. People’s beliefs about what will happen to asset prices differ and change as they receive new information or believe others are responding to new information.
• Ease of trading: In financial markets, the ease of trading means that you can switch between being a buyer and being a seller if you change your mind about whether you think the price will rise or fall. Switching between buying and selling is not possible in markets for ordinary goods and services, where sellers are firms with specialized capital goods and skilled workers, and buyers are other types of firms or households.
• Ease of borrowing to finance purchases: If market participants can borrow to increase their demand for an asset that they believe will increase in price, this allows an upward movement of prices to continue, creating the possibility of a bubble and subsequent crash.

When economists disagree Do bubbles exist?

The price movements in Figure 10.12 give the impression that asset prices can swing wildly, bearing little relation to the stream of income that might reasonably be expected from holding them.

But do bubbles really exist, or are they an illusion based only on hindsight? In other words, is it possible to know that a market is experiencing a bubble before it crashes? Perhaps surprisingly, some prominent economists working with financial market data disagree on this question. They include Eugene Fama and Robert Shiller, two of the three recipients of the 2013 Nobel Prize.

Fama denies that the term ‘bubble’ has any useful meaning at all:

These words have become popular. I don’t think they have any meaning … It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.5

This is an expression of what economists call the efficient market hypothesis, which claims that all generally available information about fundamental values is incorporated into prices virtually instantaneously.67

Robert Lucas—another Nobel laureate, firmly in Fama’s camp—explained the logic of this argument in 2009, in the middle of the financial crisis:

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s efficient-market hypothesis … If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier.8

Responding to Lucas, Markus Brunnermeier explains that this argument is not watertight. Brunnermeier argues Lucas was right to emphasize that financial market frictions are a counter-argument to the efficient market hypothesis:

Of course, as Bob Lucas points out, when it is commonly known among all investors that a bubble will burst next week, then they will prick it already today. However, in practice each individual investor does not know when other investors will start trading against the bubble. This uncertainty makes each individual investor nervous about whether he can be out of (or short) the market sufficiently long until the bubble finally bursts. Consequently, each investor is reluctant to lean against the wind. Indeed, investors may in fact prefer to ride a bubble for a long time such that price corrections only occur after a long delay, and often abruptly. Empirical research on [share] price predictability supports this view. Furthermore, since funding frictions limit arbitrage activity, the fact that you can’t make money does not imply that the ‘price is right’.

This way of thinking suggests a radically different approach for the future financial architecture. Central banks and financial regulators have to be vigilant and look out for bubbles, and should help investors to synchronize their effort to lean against asset price bubbles. As the current episode has shown, it is not sufficient to clean up after the bubble bursts, but essential to lean against the formation of the bubble in the first place.9

Shiller has argued that relatively simple and publicly observable statistics, such as the ratio of share prices to earnings per share, can be used to identify bubbles as they form. Leaning against the wind by buying assets that are cheap based on this criterion, and selling those that are dear, can result in losses in the short run, but long-term gains that, in Shiller’s view, exceed the returns to be made by simply investing in a diversified basket of securities with similar risk attributes.10

In collaboration with Barclays Bank, Shiller has launched a product called an exchange-traded note (ETN) that can be used to invest in accordance with his theory. This asset is linked to the value of the cyclically adjusted price-to-earnings (CAPE) ratio, which Shiller believes is predictive of future prices over long periods. So this is one economist who has put his money where his mouth is! You can follow the fluctuation of Shiller’s index on Barclays Bank’s website.

So there are two quite different interpretations of the ‘tech bubble’ episode in Figure 10.12:

• Fama’s view: Asset prices throughout the episode were based on the best information available at the time, and fluctuated because information about the prospects of the companies was changing sharply. In John Cassidy’s 2010 interview with Fama in The New Yorker, Fama describes many of the arguments for the existence of bubbles as ‘entirely sloppy’.11
• Shiller’s view: Prices in the late 1990s had been driven up simply by expectations that the price would still rise further. He called this ‘irrational exuberance’ among investors. The first chapter of his book, Irrational Exuberance, explains the idea.12

Exercise 10.4 Markets for gems

A New York Times article describes how the worldwide markets for opals, sapphires, and emeralds are affected by discoveries of new sources of gems.

1. Explain, using supply and demand analysis, why Australian dealers were unhappy about the discovery of opals in Ethiopia.
2. What determines the willingness to pay for gems? Why do Madagascan sapphires command lower prices than Asian ones?
3. Explain why the reputation of gems from particular sources might matter to a consumer. Shouldn’t you judge how much you are willing to pay for a stone according to how much you like it yourself?
4. Do you think that the high reputation of gems from particular origins necessarily reflects true differences in quality?
5. Could we see bubbles in the markets for gems?

Exercise 10.5 The big ten asset price bubbles of the last 400 years

According to Charles Kindleberger, an economic historian, asset price bubbles have occurred across a wide variety of countries and time periods. The bubbles of the last 100 years have predominantly been focused on real estate, shares, and foreign investment.13

• 1636: The Dutch tulip bubble
• 1720: The South Sea Company
• 1720: The Mississippi Scheme
• 1927–29: The 1920s share price bubble
• 1970s: The surge in loans to Mexico and other developing economies
• 1985–89: The Japanese bubble in real estate and shares
• 1985–89: The bubble in real estate and shares in Finland, Norway, and Sweden

• 1990s: The bubble in real estate and shares in Thailand, Malaysia, Indonesia, and several other Asian countries between 1992 and 1997, and the surge in foreign investment in Mexico 1990–99

• 1995–2000: The bubble in over-the-counter shares in the US
• 2002–07: The bubble in real estate in the US, Britain, Spain, Ireland, and Iceland

Pick one of these asset price bubbles, find out more about it, and then:

1. Tell the story of this bubble, referring to Figure 10.11 to illustrate the events.
2. Explain the relevance to your story, if any, of the arguments about the existence of bubbles (refer to the ‘When economists disagree’ box in this section).

Question 10.11 Choose the correct answer(s)

Which of the following statements about bubbles are correct?

• A bubble occurs when the fundamental value of a share rises too quickly.
• A bubble is less likely to occur in a market in which people can easily switch from buying to selling.
• Permitting the use of housing equity as collateral for new housing loans makes house price bubbles more likely.
• Bubbles can only occur in financial markets.

• A bubble occurs when the market price deviates in a sustained and significant way from the fundamental value.
• Bubbles are more likely in these circumstances.
• A rise in house prices increases home equity, and if the home-owner can use the additional equity to borrow more, this can fuel an increase in demand for housing and a further rise in price.
• A bubble could occur in a market for any asset that can be re-sold, for example, the housing market.

10.11 Housing as an asset, collateral, and house price bubbles

When households borrow to buy a house, this is a secured or collateralized loan. As part of the mortgage agreement, the bank can take possession of the house if the borrower does not keep up repayments. Collateral plays an important role in sustaining a house price boom. When the house price goes up—driven, for example, by beliefs that a further price rise will occur—this increases the value of the household’s collateral (see the left-hand diagram in Figure 10.13). Using this higher collateral, households can increase their borrowing and move up the housing ladder to a better property. This, in turn, pushes up house prices further and sustains the bubble, because the banks extend more credit based on the higher collateral. Increased borrowing, made possible by the rise in the value of the collateral, is spent on goods and services as well as on housing.

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Figure 10.13 The housing market on the way up and on the way down.

When house prices are expected to rise, it is attractive to households to increase their borrowing. Suppose a house costs $200,000 and the household makes a down payment of 10% ($20,000). This means it borrows $180,000. Its initial leverage ratio, in this case the value of its assets divided by its equity stake in the house, is 200/20 = 10. Suppose the house price rises by 10% to $220,000. The return to the equity the household has invested in the house is 100% (since the value of the equity stake has risen from $20,000 to $40,000, it has doubled). Households who are convinced that house prices will rise further will want to increase their leverage—that is how they get a high return. The increase in collateral, due to the rise in the price of their house, means they can satisfy their desire to borrow more.

On the right-hand side, we see what happens when house prices decline. The value of collateral falls and the household’s spending declines, pushing house prices down.

The assets and liabilities of a household can be represented in its balance sheet. The house is on the asset side of the household’s balance sheet. The mortgage owed to the bank is on the liabilities side. When the market value of the house falls below what is owed on the mortgage, the household has negative net worth. This condition is sometimes referred to as the household being ‘underwater’. Using the example above, if the leverage ratio is 10, a fall in the house price by 10% wipes out the household’s equity. A fall of more than 10% would place the household ‘underwater’.

10.12 Banks, housing, and the global financial crisis

Before the 1980s, financial institutions had been restricted in the kinds of loans they could make and in the interest rates they could charge. Financial deregulation generated aggressive competition for customers, and gave those customers much easier access to credit.

Financial deregulation and subprime borrowers

Moreover, in the boom period before the global financial crisis, house prices were expected to rise, and the riskiness of home loans to the banks fell. As a result, banks extended more loans. The opportunities for poor people to borrow for a home loan expanded as lenders asked for lower deposits, or even no deposit at all. This new class of homeowners were called subprime borrowers, and the effect of this deregulation in the US is shown in Figure 10.14.

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Figure 10.14 The household debt-to-income ratio and house prices in the US (1950–2020).

Financial deregulation and bank leverage

In the context of the deregulated financial system, banks increased their borrowing. This enabled them:

• to extend more loans for housing
• to extend more loans for consumer durables, like cars and furnishings
• to buy more financial assets based on bundles of home loans.

Just as households took on more mortgage debt, banks also became more leveraged.

Figure 10.15 shows the leverage of US investment banks and all UK banks.

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Figure 10.15 Leverage ratio of banks in the UK and US (1960–2018).

In the US, the leverage ratio of investment banks was between 12 and 14 in the late 1970s, rising to more than 30 in the early 1990s. It hit 40 in 1996 and peaked at 43 just before the financial crisis. By contrast, the leverage of the median UK bank remained at the level of around 20 until 2000. Leverage then increased very rapidly to a peak of 48 in 2007.

The subprime housing crisis of 2007

The interrelated growth of the indebtedness of poor households in the US and global banks meant that, when homeowners began to default on their repayments in 2006, the effects could not be contained within the local or even the national economy. The crisis caused by the problems of subprime mortgages in the US spread to other countries. Financial markets were frightened on 9 August 2007 when French bank BNP Paribas halted withdrawals from three investment funds because it could not ‘fairly’ value financial products based on US mortgage-based securities—it simply did not know how much they were worth.

The recession that swept across the world in 2008–09 was the worst contraction of the global economy since the Great Depression. The financial crisis took the world by surprise. The world’s economic policymakers were unprepared. To find out more about the global financial crisis, read Sections 17.10 and 17.11 of The Economy.

Question 10.12 Choose the correct answer(s)

Figure 10.14 shows the household debt-to-income ratio and the house prices in the US between 1950 and 2017. Based on this information, which of the following statements are correct?

• The real value of household debt more than doubled from the end of the golden age to the peak on the eve of the financial crisis.
• The causality is from the house price to household debt, that is, higher house prices encourage higher debt, but not the other way around.
• A household debt-to-income ratio of over 100 means that the household is bankrupt.
• Subprime mortgages partly explain the rise in debt in the US prior to the financial crisis.

• It is not the real value, but the ratio in proportion to household income, that has more than doubled in the 35 years.
• There exists a positive feedback in both directions (the financial accelerator). Thus, not only do higher house prices encourage higher debt via rising collateral values, but higher debt leads to higher prices through increased demand.
• A household debt-to-income ratio of over 100 does not necessarily mean that the household is bankrupt. In a low interest rate environment such a high debt level can still be maintained. A household is bankrupt if its debt is higher than its assets, not its income.
• Some of the rise in household debt in the US was lent as mortgages to households who could not really afford to repay.

Question 10.13 Choose the correct answer(s)

Figure 10.15 is the graph of leverage of banks in the UK and the US between 1960 and 2018.

The leverage ratio is defined as the ratio of the banks’ total assets to their equity. Which of the following statements are correct?

• A leverage ratio of 40 means that only 2.5% of the asset is funded by equity.
• The total asset value of US banks doubled between 1980 and the late 1990s.
• A leverage ratio of 25 means that a fall of 4% in the asset value would make a bank insolvent.
• UK banks increased their leverage rapidly in the 2000s in order to make more loans to UK house buyers.

• 2.5% equity means total assets are equal to 40 times the value of equity.
• Doubling of the leverage does not imply that the value of assets has doubled. The leverage could double even if the asset value is constant, if the amount of equity is halved.
• If assets fall by 4% then they lose one twenty-fifth of their value, which is exactly the value of the equity. This would imply a net worth of zero, so the bank would be insolvent.
• UK banks increased their borrowing not to lend to UK house buyers directly, but to buy financial assets which originated in the US housing market.

10.13 The role of banks in the crisis

House prices and bank solvency

The financial crisis was a banking crisis. The banks were in trouble because they had become highly leveraged and were vulnerable to a fall in the value of the financial assets that they had accumulated on their balance sheets (refer back to Figure 10.15 for the leverage of US and UK banks). The values of the financial assets were in turn based on house prices.

With a ratio of net worth to assets of 4%, as in the example of the bank in Figure 10.5, a fall in the value of its assets of an amount greater than this will render a bank insolvent. House prices fell by much more than 4% in many countries in the 2008–09 financial crisis. In fact, the peak-to-trough fall in house price indices for Ireland, Spain, and the US were 50.3%, 31.6%, and 34.6% respectively. This created a problem of solvency for the banks. Just as with the underwater households, banks were in danger of their net worth being wiped out.

To find out more about how they did this, and for more background on how the financial system failed during the crisis, we suggest reading The Baseline Scenario.

Governments rescue banks

Across the advanced economies, banks failed and were rescued by governments.

In Section 10.6, we highlighted the fact that banks do not bear all the costs of bankruptcy. The bank owners know that others (taxpayers or other banks) will bear some of the costs of the banks’ risk-taking activity. So the banks take more risks than they would take if they bore all the costs of their actions. As we shall see in the following unit, excess risk-taking by banks is an example of a negative external effect leading to a market failure.

It arises because of the principal–agent problem between the government (the principal) and the agent (the bank). The government is the principal because it has a direct interest in (and is held responsible for) maintaining a healthy economy, and will bear the cost of bank bailout as a consequence of excessive risk-taking by banks. Governments cannot write a complete set of rules that would align the interests of the banks with those of the government or the taxpayer.

The first row in Figure 10.16 summarizes the principal–agent problem between the government and the banks; the second and third rows review the similar principal–agent problems introduced in Units 6 and 9.

Figure 10.16 Principal–agent problems: The credit market and the labour market.

Banks expend substantial resources lobbying governments to bail them out when they fail. But there are reasons beyond the self-interest of banks to think that the failure of a bank is different from the failure of a typical firm or household and more dangerous to the stability of a capitalist economy. Banks play a central role in the payments system of the economy and in providing loans to households and firms. Chains of assets and liabilities link banks, and those chains had extended across the world in the years before the financial crisis.

Thus, the banking system, like an electricity grid, is a network. The failure of one of the elements in this connected network creates pressure on every other element. Just as happens in an electricity grid, the network effects in a banking system may create a cascade of subsequent failures, as occurred between 2006 and 2008.

Exercise 10.6 Behaviour in the financial crisis

‘The crisis of credit visualized’ is an animated explanation of the behaviour of households and banks in the financial crisis.

Use the models and concepts discussed in this unit to explain the story told in the video.

Question 10.14 Choose the correct answer(s)

Which of the following statements about the principal–agent problem in the banking system are correct?

• The government is the principal and the banks are the agents.
• The principal–agent problem arises because of the interconnectedness of the banking system.
• The result of the principal–agent problem is that banks take on more risk than they otherwise would have.
• The government can solve the principal–agent problem by enforcing stricter banking regulations.

• The government is the principal because it has a direct interest in (and is held responsible for) maintaining a healthy economy, and will bear the cost of bank bailout as a consequence of excessive risk-taking by banks.
• The interconnectedness of the banking system makes it vulnerable to system-wide failures (as in the 2008 crisis), but it is not the source of the principal–agent problem. The problem arises because governments cannot control the level of risks that banks undertake.
• If banks had to face the full costs of their investments, they would take on less risk.
• Even with stricter regulations, governments cannot write a complete set of rules that would align the interests of the banks with those of the government or the taxpayer. Hence governments cannot entirely eliminate the principal–agent problem.

10.14 Banking, markets, and morals

The deregulation of financial markets during the three decades prior to the financial crisis of 2008 not only created an institutional environment vulnerable to instability, it also altered the culture of the banking industry in many countries, changing the social norms and informal rules of moral behaviour that governed the business. In many occupations, such as medicine, professional bodies uphold an expectation of pro-social behaviour and truth-telling among their members. Members are expected to take account of the effects of their actions on others. Banking in the main financial centres of the world was no different.

But support for financial deregulation included the argument that the pursuit of profits on substantially unregulated financial markets alone was sufficient to produce socially beneficial outcomes. And if this is really the case, why not dispense with the traditional social norms among bankers, auditors, and accountants that they should take account of the interests of the debtors, investors, savers, shareholders, customers, and others with whom they interact?

Many accepted the logic that a deregulated market would punish ‘bad’ firms and individuals. ‘Greed is good’, a slogan from a 1987 film, Wall Street, expressed the idea that we can count on markets, not morals to get rid of the ‘bad actors’. This seemed to give bankers license to take advantage of their expertise and access to private information to profit in ways that ultimately contributed to the destabilization of the entire financial system, for example, taking on too much risk, and engaging in misleading if not illegal sales pitches. As a result, deregulation of financial markets contributed to the financial crisis, not only by changing the rules of the game in ways that made bubbles and busts more likely, but it also changed how bankers and others acted, and in ways that exacerbated the crisis.

The transformation of the culture of The City (of London), the hub of the UK financial system and the largest financial centre in the world, illustrates this process.

Deregulation and ‘unethical behaviour’ in the City of London

Prior to deregulation in the so-called ‘Big Bang’ of 1986, The City had a highly developed ethical culture where participants were vetted to ensure they were deemed ‘fit and proper’ to carry out their functions. The system led to the groundless exclusion of many women and ethnic minorities. But individuals, firms, and partnerships that, in the eyes of the leading firms and individuals, didn’t display pro-social preferences could not join the professional networks of The City. Investment bankers depended very much on their reputation, which was developed through long-term relationships with clients and other counterparties within The City. Most banks had centralized, and demanding, inspection regimes which ensured that rules and procedures were strictly followed and clients were served well.14

The City was deregulated progressively over the closing decades of the twentieth century, and by the eve of the global financial crisis, it had embraced the prevailing global banking culture, based on the idea that making profits is not only the bottom line, it is all that matters, as long as markets are competitive. A junior policy advisor to Prime Minister Margaret Thatcher expressed concern about the likely resulting ‘unethical behaviour’ and that financial deregulation could lead to ‘increased risk-taking’ and ‘boom and bust’. Events in The City and around the world proved him correct.15

In the run-up to the financial crisis, a violation of their responsibilities to both customers and shareholders, US issuers and underwriters of mortgage-backed securities (MBSs) bet against them even as they sold them to trusted clients and lied to shareholders about their own MBS holdings. (See the video in Exercise 10.6 for further details). Most of the largest mortgage originators and MBS issuers and underwriters have been implicated in regulatory settlements and have since paid multibillion-dollar penalties. In the UK, Barclays and four former executives have been charged with fraud dating back to 2008.16

To see why trusting the deregulated market to produce socially beneficial effects might have failed, think about a particular firm, hiring staff to sell MBSs to the public. Initially, the firm instils a code of conduct that the sales pitch should inform the potential buyer fully and honestly about the product being sold. But the idea that market competition would be sufficient to discipline sellers led to the adoption of new ways of compensating those selling financial products—pay was closely linked to how much they sold. Because these incentive-based compensation plans rewarded sales without monitoring the pitch or other sales techniques, they could be easily gamed by sellers who cut corners to make the products look safer than they were.

A vicious circle

The problem is a very general one in economics. Just like in an employment contract, these compensation plans for sellers typically cover some aspects of a transaction, like the amounts sold, but cannot cover more subtle aspects, like the degree of honesty in the sales pitch that results in the sale. Even if the firm wishes all customers to be fully informed, the use of such an incentive plan will lead at least some sellers to misinform buyers so as to increase their pay. Ethical traders were disadvantaged under these schemes, as the corner-cutters were able to bring in more sales. The result would be the advancement of the unethical employees within the firm, and perhaps the conversion of some of the ethical traders to less scrupulous methods.

Banks also increasingly took risks, for which the costs of failure would be paid by the owners of other banks (who would become insolvent if one of the banks that owed them money failed), or by tax payers, if governments bailed out ‘too big to fail’ banks.

Why morals as well as markets?

Why is it important that bankers and others in financial markets be guided by morals as well as markets? A headline from a previous financial crisis is a place to start. In the aftermath of the stock market crash of 1987 (the same year that the ‘greed is good’ film was released), the New York Times headlined an editorial, ‘Ban Greed? No: Harness It’, which continued:

Perhaps the most important idea here is the need to distinguish between motive and consequence. Derivative securities attract the greedy the way raw meat attracts piranhas. But so what? Private greed can lead to public good. The sensible goal for securities regulation is to channel selfish behaviour, not thwart it.17

As the housing bubble burst in 2008 and the financial crisis unfolded, many US homeowners found that their properties were worth less than their mortgage obligations to the bank. Some of these ‘underwater owners’ did the maths and strategically defaulted on their loans, sending the bank the keys and walking away. Unlike the New York Times two decades earlier, in 2010 Don Bisenius, then the executive vice president of Freddie Mac, the US Federal Home Loan Mortgage Corporation, made a plea for moral behaviour by homeowners in the economy on the organization’s website. He suggested that, although it might be individually advantageous to default, if default is widespread, communities and future home buyers would be harmed:

While a personal financial strategy might argue for a strategic default, entire communities and future home buyers can be harmed as a result. And that is why our broader social and policy interests will be best served by discouraging strategic defaults.18

Rather than trusting that by getting the prices right the market would induce people to internalize the external effects of their actions, Freddie Mac urged that borrowers considering a strategic default should recognize the damaging impact their actions could have on others. In short, the hope was that morals would do the work of prices.

There was no shortage of moral reasoning on the question. Large majorities of those surveyed held that strategic default is immoral. Yet most defaults were not strategic at all—they were impelled by job loss or other misfortunes. And Freddie Mac’s plea for morality from underwater debtors could not have been very persuasive for those who accused the financial institutions of having double standards. After having pursued their own interests single-mindedly for decades, they now implored home owners to act otherwise when their own house of cards tumbled. Although the main determinant of strategic default was economic—how far underwater the property was—defaulters were supported by others who gave moral reasons, such as predatory and unfair banking practices.

Exercise 10.7 Morals and market failure

Read Section 3.10 (on how monetary incentives backfired at the Haifa daycare centres) and the NY Times editorial ‘Ban Greed? No Harness it’. Consider what Kenneth Arrow, the economist, wrote:

In the absence of trust … opportunities for mutually beneficial cooperation [through market exchange] would have to be forgone … norms of social behavior, including ethical and moral codes (may be) … reactions of society to compensate for market failures.19

Explain how the messages of these three cases differ and describe how the NY Times editors might have modified their editorial had they known about the Haifa experiment or had been convinced by Arrow’s statement above.

Question 10.15 Choose the correct answer(s)

Which of the following statements about morals, markets, and money are correct?

• If markets are competitive, then the economy can function efficiently whatever the preferences of people are, including entirely selfish.
• Monetary incentives (like bonuses or fines) can motivate people to work harder and do a good job; they can also have the opposite effect.
• Moral and ethical preferences, like telling the truth and a strong work ethic, are especially important when contracts are incomplete.
• The heightened competition associated with the deregulation of financial markets make The City and other financial centres operate more efficiently.

• Competition alone will not accomplish efficiency; what is required in addition is that contracts be complete.
• The opposite effect can occur if the incentives crowd out pre-existing ethical commitments to work hard and do a good job (similar to the crowding out in the Haifa daycare experiment).
• Moral and ethical preferences may motivate a person to perform in ways that support mutual gains through exchange, even when this is not covered in a contract.
• The unregulated pursuit of monetary gain allowed practices that were costly both to those interacting with The City, and the eventual instability of the system.

10.15 Conclusion

This unit has explored the workings of a modern-day financial system, explaining how its main actors (commercial banks, the central bank, governments, pension funds, households, and non-bank firms) interact on various stages (including money markets, credit markets, stock exchanges, and bond markets) to buy and sell different types of financial assets. Banks play a key role in the economy, as they create bank money by extending new loans and provide maturity transformation services. These functions, however, expose them to both default risk and liquidity risk, the latter making bank runs possible in the event that many depositors attempt to withdraw their funds at the same time.

As the sole supplier of base money (which banks require for net daily transfers with other banks and to meet demand from depositors), the central bank can set the price of borrowing by choosing the policy interest rate. While the short-term interest rate at which banks borrow and lend in the money market is typically close to the policy rate, the bank lending rate is ordinarily substantially higher. The difference is called the markup or spread on commercial lending and is the basis of the commercial banks’ profits.

Using balance sheets, we have characterized banks as debt-heavy, profit-oriented firms whose interconnectedness, systemic importance to the economy, and political influence sometimes motivate governments to bail them out in the case of insolvency. We have also seen how a high leverage ratio implies that a small change in the value of a bank’s assets will wipe out its equity base. A principal–agent problem arises as the central bank (the principal) would like commercial banks (the agents) to avoid overly risky practices that they may find profitable, given that taxpayers are likely to bear much of the costs of a bailout should insolvency result.

The concept of present value has helped us value assets that provide a stream of income in the future. Furthermore, based on the feasible set and indifference curves of our constrained choice toolkit, we have analysed the trade-off between risk and return, and the important role that the degree of risk aversion (reflected in the slope of the indifference curves) plays in an individual’s choice between risk-free bonds and riskier shares. Wealthier people and those exposed to less risk are less risk averse.

We also showed why share prices can depart substantially from their fundamental value, resulting in bubbles.

A precursor to the global financial crisis was a house-price boom that enabled households to borrow more, based on the increasing value of their collateral (their house). At the same time, financial deregulation allowed banks to increase their leverage, exposing them to greater risk, and generated aggressive competition for customers, including subprime borrowers, many of whom would later default on their mortgages as the housing bubble burst. Overall, the financial crisis has re-emphasized the importance of government regulation of financial markets as well as moral and ethical behaviour as essential preconditions for market mechanisms to produce acceptable outcomes, especially in cases of incomplete contracts.

10.16 Doing Economics: Characteristics of banking systems around the world

In Sections 10.13 and 10.14, we discussed the role of banks in the 2008 global financial crisis. Aside from emphasizing the need for moral and ethical behaviour in the banking system to produce acceptable outcomes, the crisis also highlighted important issues in data collection and measurement, as policymakers lacked good quality, cross-country, and cross-time (so-called ‘time series’) data on financial systems.

In Doing Economics Empirical Project 10, we will use the World Bank’s Global Financial Development Database to explore the following questions:

• How do banking systems around the world differ in size and in the access that they provide to financial services?
• Have banking systems become more stable since the 2008 global financial crisis?

Go to Doing Economics Empirical Project 10 to work on this project.

Learning objectives

In this project you will:

• compare characteristics of banking systems around the world and across time
• use box and whisker plots to identify outliers
• calculate weighted averages and explain the differences between weighted and simple averages
• use confidence intervals to assess changes in the stability of financial institutions before and after the 2008 global financial crisis.

10.17 References

Consult CORE’s Fact checker for a detailed list of sources.

• Bowles, Samuel. 2016. The Moral Economy: Why Good Incentives Are No Substitute for Good Citizens. New Haven, CT: Yale University Press.
• Brunnermeier, Markus. 2009. ‘Lucas roundtable: Mind the frictions’. The Economist. Updated 6 August 2009.
• Cassidy, John. 2010. ‘Interview with Eugene Fama’. The New Yorker. Updated 13 January 2010.
• Fligstein, N., and A. Roehrkasse. 2016. ‘The causes of fraud in the financial crisis of 2007 to 2009’. American Sociological Review 81 (4): pp. 617–43.
• Graeber, David. 2012. ‘The Myth of Barter’. Debt: The First 5,000 years. Brooklyn, NY: Melville House Publishing.
• Harford, Tim. 2012.‘Still think you can beat the market?’. The Undercover Economist. Updated 24 November 2012.
• Jaffer, S., N. Morris, E. Sawbridge, and D. Vines. 2014. ‘How changes to the financial services industry eroded trust’. In Capital Failure: Rebuilding Trust in Financial Services, ed. N. Morris and D. Vines. Oxford: Oxford University Press.
• Kindleberger, Charles P. 2005. Manias, Panics, and Crashes: A History of Financial Crises. Hoboken, NJ: Wiley, John & Sons.
• Lucas, Robert. 2009. ‘In defence of the dismal science’. The Economist. Updated 6 August 2009.
• Malkiel, Burton G. 2003. ‘The efficient market hypothesis and its critics’. Journal of Economic Perspectives 17 (1) (March): pp. 59–82.
• Martin, Felix. 2013. Money: The Unauthorised Biography. London: The Bodley Head.
• New York Times. 1988. ‘Ban greed? No: Harness it’. 20 January: editorial page.
• Pickard, J., and B Thompson. 2014. ‘Archives 1985 & 1986: Thatcher policy fight over “Big Bang” laid bare’. Financial Times. Accessed 7 August 2018.
• Shiller, Robert J. 2003. ‘From Efficient Markets Theory to Behavioral Finance’. Journal of Economic Perspectives 17 (1) (March): pp. 83–104.
• Shiller, Robert J. 2015. Irrational Exuberance, Chapter 1. Princeton, NJ: Princeton University Press.
• The Economist. 2017. ‘Barclays and four former executives are charged with fraud’. 22 June: Finance and Economics section.

Which of the following is not true about huff gravity model?

Which of the following is typically the step after conducting a competitive analysis during site selection?

Which analysis tool compares the local average expenditure by product to the national average amount expended?

What describes the analog method and regression analysis?