FINANCIAL SYSTEMS: HISTORY
AND THEIR ROLE
Hasan Ersel
HIGHER SCHOOL OF ECONOMICS,
MOSCOW
May 20, 2011
I. HISTORY OF FINANCE IN A NUTSHELL
THE BIRTH OF FINANCE
3000 BC: Banking originated in Babylonia: Temples
and palaces were used as safe places for the
storage of valuables. Initially the valuable that can
be deposited was only grain, but later cattle and
precious materials are also included.
In the Sumerian city Uruk in Mesopotamia
(population 10.000) trade was supported by lending.
Interest was paid.
“INTEREST” IN ANCIENT CULTURES
In Sumerian “interest” was mas, which also meant
calf.
In Greece and Egypt the words used for interest
(tokos and ms respectively) also meant “to give
birth”.
In these cultures interest indicates an increase in
something. They seem to consider it from lenders
point of view.
EARLY STATE INTERVENTION TO
FINANCE
• 2250-2150 BC: Cappadocian rulers guaranteed the
weight and purity of silver ingots.
• 1792-1750 BC : Reign of Hammurabi in Babylon (the
capital city of Babylonia). The famous Code of
Hammurabi
includes
laws
governing
banking
operations; e.g. Article 100 on the timely payment of
interest.
• The Babylonians, were accustomed to charge interest at
the rate of 20 per cent per annum. Nearly, if not quite, all
of their contract tablets show this rate of increase.
OLD TASTEMENT AND INTEREST
1300 BC: The Old Testament takes a negative attitude against
interest:
“25
If you lend money to any of my people with you who is poor, you shall not
be him as a creditor, and you shall not exact interest from him. “ The Old
Testament-Exodus 22(25), The Bible, Standard Version, New York:
William Collins, p. 67.
However the following quotation implies that taking
interest is forbidden among Jews, but Jews are allowed
to take interest from others (Gentile):
“19You shall not lend upon interest to your brother, interest on money,
interest on victuals [foodstuff] interest on anything that is lent for interest.
20To a foreigner you may lend upon interest , but to your brother you shall
not lend upon interest…” The Old Testament-Deuteronomy 23(19-20),
The Bible, Standard Version, New York: William Collins, p. 176.
WHY RECEIVING INTEREST FROM
GENTILE IS NOT PROHIBITED FOR
JEWS?
• The reason for the non-prohibition of the receipt by a
Jew of interest from a Gentile, and vice versa, is held by
modern rabbis to lay in the fact that the Gentiles had at
that time no law forbidding them to practice usury; and
that as they took interest from Jews, the Torah
considered it equitable that Jews should take interest
from Gentiles.
• Conditions changed when Gentile laws were enacted
forbidding usury; and the modern Jew is not allowed by
the Jewish religion to charge a Gentile a higher rate of
interest than that fixed by the law of the land.
INTEREST IN HEBREW
• In Hebrew, interest is neshek.
• It also means a bite… Something taken apart…
• In contrast to ancient civilizations “interest is
considered from borrowers point of view.
1200 BC-570 BC
• 1200 BC: Cowrie shell is used as “money” in China.
• 640-630 BC: Lydians started to use coin money. Lydia
was the first place where permanent retail shops
opened. [Herodotus mentioned the use of crude coins in
Lydia in an earlier date, i.e. 687 BC.]
• 600 BC: Pythius became identified as the first banker
that had records. He was operating both in Western
Anatolia and in Greece.
• 600-570 BC: Coin usage became widespread: (1)
Chinese started to use coins made of base metal. The
city-states (2) Aegina (595 B.C.), Athens (575 B.C.) and
Corinth (570 B.C.) started to mint their own coins
VIEWS ON INTEREST IN ANCIENT
GREECE
• 427-348 BC: Platon in his Laws (Book V;
paragraph 742) opposed receiving interest.
• 405 BC: First known statement of the Gresham
Law, i.e. bad money drives out good:
Aristophanes’ The Frogs
• 384-322 BC: Aristotoles in his Politics
(paragraph 1258) characterized interest as the
most unnatural category of earning.
INTEREST AND FINANCE IN ANCIENT
GREECE
• 350 BC: According to Demosthenes in Greece
the interest rate was 10% for ordinary business.
For risky business, such as shipping, lending
rates were between 20-30%.
• 200 BC: The Greek island Delos became the
first financial center.
THE VIEWS ON INTEREST IN THE
ROMAN EMPIRE
• Leading thinkers and statesmen, such as Marcus
Pocius Cato Censorius [Cato the Elder] (234 BC-149
BC) and Marcus Pocius Cato Uicensis [Cato the
Younger] (95 BC-46 BC) as well as Marcus Tallius
Cicero (106 BC-43 BC), Lucius Annaeus Seneca (4
BC-AD 65) and Masterius Plutarch (46 AD-120 AD)
were against usury.
• In Republican Rome (340 BC) interest was outlawed
altogether.[Lex Genucia reforms]
• Under the banner of Julius Caesar, a ceiling on interest
rates of 12% was set, and later under Justinian, it was
lowered even further to between 4% and 8%
JESUS CHRIST AND INTEREST
30 AD: Jesus Christ reacted against usury:
“And
Jesus entered the temple of God and drove out all
who sold and bought in the temple and overturned the
tables of the money changers and the seats of those
who sold pigeons. He said to them “It is written ’My
house shall be called a house of prayer’; but you make it
a den of robbers.”
The New Testament-Mathew 21(12-13), The Bible,
Standard Version, New York: William Collins, p. 21.
MONETARY POLICY IN ROME
• 250 AD: Silver content of Roman coins reduced down to
40%. Inflation in Rome…
• 295 AD: Gresham’s Law proves itself: The almost pure
silver coins issued by Aurelian were driven out by the
old, impure coins… Inflation accelerates…
• 301 AD: Emperor Gaius Aurelius Valerius
Diocletianus (244-311), [commonly known as
Diocletian], introduced direct controls on prices and
wages. This move defeated by markets… First
unsuccessful incomes policy experiment!…
• 305 AD: Diocletian introduced world’s first system of
annual budgets to Rome…
INFLATION AND THE FALL OF ROME
• 307 AD: The value of Denarii (the coin that was
introduced by Diocletian in 301 AD) declined to
half of its original value… One pound of gold is
100.000 Denarii…
• 324 AD: Inflation further accelerates in Rome:
One pound of gold is 300.000 Denarii…
• Then towards 350 AD Denarii loses its value
dramatically: one pound of gold 2 120 000 000
Denarii!!!
• 410 AD: Rome falls to the Visigots… (No wonder
why!!!)
KORAN’s ATTITUTE TOWARDS USURY
AD 610-632: Koran prohibits usury (riba):
“2: 275 Those that live on usury shall rise before Allah
like men whom Satan has demented by his touch; for
they claim that usury is like trading. But Allah has
permitted trading and forbidden usury…” Koran, AlBaqara,
2:275,
translated
by
N.J.
Dawood,
Hammondsworth, Middlesex: Penguin Books, 1974, p.
363.
HINDU AND BUDDHIST VIEWS ON
INTEREST-1
• Vedic texts of Ancient India (2,000-1,400 BC) in
which the “usurer” (kusidin) is interpreted as any
lender at interest. More frequent and detailed
references to interest payment are to be found
• In the later Sutra texts (700-100 BC), as well as the
also made detailed references to interest.
• Vasishtha, a well known Hindu law-maker of that
time, made a special law which forbade the higher
castes of Brahmanas (priests) and Kshatriyas
(warriors) from being usurers or lenders at interest.
HINDU AND BUDDHIST VIEWS ON
INTEREST-2
• In the Buddhist Jatakas (600-400 BC), usury is referred
to in a demeaning manner: “hypocritical ascetics are
accused of practicing it”.
• By the 2nd century AD, however, usury had become a
more relative term, as is implied in the Laws of Manu of
that time: “Stipulated interest beyond the legal rate
being against (the law), cannot be recovered: they call
that a usurious way (of lending)”
• The dilution of the concept of usury seems to have
continued through the remaining course of Indian history
so that today, while it is still condemned in principle,
usury refers only to interest charged above the prevailing
socially accepted range and is no longer prohibited or
controlled in any significant way.
FINANCIAL INNOVATIONS: PAPER
MONEY and FOREIGN EXCHANGE
CONTRACT
• 806-821 AD: In China, Emperor Hien-Tsung is
reigning… Shortage of copper causes emperor to issue
paper money… Chinese liked the idea.
• In 1032 AD there were 16 note-issuing houses in China.
Paper money increased so much that in 1166 China
went into hyperinflation…. In 1455 China abandoned
paper money.
• 1156: First foreign exchange contract: two brothers
borrowed 115 Genoa pounds and agreed to pay 560
bezants in Constantinople one month after their arrival to
the that city.
INTEREST IN CHRISTIANITY-1
• The Church, declared any extra return upon a
loan as against the divine law, and this
prevented any mercantile use of capital by pious
Christians.
• As the canon law1 did not apply to Jews, these
were not liable to the ecclesiastical punishments
which were placed upon usurers by the popes
• ------------------------1Canon
law is the body of laws and regulations made by or adopted by
ecclesiastical authority, for the government of the Christian organization and
its members. It is the internal ecclesiastical (of or relating to the Christian
Church or its clergy) law governing the Roman Catholic Church, the Eastern
and Oriental Orthodox Churches and the Anglican Communion Churches
INTEREST IN CHRISTIANITY-2
• Pope Alexander III, in 1179, having
excommunicated all manifest usurers.
• Christian rulers gradually saw the advantage of
having a class of men like the Jews who could
supply capital for their use without being liable to
excommunication, and the money trade of
western Europe by this means fell into the hands
of the Jews.
EARLY MODERN BANKING IN EUROPE
• Banking in the modern sense of the word can be
traced to medieval and early Renaissance Italy, to
the rich cities in the north like Florence, Venice and
Genoa.
• The Bardi and Peruzzi families dominated banking
in 14th century Florence, establishing branches in
many other parts of Europe.
MEDIEVAL BANKING IN EUROPE
• 1151 The first bank in Venice was established.
• 1255, Orlando Bonsignori formed a consortium
called the Gran Tavola ("Great Table"), which soon
became the most powerful bank in Europe.
• 1345 first bank was established in Geneva
• 1397 The Medici Bank (1397–1494) was created by
the Giovanni Medici in Florance, Italy.
XVth CENTURY DEVELOPMENTS IN
FINANCE (1)
• 1401: Bank of Barcelona founded.
• 1403: The lawyer and theologian Lorenzo di
Antonio Ridolfi won a legal case which led to
legalization of the interest payments by the
Florentine government.
• 1407: Fugars Bank is founded in Augsburg.
• 1407 The earliest known state deposit bank,
Ufficio di San Giorgio in Genoa (Casa di San
Giorgio) was established as a financial institution of
the Republic of Genoa
XVth CENTURY DEVELOPMENTS IN
FINANCE (2)
• 1444: Fatih Sultan Mehmet’s debasement of
“akçe”. He was the first Ottoman Sultan who used
debasement to raise public revenue. [see Pamuk
(1999; Chapter III)]
• 1472 Monte dei Paschi di Siena was established in
Siena, Italy. (Still Operating)
• 1494: First book on double entry bookkeeping is
published in Italy: It is Friar Luca Pacioli’s Summa
di Arithmetica, Geometrica, Proportioni et
Proportionalita…
XVIth CENTURY THOUGHT
ON FINANCE-1
• 1515: John Egk from Bologna University published a
thesis that advocated the freeing certain types of
interest. His research financed by the rulers of Augsburg.
Augsburg was competing with Florence in controlling
trade in that region. Egk was a student of Conrad
Summenhart who advocated the abandonment of
Aristotoles’ views on interest.
• 1526: Nicholas Copernicus published his Treatise on
Debasement. He argued that the buying power of
currency depends on the total number of coins in
circulation rather than the weight of metal they contain.
XVIth CENTURY THOUGHT
ON FINANCE-2
• 1536: John Calvin ended the discussion on
prohibiting interest by arguing that “If I buy a piece
of land, isn’t it still true that money will bear money?”
• [NOTE: Obviously any scholastic can challenge this idea
by pointing out that, what bears money is the land and
labor not money. John Calvin, anyway, won the case -not
because of his intellectual superiority but because of the
support he got from traders and his followers military
superiority] .
XVIth CENTURY DEVELOPMENTS
• 1542-1551: Henry VIII debases the coinage of
England
• 1545: Henry VIII legalizes interest charges on loans
(An upper limit of 10% per annum is set)
• The first English joint stock company is founded
• Queen Elisabeth I recalled the debased coins.
• 1585: Bank of Genoa founded
• 1587:
Banco della Piazza del Rialto, first
government bank in Europe, founded
• 1590 Barenbank was established in Hamburg (Still
operating)
XVIIth CENTURY-1
• 1615: Sir Lionell Cranfield and Mr. Wolstenholme
made the first balance of trade and balance of
payments calculations for England.
• 1661: Bank of Stockholm issued banknotes and
became first chartered bank in Europe to do so.
• 1668: Swedish Parliament established world’s first
central bank: Rikens Ständers Bank (today known
as Svierges Riksbank).
XVIIth CENTURY-2
• 1682:
Sir
William
Petty
published
Quantulumcuque Concerning Money that argues
development of banking is a major stimulus to the
English economy and world trade.
• 1694: Bank of England is established as a quasicentral bank.
XVIIIth CENTURY-1
• 1705: John Law published Money and Trade
Reconsidered and advocated the view that the
banknotes issued and managed by a public bank
would remove the brakes on the economy…
• 1729: Benjamin Franklin published Modest
Inquiry into Nature and Necessity of Paper
Currency. Following that publication, he was
awarded the contract for printing Pennsylvania Land
bank’s third issue of notes.
XVIIIth CENTURY-2
• 1762: Baring Bank was founded (When it went bankrupt
after a scandal in 1995, it was the oldest merchant bank
in Britain)
• 1768: Catherine the Great of Russia established two
state owned banks to finance the war against Ottomans.
The Assignat Bank was entrusted to issue paper money.
• 1776: Adam Smith, in his famous book The Wealth of
Nations defended paper money on the ground that it
stimulated business in Scotland and American colonies.
• 1781 The first American bank, Bank of North America,
was founded.
• 1792: The Dollar is adopted as the money unit in the
United States.
XIXth CENTURY-1
• 1800: Bank de France established as the central
bank of France.
• 1856: Bank-ı Osmani (Ottoman Bank) established.
• 1857: World wide banking crisis started in the USA
(contagion problem)
• 1863: Bank-ı Osmanii Şahane started to play the
role of a central bank
• 1873: The Great Depression in Britain (Continued
until 1885)
XIXth CENTURY-2
• 1875: Deutsche Reichsbank is established as
Germany’s central bank.
• 1882: Nippon Ginkō (Bank of Japan) was
established as Japan’s central bank.
• 1886: Ziraat Bankası was established. (Although
the date for the establishment of the Ziraat Bankası
is given as 1863 it is not exactly correct. That date
refers to the establishment of Menafi Sandıkları,
which were rather simple credit institutions for
farmers.)
• 1890: (First) Baring Bank crisis in England,
Uruguay and Argentina.
FIRST HALF OF XXth CENTURY-1
• 1913: U.S. Federal Reserve System was
established.
• 1923: Inflation in Weimar Germany reached to
3,25x106 %!
• On November 15, 1923 Rentenbank introduced a
new currency, Rentenmark (Security Mark), which
was equal to 1.1 trillion Papiermarks. The
Papiermark was pegged to US Dollar with a parity of
one US$ = 4,2 trillion Papiermarks! (It even climbed
up to 11,7 trillion papiermarks in French occupied
Cologne)]
FIRST HALF OF XXth CENTURY-2
• 1924: Reichmark became the legal tender in
Germany
• 1924: Türkiye İş Bankası was established.
• 1929: Great Depression
• 1930 Bank of International Settlements (BIS) was
founded
• 1931: On October 3, Türkiye Cumhuriyet Merkez
Bankası became operational.
POST II.WW DEVELOPMENTS-1
• 1944: Bretton Wood international monetary
agreements.
• 1947: International Monetary Fund became
operational.
• 1971: United States devalues dollar and gold
convertibility for all currencies ends.
• 1973: The US abandons the gold standard
• 1979: European Monetary System created
POST II.WW DEVELOPMENTS-2
•
•
•
•
•
•
•
1982: Mexican Debt Crisis
1985: Savings and Loan Association Crisis
1991: BCCI scandal- biggest banking fraud
1992: Maastrich Treaty
1994: Financial Crisis in Turkey
1995: Barings Bank fails for a second time.
1997: East Asian Financial Crisis
LAST DECADE-1
• 1998: Russian Financial Crisis
• 1999: Eleven European countries introduced Euro
as an accounting currency
• 2001: Turkish Financial Crisis
• 2002: Euro banknotes and coins are launched
LAST DECADE-2
• 2005: China emerged as a major player in the global
financial system
• 2006: Problems in the US Mortgage Market
• 2007: US Mortgage Crisis and Recession
• 2008-?: Global Economic Crisis
ON THE DANGERS OF BANKING!
"I believe that banking institutions are more
dangerous to our liberties than standing armies. If
the American people ever allow private banks to
control the issue of their currency, first by inflation,
then by deflation, the banks and corporations that
will grow up around the banks will deprive
the people of all property until their children wakeup homeless on the continent their fathers
conquered.“
Thomas Jefferson 1802
MACROFINANCIAL SYSTEM-1
Goods Market
 Goods
Expenditure
Households
Firms
Factors Market
Labor 
 Wages
II. THE ROLE OF THE FINANCIAL
SYSTEM
MACROFINANCIAL SYSTEM-2
Goods Market
 Goods
Expenditure
Households
Firms
Factors Market
Labor 
 Wages
Savings
Investment
MACROFINANCIAL SYSTEM-3
Goods Market
 Goods
Expenditure
Households
Firms
Factors Market
Labor 
 Wages
Savings
Investment
Financial System
STRUCTURE OF THE FINANCIAL
SYSTEM
Financial Markets
Households
Firms
Banks
COMPONENTS OF FINANCIAL SYSTEM
1.
Money
To pay for purchases and store wealth
2.
Financial Instruments
To transfer resources from savers to investors and to transfer risk to those best
equipped to bear it.
3.
Financial Markets
Buy and sell financial instruments
4.
Financial Institutions.
Provide access to financial markets, collect information & provide services
5.
Central Banks
Monitor financial Institutions and stabilize the economy
FINANCIAL MARKETS
• Markets in which funds are transferred from
people who have an excess of available funds to
people who have a shortage of funds.
FUNCTIONS OF FINANCIAL MARKETS
• Perform the essential function of channeling
funds from economic players that have
saved surplus funds to those that have a
shortage of funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which
increases production
• Directly improve the well-being of consumers
by allowing them to time purchases better
STRUCTURE OF FINANCIAL MARKETS
• Debt and Equity Markets
• Primary and Secondary Markets
– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets
• Centralized vs. and Over-the-Counter (OTC) Markets
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital
markets
deal
in
longer-term
debt
equity instruments
and
THE BOND MARKET AND THE INTEREST
RATE
• A security (financial instrument) is a claim on
the issuer’s future income or assets
• A bond is a debt security that promises to make
payments periodically for a specified period of
time
• Interest rate is the cost of borrowing or the price
paid for the rental of funds
THE STOCK MARKET
• Common stock represents a share of ownership
in a corporation
• A share of stock is a claim on the earnings and
assets of the corporation
INTERNATIONALIZATION OF FINANCIAL
MARKETS
• Foreign Bonds—sold in a foreign country and
denominated in that country’s currency
• Eurobond—bond denominated in a currency
other than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited
in banks outside the home country
– Eurodollars—U.S. dollars deposited in foreign
banks outside the U.S. or in foreign branches of
U.S. banks
• World Stock Markets
THE FOREIGN EXCHANGE MARKET
• The
foreign
exchange
price
of
one
currency
another currency
rate
is
the
in
terms
of
• The foreign exchange market is where funds are
converted from one currency into another and
the foreign exchange rate is determined.
BANKING AND FINANCIAL
INSTITUTIONS
• Financial
Intermediaries—institutions
that
borrow funds from people who have saved
and make loans to other people
• Banks—institutions that accept deposits and
make loans
• Other
Financial
Institutions—insurance
companies, finance companies, pension
funds, mutual funds and investment banks
• Financial Innovation—in particular, the advent
of the information age and e-finance
FUNCTION OF FINANCIAL
INTERMEDIARIES: INDIRECT FINANCE
• Lower transaction costs
– Economies of scale
– Liquidity services
• Reduce Risk
– Risk Sharing (Asset Transformation)
– Diversification
• Asymmetric Information
– Adverse Selection (before the transaction)—more likely to select
risky borrower
– Moral Hazard (after the transaction)—less likely borrower will
repay loan
WELL KNOWN (!) “CORE PRINCIPLES”
FROM MICROECONOMICS
1.
2.
3.
4.
Time has value
Risk requires compensation
Information is the basis for decisions
Markets determine prices and allocation
of resources
5. Stability improves welfare
TIME HAS VALUE
– Time affects the value of financial instruments
– Interest payments exist because of time
properties of financial instruments
RISK REQUIRES COMPENSATION
– In a world of uncertainty, individuals will
accept risk only if they are compensated in
some form.
INFORMATION IS THE BASIS FOR
DECISIONS
– The collection and processing of information
is the basis of foundation of the financial
system.
– Information Theory and Economics:
 John Maynard Keynes/Frank Knight
 KennethJ. Arrow
 Joseph E. Stiglitz/Michael Spence/Geoge Akerlof
 Claude Elwood Shannon/Christopeher Sims
MARKETS DETERMINE PRICES AND
ALLOCATE RESOURCES
 Markets are “places” where buyers & sellers
“meet”.
 In a market based system prices (as well as
quantities) are determined by markets.
Therefore markets allocate resources.
STABILITY IMPROVES WELFARE
 A stable economy is believed to reduce risk.
Lowering risk may lead to an improvement in
everyone's welfare.
 Is the competitive market mechanism stable?
Kenneth J. Arrow, Leonid Hurwicz, Frank Hahn
et. al.’s contributions: What they really show?
Stability of the competitive equilibrium or its
general instability?)
MONEY
MONEY AND THE PAYMENTS SYSTEM
1. What is money?
2. How do we use money?
3. How do we measure money?
DEFINITION OF MONEY
Money is an asset that is generally accepted as
payment for goods and services or repayment of
debt.
MONEY: CHARACTERISTICS
1. Means of payment: Used in exchange for
goods & services
2. Unit of account: Used to quote prices
3. Store of value: Used to move purchasing
power into the future
HOW WE PAY FOR THINGS-1
• Commodity Money: Objects with intrinsic value
• Fiat Money: Value comes from government
decree (or fiat)
• Checks: Instructions to the bank to shifts funds
from your account to that of the person or firm
whose name is written in the “Pay to the Order
of” line.
HOW WE PAY FOR THINGS-1
•
•
•
•
•
Credit Cards
Debit Cards
Electronic Funds transfers:
Stored Value Cards
E-Money
CREDIT AND DEBIT CARDS
• Credit cards:
– Deferred payment
– Issuer makes payment for you
– You have to pay it back
• Debit cards:
– Like a check
– Electronic message to your bank to transfer
funds immediately
THE FUTURE OF MONEY
Question: Which function of money will be with
us for a long time?
Answer:
– Means of payment: disappearing
– Unit of account: likely to remain
– Store of value: disappearing
TECHNOLOGICAL ADVANCES AND
PAYMENT METHODS
• Technological advances create new methods of
payment.
• Cell phones and other types of hand-held mobile
devices are providing access to the payments
system.
• What will be next?
MEASURING MONEY
• Changes in the quantity of money are
related to
– Interest Rates
– Economic Growth
– Inflation
• How do we measure money?
DEFINITION OF LIQUIDITY
Liquidity a measure of the ease an asset
can be turned into a means of payment
(Money).
THE LIQUIDITY SPECTRUM
MEASURING MONEY
Different Definitions of money are based upon
degree of liquidity.
M1: Narrowest definition, only most liquid assets
M1 (TURKEY)= Currency in Circulation
+ Sight Deposits
M2: Broader definition ,includes assets, in
general, not used as means of payment.
M2 (TURKEY)= M1+ Time Deposits
MONEY AND BUSINESS CYCLES
• Evidence suggests
important
role
business cycles
that
money plays an
in
generating
• Recessions
(unemployment)
(inflation) affect all of us
and
booms
• Monetary theory ties changes in the money
supply to changes in aggregate economic
activity and the price level
INFLATION
• Inflation: The rate at which the general price
level is increasing over time
• Inflation rate: The measure of the inflation
process
MONEY AND INFLATION
• The general (aggregate) price level is the
average price of goods and services in an
economy
• Question: Asset prices?
• A continual rise in the price level (inflation)
affects all economic players
• Data shows a connection between the money
supply and the price level
CONSUMER PRICE INDEX (CPI)
• The CPI answers the question:
"How much more would it cost for people to
purchase today the same basket of goods and
services that they actually bought at some fixed
time in the past?“
MONEY AND INTEREST RATES
• Interest rate is the price of money
• In the USA prior to 1980, the rate of money
growth and the interest rate on long-term
Treasury bonds were closely tied
• Since then, the relationship is less clear but still
an important determinant of interest rates
MONETARY AND FISCAL POLICY
• Monetary policy is the management of the
money supply and interest rates
– Conducted by the TCMB in Turkey [by the Federal
Reserve Bank (Fed) in the USA]
• Fiscal policy is government spending
and taxation
– Budget deficit is the excess of expenditures over
revenues for a particular year
– Budget surplus is the excess of revenues over
expenditures for a particular year
– Any deficit must be financed by borrowing
III. WHAT IS A BANK? A CLOSER
LOOK
What is robbing a bank compared
to founding one....
Bertold Brecht (1898-1956)
BANK CONCEPT IN A NUTSHELL
A Bank is an institution whose current
operations consist in granting loans and
receiving deposits from the public.
ANALYSIS OF THE DEFINITION
i) “Current”: “Temporary Landing is not counted”
ii) “and”: Mutual Funds only collect “deposits”, they
do not extend loans, instead they hold portfolios,
“finance companies” only lend by issuing equity or
debt instruments.
iii) “public”: Service is given to “general public” and
not to specialists.
BANKING FUNCTIONS
I. Liquidty and Payment Services
i) Money Changing
ii) Payment Services
II. Asset Transformation
i) Convenience of Denomination (unit size)
ii) Quality Transformation (better risk return characteristic)
iii) Maturity Transformation
III. Managing Risk
i) Estimating Risk on Bank Loans
ii) Managing Interest Rate and Liquidity Risk
iii) Off-Balance Sheet Operations
IV. Monitoring and Information Processing
BANKS AND THE REAL ECONOMY
• Do banks really play an important role in an
economy? Are banking services indispensable?
• In order to answer this question one needs to
formulate the working mechanism for an
economy and examine the role of banks in it.
• The general equilibrium approach to the market
economy may serve the purpose.
• This approach was initiated by Leon Walras
(1834-1910) and became a major tool of
economists after the contributions made,
notably,
by Kenneth J. Arrow & Gerard
Debreu in early 1950s.
Leon WALRAS (1834-1910)
Kenneth ARROW (1921)
Gerard DEBREU (1921-2004)
ARROW-DEBREU ECONOMY
1) Consider a two period, competitive economy with three
type of agents: i) consumers, ii) firms and iii) banks.
2) Suppose that there is one physical good which is initially
owned by households. Households can consume
part (or all) of it in the first period or it can be invested
by firms to produce consumption in the second
period.
3) Firms finance their investments either by issuing bonds
(Bf) or through loans (credits) from banks (L-) (Loan
Demand) .
4) Banks finance their loans (L+) (Loan Supply) by
collecting deposits (D-), or issuing bank bonds, (Bb).
5) Households hold their savings (S) either in the form of
bonds (Bh) or deposits (D+) (Deposit Supply).
MARKETS IN AN ARROW-DEBREU
ECONOMY
In this economy there are four markets:
1) Goods Market (Equilibrium Condition: I=S)
2) Deposit Market (Equilibrium Condition: D+= D-)
3) Loan (Credit) Market (Equilibrium Condition L+= L-)
4) Financial Market (Equilibrium Condition Bh= Bf+Bb)
In the (Walras-) Arrow-Debreu framework the general
equilibrium of an economy is achieved when all four
markets are in equilibrium.
Financial Markets
Bh
Bf
Bb
Households
Firms
L+
D+
Banks
D-
L-
CONSUMER-1
Consumer maximizes her utility by allocating her savings
(S) between securities (Bh) and bank deposits (D+).
max u(C1,C2 )
(1)
subject to
C1  Bh  D   1
(2)
C2   f   b  (1  r )Bh  (1  rD )D 
(3)
CONSUMER-2
• Consumer’s instruments are bonds and deposits.
• Her problem is to maximize her utility.
• She will determine optimum levels of bonds and
deposits, given her initial wealth, interest rates and
profits she expects to get at time 2.
CONSUMER-3
U
U
U

( 1) 
(1  r )  0
Bh C1
C2
U
U
U

(

1)

(1  rD )  0
D  C1
C2
from these
U C1
 (1  r )
U C2
U C1
 (1  rD )
U C2
and therefore
r=rD
(4)
FIRM-1
The firm chooses its investment level (I) and its mode of
financing; i.e. by bank credit (L) or through issuing
securities Bf. The firm’s problem is, then, can be
formulated as:
max  f
(5)
 f  f (I )  (1  r )Bf  (1  rL )L
(6)
I  Bf  L
(7)
FIRM-2
 f f
 (1)  (1  r )  0
Bf I
 f f
 (1)  (1  rL )  0
L I
from these two equations we obtain
f
 (1  r )  (1  rL )
I
or
r  rL
(8)
BANK-1
• Bank determines its credit volume (L+), and
finances it through collecting deposits (D-) or
issuing securities (Bb).
max  b
(9)
 b  rLL  rBb  rDD 
(10)
L  Bb  D 
(11)
BANK-2
• Substituting (1) and (11) into (9) and taking derivatives
with respect to D- and Bb, the following two equations are
obtained:
 b
 rL  rD  0

D
 b
 rL  r  0
Bb
from these two equations we get
r  rD
(4)
and
r  rL
(8)
EQUILIBRIUM
•
•
•
•
•
•
By definition in equilibrium all markets clear, i.e.
I=S (Goods market)
D+=D- (Deposit market)
L+=L- (Credit market)
Bh= Bf +Bb (Financial market)
Consider the profit function of a bank in equilibrium.
Using (4) and (8) and equilibrium conditions one gets
ˆb  r (Bb  D  )  rBb  rD  =0
that is in equilibrium, bank profit is zero!
(12)
BANKS IN AN ARROW-DEBREU
ECONOMY:CONCLUSION
•
Moreover, notice that bank decisions have no impact
on other agents, since:
1) Consumers are indifferent between making deposits
and holding securities;
2) Firms also do not make any distinction between
financing themselves by bank credit or through issuing
bonds.
•
Are banks useless?