ISSUES IN THE APPLIED ECONOMICS OF MONEY AND BANKING
Jacek Rostowski
Fall, 1995
Department of Economics
CENTRAL EUROPEAN UNIVERSITY


Course Description

The main purpose of the course is to examine the role of financial intermediaries, and in particular of banks, on the economy. The banking system is the interface where some of the major microeconomic and macroeconomic issues facing economic policy marketing meet.

Intermediaries arise when unintermediated markets cannot function because of some kind of market failure. Financial intermediaries are no exception.

After examining the function of financial markets in the context of capital markets explanations for the existence of financial intermediaries and particularly debt issuing and debt holding intermediaries (including banks), are examined, as is the rationale for the regulation of financial intermediaries and banks in particular. The role of intermediaries in providing the payments system of a modem economy is also considered.

The arguments for bank regulation provide an introduction to macroeconomic impact of bank behaviour, particularly of bank crises, and to the changing nature of bank regulation since the 1930s. This leads on to consideration of the decline of the banking industry since deregulation in the 1980s, as well as of the debate surrounding "commitment" banking and the likely evolution of the "banking economies" of Germany and Japan in the direction of the Anglo-Saxon "market economies".

The role of central banks in supervision and monetary policy and the tools of monetary policy are considered as is the debate regarding the "credit approach" to central bank macroeconomic policy and bank regulation. This leads on to a consideration of "debt deflation" as a cause of business cycles, including credit and equity rationing.

Finally, the evolution of financial and banking systems in post-communist countries will be examined, as will proposals for radical restructuring of the financial system (e.g. narrow banking).

***

The course will consist of lectures and seminars. Students will be required to present a seminar paper on a specific topic relating to the course, to submit this paper after revision, as a term paper and to pass a written 3 hour essay-type exam at the end of the course.

The purpose of this form of assessment is to help develop students' presentational and writing skills, as well as their ability to summarise arguments, cogently and convincingly.

Grading

Term paper 30%
Term examination 70%

SUMMARY OF COURSE

PART ONE: INTRODUCTION.

PART TWO: THE STRUCTURE OF FINANCIAL SYSTEMS.

PART THREE: THEORY OF BANKING - REASONS FOR THE EXISTENCE OF BANKS.

PART FOUR: BANK RUNS AND BANK REGULATION - SOME THEORETICAL ASPECTS.

PART FIVE: OTHER REASONS FOR BANK REGULATION.

PART SIX: THE EVOLUTION OF BANKING REGULATION SINCE THE 1930s.

PART SEVEN: INTEREST RATES, MONEY AND CENTRAL BANKS IN MACROECONOMIC POLICY.

PART EIGHT: BANKING AND THE MONETARY TRANSMISSION MECHANISM.

PART NINE: DEBT DEFLATION.

PART TEN: MONEY AND BANKING IN POST-COMMUNIST ECONOMIES.

PART ELEVEN: PROPOSALS FOR THE RADICAL REFORM OF BANKING SYSTEMS.

PART ONE: INTRODUCTION.

1. Overview of the Course.
2. Introduction: a field in search of a Theory.

PART TWO: THE STRUCTURE OF FINANCIAL SYSTEMS.

1. Wealth accounting.
2. Physical assets, financial assets and capital markets.
3. The function of credit markets.
4. Credit, investment and the banking system.
5. Credit as a short term facilitator of investment.
6. The interaction of bank credit and equity finance.
7. The structure and evolution of debt in the US since 1920.

PART THREE: THEORY OF BANKING - REASONS FOR THE EXISTENCE OF BANKS.

1. Traditional explanations for the existence of banks.
2. Adverse selection and the existence of banks.
3. The ex-post verification problem for shareholders and the existence of banks (the Diamond model).
4. Moral hazard and the Diamond model.
5. The bank - lender relation: why lenders need banks.
6. Firm size and the relevance of the Diamond model.
7. Weaknesses of the asymmetric information explanation for the existence of banks.
8. Firm bankruptcy costs and the existence of banks.
9. Time inconsistency, risk sharing and commitment (the German and Japanese models).

PART FOUR: BANK RUNS AND BANK REGULATION - SOME THEORETICAL ASPECTS.

1. Justifications of bank regulation.
2. Unconvincing arguments for bank regulation.
3. Are banks "high risk institutions"?
4. Causes of bank runs: analysis of the individual bank.
5. Information based runs.
6. Runs on the banking system.
7. A brief history of banking cries in the US during the great depression.
8. Recent bank runs.
9. What the authorities can do about bank runs.
i. lender of last resort.
ii. deposit insurance.
iii. augment the "charter value" of banks.
10. What banks can do to prevent bank runs.
i. suspension of convertibility.
ii. capital asset ratios.
iii. reserve ratios.
iv. borrow on the inter-bank market.
v. private liquidity guarantees.
vi. private deposit insurance.
11. Problems with private and public solutions to the problem of bank runs.

PART FIVE: OTHER REASONS FOR BANK REGULATION.

1. Competition among banks and multiple equilibria.
i. competition on the liabilities side.
ii. competition on the assets side.
2. Double competition.
3. A Neo-Austrian view of banking competition.

PART SIX: THE EVOLUTION OF BANKING REGULATION SINCE THE 1930s.

1. A typology of banking regulation.
2. A short history of regulation of the financial sector and financial innovation.
3. Main mechanisms of regulation during the "Keynesian" period.
4. The erosion of controls since the 1960s and inflation.
5. Inflation and financial innovation.
6. Changes in supply conditions: telecoms and computers.
7. The crisis in bank regulation.
8. The decline of the banking industry.
9. New approaches to banking regulation.
10. Implications of the decline of the banking industry for regulation.
11. The "new regulatory framework".
12. The "optimal location" of regulation.
13. Problems with the "Representation hypothesis" - the UK case.
14. International harmonization in the "New Framework".

PART SEVEN: INTEREST RATES, MONEY AND CENTRAL BANKS IN MACROECONOMIC POLICY.

1. Monetarist and Keynesian transmission mechanisms.
2. The traditional role of interest rates in the Keynesian transmission mechanism.
3. Should central banks control interest rates or the monetary base?
4. How central banks control short-term interest rates.
5. Traditional explanations for the behaviour of yield curves.
6. The perverse effect of international capital mobility on the term structure of interest rates.
7. Other channels for the monetary transmission mechanism.

PART EIGHT: BANKING AND THE MONETARY TRANSMISSION MECHANISM.

1. Credit rationing.
2. Collateral and credit rationing.
3. Credit rationing and the "credit channel" for monetary policy.
4. Conditions for the operation of the credit channel.
5. Empirical evidence for the credit channel and its effects.
6. Equity rationing.
7. Net worth, equity rationing and business cycles.
8. The Greenwald-Stiglitz model and credit rationing.

PART NINE: DEBT DEFLATION.

1. Debt deflation and the Greenwald-Stiglitz model.
2. Unemployment in the Greenwald-Stiglitz model.
3. Anatomy of a debt deflation.
4. Debt deflation vs. sticky wages as explanations for depressions.
5. Debt deflation via the aggregate demand channel.
6. A "correct" measure of the price level for monetary policy purposes.
7. Problems of monetary policy under the "asset price transmission mechanism".
8. Asset prices in the inter-war period in the US.
9. Output targeting - the current UK Treasury approach.


MONEY AND BANKING - SEMINAR TOPICS

1. Should Central Banks supervise the Banking and Financial Systems?
C.A.E. Goodhart "Institutional Separation Between Supervisory and Monetary Agencies" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.
C.A.E. Goodhart "The Regulatory Debate in London" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.

2. Assess the "Representation Hypothesis" of financial supervision.
Dewatripont,M. and Tirole,J. The Prudential Regulation of Banks, 1995.

3. Why has financial liberalization often led to banking crises in middle developped countries?
Sundararajan,V. and Balino,J.T., Banking Crises: Cases and Issues, IMF, 1991.
P.S.Andersen "Economic Growth and Financial Markets: the Experience of Four Asian Countries", Finance and the International Economy: 7, The AMEX BANK Review 1993.

4. Is the US economy more financially fragile today than in the 1950s, and does this matter?
Feldstein,M. ed. The Risk of Financial Crisis, Chicago UP, 1991, Parts I and III.

5. Assess the empirical evidence on the imperfection of capital markets.
Fazzari,S., Hubbard,R. and Petersen,B. (1988) "Financing Constraints and Corporate Investment", Brookings Papers in Economic Activity, I,141-206.
Kashyap,A.,Lamont,O. and Stein,J. (1994) "Credit Conditions and the Cyclical Behaviour of Inventories" Quarterly Journal of Economics.
Devereux,M. and Schiantarelli,F- (1990) "Investment, Financial Factors and Cash Flow: evidence from UK panel data", in Asymmetric Information, Capital Markets and Investment, ed. R. Hubbard, Chicago UP.

6. Does a "pensions overhang" threaten the macroeconomic stability of the developed countries?
E.Phillip Davis "The Development of Pension Funds: an approaching Financial Revolution for Continental Europe" Finance and the International Economy: 7, The AMEX BANK Review 1993.
The World Bank Averting the Old Age Crisis, Oxford UP, 1994.

7. Discuss the monetary controversies of early l9th century England.
A.J.Schwartz "Banking School, Currency School, Free Banking School" in The New Palgrave Dictionary of Economics: Volume on Money, eds. J.Eatwell, M.Millgate and P.Newman, MacMillan, 1989.
D.Laidler "The Bullionist Controversy" in The New Palgrave Dictionary of Economics: Volume on Money, eds. J.Eatwell, M.Millgate and P.Newman, MacMillan, 1989.
R.Green "The Real Bills doctrine" in The New Palgrave Dictionary of Economics: Volume on Money, eds. J.Eatwell, M.Millgate and P.Newman, MacMillan, 1989.

8. Why not private central banking?
C.A.E.Goodhart The Evolution of Central Banks, ICERD Monograph, London School of Economics, 1985.

9. Is there anything to be said for the Bank of England's approach to management of the money supply?
C.A.E.Goodhart Money, Information and Uncertainty, 2nd edition, MacMillan 1989, Chapter X and Appendix to that Chapter.
C.A.E.Goodhart "The Conduct of Monetary Policy" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.
C.A.E.Goodhart "Money Supply Control" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.
C.A.E.Goodhart "The Operational Role of the Bank of England" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.

10. Discuss the arguments for and against the independence of central banks.
C.A.E. Goodhart "Central Bank Independence" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.
A.S.Posen "Why Central bank Independence Does Not Cause Low Inflation: There is no Institutional Fix for Politics", Finance and the International Economy: 7, The AMEX BANK Review 1993.
A.Alesina "Politics and Business Cycles in the Industrial Democracies", Economic Policy, April 1989.

11. How important is the lending channel for macroeconomic policy?
Kashyap,A. and Stein,J. "Monetary Policy and Bank Lending" in G.Mankiw ed. Monetary Policy, Chicago UP, 1994.
Miron,J., Romer,C. and Weil,D. "Historical Perspectives on the Monetary Transmission Mechanism", in G.Mankiw ed. Monetary Policy, Chicago UP, 1994.

12. Discuss the role of the European Central Bank in the context of European Economic and Monetary Union.
C.A.E. Goodhart "The Political Economy of Monetary Union" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.
C.A.E. Goodhart "A European Central Bank" in The Central Bank and the Financial System, C.A.E.Goodhart, 1995.

13. Universal Banking
Allen, F. and Gale, D. (1994). 'A Welfare Comparison of the German and US Financial Systems', LSE Financial Markets Group Discussion Paper, no. 195.
Corbet, J. (1987), 'International Perspectives on Financing: Evidence from Japan', Oxford Review of Economic Policy, 3(4), 30-55.
Corbet, J., Jenkinson, T. J. (1994), 'The Financing of Industry, 1970-89: An International Comparison', CEPR Discussion Paper, No. 948.
Edwards, J. and Fischer, K. (1994), Banks, Finance and Investment in Germany, Cambridge, Cambridge University Press.
Elston, J. (1993), 'Firm Ownership Structure and Investment, Theory and Evidence from German Panel Data', mimeo.
Elston, J. (1994b), 'Ownership and Control of German Corporations', London Business School working paper.
Hoshi, T., Kashyap, A. and Scharfstein, D. (1990a) 'Bank Monitoring and Investment: Evidence from the Changing Structure of Japanese Corporate Banking Relations', in R. G. Hubbard (ed.) Asymmetric Information, Corporate Finance and Investment,
Hoshi, T., Kashyap, A. and Scharfstein, D. (1990b), 'The Role of Banks in Reducing the Costs of Financial Distress in Japan', Journal of Financial Economics, 27, 67-88.
Hoshi, T., Kashyap, A. and Scharfstein, D. (1991), 'Corporate Structure, Liquidity, and Investment: Evidence from Japanese Industrial Groups', Quarterly Journal of Economics, 106, 33-60.
Hoshi, T., Kashyap, A. and Scharfstein, D. (1990), 'Financial Systems, Corporate Finance and Economic Development', in RG. Hubbard (ed.), Asymmetric Information, Corporate Finance and Investment, Chicago, IL, University of Chicago Press.



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Modified: May, 1996

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