1. Banking and the Business Cycle
International Economic Relations
Metropolitan University Prague
Martin Kolmhofer
2012/2013
2. Are Business Cycles avoidable?
• Why is there a sudden general cluster of
business errors?
• Individual entrepreneurial mistakes are
normal
• Where do the peaks come from? Are they
linked to a common cause?
3. Time Preferences
• People usually value the present higher than
the future
• Reasons: Shortness and uncertainty of life - it
takes imagination to visualize the future
(people systematically underestimate future
needs)
• Example: Soldiers before the battle
6. Time Preferences
• Capital (Def: factors of production that were created by people and enhance
our ability to produce output in the future ) comes from Savings
Capital-building requires:
• Sacrifices in the Present Example: breeding cattle rather
• Patience than eating it immediately
• Ability to Set Goals
• Imagination (Future Scenarios)
7. Time Preferences and Interest
Rates
• Time preference determines propensity to save
• People with a high time preference demand a
high compensation to delay current
consumption
• People with a low time preference demand a
relatively low compensation to delay current
consumption
• This compensation is the INTEREST RATE
(= “Price for Savings / Price for Time”)
8. Rate of Interest
• The interest rate links the future to the
present. It allows individuals to evaluate the
value today – the present value – of future
income and cost. In essence, it is the market
price of earlier availability.
9. Time Preferences and Interest
Rates
• Example:
People with a high time preference will only
delay the consumption of 100 blueberries for
a year if they get back 110 blueberries after
one year. INTEREST RATE = 10 %
• People with a lower time preference would be
willing to delay consumption for an additional
5 blueberries. INTEREST RATE = 5 %
10. Time Preferences and Interest Rates
Banks offer a higher interest rate and return to the depositor when there is
certainty over the length of time that the bank can have access to the depositor's
money to re-lend to other borrowers (and therefore make a profit)
11. Rate of Interest
Thought Experiment
• Will rate of interest be high or low if:
1) Asteroid will hit the earth tomorrow? 2) New invention allows humans to live forever?
12. The Interest Rate Mechanism
• Banks are in the ideal position to determine the best
interest rates to pay depositors and to charge borrowers:
• On the lending side they offer the lowest interest rate to
the most secure borrowers (those with the highest ability
to repay the loan)
• For less trustworthy borrowers they charge a higher rate to
compensate for the added risk
13. The Interest Rate Mechanism
• These loan rates then determine how much interest the
bank can pay depositors
• Entire interest rate system fluctuates according to market
conditions. If there are a lot of savings (caused for example
by productivity gains etc…) banks are willing to drop the
rates charged on loans.
• With little need to attract new savings, such an
environment would also lead to lower payments to
depositors, which would discourage savings.
14. The Interest Rate Mechanism
• When there are few savings, banks have to be extra careful
with loans.
• They charge higher rates to borrowers and offer higher
rates to depositors to encourage more savings.
• Higher rates would discourage borrowing and slow
business growth. But the higher rates also encourage
savings. Eventually coffers would build up again and rates
would then start to drop.
15. Natural Rate of Interest
• This cyclical Interest Rate Mechanism
would produce a rate of interest that
stabilizes the market = “Natural Rate of
Interest”
• Knut Wicksell (1851 – 1926)
• The rate of interest at which the
demand for funds and the supply of
savings exactly agree
16. The Interest Rate Mechanism
• ECB Refinancing Rate
The main refinancing rate or minimum bid rate is the interest rate which
banks do have to pay when they borrow money from the ECB. Banks do so
when they are short on liquidities. There is a strong response of interbank
interest rates (like the Euribor) to changes in the ECB refinancing rate.
17. The Interest Rate Mechanism
• EURIBOR
The Euro Interbank Offered Rate (Euribor) is the average interest rate at
which 57 euro area banks are prepared to extend loans to each other in
euro.
18. “Setting Interest Rates” - Price Fixing
• Credit expansion unsupported by savings
• Credit expansion by the banks makes it appear
as if the supply of "saved funds" ready for
investment has increased, for the effect is the
same: the supply of funds for investment
purposes increases, and the interest rate is
lowered.
19. The interest rate as a signal for
entrepreneurs
• The rate of interest tells entrepreneurs whether
a particular investment is worth making or not.
• Low interest rate indicates that people have
enough in the present and want to consume
more in the future
• Entrepreneurs invest especially in “interest-rate
sensitive“ sectors (i.e. housing…).
20. The interest rate as a signal for
consumers
• Low interest rates make saving unattractive –
encourage consumption
• So an artificially low interest rate gives
contradictory signals to entrepreneurs and
consumers:
• For consumers saving does not pay off
anymore – entrepreneurs think that savings
have increased
21. Consequence:
Misallocation of resources
• Goods that come to the market cannot be
purchased because the real savings are not
available
• Ludwig von Mises (1881 – 1973)
• Business Cycles as the inevitable
consequence of excessive growth
in bank credit
23. Example “Out of Gas”
• Driver = Entrepreneur
• Gas = Sum of the resources available in the
economy
• Trip across Desert = Period of Production
• Passengers = Consumers
• Air Conditioning = Present Consumption
• Speed of Bus = Amount of Investment Spending
24. Goods that come to the market cannot be purchased because the real savings are
not available.
26. Continued Credit Expansion?
• Who can benfit? Who gets the money first?
• New money is not distributed evenly (like a
helicopter spreading cash equally to all
citizens)
• Those who get the money first benefit more
than those who get the money last (the latter
have to buy at an already increased price
level)
27. “Hangover” Theory
• Metaphor: The Central Bank’s job is to take away the
punch bowl once the “party gets going”. Otherwise,
later at the party, it will become apparent that too
many guys have planned on taking the same girl
home.
• This means: There are too few resources available
for all the plans to succeed. The most crucial – and
most general – unavailable factor is a continuing flow
of investment funds.
• Such a boom cannot be sustained indefinitely
without eventual price inflation
28. End of the Boom
• Shoe-shine boy phenomenon:
• “When even shoeshine boys are giving you
stock tips, it’s time to sell”
(Joseph P. Kennedy)
29. End of the Boom – 2 Scenarios
1. Inflation: Even if the banks wanted to, they could not
carry on with credit expansion indefinitely, not even if
they were being forced to do so by the strongest
pressure from outside. The continuing increase in the
quantity of money leads to continual price increases.
Inflation can continue only so long as the opinion persists
that it will stop in the foreseeable future. However, once
the conviction gains a foothold that the inflation will not
come to a halt, then a panic breaks out.
2. Deflation: Central Bank has to raise interest rates to fight
inflation. Liquidation of Bad Debt
Inflation benefits debtors, Deflation benfits holders of cash
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