THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
19: Inequality
22: Politics and policy
UNIT 10
BANKS, MONEY, AND THE
CREDIT MARKET
HOW CREDIT, MONEY, AND BANKS EXPAND
OPPORTUNITIES FOR MUTUAL GAIN, AND THE
FACTORS THAT LIMIT THEIR CAPACITY TO
ACCOMPLISH THIS
• People can rearrange the timing of their spending by borrowing,
lending, investing, and saving.
• While mutual gains motivate credit market transactions, there is a
conflict of interest between borrowers and lenders over the rate of
interest, the prudent use of loaned funds, and their repayment.
• Borrowing and lending is a principal–agent relationship, in which the
lender (the principal) cannot guarantee repayment of the loan by the
borrower (the agent) by means of an enforceable contract.
• To solve this problem, lenders often require borrowers to contribute
some of their own funds to a project.
• As a result, people with limited wealth are sometimes unable to secure
loans, or can only do so at higher interest rates.
• 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, and is accepted as payment because others can use it for the
same purpose.
• Banks are profit-maximizing firms that create money in the form of
bank deposits in the process of supplying credit.
• A nation’s central bank creates a special kind of money called legal
tender and lends to banks at its chosen policy interest rate.
• The interest rate charged by banks to borrowers (firms and households)
is largely determined by the policy interest rate chosen by the central
bank.
The market town of Chambar in southeastern Pakistan serves as the finan-
cial centre for 2,400 farmers in surrounding villages. At the beginning of
the kharif-planting season in April, when they sow cotton and other cash
QR code on a market stall
409
collateral An asset that a borrower
pledges to a lender as a security for
a loan. If the borrower is not able
to make the loan payments as
promised, the lender becomes the
owner of the asset.
crops, they will buy fertilizer and other inputs. Months have passed since
they sold the last harvest and so the only way they can buy inputs is to
borrow, promising to repay at the next harvest. Others borrow to pay for
medicines or doctors. But few of them have ever walked through the shiny
glass and steel doors of the JS Bank on Hyderabad Road. Instead, they visit
one of approximately 60 moneylenders.
If they are seeking a first-time loan, they will be questioned intensively
by the moneylender, asked for references from other farmers known to the
lender, and in most cases given a small trial loan as a test of
creditworthiness. The lender will probably visit to investigate the condition
of the farmer’s land, animals, and equipment.
The lenders are right to be wary. If the farmer’s crop fails due to the
farmer’s lack of attention, the lender loses money. Unlike many financial
institutions, lenders do not usually require that the farmer set aside some
property or belongings (called collateral) that would become the lender’s
property if the farmer were unable to repay the loan—for example, some
gold jewelry.
If the would-be first-time borrower looks reliable or trustworthy
enough, he will be offered a loan. In Chambar, this is at an average interest
rate of 78% per annum. If the borrower is paying the loan back in four
months (the growing period of the crop prior to harvest), 100 rupees
borrowed before planting will be paid back as 126 rupees. Knowing that
more than half the loan applications are refused, the borrower would con-
sider himself fortunate.
And indeed he would be, at least compared to some people 12,000 km
away in New York, who take out short-term loans to be repaid when their
next paycheck comes in. These payday loans bear interest rates ranging
from 350% to 650% per annum, much higher than the legal maximum
interest rate in New York (25%). In 2014, the ‘payday syndicate’ offering
these loans was charged with criminal usury in the first degree.
Given the interest rate, is lending in Chambar likely to be exceptionally
profitable? The evidence suggests it is not. Some of the funds lent to farm-
ers are borrowed from commercial banks like the JS Bank at interest rates
averaging 32% per annum, representing a cost to the moneylenders. And
the costs of the extensive screening and collection of the debts further
reduces the profits made by the lenders.
Partly as a result of the careful choices made by the moneylenders,
default is rare: fewer than one in 30 borrowers fail to repay. By contrast,
default rates on loans made by commercial banks are much higher: one in
three. The moneylenders’ success in avoiding default is based on their
accurate assessment of the likely trustworthiness of their clients.
Money and trust are more closely related than you might think.
On 4 May 1970, a notice appeared in the Irish Independent newspaper in
the Republic of Ireland, titled ‘Closure of Banks’. 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 … from 1 May,
until further notice.
Banks in Ireland did not open again until 18 November, six-and-a-half
months later.
Irfan Aleem. 1990. ‘Imperfect
information, screening, and the
costs of informal lending: A study
of a rural credit market in
Pakistan’ (https://tinyco.re/
4382174). The World Bank Eco-
nomic Review 4 (3): pp. 329–349.
Jessica Silver-Greenberg. 2014.
‘New York Prosecutors Charge
Payday Loan Firms with Usury’
(https://tinyco.re/8917188).
DealBook.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
410
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 (£1 equalled 1 Irish
punt at the time) 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.
The Irish bank closures are 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 has to 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 credit or 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,
about £5 billion of cheques were written by individuals and businesses, but
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
Felix Martin. 2013. Money: The
Unauthorised Biography. London:
The Bodley Head.
Antoin E. Murphy. 1978. ‘Money in
an Economy without Banks: The
Case of Ireland’. The Manchester
School 46 (1) (March): pp. 41–50.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
411
money Money is something that
facilitates exchange (called a
medium of exchange) consisting of
bank notes and bank deposits, or
anything else that can be used to
purchase goods and services, and is
generally accepted by others as
payment because others can use it
for the same purpose. The
‘because’ is important and it
distinguishes exchange facilitated
by money from barter exchange in
which goods are directly
exchanged without money
changing hands.
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.
Irish publicans and the moneylenders in the market town of Chambar
would perhaps not recognize, among the many things they had in common,
that they were creating money, and they would not know that in doing so
they were providing a service essential to the functioning of their respective
economies.
Not everyone passes the trustworthiness tests set by pub owners and
moneylenders, of course. And, in Chambar and New York, some of those
who do pay much higher interest rates than others.
10.1 MONEY AND WEALTH
Borrowing and lending money, and the trust that makes this possible, are
about shifting consumption and production over time. The moneylender
offers funds to the farmer to purchase fertilizer now, and he will pay back
after the crop matures, as long as it was not destroyed by a drought. The
payday borrower will be paid at the end of the month but needs to buy food
now. She wants to bring some of her future buying power to the present.
The passage of time is an essential part of concepts such as money,
income, wealth, consumption, savings, and investment.
Money
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,
and is accepted as payment because others can use it for the same purpose.
The ‘because’ is important and it distinguishes exchange facilitated by
money from barter exchange. 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 will be 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.
For money to do its work, almost everyone must believe that if they
accept money from you in return for handing over their good or service,
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. But the Irish
bank closure shows that, when there is sufficient trust among 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.
This is the fundamental characteristic of money. It is a medium of
exchange.
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.
Jonathan Morduch. 1999. ‘The
Microfinance Promise’
(https://tinyco.re/7650659). Journal
of Economic Literature 37 (4)
(December): pp. 1569–1614.
David Graeber. 2012. ‘The Myth of
Barter’ (https://tinyco.re/6552964).
Debt: The First 5,000 years.
Brooklyn, NY: Melville House
Publishing.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
412
wealth Stock of things owned or value of that stock. It includes
the market value of a home, car, any land, buildings, machinery
or other capital goods that a person may own, and any finan-
cial assets such as shares or bonds. Debts are subtracted—for
example, the mortgage owed to the bank. Debts owed to the
person are added.
human capital The stock of knowledge, skills, behavioural
attributes, and personal characteristics that determine the
labour productivity or labour earnings of an individual. Invest-
ment in this through education, training, and socialization can
increase the stock, and such investment is one of the sources of
economic growth. Part of an individual’s endowments. See also:
endowment.
income The amount of profit, interest, rent, labour earnings,
and other payments (including transfers from the government)
received, net of taxes paid, measured over a period of time
such as a year. The maximum amount that you could consume
and leave your wealth unchanged. Also known as: disposable
income. See also: gross income.
earnings Wages, salaries, and other income from labour.
flow A quantity measured per unit of time, such as annual
income or hourly wage.
stock A quantity measured at a point in time. Its units do not
depend on time. See also: flow.
depreciation The loss in value of a form of wealth that occurs
either through use (wear and tear) or the passage of time
(obsolescence).
net income Gross income minus depreciation. See also:
income, gross income, depreciation.
Wealth
One way to think about wealth is that it is the
largest amount that you could consume without
borrowing, after having paid off your debts and
collected any money owed to you—for example if
you sold your house, car, and everything you
owned.
The term wealth is also sometimes used in a
broader sense to include immaterial aspects such
as your health, skills, and ability to earn an income
(your human capital). But we will use the
narrower definition of material wealth in this
unit.
Income
Income is the amount of money you receive over
some period of time, whether from market earn-
ings, investments, or from the government.
Since it is measured over a period of time (such
weekly or yearly), it is a flow variable. Wealth is a
stock variable, meaning that it has no time
dimension. At any moment of time it is just there.
In this unit we only consider after-tax income,
also known as disposable income.
To remember the difference between wealth
and income, think of filling a bathtub, as in Figure
10.1. Wealth is the amount (stock) of water in the
tub, while income is the flow of water into the tub.
The inflow is measured by litres (or gallons) per
minute; the stock of water is measured by litres
(or gallons) at a particular moment in time.
As we have seen, wealth often takes physical
forms such as a house, or car, or office, or factory.
The value of this wealth tends to decline, either
due to use or simply the passage of time.
This reduction in the value of a stock of wealth
over time is called depreciation. Using the
bathtub analogy, depreciation would be the
amount of evaporation of the water. Like income,
it is a flow (you could measure it in litres per year),
but a negative one. So when we take account of
depreciation we have to distinguish between net
income and gross income. Gross income is the
flow into the bathtub (remember that income means disposable or after-tax
income), while net income is this flow less depreciation. Net income is the
maximum amount that you could consume and leave your wealth
unchanged.
10.1 MONEY AND WEALTH
413
consumption (C) Expenditure on
consumer goods including both
short-lived goods and services and
long-lived goods, which are called
consumer durables.
saving When consumption
expenditure is less than net
income, saving takes place and
wealth rises. See also: wealth.
investment (I) Expenditure on
newly produced capital goods
(machinery and equipment) and
buildings, including new housing.
Expenditure
The tub also has an outflow pipe or drain. The flow through the drain is
called consumption expenditure, and it reduces wealth just as net income
increases it.
An individual (or household) saves when consumption is less than net
income, so wealth increases. Wealth is the accumulation of past and current
saving. One form that saving can take is the purchase of a financial asset
such as shares (or stocks) in a company or a government bond. Although in
everyday language these purchases are sometimes referred to as ‘invest-
ment’, in economics, investment means expenditure on capital goods,
which are goods such as machinery or buildings.
The distinction between investment and purchasing shares or bonds is
illustrated by a sole-proprietor business. At the end of the year, the owner
decides what to do with her net income. Out of the net income, she decides
on her consumption expenditure for the year ahead and saves the
remainder. By default, the saving would take the form of bank deposits
since her income would be paid into the bank. With her savings, she could
buy financial assets such as shares or bonds, which provide funds to busi-
nesses or the government. Or, instead, she could spend on new assets to
expand her business, which would be considered an investment.
QUESTION 10.1 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements are correct?
Your material wealth is the largest amount that you can consume
without borrowing, which includes the value of your house, car, fin-
ancial savings, and human capital.
Net income is the maximum amount that you can consume and
leave your wealth unchanged.
In economics, investment means saving in financial assets such as
stocks and bonds.
Depreciation is the loss in your financial savings due to
unfavourable movements in the market.
Wealth
Depreciation
Gross
income
Consumption
Figure 10.1 Wealth, income, depreciation, and consumption: The bathtub analogy.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
414
opportunity cost When taking an
action implies forgoing the next
best alternative action, this is the
net benefit of the foregone
alternative.
QUESTION 10.2 CHOOSE THE CORRECT ANSWER(S)
Mr Bond has wealth of £500,000. He has a market income of £40,000
per year, on which he is taxed 30%. Mr Bond’s wealth includes some
equipment, which depreciates by £5,000 every year. Based on this
information, which of the following statements is correct?
Mr Bond’s disposable income is £40,000.
Mr Bond’s net income is £28,000.
The maximum amount of consumption expenditure possible for Mr
Bond is £23,000.
If Mr Bond decides to spend 60% of his net income on consumption
and the rest on investment, then his investment is £9,200.
10.2 BORROWING: BRINGING CONSUMPTION
FORWARD IN TIME
To understand borrowing and lending we will use feasible sets and indiffer-
ence curves. In Units 3 and 5 you studied how Alexei and Angela make
choices between conflicting objectives such as free time and grades or
bushels of grain. They made choices from the feasible set, based on prefer-
ences described by indifference curves that represented how much they
valued one objective relative to the other.
Here you will see that the same feasible set and indifference curve
analysis applies to choosing between having something now, and having
something later. In earlier units we saw that giving up free time is a way of
getting more goods, or grades, or grain. Now we see that giving up some
goods to be enjoyed now will sometimes allow us to have more goods later.
The opportunity cost of having more goods now is having fewer goods
later.
Borrowing and lending allow us to rearrange our capacity to buy goods
and services across time. Borrowing allows us to buy more now, but
constrains us to buy less later. To see how this works, think about Julia, who
needs to consume now but has no money today. She knows that in the next
period (later) she will have $100 from her paycheck or harvest. Julia’s situ-
ation is shown in Figure 10.2. Each point in the figure shows a combination
of Julia’s capacity to consume things, now and later. We assume that she
spends everything that she has, so each point in the figure gives her con-
sumption now (measured on the horizontal axis) and later (measured on the
vertical axis).
Initially Julia is at the point labelled ‘Julia’s endowment’ in Figure 10.2.
To consume now, Julia is considering taking out a payday loan (or she could
be a farmer borrowing to finance her consumption before she can harvest
and sell her crop).
Julia could, for example, borrow $91 now and promise to pay the lender
the whole $100 that she will have later. Her total repayment of $100 would
include the principal (how much she borrowed) plus the interest charge at
the rate r, or:
10.2 BORROWING: BRINGING CONSUMPTION FORWARD IN TIME
415
interest rate The price of bringing
some buying power forward in
time. See also: nominal interest
rate, real interest rate.
And if ‘later’ means in one year from now, then the annual interest rate, r,
is:
0
23
0
67
100
30 56 70 91
Feasible frontier
(10% interest rate)
Julia’s endowment
Feasible frontier
(78% interest rate)
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.2 Borrowing, the interest rate, and the feasible set.
1. Julia has nothing
Julia has no money now, but she knows
that in the next period she will have
$100.
2. Bringing future income to the
present
Julia could, for example, borrow $91
now and promise to pay the lender the
$100 that she will have later. The
interest rate would be 10%.
3. Borrowing less
At the same interest rate (10%), she
could also borrow $70 to spend now,
and repay $77 at the end of the year. In
that case she would have $23 to spend
next year.
4. Borrowing even less
At the same interest rate (10%), she
could also borrow $30 to spend now,
and repay $33 at the end of the year. In
that case she would have $67 to spend
next year.
5. Julia’s feasible set
The boundary of Julia’s feasible set is
her feasible frontier, shown for the
interest rate of 10%.
6. Julia’s feasible frontier
Juila can borrow now and choose any
combination on her feasible frontier.
7. A higher interest rate
If, instead of 10%, the interest rate is
78%, Julia can only borrow a maximum
of $56 now.
8. The feasible set
The feasible set with the interest rate
of 78% is the dark shaded area, while
the feasible set with an interest rate of
10% is the dark shaded area plus the
light shaded area.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
416
You can think of the interest rate as the price of bringing some buying
power forward in time.
At the same interest rate (10%), she could also borrow $70 to spend now,
and repay $77 at the end of the year, that is:
In that case she would have $23 to spend next year. Another possible com-
bination is to borrow and spend just $30 now, which would leave Julia with
$67 to spend next year, after repaying her loan.
All of her possible combinations of consumption now and consumption
later (($91, $0), ($70, $23) ($30, $67), and so on) generate the feasible
frontier shown in Figure 10.2, which is the boundary of the feasible set
when the interest rate is 10%.
The fact that Julia can borrow means that she does not have to consume
only in the later period. She can borrow now and choose any combination
on her feasible frontier. But the more she consumes now, the less she can
consume later. With an interest rate of r = 10%, the opportunity cost of
spending one dollar now is that Julia will have to spend 1.10 = 1 + r dollars
less later.
One plus the interest rate (1 + r) is the marginal rate of transformation of
goods from the future to the present, because to have one unit of the good
now you have to give up 1 + r goods in the future. This is the same concept
as the marginal rate of transformation of goods, grain, or grades into free
time that you encountered in Units 3 and 5.
But suppose that, instead of 10%, the interest rate is now 78%, the
average rate paid by the farmers in Chambar. At this interest rate Julia can
now only borrow a maximum of $56, because at 78% the interest on a loan
of $56 is $44, using up all $100 of her future income. Her feasible frontier
therefore pivots inward and the feasible set becomes smaller. Because the
price of bringing buying power forward in time has increased, the capacity
to consume in the present has fallen, just as your capacity to consume grain
would fall if the price of grain went up (assuming you are not a producer of
grain).
Of course the lender will benefit from a higher interest rate, as long as
the loan is repaid, so there is a conflict of interest between the borrower
and the lender.
10.3 IMPATIENCE AND THE DIMINISHING MARGINAL
RETURNS TO CONSUMPTION
Given the opportunities for bringing forward consumption shown by the
feasible set, what will Julia choose to do? How much consumption she will
bring forward depends on how impatient she is. She could be impatient for
two reasons:
• She prefers to smooth out her consumption instead of consuming
everything later and nothing now.
• She may be an impatient type of person.
10.3 IMPATIENCE AND THE DIMINISHING MARGINAL RETURNS TO CONSUMPTION
417
diminishing marginal returns to
consumption The value to the indi-
vidual of an additional unit of
consumption declines, the more
consumption the individual has.
Also known as: diminishing mar-
ginal utility.
pure impatience This is a
characteristic of a person who
values an additional unit of con-
sumption now over an additional
unit later, when the amount of con-
sumption is the same now and
later. It arises when a person is
impatient to consume more now
because she places less value on
consumption in the future for
reasons of myopia, weakness of
will, or for other reasons.
IMPATIENCE
Any preference to move consump-
tion from the future to the present.
This preference may be derived
from:
• pure impatience
• diminishing marginal returns to
consumption
Smoothing
She would like to smooth her consumption because she enjoys an addi-
tional unit of something more when she has not already consumed a lot of
it. Think about food—the first few bites of a dish are likely to be much more
pleasurable than bites from your third serving. This is a fundamental
psychological reality, sometimes termed the law of satiation of wants.
More generally, the value to the individual of an additional unit of con-
sumption in a given period declines the more that is consumed. This is
called diminishing marginal returns to consumption. You have already
encountered something similar in Unit 3, in which Alexei experienced
diminishing marginal returns to free time. Holding his grade constant, the
more free time he had, the less each additional unit was worth to him,
relative to how important the grade would be.
Use the analysis in Figure 10.3a to see how Julia can choose her con-
sumption now and later, and how her preferences can be represented by
indifference curves. Diminishing marginal returns to consumption in each
period mean that Julia would like to smooth her consumption, that is, to
avoid consuming a lot in one period and little in the other.
Pure impatience, or how impatient you are as a person
If Julia knows she can have two meals tomorrow but she has none today,
then we have seen that diminishing marginal returns to consumption could
explain why she might prefer to have one meal today and one tomorrow
instead. Note that Julia would opt for the meal now not because she is an
impatient person, but because she does not expect to be hungry in the
future. She prefers to smooth her consumption of food.
But there is a different reason for preferring the good now, called pure
impatience. To see whether someone is impatient as a person, we ask
whether she values a good now more highly than later, when her initial
endowment is having the same amount in both periods. There are two
reasons for pure impatience:
• Myopia (short-sightedness): People experience the present satisfaction of
hunger or some other desire more strongly than they imagine the same
satisfaction at a future date.
• Prudence: People know that they may not be around in the future, and so
choosing present consumption may be a good idea.
To see what pure impatience means, we compare two points on the same
indifference curve in Figure 10.3b. At point A she has $50 now and $50
later. We ask how much extra consumption she would need to have later in
order to compensate her for losing $1 now. Point B on the same indiffer-
ence curve gives us the answer. If she had only $49 now, she would need
$51.50 later in order to stay on the same indifference curve and be equally
happy. So she needed $1.50 later to compensate for losing $1 now. Julia has
pure impatience because rather than preferring to perfectly smooth her
consumption, she places more value on an additional unit of consumption
today than in the future.
The slope of the indifference curve of 1.5 (in absolute value) at point A in
Figure 10.3b means that she values an extra unit of consumption now 1.5
times as much as an extra unit of consumption later.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
418
00
C
F
E
Julia’s indifference curve
Julia’s indifference curve
(higher utility)
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.3a Consumption smoothing: Diminishing marginal returns to
consumption.
1. Julia’s choices
The dashed line shows the combina-
tions of consumption now and
consumption later from which Julia can
choose.
2. Diminishing marginal returns to
consumption
Julia’s indifference curve is bowed
toward the origin as a consequence of
diminishing marginal returns to con-
sumption in each period: the more
goods she has in the present, the less
she values an additional one now
relative to more in the future. The slope
of the indifference curve is the mar-
ginal rate of substitution (MRS)
between consumption now and con-
sumption later.
3. What choices would Julia make?
The MRS at C is high (the slope of her
indifference curve is steep): Julia has
little consumption now and a lot later,
so diminishing marginal returns mean
that she would like to move some con-
sumption to the present. The MRS at E
is low: She has a lot of consumption
now and less later, so diminishing mar-
ginal returns mean that she would like
to move some consumption to the
future. So she will choose a point
between C and E.
4. MRS falls
We can see that the MRS is falling as
we move along the indifference curve
from C to E: the slope is steeper at C
than at E.
5. Julia’s optimal choice
Given the choice shown by the line CE,
Julia will choose point F. It is on the
highest attainable indifference curve.
She prefers to smooth consumption
between now and later.
10.3 IMPATIENCE AND THE DIMINISHING MARGINAL RETURNS TO CONSUMPTION
419
EXERCISE 10.1 THE CONSEQUENCES OF PURE IMPATIENCE
1. Draw the indifference curves of a person who is more impatient than
Julia in Figure 10.3b, for any level of consumption now and consump-
tion later.
2. Draw a set of indifference curves for Julia if she does not experience
diminishing marginal returns to consumption but has pure impatience.
Would she then want to smooth her consumption?
3. Draw a set of indifference curves for Julia if she does not experience
diminishing marginal returns to consumption, has no pure impatience,
and equally cares about consumption now and consumption later.
QUESTION 10.3 CHOOSE THE CORRECT ANSWER(S)
Figure 10.3a (page 419) depicts Julia’s indifference curves for con-
sumption in periods 1 (now) and 2 (later). Based on this information,
which of the following statements is correct?
The slope of the indifference curve is the marginal rate of substitu-
tion between the consumption in the two periods.
The marginal return to consumption in period 1 is higher at E than
at C.
Julia’s consumption is more equal (more ‘smoothed’) at C than at E.
Therefore she prefers consumption choice C to E.
Consuming exactly the same amount in the two periods is Julia’s
most preferred choice.
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
0
50
0
A
B
Julia’s indifference curve
49 50
51.5
Figure 10.3b Pure impatience.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
420
A PERSON’S DISCOUNT RATE
A person’s discount rate, ρ, is a
measure of a person’s impatience:
how much she values an extra unit
of consumption now over an extra
unit of consumption later. This is
the slope of her indifference curve
between consumption now and
consumption later, minus one.
Her discount rate depends on two
factors:
• Her desire to smooth consump-
tion: This is affected by the
situation she is in (the current
distribution of consumption
now and later).
• Her pure impatience as a
person: This is also sometimes
referred to as her subjective
discount rate because it is
based in part on her
psychology.
10.4 BORROWING ALLOWS SMOOTHING BY BRINGING
CONSUMPTION TO THE PRESENT
How much will Julia borrow? If we combine Figures 10.2 and 10.3a we will
have the answer. As in the other examples of a feasible set and indifference
curves, Julia wishes to get to the highest possible indifference curve, but is
limited by her feasible frontier. The highest feasible indifference curve
when the interest rate is 10% will be the one that is tangent to the feasible
frontier, shown as point E in Figure 10.4.
Here, she chooses to borrow and consume $58 and repay $64 later,
leaving her $36 to consume later. We know that at this tangency point, the
slope of the indifference curve is equal to the slope of the feasible frontier
(otherwise the curves would cross). We define a person’s discount rate, ρ
(economists use the Greek letter rho, which rhymes with ‘toe’), as the slope
of the indifference curve minus one, which is a measure of how much Julia
values an extra unit of consumption now, relative to an extra unit of con-
sumption later.
For example, in Figure 10.3b, ρ = 50% at point A because an extra unit of
consumption today was worth 1.5 extra units later. This means that Julia
borrows just enough so that:
We know that:
So:
If we subtract 1 from both sides of this equation we have:
Her discount rate ρ depends on both her desire to smooth consumption and
on her degree of pure impatience.
Use the analysis in Figure 10.4 to see how Julia will choose consumption
when the interest rate is 10% and when it is 78%.
EXERCISE 10.2 INCOME AND SUBSTITUTION EFFECTS
1. Use Figure 10.4 (page 422) to show that the difference in current con-
sumption at the lower and higher interest rate (at E and G), namely $23,
is composed of an income effect and a substitution effect. It will be
helpful to review income and substitution effects from Unit 3 before
doing this.
2. Why do the income and substitution effects work in the same direction
in this example?
10.4 BORROWING ALLOWS SMOOTHING
421
QUESTION 10.4 CHOOSE THE CORRECT ANSWER(S)
Figure 10.4 depicts Julia’s choice of consumptions in periods 1 and 2.
She has no income in period 1 (now) and an income of $100 in period 2
(later). The current interest rate is 10%. Based on this information,
which of the following statements is correct?
At F, the interest rate exceeds Julia’s discount rate (degree of
impatience).
At E, Julia is on the highest possible indifference curve given her
feasible set.
E is Julia’s optimal choice, as she is able to completely smooth out
her consumption over the two periods and consume the same
amount.
G is not a feasible choice for Julia.
0
38
0
100
35 56 58 91
FF (10% interest rate)
FF (78% interest rate)
E
G
Julia’s
endowment
36
F
Julia’s IC (lower utility)
Julia’s IC (through point F)
Julia’s IC
Julia’s IC (higher utility)
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.4 Moving consumption over time by borrowing.
1. Julia’s feasible frontier
Julia wishes to get to the highest
indifference curve but is limited by her
feasible frontier.
2. Julia’s best option
When the interest rate is 10%, the high-
est attainable indifference curve will
be the one that is tangent to the feas-
ible frontier shown as point E.
3. MRS and MRT
At this point, MRS = MRT.
4. The decision to borrow
At point F, her discount rate, ρ, exceeds
r, the interest rate, so she would like to
bring consumption forward in time.
Similar reasoning eliminates all points
on the feasible frontier except E.
5. An increase in the interest rate
If the interest rate at which she can
borrow increases, the feasible set gets
smaller.
6. The effect of a higher interest rate
The best Julia can do now is to borrow
less ($35 instead of $58), as shown by
point G.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
422
reservation indifference curve A
curve that indicates allocations
(combinations) that are as highly
valued as one’s reservation option.
10.5 LENDING AND STORING: SMOOTHING AND
MOVING CONSUMPTION TO THE FUTURE
Now think about Marco, an individual facing a different situation from
Julia who was considering a payday loan, or a farmer in Chambar seeking a
loan until the harvest. While Julia is deciding how much to borrow, Marco
has some goods or funds worth $100, but does not (yet) anticipate receiving
any income later. Julia and Marco will both get $100 eventually, but time
creates a difference. Marco’s wealth, narrowly defined, is $100. Julia’s
wealth is zero.
We saw that Julia, who will earn $100 in the future, wants to borrow.
The situation that she is in gives her a strong desire to smooth by borrow-
ing. Think about what Julia’s indifference curve, passing through her
endowment point, might look like. As shown in Figure 10.5, it is very steep.
Because she currently has nothing, she has a strong preference for
increasing consumption now.
This is called Julia’s reservation indifference curve, because it is made
of all of the points at which Julia would be just as well off as at her reserva-
tion position, which is her endowment with no borrowing or lending
( Julia’s endowment and reservation indifference curves are similar to those
of Angela, the farmer, in Unit 5).
Look at Marco’s indifference curve passing through his endowment
point, which is $100 now and nothing later. As shown in Figure 10.5, it is
quite flat now, indicating that he is looking for a way to transfer some of his
consumption to the future.
Marco and Julia’s indifference curves and hence their pure impatience
are similar. They differ according to their situation, not their preferences.
Julia borrows because she is poor in the present, unlike Marco, and that is
why she is impatient—she needs to smooth her consumption.
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
0
0
100
100
Julia’s
endowment
Marco’s endowment
Julia’s reservation IC
Marco’s reservation IC
Figure 10.5 Reservation indifference curves and endowments.
10.5 LENDING AND STORING
423
Marco has $100 worth of grain just harvested, and no debts to pay off.
He could consume it all now, but as we have seen, this would probably not
be the best he could do given the circumstances:
• We have assumed his income in the future is zero.
• Like Julia, he has diminishing marginal returns to consumption of grain.
In order to smooth, he wishes to move some goods to the future. He could
store the grain, but if he did, mice would eat some of it. Mice are a form of
depreciation. The grain they eat represents a reduction in Marco’s wealth
due to the passage of time. So, taking account of the mice, if he consumed
nothing at all during this period he would have just $80 worth of grain a
year later. This means that the cost of moving grain from the present to the
future is 20% per year.
In Figure 10.6, we see that Marco’s endowment is on the horizontal axis,
as he has $100 of grain available now. The dark line shows Marco’s feasible
frontier using storage, and the dark shaded area shows his feasible set. If
this were the only option, and if his indifference curves were as indicated,
he would definitely store some of the grain. In Figure 10.6, some part of his
feasible frontier lies outside his endowment indifference curve, so he can
do better by storing some grain.
But how much? Like Julia, Marco will find the amount of storage that
gets him to the highest feasible indifference curve by finding the point of
tangency between the indifference curve and the feasible frontier. This is
point H, so he will eat $68 of the grain now, and consume $26 of it later
(mice ate $6 of the grain). At point H, Marco has equated his MRS between
consumption now and in the future to the MRT, which is the cost of
moving goods from the present to the future.
He could avoid the mice by selling the grain and putting $100 under his
mattress. His feasible frontier would then be a straight line (not shown)
from consumption now of $100, to consumption later of $100. We are
assuming that his $100 note will not be stolen and that $100 will purchase
the same amount of grain now and later because there is no inflation (we
explain inflation, and its effects, in Unit 13). Under these assumptions,
storing money under the mattress is definitely better than storing grain
when there are mice.
A better plan, if Marco could find a trustworthy borrower, would be to
lend the money. If he did this and could be assured of repayment of $(1 + r)
for every $1 lent, then he could have feasible consumption of 100 × (1 + r)
later, or any of the combinations along his new feasible consumption line.
The light line in Figure 10.6 shows the feasible frontier when Marco lends
at 10%. As you can see from the figure, compared to storage or putting the
money under his mattress, his feasible set is now expanded by the oppor-
tunity to lend money at interest. Marco is able to reach a higher
indifference curve.
As we have seen, in a contemporary economy, there are a variety of fin-
ancial instruments that Marco can use to shift consumption to the future by
lending such as term deposits, or bonds issued by companies or by the gov-
ernment.
If Marco faced an investment opportunity that meant he could invest his
asset today and have it be worth more in a year—for instance, if he owns
land where he could use the grain as seed and cultivate more grain—then
that would similarly expand his feasible set.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
424
•10.6 INVESTING: ANOTHER WAY TO MOVE
CONSUMPTION TO THE FUTURE
If Marco owns some land, he could do even better. He could invest the
grain (planting it as seed and feeding it to his draft animals to help him
work the fields until harvest). This opportunity to invest will further
expand his feasible set. Suppose that if he were to invest all of his grain, he
could harvest $150 worth of grain later, as shown in Figure 10.7. He has
invested $100, harvested $150, and so earned a profit of $150 − $100 = $50,
or a profit rate (profits divided by the investment required) of $50/$100 =
50%. The slope of the red line is −1.5, where the absolute value (1.5) is the
marginal rate of transformation of investment into returns, or 1 plus the
rate of return on the investment.
If Marco could get a loan at 10%, he would quickly see that he would be
better off with an entirely new plan: invest everything he has, with a harvest
next year of $150, but also borrow now in order to be able to consume
more both now and in the future. This ‘invest-it-all’ plan is shown in
0
39
0
110
65 68 100
FF (store grain; 20% losses)
FF (lend at 10%)
J
26
Marco’s IC (low utility)
Marco’s endowment
Marco’s IC (medium utility)
80
H
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
MRS = MRT
Figure 10.6 Smoothing consumption by storing and lending.
1. Marco has wealth today
Marco has $100 of grain available now.
2. Marco’s feasible frontier
The dark line shows Marco’s feasible
frontier using storage, and the shaded
area shows his feasible set.
3. Marco’s preferences
Marco’s reservation indifference curve
goes through his endowment.
4. Marco’s decision to store
Point H on Marco’s indifference curve
denotes the amount of storage that he
will choose.
5. Marco’s decision to lend
The light line shows the feasible
frontier when Marco lends at 10%.
6. The effect of the decision to lend
Marco is now able to reach a higher
indifference curve.
10.6 INVESTING: ANOTHER WAY TO MOVE CONSUMPTION TO THE FUTURE
425
Figure 10.8. The plan shifts Marco’s feasible frontier out even further, as
shown by the dotted red line. Marco ends up consuming at a new point, L,
with more both now and in the future.
Figure 10.9 summarizes how the ‘invest-it-all and borrow’ plan works
compared to the other options.
The feasible sets for all of Marco’s options are shown in Figure 10.10.
Let’s return to how Marco differs from Julia. Compare the feasible sets
of Julia shown in Figure 10.4 and of Marco, whose options are shown in
Figure 10.10.
Three differences between Marco and Julia explain the disparity in their
outcomes.
• Marco starts with an asset while Julia starts with nothing: Julia has the
prospect of a similar asset later, but this puts the two on opposite sides
of the credit market.
• Marco has a productive investment opportunity while Julia does not.
• Marco and Julia may face different interest rates: The less-obvious differ-
ence is that if Marco (after investing his entire asset at a 50% return)
0
60
0
150
60 100
FF (invest grain; 50% return)
K
Marco’s IC
Marco’s endowment
Consumption now Investment
Co
ns
um
pt
io
n
la
te
r
1
1.5
MRS = MRT
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.7 Investing in a high-return project.
1. The return on investment
If Marco were to invest all of his grain,
he could harvest $150 worth of grain
later.
2. The return on investment
The slope of the red line is −1.5, where
the absolute value (1.5) is 1 plus the
rate of return on the investment.
3. Marco’s optimal choice
Marco chooses to consume $60 now
and $60 later, as shown by point K. At
this point, the feasible frontier is
tangent to an indifference curve.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
426
wants to move his buying power forward in time, he borrows against his
future income at a rate of 10%. Julia, lacking assets like the poor farmers
in Chambar, may have no alternative but to borrow at the higher rate of
78%. The paradox is that Marco can borrow at a low interest rate because
he does not need to borrow.
0
60
0
150
60 100 136
FF (invest grain; 50% return)
FF (invest grain; 50% return; borrow at 10%)
K
Marco’s IC
(high utility)
Marco’s IC
(very high utility)
Marco’s
endowment
Consumption now
Investment
Co
ns
um
pt
io
n
la
te
r
Re
pa
ym
en
t o
f l
oa
n
62
80
L
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.8 Borrowing to invest in a high-return project.
Plan (points in Figures
10.6 and 10.8)
Rate of return or
interest
Consumption now,
consumption later
Investment Ranking by utility (or combined
consumption)
Storage (H) −20% (loss) $68, $26 n/a Worst ($94)
Lending only (J) 10% $65, $39 n/a Third best ($104)
Investment only (K) 50% $60, $60 $40 Second best ($120)
Investment and
borrowing (L)
50% (investment), −10%
(lending)
$80, $62 $100 Best ($142)
Figure 10.9 Storage, lending, investment, and borrowing provide Marco with many
feasible sets.
1. Marco’s optimal choice when he can
invest
His optimal choice when he can invest
is at point K.
2. Marco gets a loan
If he could get a loan at 10%, he would
be better off by investing everything he
has. This expands his feasible set, as
shown by the dotted red line.
3. Optimal choice after getting a loan
Marco ends up consuming at point L,
with $80 now and $62 in the future.
10.6 INVESTING: ANOTHER WAY TO MOVE CONSUMPTION TO THE FUTURE
427
To summarize, borrowing, lending, storing, and investing are ways of
moving goods consumption forward (to the present) or backwards (to the
future) in time.
People engage in these activities because:
• They can increase their utility by smoothing consumption: Or, if they have
pure impatience, by moving consumption to the present.
• They can increase their consumption in both periods: By lending, or
investing.
People differ in which of these activities they engage (some borrowing,
some lending) because:
• They have differences in their situation: For example, having an income
now or later will affect their discount rates and their opportunities. Also,
some have investment opportunities (like Marco), while others do not.
• They differ in their level of pure impatience.
EXERCISE 10.3 AN INCREASE IN THE INTEREST RATE
1. Use a diagram like Figure 10.4 (page 422) to show the income and the
substitution effects of an increase in the interest rate for Marco who
receives his endowment today.
2. Compare these effects with those for Julia in Exercise 10.2 and explain
your results.
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
0
60
0
150
60 65 68 100 136
FF (lend at 10%)
FF (invest grain; 50% return; borrow at 10%)
K
Lending
Storing
Investing it all and borrowing
Marco’s
endowment
62
80
L
26
39
H
J
80
110
FF (store grain; 20% losses)
FF (invest grain; 50% return)
Investing
Figure 10.10 Options for the individual (Marco) who starts with assets.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
428
EXERCISE 10.4 LIFETIME INCOME
Consider an individual’s income over his or her lifetime from leaving
school to retirement. Explain how an individual may move from a situation
like Julia’s to one like Marco’s over the course of their lifetime (assume
that their pure impatience remains unchanged over their lifetime).
QUESTION 10.5 CHOOSE THE CORRECT ANSWER(S)
Figure 10.6 (page 425) depicts Marco’s choice of consumption in
periods 1 (now) and 2 (later). He has $100 worth of grain in period 1
and no income in period 2. Marco has two choices. In scheme 1, he can
store the grain that he does not consume in period 1. This results in a
loss of 20% of the grain due to pests and rotting. In scheme 2, he can
sell the grain that he does not consume and lend the money at 10%.
Based on this information, which of the following statements is
correct?
With scheme 1, if Marco consumes $68 worth of grain in period 1, he
can consume $32 worth of grain in period 2.
With scheme 2, if Marco consumes $68 worth of grain in period 1, he
can consume $35 worth of grain in period 2.
The marginal rate of transformation is higher under scheme 1 than
under scheme 2.
Marco will always be on a higher indifference curve under scheme 2
than under scheme 1.
QUESTION 10.6 CHOOSE THE CORRECT ANSWER(S)
Figure 10.10 (page 428) depicts four possible feasible frontiers for
Marco, who has $100 worth of grain in period 1 (now) and no income in
period 2 (later). In scheme 1, he can store the grain that he does not
consume in period 1. This results in 20% loss of the grain due to pests
and rotting. In scheme 2, he can sell the grain that he does not con-
sume and lend the money at 10%. In scheme 3, he can invest the
remaining grain (for example by planting it as seed) for a return of
50%. Finally in scheme 4, he can invest the entire amount of grain and
borrow against his future income at 10%. Based on this information,
which of the following statements is correct?
20% depreciation from storage means that Marco is worse off at H
than at his initial endowment of consuming all $100 worth of grain
in period 1.
The consumption choice J can only be attained under scheme 2.
If the rate of lending increases, the feasible frontier for scheme 2
tilts inwards from the point 100 on the horizontal axis (becomes
flatter).
If the rate of borrowing increases, the feasible frontier for scheme 4
tilts inwards from the point 150 on the vertical axis (becomes
steeper).
10.6 INVESTING: ANOTHER WAY TO MOVE CONSUMPTION TO THE FUTURE
429
balance sheet A record of the
assets, liabilities, and net worth of
an economic actor such as a house-
hold, bank, firm, or government.
asset Anything of value that is
owned. See also: balance sheet,
liability.
liability Anything of value that is
owed. See also: balance sheet,
asset.
net worth Assets less liabilities. See
also: balance sheet, equity.
10.7 ASSETS, LIABILITIES, AND NET WORTH
We will see that a person’s wealth is an important aspect of their situation
in the process of borrowing, lending, and investing, and that those with
more wealth like Marco have opportunities not available to those with less
wealth, like Julia. Balance sheets are an essential tool for understanding
how wealth changes when an individual or a firm borrows and lends.
A balance sheet summarizes what the household or firm owns, and what
it owes to others. What you own (including what you are owed by others) is
called your assets, and what you owe others is called your liabilities (to be
liable means to be responsible for something, in this case to repay your
debts to others). The difference between your assets and your liabilities is
called your net worth. The relationship between assets, liabilities, and net
worth is shown in Figure 10.11.
When the components of an equation are such that by definition, the
left-hand side is equal to the right-hand side, it is called an accounting
identity, or identity for short. The balance sheet identity states:
Net worth is accumulated savings over time. We can also turn the identity
around by subtracting liabilities from both sides, so that:
In the bathtub analogy, the water in the bathtub represents wealth as accu-
mulated savings, and is the same as net worth. As we saw, net worth or wealth
increases with income, and declines with consumption and depreciation. For
a household, income increases bank deposits, while consumption is paid with
bank deposits. Because bank deposits are an asset for their owner, these
operations affect the asset side of the household’s balance sheet.
But your wealth or net worth does not change when you lend or borrow.
This is because a loan creates both an asset and a liability on your balance
sheet: if you borrow money you receive cash as an asset, while the debt is an
equal liability.
Assets
Liabilities
=
Net worth
Figure 10.11 A balance sheet.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
430
Julia started off with neither assets nor liabilities and a net worth of
zero, but on the basis of her expected future income she borrowed $58
when the interest rate was 10% (point E in Figure 10.4). At this time her
asset is the $58 in cash that she is holding, while her liability is the loan that
she has to pay back later. We record the value of the loan as $58 now, since
that is what she received for getting into debt (her liability rises to $64 later
only once interest has been added). This is why taking out the loan has no
effect on her current net worth—the liability and the asset are equal to one
another, so her net worth remains unchanged at zero. In Figure 10.12 this is
recorded in her balance sheet under the heading ‘Now (before consuming)’.
She then consumes the $58—it flows out through the bathtub drain, to
use our earlier analogy. Since she still has the $58 liability, her net worth
falls to –$58. This is recorded in Figure 10.12 in her balance sheet under
the heading ‘Now (after consuming)’.
Later, she receives income of $100 (an inflow to the bathtub). Also,
because of accumulated interest, the value of her loan has risen to $64. So
her net worth becomes $100 – $64 = $36. Again, we suppose that she then
consumes the $36, leaving her with $64 in cash to pay off her debt of $64.
At this point her net worth falls back to zero. The corresponding balance
sheets are also shown in Figure 10.12.
Now – before consuming
Julia's assets Julia's liabilities
Cash $58 Loan $58
Net worth = $58 − $58 = $0
Now – after consuming
Julia's assets Julia's liabilities
Cash 0 Loan $58
Net worth = −$58
Later – before consuming
Julia's assets Julia's liabilities
Cash $100 Loan $64
Net worth = $100 − $64 = $36
Later – after consuming
Julia's assets Julia's liabilities
Cash $64 Loan $64
Net worth = 0
Figure 10.12 Julia’s balance sheets.
10.7 ASSETS, LIABILITIES, AND NET WORTH
431
QUESTION 10.7 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts Julia’s choice of consumption in periods
1 (now) and 2 (later) when the interest rate is 78%. She has no income
in period 1 and an income of $100 in period 2. She chooses the con-
sumption choice G. Based on this information, which of the following
statements regarding Julia’s balance sheet is correct?
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
0
38
0
100
35 56
G
Julia’s indifference curve
(lower utility)
Feasible consumption frontier
(78% interest rate)
Julia’s
status quo
The asset after borrowing but before consumption in period 1 is 56.
The net worth after consumption in period 1 is 0.
The liability before consumption in period 2 is 35.
The asset after consumption but before repaying the loan in period
2 is 62.
••10.8 BANKS, MONEY, AND THE CENTRAL BANK
Among the moneylenders in Chambar, the profitability of their lending
business depends on:
• the cost of their borrowing
• the default rate on the loans they extended to farmers
• the interest rate they set
The closure of Irish banks for six months revealed how money can be
created in an economy and how it depends on trust.
These case studies and the two-period model provide much of what we
need in order to understand the role of the financial system in the economy.
But we must introduce two more actors on the economic stage: banks and
the central bank.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
432
bank A firm that creates money in
the form of bank deposits in the
process of supplying credit.
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.
central bank The only bank that
can create base money. Usually
part of the government.
Commercial banks have accounts
at this bank, holding base money.
Abacus Bank's assets Abacus Bank's liabilities
Base money $100 Payable on demand to Marco $100
Figure 10.13a Marco deposits $100 in Abacus Bank.
Abacus Bank's assets Abacus Bank's liabilities
Base money $80 Payable on demand to Marco $80
Bonus Bank's assets Bonus Bank's liabilities
Base money $20 Payable on demand to Gino $20
Figure 10.13b Marco pays $20 to Gino.
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 allows banks to
make profits.
To explain this process, we first have to explore in more detail the
concept of money.
We saw that anything that is accepted as payment can be counted as
money. But money in this sense is different from legal tender, which is also
called base money or high-powered money. Unlike bank deposits or
cheques, legal tender has to be accepted as payment by law. It comprises
cash (notes and coins) and accounts 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 house-
holds 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 legal tender issued by the central
bank, but instead is created by commercial banks when they make loans.
We explain using bank balance sheets.
Unlike our earlier example in which a bank deposit arises from a loan,
let us suppose in this case that Marco has $100 in cash and he puts it in a
bank account in Abacus Bank. Abacus Bank will put the cash in a vault, or it
will deposit 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 10.13a.
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 paying Gino using a debit card). This is shown on
the balance sheets of the two banks in Figure 10.13b: Abacus Bank’s assets
and liabilities both go down by $20, while Bonus Bank’s assets are increased
by this addition of $20 of base money, and its liabilities increase by $20
payable on demand to Gino.
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.
10.8 BANKS, MONEY, AND THE CENTRAL BANK
433
Bonus Bank's assets Bonus Bank's liabilities
Base money $20
Bank loan $100
Total $120
Payable on demand to Gino $120
Figure 10.13c Bonus Bank gives Gino a loan of $100.
Abacus Bank's assets Abacus Bank's liabilities
Base money $90 Payable on demand to Marco $90
Bonus Bank's assets Bonus Bank's liabilities
Base money $10
Bank loan $100
Total $110
Payable on demand to Gino $110
Figure 10.13d Gino pays Marco $10.
This illustrates the payment services provided by banks. So far we have just
considered transactions using base money, or legal tender. We now show
how banks create money in the process of making loans.
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. 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 it is owed by Gino,
and its liabilities have grown by the $100 it has credited to his bank
account, shown in Figure 10.13c.
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.
Base money remains essential, however, partly because customers some-
times take out cash, but also because when Gino wants to spend his loan,
his bank has to transfer base money. Suppose Gino employs Marco to work
in his shop, and pays him $10. Then Bonus Bank has to transfer $10 of base
money from Gino’s bank account to Marco’s bank account in Abacus Bank.
This transaction is shown in Figure 10.13d.
In practice, banks make many transactions to one another in a given day,
most cancelling each other out, and they settle up at the end of each day. So
at the end of each day, each bank will transfer or receive the net amount of
transactions they have made. This means they do not need to have available
the legal tender to cover all transactions or demand for cash.
Note that if Marco and Gino were customers of the same bank, there
will be no loss of base money. This is one reason why banks fight to get a
larger share of deposits.
Because of the loan, the total ‘money’ in the banking system has grown,
as Figure 10.13e shows.
Creating money may sound like an easy way to make profits, but the
money banks create is a liability, not an asset, because it has to be paid on
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
434
Abacus Bank and Bonus Bank's assets Abacus Bank and Bonus Bank's liabilities
Base money $100
Bank loan $100
Total $200
Payable on demand $200
Figure 10.13e The total money in the banking system has grown.
maturity transformation The practice of borrowing money
short-term and lending it long-term. For example, a bank
accepts deposits, which it promises to repay at short notice or
no notice, and makes long-term loans (which can be repaid
over many years). Also known as: liquidity transformation
mortgage (or mortgage loan) A loan contracted by households
and businesses to purchase a property without paying the total
value at one time. Over a period of many years, the borrower
repays the loan, plus interest. The debt is secured by the
property itself, referred to as collateral. See also: collateral.
liquidity risk The risk that an asset cannot be exchanged for
cash rapidly enough to prevent a financial loss.
default risk The risk that credit given as loans will not be
repaid.
bank run A situation in which
depositors withdraw funds from a
bank because they fear that it may
go bankrupt and not honour its
liabilities (that is, not repay the
funds owed to depositors).
demand to the borrower. It is the corresponding loan that is an asset for the
bank. Banks make profits out of this process by charging interest on the
loans. So if Bonus Bank lends Gino the $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.
Base money (excluding legal tender held by banks) plus bank money is
called broad money. Broad money is money in the hands of the non-bank
public.
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.
By taking deposits and making loans, banks
provide the economy with the service of
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.
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 legal
tender, because they count on depositors not to need their funds all at the
same time. The risk they face is that depositors can all decide they want to
withdraw money instantaneously, but the money won’t be there. In Figure
10.13e, 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.
10.8 BANKS, MONEY, AND THE CENTRAL BANK
435
interest rate (short-term) The price
of borrowing base money.
Like any other firm in a capitalist system, banks can also 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 finan-
cial 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. In Unit 17 we will see how bank
failures were involved in the global financial crisis of 2008.
QUESTION 10.8 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
Money is the cash (coins and notes) used as the medium of
exchange to purchase goods and services.
Bank money is the total money in the savers’ deposit accounts at
the bank.
Base money is broad money plus legal tender held by banks minus
bank money.
Liquidity transformation occurs when the banks transform illiquid
deposits into liquid loans.
••10.9 THE CENTRAL BANK, THE MONEY MARKET, 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 will cover the net transactions they have to
make on a daily basis. The price of borrowing base money is the short-term
interest rate.
Suppose in the above example that Gino wants to pay $50 to Marco (and
there are no other transactions 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 10.13f.
So Bonus Bank has to 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 account, and others not
enough. They could try to induce someone to deposit additional money in
another bank account, but deposits also have costs due to interest payments,
marketing, and maintaining bank branches. Thus, cash deposits are only one
part of bank financing.
Once 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, as an
article in The Economist explains
(https://tinyco.re/6787148).
Bonus Bank's assets Bonus Bank's liabilities
Base money $20
Bank loan $100
Total $120
Payable on demand to Gino $120
Figure 10.13f Bonus Bank does not have enough base money to pay $50 to Abacus
Bank.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
436
policy (interest) rate The interest
rate set by the central bank, which
applies to banks that borrow base
money from each other, and from
the central bank. Also known as:
base rate, official rate. See also:
real interest rate, nominal interest
rate.
lending rate (bank) The average
interest rate charged by
commercial banks to firms and
households. This rate will typically
be above the policy interest rate:
the difference is the markup or
spread on commercial lending.
Also known as: market interest rate.
See also: interest rate, policy rate.
government bond A financial
instrument issued by governments
that promises to pay flows of
money at specific intervals.
yield The implied rate of return
that the buyer gets on their money
when they buy a bond at its market
price.
present value The value today of a
stream of future income or other
benefits, when these are
discounted using an interest rate or
the person’s own discount rate. See
also: net present value.
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 how many transactions
commercial banks have to make.
• The supply of base money is simply a decision by the central bank.
Since the central bank controls the supply of base money, it can also decide
the interest rate. The central bank intervenes in the money market by
saying it will lend 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 will respect that price: no bank will borrow at
a higher rate or lend 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 rate.
The base rate applies to banks that borrow base money from each other,
and from the central bank. But it 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 will typically be above the policy interest rate,
to ensure that banks make profits (it will also be higher for borrowers
perceived as risky by the bank, as we saw earlier). The difference between
the bank lending rate and the base rate is the markup or spread on
commercial lending.
In the UK, for example, the policy interest rate set by the Bank of
England was 0.5% in 2014, 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 2014 was 11% but the bank lending rate was 32%.
The central bank does not control this markup, but generally the bank
lending rate goes up and down with the base rate, just as other firms
typically vary their prices according to their costs.
Figure 10.14 greatly simplifies the financial system. In this model, we
show savers facing just two choices: to deposit money in a bank current
account, which we assume pays no interest, or buy government bonds in
the money market. The interest rate on government bonds is called the
yield. Read the Einstein at the end of this section 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.
We have now seen a model of how the central bank sets the policy
interest rate and how this affects the lending interest rate. But why should a
central bank do this at all? To understand the role of the central bank, we
must look at two questions:
• How does the lending rate affect spending in the economy? We will answer
this question in Section 10.11.
• Why does the central bank wish to affect spending by changing the interest
rate (as mentioned in Figure 10.14)? We will answer this much larger
question in Units 13–15, when we explain fluctuations in employment
10.9 THE CENTRAL BANK, THE MONEY MARKET, AND INTEREST RATES
437
Commercial banks
Set lending rate to maximize
profits given the policy rate and
the perceived riskiness of
the loan
Borrowers
Private sector
Savers
Central bank
Sets policy rate
to achieve
desired private
sector spending
Money
market
Banks put
money on
reserve at the
central bank
Banks respond to
requests for risky
loans from borrowers,
loan demand depends
on lending rate
Savers lend money in
money market by buying
government bonds
Savers put
deposits
in banks
Banks borrow
money from the
money market
Central
bank sets
the interest
rate in the
money
market
Figure 10.14 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.
arbitrage The practice of buying a
good at a low price in a 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.
and inflation in the economy as a whole, and reasons why central banks
are frequently given responsibility for moderating those fluctuations by
changing the interest rate.
EXERCISE 10.5 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, with the date on the horizontal axis and the interest rate
on the vertical axis.
2. How does the banking markup (interest rate margin) compare between
the two countries?
3. Do banking markups change over time? Suggest possible reasons for
what you observe.
EINSTEIN
Present value (PV)
Assets like shares in companies, bank loans, or bonds typically provide a
stream of income in the future. Since these assets are bought and sold,
we have to 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 have to assume that people participating
in the market to buy and sell assets have the capability to save and
borrow at a certain interest rate. So, imagine 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?
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
438
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 (PV) for this contract would make you
indifferent between buying the contract and not buying it. It has to 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:
€94.34 today is worth the same to you as €100 in a year’s time, because
if you put €94.34 in the bank, then it would be worth €100 in a year.
Equivalently, if you borrowed €94.34 today from the bank to buy the
asset, you would have to pay back €100 in a year’s time, exactly
offsetting the €100 the asset gives you.
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, where we allow for
interest compounding over time. If you receive €100 in t years’ time,
then today its value to you is:
Now suppose an asset gives a payment each year for T years, paying Xt in
year t, starting next year in year 1. Then each payment Xt has to be
discounted according to how far in the future it is. So with an interest
rate of i the PV of this asset 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. So if a
firm is considering whether or not to make an investment, they have to
compare the cost of making the investment with the present value of the
profits they expect it to provide in the future. 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
10.9 THE CENTRAL BANK, THE MONEY MARKET, AND INTEREST RATES
439
present value of the expected profits is PV, then the NPV of making the
investment is:
If this is positive then the investment is worth making, because the
expected profits are worth more than the cost (and vice versa).
Bond prices and yields
A bond is a particular kind of financial asset, where the bond issuer
promises to pay a given amount over time to the bondholder. Issuing or
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.
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 (for example, every year or every 3 months) until maturity.
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 will be
willing to pay for a bond will be 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 their 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 will solve 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
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
440
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.
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 will be very close to the rate
of interest in the money market. 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.
10.10 THE BUSINESS OF BANKING AND BANK
BALANCE SHEETS
To understand the business of banking in more detail, we can look at a
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.
Like 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,
which summarizes its core business of lending and borrowing. Banks
borrow and lend to make profits:
10.10 THE BUSINESS OF BANKING AND BANK BALANCE SHEETS
441
insolvent An entity is this if the
value of its assets is less than the
value of its liabilities. See also:
solvent.
liquidity Ease of buying or selling a
financial asset at a predictable
price.
• Bank borrowing is on the liabilities side: Deposits, and borrowing (secured
and unsecured) are recorded as liabilities.
• Bank lending is on the assets side.
As we saw above:
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.
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 account at the central bank,
called its reserve balances. 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. As we saw above, money
created by the central bank is a very small proportion of the broad
money that circulates in the economy.
• (A2) Bank’s own financial assets: These assets can be used as collateral for
the bank’s borrowing in the money market. As we discussed above, they
borrow to replenish their cash balances (item A1, Figure 10.15) when de-
positors withdraw (or transfer) more funds than the bank has available.
Assets (owned by the bank or owed
to it)
% of
balance
sheet
Liabilities (what the
bank owes households,
firms and other banks)
% of
balance
sheet
Cash reserve balances at the
central bank (A1)
Owned by the
bank:
immediately
accessible funds
2 Deposits (L1) Owned by
households and firms
50
Financial assets, some of which
(government bonds) may be used
as collateral for borrowing) (A2)
Owned by the
bank
30 Secured borrowing
(collateral provided)
(L2)
30
Loans to other banks (A3) Via the money
market
11 Unsecured borrowing
(no collateral provided)
(L3)
Includes borrowing
from other banks via
the money market 16
Loans to households (A4) 55
Fixed assets such as buildings and
equipment (A5)
Owned by the
bank
2
Total assets 100 Total liabilities 96
Net worth = total assets − total liabilities = equity (L4) 4
Figure 10.15 A simplified bank balance sheet.
Adapted from Figure 5.9 in Chapter 5 of Wendy Carlin and David Soskice. 2015. Macroeco-
nomics: Institutions, Instability, and the Financial System. Oxford: Oxford University Press.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
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equity An individual’s own invest-
ment in a project. This is recorded
in an individual’s or firm’s balance
sheet as net worth. See also: net
worth. An entirely different use of
the term is synonymous with
fairness.
leverage ratio (for banks or
households) The value of assets
divided by the equity stake in those
assets.
• (A3) Loans to other banks: A bank will also have 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 10.15. This is the
bank’s core business. Some of this will be secured lending. A loan is se-
cured if the borrower has provided collateral. In the case of housing loans,
called mortgages, the value of the house is the collateral. Other bank loans
are unsecured, like overdrafts, credit card balances, and consumer loans.
• (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 10.15:
• (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 house-
holds 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. Some of this is secured borrowing: The bank provides collateral
using its financial assets (which appear on the left-hand side of the
balance sheet in item (L2)). Some borrowing is unsecured.
• (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.
We can see this from real-world examples illustrated in Figures 10.16 and
10.17.
Figure 10.16 shows the simplified balance sheet of Barclays Bank (just
before the financial crisis) and Figure 10.17 shows the simplified balance
sheet of a company from the non-financial sector, Honda.
Current assets refers 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 or gearing.
10.10 THE BUSINESS OF BANKING AND BANK BALANCE SHEETS
443
Assets Liabilities
Cash reserve balances at the
central bank
7,345 Deposits 336,316
Wholesale reverse repo
lending
174,090 Wholesale repo borrowing
secured with collateral
136,956
Loans (for example
mortgages)
313,226 Unsecured borrowing 111,137
Fixed assets (for example
buildings, equipment)
2,492 Trading portfolio liabilities 71,874
Trading portfolio assets 177,867 Derivative financial instruments 140,697
Derivative financial
instruments
138,353 Other liabilities 172,417
Other assets 183,414
Total assets 996,787 Total liabilities 969,397
Net worth
Equity 27,390
Memorandum item: Leverage ratio (total assets/net worth) 996,787/27,390 = 36.4
Figure 10.16 Barclays Bank’s balance sheet in 2006 (£m).
Barclays Bank. 2006. Barclays Bank PLC
Annual Report (https://tinyco.re/
6435688). Also presented as Figure 5.10
in Chapter 5 of Wendy Carlin and David
Soskice. 2015. Macroeconomics: Institu-
tions, Instability, and the Financial
System. Oxford: Oxford University Press.
Assets Liabilities
Current assets 5,323,053 Current liabilities 4,096,685
Finance subsidiaries-receivables, net 2,788,135 Long-term debt 2,710,845
Investments 668,790 Other liabilities 1,630,085
Property on operating leases 1,843,132
Property, plant and equipment 2,399,530
Other assets 612,717
Total assets 13,635,357 Total liabilities 8,437,615
Net worth
Equity 5,197,742
Memorandum item: Leverage ratio as defined for banks
(total assets/net worth)
13,635,357/
5,197,742 = 2.62
Memorandum item: Leverage ratio as defined for non-banks
(total liabilities/total assets)
8,437,615/
13,635,357 = 61.9%
Figure 10.17 Honda Motor Company’s balance sheet in 2013 (¥m).
Honda Motor Co. 2013. Annual Report.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
444
Unfortunately the term leverage ratio is defined differently for financial
and non-financial companies (both definitions are shown in Figures 10.16
and 10.17). 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.
LEVERAGE FOR NON-BANKS
This 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. 1932–1947.
QUESTION 10.9 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 is
correct?
Assets Liabilities
Cash and reserves £2m Deposits £45m
Financial assets £27m Secured borrowing £32m
Loans to other banks £10m Unsecured borrowing £20m
Loans to households and firms £55m
Fixed assets £6m
Total assets £100m Total liabilities £97m
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.
10.10 THE BUSINESS OF BANKING AND BANK BALANCE SHEETS
445
•10.11 THE CENTRAL BANK’S POLICY RATE CAN AFFECT
SPENDING
Households and firms borrow to spend: the more it costs to borrow
(equivalently, the higher the interest rate), the less they spend now. This
allows the central bank to influence the amount of spending in the eco-
nomy, which then affects firms’ decisions about how many people to
employ and what prices to set. In this way, the central bank can affect the
level of unemployment and inflation (rising prices), as we shall see in detail
in Units 13 to 15.
To see the effect of a lower interest rate on consumption spending, we
return to Julia, who has no wealth, but expects to receive $100 one year
from now. Use the analysis in Figure 10.18 to see how the interest rate
affects her decision over how much to spend now.
In many rich countries, when people borrow it is most often to purchase
a car or a home (mortgages for housing are less common in countries where
financial markets are less developed). Loans for this purpose are readily
available even to people of limited wealth because, unlike loans to purchase
food or daily consumption items, mortgage loans purchase a car or house
that can be signed over to the bank as collateral. This insures the bank
against default risk. For this reason, an important channel for the effects of
In
te
re
st
ra
te
0
38
0
100
35 56 58 91
FF (10% interest rate)
FF (78% interest rate)
E
G
36
Julia’s IC (lower utility)
Julia’s IC
0
0
10
78
35 58
E
G
Consumption now ($)
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
Figure 10.18 Interest rates and consumption spending.
1. Julia has no wealth now
She expects to receive $100 in one
year.
2. The moneylender’s interest rate
At the moneylender’s interest rate of
78%, she borrowed in order to spend
$35 now (point G).
3. A lower interest rate
At the interest rate of 10% she would
borrow and spend $58 now (point E).
4. As the interest rate falls …
The right-hand panel of the figure
traces out Julia’s consumption spend-
ing now as the interest rate falls, with G
and E corresponding to the same points
in the left-hand panel.
5. Julia’s demand curve
The downward-sloping line is Julia’s
demand for loans, which also shows
her expenditure now.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
446
the interest rate on domestic spending in many rich economies is through
its effect on home purchases and consumer durables such as automobiles.
The interest rates set by central banks can help to moderate ups and downs
in spending on housing and consumer durables, and so smooth out the
fluctuations in the whole economy.
QUESTION 10.10 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts Julia’s choice of consumptions in
periods 1 (now) and 2 (later) under different interest rates. She has no
income in period 1 but an income in period 2 against which she can
borrow. Based on this information, which of the following statements
are correct?
Co
ns
um
pt
io
n
la
te
r (
$)
Consumption now ($)
0
0
Julia’s
status quo
Julia’s indifference curve
Julia’s indifference curve
A cut in the interest rate increases the marginal rate of
transformation of consumption from period 2 to period 1.
Julia will unambiguously increase her consumption in period 1 after
an interest rate cut.
Julia will unambiguously decrease her consumption in period 2
after an interest rate cut.
The graph of interest rate (vertical axis) versus period-1 consump-
tion (horizontal axis) is downward sloping.
EXERCISE 10.6 INTEREST RATES AND CONSUMPTION SPENDING
Think about the income and substitution effects of a rise in the interest
rate, as analysed in Exercise 10.2 and 10.3. Comment on whether a rise in
the interest rate would be expected to reduce consumption expenditure in
an economy in which a proportion of households are like Julia, and a
proportion are like Marco.
10.11 THE CENTRAL BANK’S POLICY RATE CAN AFFECT SPENDING
447
principal–agent relationship This
relationship exists when one party
(the principal) would like another
party (the agent) to act in some
way, or have some attribute that is
in the interest of the principal, and
that cannot be enforced or
guaranteed in a binding contract.
See also: incomplete contract. Also
known as: principal–agent problem.
collateral An asset that a borrower
pledges to a lender as a security for
a loan. If the borrower is not able
to make the loan payments as
promised, the lender becomes the
owner of the asset.
•10.12 CREDIT MARKET CONSTRAINTS:
A PRINCIPAL–AGENT PROBLEM
Lending is risky. A loan is made now and has to be repaid in the future.
Between now and then, unanticipated events beyond the control of the
borrower can occur. If the crops in Chambar, Pakistan were destroyed by bad
weather or disease, the moneylenders would not be repaid even though the
farmers were hard-working. The obsolescence of the skill you have invested
in using your student loan is an unavoidable risk, and will mean the loan may
not be repaid. The interest rate set by a bank or a moneylender would be
greater if the default risk due to unavoidable events was greater.
But lenders face two further problems. When loans are taken out for
investment projects, the lender cannot be sure that a borrower will exert
enough effort to make the project succeed. Moreover, often the borrower
has more information than the lender about the quality of the project and
its likelihood of success. Both of these problems arise from the difference
between the information the borrower and the lender have about the
borrower’s project and actions.
This creates a conflict of interest. If the project doesn’t succeed because
the borrower made too little effort, or because it just wasn’t a good project,
the lender loses money. If the borrower were using only her own money, it
is likely that she would have been more conscientious or maybe not
engaged in the project at all.
The relationship between the lender and the borrower is a
principal–agent problem. The lender is the ‘principal’ and the borrower
is the ‘agent’. The principal–agent problem between borrower and lender is
similar to the ‘somebody else’s money’ problem discussed in Unit 6. In that
case, the manager of a firm (the agent) is making decisions about the use of
the funds supplied by the firm’s investors (the principals), but they are not
in a position to require him to act in a way that maximizes their wealth,
rather than pursuing his own objectives.
In the case of borrowing and lending, it is often not possible for the
lender (the principal) to write a contract that ensures a loan will be repaid
by the borrower (the agent). The reason is that it is impossible for the lender
to ensure by contract that the borrower will use the funds in a prudent way
that will allow repayment according to the terms of the loan.
The table in Figure 10.19 compares two principal–agent problems.
One response of the lender to this conflict of interest is to require the
borrower to put some of her wealth into the project (this is called equity). The
more of the borrower’s own wealth is invested in the project, the more closely
Actors Conflict of interest over Enforceable
contract
covers
Left out of contract (or
unenforceable)
Result
Labour market
(Units 6 and 9)
Employer
Employee
Wages, work (quality and
amount)
Wages, time,
conditions
Work (quality and amount),
duration of employment
Effort under-
provided;
unemployment
Credit market
(Units 10 and 12)
Lender
Borrower
Interest rate, conduct of
project (effort, prudence)
Interest rate Effort, prudence, repayment Too much risk,
credit constraints
Figure 10.19 Principal–agent problems: The credit market and the labour market.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
448
Those seeking loans to purchase a
car are often required to allow a
device to be installed in the vehicle
that is controlled by the bank,
which will disable the ignition of
the car if the loan payments are not
made as required, as this New York
Times video shows. The practice
has not made lenders very popular.
https://tinyco.re/7861205
credit rationing The process by
which those with less wealth
borrow on unfavourable terms,
compared to those with more
wealth.
credit-excluded A description of
individuals who are unable to
borrow on any terms. See also:
credit-constrained.
credit-constrained A description of
individuals who are able to borrow
only on unfavourable terms. See
also: credit-excluded.
aligned her interests are with those of the lender. Another common response,
whether the borrowers are home buyers in New Zealand or car buyers in New
Orleans, is to require the borrower to set aside property that will be
transferred to the lender if the loan is not repaid (this is called collateral).
Equity or collateral reduces the conflict of interest between the
borrower and the lender. The reason is that when the borrower has some of
her money (either equity or collateral) at stake:
• She has a greater interest in working hard: She will try harder to make
prudent business decisions to ensure the project’s success.
• It is a signal to the lender: It signals that the borrower thinks that the
project is of sufficient quality to succeed.
But there is a hitch. If the borrower had been wealthy, she could either use
her wealth as collateral and as equity in the project, or she could have been
on the other side of the market, lending money. Typically the reason why
the borrower needs a loan is that she is not wealthy. As a result, she may be
unable to provide enough equity or collateral to sufficiently reduce the
conflict of interest and hence the risk faced by the lender, and the lender
refuses to offer a loan.
This is called credit rationing: those with less wealth borrow on
unfavourable terms compared with those with more wealth, or are refused
loans entirely.
Borrowers whose limited wealth makes it impossible to get a loan at any
interest rate are termed credit-excluded. Those who borrow, but only on
unfavourable terms, are termed credit-constrained. Both are sometimes said
to be wealth-constrained, meaning that their wealth limits their credit market
opportunities. Adam Smith had credit rationing in mind when he wrote:
The relationship between wealth and credit is summarized in Figure
10.20.
The exclusion of those without wealth from credit markets or their
borrowing on unfavourable terms is evident in these facts:
• In a survey, one in eight US families had their request for credit rejected by a
financial institution: The assets of these credit-constrained families were
63% lower than the unconstrained families. ‘Discouraged borrowers’
(those who did not apply for a loan because they expected to be
rejected) had even lower wealth than the rejected applicants.
• Credit card borrowing limits are often increased automatically: If borrow-
ing increases in response to an automatic change in the borrowing
limit, we can conclude that the individual was credit-constrained. The
authors of this study suggested that approximately two-thirds of US
families may be credit-constrained or excluded.
• Inheritance leads the self-employed to considerably increase the scale of their
operations: An inheritance of £5,000 in 1981 (around $24,000 today)
doubled a typical British youth’s likelihood of setting up a business.
Adam Smith, ‘Of the Profits of
Stock’ (https://tinyco.re/6397441).
In An Inquiry into the Nature and
Causes of the Wealth of Nations,
1776.
Money, says the proverb, makes money. When you have got a little it
is often easy to get more. The great difficulty is to get that little. (An
Inquiry into the Nature and Causes of the Wealth of Nations, 1776)
David Gross and Nicholas Souleles.
2002. ‘Do Liquidity Constraints and
Interest Rates Matter for Consumer
Behavior? Evidence from Credit
Card Data’. The Quarterly Journal
of Economics 117 (1) (February):
pp. 149–185.
10.12 CREDIT MARKET CONSTRAINTS: A PRINCIPAL–AGENT PROBLEM
449
• Owning a house can be used as collateral: A 10% rise in value of housing
assets that could be used as collateral to secure loans in the UK increases
the number of startup businesses by 5%.
• Asset-poor people in the US frequently take out short-term ‘payday loans’: In
the state of Illinois, the typical short-term borrower is a low-income
woman in her mid-thirties ($24,104 annual income), living in rental
housing, borrowing between $100 and $200, and paying an average
annual rate of interest of 486%.
• Poor and middle-income Indian farmers could substantially raise their
incomes if they did not face credit constraints: Not only do they generally
underinvest in productive assets, but the assets they hold are biased
towards those they can sell in times of need (bullocks) and against highly
profitable equipment (irrigation pumps), which have little resale value.
QUESTION 10.11 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements are correct regarding the
principal–agent problem?
A principal–agent problem exists in loans due to a positive
possibility of the principal not being repaid.
The principal–agent problem can be resolved by writing a binding
contract for the borrower to exert full effort.
One solution for the principal–agent problem in loans is for the
borrower to provide equity.
The principal–agent problem leads to credit rationing in the loans
market.
Samuel Bowles. 2006. Micro-
economics: Behavior, Institutions,
and Evolution (the Roundtable
Series in Behavioral Economics).
Princeton, NJ: Princeton University
Press.
Lender assesses
the characteristics
of the borrower
and project
Wealth of
borrower
Quality of
project (known
better to borrower
than to lender)
Borrower’s equity
stake in project
or collateral
Borrower’s
incentive to
work hard
Borrower’s
incentive to
select a high
quality project
Lender’s loan
decision
Lender finds
out what the
borrower is willing
to contribute
Lender uses this
information
to assess the
borrower’s
incentives
Lender’s
decision
1 2 3 4
Figure 10.20 Wealth, project quality, and credit.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
450
EXERCISE 10.7 MICROFINANCE AND LENDING TO THE POOR
Read the paper ‘The Microfinance Promise’ (https://tinyco.re/2004502).
The Grameen Bank in Bangladesh makes loans available to groups of indi-
viduals who together apply for individual loans, under the condition that
the loans to the group members will be renewed in the future if (but only
if) each member has repaid the loan on schedule.
Explain how you think such an arrangement would affect the
borrower’s decision about what to spend the money on, and how hard she
will work to make sure that repayment is possible.
•10.13 INEQUALITY: LENDERS, BORROWERS, AND
THOSE EXCLUDED FROM CREDIT MARKETS
Long before there were the employers, employees, and the unemployed that
we studied in the previous unit, there were lenders and borrowers. Some of
the first written records of any kind were records of debts. Differences in
income between those who lend (people like Marco) and those who borrow
(people like Julia) remain an important source of economic inequality today.
We can analyse inequalities between borrowers and lenders (and among
the borrowing class) using the same Lorenz curve and Gini coefficient
model that we used to study inequality among employers and employees.
Here is an illustration. An economy is composed of 90 farmers who
borrow from 10 lenders, and use the funds to finance the planting and
tending of their crops. The harvest (on average) is sold for an amount
greater than the farmer’s loan, so that for every euro borrowed and invested
the farmer gains income of 1 + Π, where Π is called the rate of profit.
Following the harvest, the farmers repay the loans with interest, at rate i.
We simplify by assuming that all of the loans are repaid and that all lenders
lend the same amount to the farmers at the same interest rate.
Since each euro invested produces total revenue of 1 + Π, each farmer
produces income (revenue less costs) of Π. But this income is divided
between the lender, who receives an income of i for every euro lent, and the
borrower who receives the remainder, namely Π − i. So the lender receives
a share of i/Π of total output, and the borrower receives a share of 1 − (i/Π).
Thus if i = 0.10 and Π = 0.15 then the lenders’ share of total income is 2/
3 and the borrowers’ is 1/3.
Inequality in this economy is depicted in Figure 10.21. The Gini coeffi-
cient is 0.57.
In the previous sections we showed why some would-be borrowers
(those unable to post collateral or lacking their own funds to finance a
project) might be excluded entirely from borrowing even if they would be
willing to pay the interest rate. How does this affect the Lorenz curve and
the Gini coefficient?
To explore this, imagine that 40 of the prospective borrowers are
excluded (and since they cannot borrow, they receive no income at all) and
that nothing else in the situation changes (i and Π remain unchanged).
The dashed line in Figure 10.21 shows the new situation. The new Gini
coefficient is 0.70, showing an increase in inequality as the result of the
credit market exclusion of the poor.
Jonathan Morduch. 1999. ‘The
Microfinance Promise’. Journal of
Economic Literature 37 (4)
(December): pp. 1569–1614.
10.13 INEQUALITY
451
Cu
m
ul
at
iv
e
sh
ar
e
of
in
co
m
e
(%
)
Cumulative share of the population
from lowest to highest income (%)
0
(1 – i/Π) = 1/3
0
100
40 100
Gini coefficient: 0.57
Gini coefficient with excluded borrowers: 0.70
90
Credit market excluded LendersBorrowers
Figure 10.21 Inequality in a borrowing and lending economy. Note: The Gini
coefficient when there are no borrowers excluded is 0.57; when 40 are excluded, it
is 0.70.
1. A model economy of lenders and
borrowers
An economy is composed of 90 farmers
who borrow from 10 lenders. Since
i = 0.10 and Π = 0.15, the lenders’ share
of total income is 2/3 and the
borrowers’ is 1/3. The Gini coefficient is
0.57.
2. Some borrowers are credit market
excluded
Suppose that 40 of the prospective
borrowers are excluded. Since they
cannot borrow, they receive no income
at all.
3. Inequality increases
When some prospective borrowers are
excluded, the Gini coefficient increases
to 0.70.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
452
QUESTION 10.12 CHOOSE THE CORRECT ANSWER(S)
In an economy with a population of 100, there are 80 farmers and 20
lenders. The farmers use the funds to finance the planting and tending
of their crops. The rate of profit for the harvest is 12.5%, while the
interest rate charged is 10%. Compare the following two cases:
1. Case A: All farmers are able to borrow.
2. Case B: Only 50 farmers are able to borrow.
Based on this information, which of the following statements is
correct?
The share of total output received by the farmers who can borrow is
25%.
The Gini coefficient for Case A is 0.5.
The Gini coefficient for Case B is 0.6.
There is a 16.7% increase in the Gini coefficient in Case B compared
to Case A.
This example illustrates the fact that one cause of inequality in an economy
is that some people (like Marco) are in a position to profit by lending money
to others, just as others (like Bruno in Unit 5) are in a position to profit by
employing others.
Bruno and Marco are probably not the best-loved characters in the eco-
nomy. For similar reasons, banks are not the most popular or trusted
institutions. In the US, for example, 73% of people expressed ‘a great deal’
or ‘quite a lot’ of confidence in the military in 2016, exactly the same as the
level a decade earlier. By contrast, in 2016, only 27% expressed a degree of
confidence in banks, down from 49% a decade earlier. Surveys show that
the public in Germany, Spain and many other countries hold their banks in
low esteem. This has particularly been the case since the financial crisis of
2008.
It is sometimes said that rich people lend on terms that make them rich,
while poor people borrow on terms that make them poor. Our example of
Julia and Marco made it clear that one’s view of the interest rate—as a cost
for Julia and as a source of income for Marco—depends on one’s wealth.
People with limited wealth are credit-constrained, which limits their ability
to profit from the investment opportunities that are open to those with
more assets.
It is also true that, in determining the rate of interest at which an indi-
vidual will borrow, the lender often has superior bargaining power, and so
can set a rate that enables him to capture most of the mutual gains from the
transaction.
But do banks and the financial system make some people poor and other
people rich? To answer this question, compare banks to other profit-
making firms. Both are owned by wealthy people, who profit from the
business they do with poorer people. Moreover, they often transact on
terms (rates of interest, wages) that perpetuate the lack of wealth of
borrowers and employees.
10.13 INEQUALITY
453
EXERCISE 10.8 UNPOPULAR BANKS
Why do you think that banks tend to be more unpopular than other profit-
making firms (Honda or Microsoft, for example)?
But even those who dislike banks do not think that the less wealthy would
be better off in their absence, any more than that the less wealthy would
benefit if firms ceased to employ labour. Banks, credit, and money are
essential to a modern economy—including to the economic opportunities
of the less well off—because they provide opportunities for mutual gains
that occur when people can benefit by moving their buying power from one
time period to another, either borrowing (moving it to the present) or
lending (the opposite).
EXERCISE 10.9 LIMITS ON LENDING
Many countries have policies that limit how much interest a moneylender
can charge on a loan.
1. Do you think these limits are a good idea?
2. Who benefits from the laws and who loses?
3. What are likely to be the long-term effects of such laws?
4. Contrast this approach to helping the poor gain access to loans with
the Grameen Bank in Exercise 10.7.
10.14 CONCLUSION
As the Irish bank closure showed, money and credit are so fundamental to
economic interactions that people find ways to recreate money even when
formal institutions fail. Indeed, archaeologists have discovered evidence of
lending and the use of money to denominate debts and to facilitate
exchange, from long before banks or governments existed. This is because
substantial mutual gains are made possible when a group of people develop
sufficient trust in each other and in a particular medium of exchange.
In modern economies, the creation of money is inextricably tied up with
the creation of credit, or the process of lending by commercial banks whose
actions are regulated by government and managed by the central bank.
Borrowing and lending allows people to smooth consumption when they
have irregular incomes, to satisfy their impatience, or to finance investment
that can increase their future consumption possibilities. The credit market
produces mutual gains for borrowers and lenders but, like many economic
transactions, the distribution of those gains via the interest rate represents a
conflict of interest.
UNIT 10 BANKS, MONEY, AND THE CREDIT MARKET
454
Concepts introduced in Unit 10
Before you move on, review these definitions:
• Money, broad money, base money, bank money
• Wealth
• Income
• Diminishing marginal returns to consumption
• A person’s discount rate
• Pure impatience
• Collateral
• Balance sheet, assets, liabilities, net worth, equity, solvency
• Leverage ratio
• Credit-constrained, credit-excluded
• The central bank’s policy interest rate
10.15 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Aleem, Irfan. 1990. ‘Imperfect information, screening, and the costs of
informal lending: A study of a rural credit market in Pakistan’
(https://tinyco.re/4382174). The World Bank Economic Review 4 (3):
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Bowles, Samuel. 2006. Microeconomics: Behavior, institutions, and evolution
(the roundtable series in behavioral economics). Princeton, NJ: Princeton
University Press.
Carlin, Wendy and David Soskice. 2015. Macroeconomics: Institutions,
Instability, and the Financial System. Oxford: Oxford University Press.
Chapters 5 and 6.
Graeber, David. 2012. ‘The Myth of Barter’ (https://tinyco.re/6552964). In
Debt: The First 5,000 years. Brooklyn, NY: Melville House Publishing.
Gross, David, and Nicholas Souleles. 2002. ‘Do Liquidity Constraints and
Interest Rates Matter for Consumer Behavior? Evidence from Credit
Card Data’. The Quarterly Journal of Economics 117 (1) (February):
pp. 149–185.
Martin, Felix. 2013. Money: The Unauthorised Biography. London: The
Bodley Head.
Morduch, Jonathan. 1999. ‘The Microfinance Promise’ (https://tinyco.re/
7650659). Journal of Economic Literature 37 (4) (December):
pp. 1569–1614.
Murphy, Antoin E. 1978. ‘Money in an Economy Without Banks: The Case
of Ireland’. The Manchester School 46 (1) (March): pp. 41–50.
Silver-Greenberg, Jessica. 2014. ‘New York Prosecutors Charge Payday
Loan Firms with Usury’ (https://tinyco.re/8917188). DealBook.
Spaliara, Marina-Eliza. 2009. ‘Do Financial Factors Affect the
Capital–labour Ratio? Evidence from UK Firm-level Data’. Journal of
Banking & Finance 33 (10) (October): pp. 1932–1947.
The Economist. 2012. ‘The Fear Factor’ (https://tinyco.re/6787148). Updated
2 June 2012.
10.15 REFERENCES