Financial Intermediation

Question 1

Why are Loan Demand and Loan Supply vital to consider?

Answer 1

• The opinion is that there is only one rate in many of these formulae
• Savers are willing to supply funds at rate r
• Borrowers are demand funds by paying r
• There is a linear relationship due to homogeneity of borrowes

Question 2

What are the functions of LD and LS? Why do these behave in a particular way?

Answer 2

• Both are functions of r
• This means that other variables are constant
• By changing Y in the schedule, we find that the IS curve is a function of r and Y, hence can be found
• If income rises, LS should increase and LD should fall
• rED for borrowers>savers, LS shift>LD shifts
• In shifts, Higher equilibrium lending and r due to rED

Question 3

Why are there different interest rates?

Answer 3

• Interest rates vary in liquidity, risk and maturity
• FIs role is to channel saver’s funds to borrowers, without direct contact
• If rB > rS; there is risk as there is a cost of providing a loan
• rB - rS = IR spread
• LD = LS is not necessarily an equilibrium, instead determining the volume of lending

Question 4

How can the market for intermediation be modelled using XS and XD?

Answer 4

• The equilibrium credit spread is where XD and XS meet
• These variables show how the interest rate spread and quantity of loans meet
• As IR spread increase XS>XD
• Variables are capital dependant

Question 5

How does the rate spread [w(Y)] impact output?

Answer 5

• As Y increases, w(Y) falls
• This is because as assets and net worth rise, borrowing by FIs increase, due to the lower risk perception and rB
• The change in Y means rS falls due to the cost of funding falling, XS shifts out- reducing the wY

Question 6

What determines rS and rB, including assumptions? How do the rates interact with eachother?

Answer 6

• rS = f(π, Y); we know this through MP
• Households and fimrs borrow at rB
• rB = rS + w; this can be illustrated within the PE curve
• Assumptions include: Households save less to afford purchases and C.B. may consider the borrwing rate when considering their own rate

Question 7

How can the Keynesian cross be considered within the Credit Spread Model?

Answer 7

• We know that income is affecting investment (w is a function of Y, giving Y an extra channel to impact PE)
• This makes the slope STEEPER, reducing PE and Y
• Due to the spread, rS reduces investment relative to rS = rB
• This makes the IS curve shift left
• We also know that varying the interest rate will impact the gradient
• For a given change in r, we have greater effect on output- meaning that the IS curve flattens
• The distance between the curves is w(Y)
• Slope becomes greater as Y rises

Question 8

What is the concept of a financial accelerator?

Answer 8

• As MP shifts, this has a larger effect on output
• As Y rises, this impacts FIs
• Borrowers become less risky, increased collateral, reducing rB
• This leads to lower external finance and w(Y)
• Increased investment means that Y also increases more

Question 9

What are the implications of the disruption of credit supply?

Answer 9

• This shifts XS inwards, meaning that w falls and L increases
• This happened in 2007 with the SPM [Asymmetric information]
• Credit Supply rose, XS fell as w increases and L fell
• C.B. responds by reducing the interest rate

Question 10

How does the Collapse of Lehmann Brothers link with Credit Supply?

Answer 10

• XS fell by alot more
• Due to the perception of risk, the loss margin spiral and asymmetric info increased by alot in financial markets
• This lead to the IS curve falling despite rS falling
• Increasing precautionary saving
• This often occur at ZLB
• As Fed increases r, risk is low, easier to get credit and XS increases again

Question 11

What should be learnt from financial intermediation?

Answer 11

• Taking into account financial conditions is imperitive
• Credit spread should be included as a shift factor of the MP curve
• Policy rate should be lowered if w is larger- although ZLB may impare this
• Unconventional MP: Shifting XS to the right via Term Asset Back lending Facility
• Eases the loaning by extension of credit to FI, purchasing illiquid assets, injecting liquidity, reduce w (despite this amplifying the cycle) and direct purchases of debt claims