Financial Markets (Perfect FM & FA model) Flashcards
(28 cards)
2 ways financial markets cause shocks, or add to non-financial shocks.
Frictions in financial markets magnify shocks
Financial crisis’ itself can create shocks to disrupt real economy
Perfectly functioning financial markets: (baseline model)
2 periods, household has endowment E of the single good in economy. No endowment in period 2.
Household maximises EXPECTED value of lifetime utility. What is the expression (v) (simple)
V = U(C1) + βU(C2)
β is discount factor
We let U’ > 0 i.e utility increases with consumption
And U’’ < 0 i.e DMR!
Pg3
N possible investment projects by firms.
S possible states of world in period 2 e.g recession or no recession.
Suppose quantity Ki (>0) of period 1 output (endowment from households) is devoted to investment project i;
Assume in period 2, for state of world s, project (i) generates payoff:
KiRis
Ki is quantity of output given for investment
Ris is return to project i, in state s!
How do we describe outcomes: what does the equilibrium consist of (3)
B) what is qs expressed in terms of
A set of prices over future states (qs)
Investment decisions Ki
Consumption choices (C1) and (CS2)
No S for C1 since it is the same state for everyone
B) qs is priced in terms of period 1 output. I.e period 1 output is the numeraire
- Household maximise expected lifetime utility we said.
What is their budget constraint (hint: RHS= endowment)
C1 + Σ qsCs2 = E
C1 is what they consume
qsCs2 is what they invest! So qs marks the price of a claim on period 2 output
So what they consume and invest has to equal endowment (no endowment wasted)
If we reduce C1 and use proceeds to increase Cs2, what will happen to lifetime utility
Unaffected (we explained this in RBC!)
Euler equation for all s
U’(c1) = 1/qs x πsβU’(Cs2)
MU from consumption in period 1 taken away.
MU from consumption in period 2 in state s increases.
1/qs is price of claim on period 2 output.
E.g if qs = 2, giving up 1 unit in period 1, only get back 1/2 (since price qs has gone up!)
If qs = 3, giving up 1 unit of consumption today can only buy back 1/3 in period 2, since price increased.
Rearrange Euler to make qs subject
B) how can we use this, explain in Ceri’s example of rain insurance.
And using rearranged equation, what increases qs? (4)
qs = πs βU’(Cs2) / U’(C1)
B) see it like insurance contract. qs is price of insurance; you get sent an umbrella. If it rains, its value is more. If it doesn’t rain, the umbrella has little value.
See qs like the price of the contract.
The higher probability of state s (to rain), the more willing to pay.
The higher β = more patient, more willing to pay.
The higher MU from consumption in p2 in state s, the more willing to pay.
The lower MU from consumption in p1, more willing to pay.
So EE can be rearrange to
qs = πs βU’(Cs2) / U’(C1)
What is βU’(Cs2) / U’(C1) known as
Stochastic discount factor - shows how household values future state-contingent discounted consumption relative to consumption today
- Next in this model: there must be no unexploited profit opportunities
what does this mean if I wanted to invest marginally more in project i (what is the opportunity cost)
The opportunity cost of investing a bit more in project i, is giving up 1 unit of C1.
What is the payoff to this investment of 1 unit of c1.
You get the state contingent output in state s, given the state materialises. Then can sell it for revenue.
e.g in our example, if s occurs i.e rains, we get the umbrella. We can then sell the umbrella
If a positive amount is invested into a particular project (Ki>0) , what must the payoff to investing marginally more in that project be equal to?
Payoff to the additional investment must equal cost (i.e profits competed away - no unexploited profit opportunities)
What if nothing is invested in project i?
Ki = 0, so payoff must be negative (makes sense, as payoff negative, hence why noone invests!)
How can no unexploited profit opportunites be summmarised in expression (pg5)
Σ qsRis {=1 if Ki>0) payoff=cost. profits competed away
{<1 if Ki=0) payoff negative hence why nobody invests)
- Market clearing
What is market clearing for households in period 1
(Hint: similar to BC: C1 + ΣqsCS2 = E)
b) in period 2
In period 1
C1 + ΣKi = E
Consumption from p1 + all the investment projects households have invested in, have to equal endowment (no endowment wasted) i.e consumed or invested
b)
Cs2 = ΣKiRis
In the state s, for all investment projects they took part in period 1, their return Ris = Cs2, cannot exceed consumption. (i.e consumption from p2 purely comes from returns from investment period 1
Is this model pareto efficient and why
Yes, as markets are perfectly competive, full info, no externalities.
this is not realistic IRL! there are frictions…
In reality what is main difference/friction between firms and households?
b) how to solve
Asymmetric info - firms know more about potential investment projects than investors.
b)
banks as intermediaries to gather info, however still cannot perfectly obtain!
This asymmetric info is bad as creates moral hazard and adverse selection.
How does moral hazard and adverse selection exist with firms
Moral hazard: burden is on investors so firms are more reckless with investor capital then their own
Adverse selection - risky investments could be picked, incurring monitoring costs in model
2nd model: Financial accelerator model (with imperfections/frictions)
What is the agency problem, and what is required to solve
Principle agent problem - agent differs in incentive from principle, so acts against them.
thus solve with monitoring, which has agency costs i.e monitoring costs, to make sure investors make sure money is being used right
Financial accelerator model
What do we assume for agency costs for wealthier entrepreneurs?
Agency/monitoring costs are lower for wealthier entreprenuers (as more skin in game)
as wealthier entrepeneurs can put more of their own funds, so care more themselves, so less monitoring required.
So wealthier you are, monitoring costs fall.
Why is there a vicious cycle created between wealth and investment…. Consider a recession
A recession means wealth falls. So monitoring costs increase, thus investment is more expensive. So investment falls.
With less investment wealth falls again, so monitoring costs increase further. Cycle continues
Credit spreads
B) credit spread net worth relationship
Cost of external borrowing over the risk free rate
B) Inverse - as net worth up, lenders are willing to lend at a lower rate since safer, so credit spread falls
basically agency costs are higher when principle agent interests are less aligned, since need more monitoring.
How does this show credit spreads is a financial accelerator
As credit spread (borrowing costs) are countercyclical increase during recessions! - amplifies/accelerates the shocks
It is a destablising force, unlike automatic stabilisers like the progressive tax/transfer system which lowers tax as you get poorer!
Suppose collateral is needed to obtain finance.
If a recession reduces the value of this collateral - what happens to the financial accelerator effect
Strengthens it - collateral worth less, net worth falls, so lender wants more reassurance as less safe, so increase credit spread! (borrowing cost)
once again shows financial accelerator - how financial market imperfections amplify shocks
