The University of the West Indies, St.

Augustine
The Department of Economics

ECON 3005: Monetary Theory and Policy

Tutorial Sheet # 2

1. Using Ghatak (1995), outline five (5) reasons why monetary policy plays a limited role in
developing countries?

According to Subrata Ghatak (1995), the role of monetary policy is instrumental in influencing
the rate of economic growth in the economy over a period of time. The reason why monetary
policy plays a limited role:

1. The existence of a large non-monetized sector would act as an impediment to the success of
monetary policy in developing countries.

2. The narrow size of money and capital markets leads to the presence of a limited array of
financial assets which hinders the effective execution of monetary policy. It can interfere with
the transmission channels of monetary policy, particularly the asset price channel, which is
largely absent because there are no developed financial markets in which asset prices are
formed efficiently.

3. The existence of a major proportion of money supply in the form of currency. It implies the
relative insignificance of bank money (deposits at financial institutions) in controlling the
money supply. The effects of the monetary authorities policy will often be on bank credits
(loans) making monetary policy less effective.

4. The rise of non-financial institutions poses a serious challenge to effective manipulation of

monetary policy so long as non-financial institutions are excluded from regulatory and
supervisory control of the Central Bank.

5. The presence of foreign owned commercial banks in developing countries or local branches
of foreign banks restricts the successful implementation of monetary policy since foreign
counterparts of such banks can quickly and easily transfer funds across borders. It tends to
neutralize the intent of domestic monetary policy.

2. What are the reasons for high interest rate spreads in the Caribbean?

In the Caribbean region, the reasons for the prominence of high interest rate spreads are:

- Inefficiency of banks
- High reserve requirements (unremunerated or lowly remunerated)
- Higher costs of financial intermediation such as operating costs
- Higher ratios of non-performing loans
- Lack of competition among lenders results in high loan rates
- Internal characteristics of banks: tendency to maximize profits in an oligopolistic market

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3. Describe the features of the banking sector in the Caribbean.
1. Relative size of bank operations is measured in terms of assets, positively correlated to the
level of GDP of the respective territories. However, the markets contrasted sharply in terms
of relative size which has profound implications for intra-regional trade in the sector. Banks
in the larger territories possess a strong advantage in terms of scale and would be in a better
position to raise large sums of capital compared to their counterparts in smaller territories and
therefore are likely to dominate the intra-regional trade in banking services.

2. Distribution of banking services measured in terms of branches and ATMs in existence. It

was founds that the number of branches in each submarket was strongly related to the size of
the economy measured in terms of GDP. When accessibility was compared to what exist in
the US and UK, the level of accessibility to branches was lower in most territories in
CARICOM. Banks have engaged in diversifying their services through the use of ATMs
which has enhanced accessibility.

3. Openness and industry dynamics. Financial markets in most CARICOM territories are quite
open to entry of foreign banks within confinements subjected to prudential regulation and
supervision. In Trinidad, there are few new banks that have emerged over the last decade
operating with some measure of success. Under a regime of economic and financial
liberalization, economic theory predicts that there would be an inherent easing of market
entry conditions and an increased number of entrants in the liberalized sector. This occurred
initially but reversed in the early path of the 21 st century. A decline in the number of banks
occurred in 2003 largely due to merger activities.

4. What is financial development? (Include a discussion of the five financial functions) See
Levine (2005).

Financial development (Levine 2005), occurs when financial instruments, markets and intermediaries
ameliorate, though do not necessarily eliminate, the effects of information enforcement and
transaction costs and improve on the five financial functions. Each of these financial functions may
influence savings and investment decisions and economic growth.

Five functions:

1. Producing information and allocating capital.

There are large costs associated with evaluating firms, managers and market conditions before
making investment decisions. Financial intermediaries, by economizing on information
acquisition cost, improve the ex ante assessment of investment opportunities with positive
ramifications on resource allocation. By improving information, financial intermediaries can
accelerate economic growth, besides identifying the best production technologies. Financial
intermediaries can boost technological innovation by identifying entrepreneurs with the best
chances of successfully initiating new goods and production services.

2. Monitoring firms and exerting corporate governance.

The degree to which providers of capital to a firm can effectively monitor and influence how
firms use capital has ramifications on savings and allocation decisions. To the extent that
shareholders and creditors effectively monitor firms and induce managers to maximize firm value

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 will improve efficiency with which firms allocate resources and make savers willing to finance
production and innovation. Usually shareholders can exert corporate governance directly by
voting on issues such as mergers and indirectly by electing Boards of Directors to represent the
interest of owners and oversee managerial decisions. However, minority shareholders may not
have the opportunity to exert effective corporate governance due to lack of information (high cost
of monitoring), lack of expertise and complexity of overseeing and exerting corporate
governance. Well-functioning financial intermediaries influence growth by boosting corporate
governance, economizing on monitoring cost thereby reducing credit rationing, boosting
productivity, capital accumulation and growth. Financial intermediaries facilitate the flow of
resources from savers to investors in the presence of informational asymmetries with positive
growth.

3. Risk amelioration.
Financial system may mitigate risk associated with individual projects, firms, industries or
countries. Banks, mutual funds and securities markets all provide vehicles for trading, pooling
and diversifying risks. Financial systems’ ability to provide risk diversification services can affect
long run economic growth by altering resource allocation and savings rates. Financial systems
that allow agents to hold a diversified portfolio of risky projects foster a reallocation of savings
towards high return ventures with positive repercussions on growth. Financial systems that ease
risk diversification can accelerate technological change and economic growth.

4. Pooling of savings.
This involves overcoming transaction costs associated with collecting savings from different
individuals and overcoming informational asymmetries associated with making savers feel
comfortable in relinquishing control of their savings. Financial systems that are more effective at
pooling the savings of individuals can affect economic development by increasing savings and
exploiting economies of scale as well as boosting technological innovation and improving
resource allocation. Without access to multiple investors, many production processes would be
constrained to economically inefficient scales.

5. Easing of exchange.
Financial arrangements that have lower transaction costs can promote specialization,
technological innovation and growth. Financial innovation can lead to a fall in these costs.
Financial systems facilitate transactions in the economy. Well-functioning banks or
intermediaries can reduce transaction costs, promote specialization, innovation and growth.

5. Outline the ‘supply leading’ and ‘demand following’ relationship between finance and
economic growth.
Supply leading: The basic premise is that financial development causes economic growth. A
well-functioning financial system enables the real economy to grow. Financial sector
development which is the evolution of financial institutions precedes the demand for services and
economic growth. Financial intermediaries are a driving force for economic growth by
channeling savings from small savers to large investors. This system may initially be government
owned and supported.

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 Demand following: The basic premise is that economic growth causes financial development.
When the real economy grows, there is an increased demand for financial services by investors
and savers leading to the creation and evolution of financial institutions. Financial institutions do
not have an active role in economic growth as they simply evolve in response to the demand for
them as real economic growth occurs.

6. Define financial liberalization and financial repression.

Financial liberalization is an alternative to a financially repressive administration. According to
Henry (2000), it is the abolition of foreign exchange controls, permission of residences to hold
foreign currency deposits and deregulation of the financial system. It entails the removal of
restrictions on interest rates and easing markets entry conditions.

Ghosh (2005), defines financial liberalization as measures directed at diluting or dismantling

regulatory control over institutional structures, instruments and activities of agents in different
segments of the financial sector.

Financial repression is a policy implemented by government to promote growth and raise revenue
to artificially lower interest rates and inflationary monetary policy. The characteristics of
financial repression are:

(i) Interest and credit ceilings

(ii) Directed credit programs based on political priorities
(iii) Government influences on banks (public ownership and heavy moral suasion)
(iv) Inflation

Mckinnon and Shaw (1973), define financial repression as the indiscriminate distortion of
financial prices including interest rates and foreign exchange rates. It reduces the real interest rate
of growth and the real size of the financial system. It retards the development process in
developing countries.

Fry (1997) states that financial repression is a particularly damaging quasi-tax from the
perspective of economic growth. Many developing countries that encounter difficulties on
satisfying their inter-temporal budget constraints with regular tax revenue resorted to financial
markets where they borrowed funds at low interest rates.

7. State the main causes of financial crises according to Mishkin.

A financial crisis occurs when an increase in asymmetric information from a disruption in the
financial system causes severe adverse selection and moral hazard problems that render financial
markets incapable of channeling funds efficiently from savers to households and firms with
productive investment opportunities. When financial markets fail to function efficiently,
economic activity contracts sharply. To understand why financial crises occur and, more
specifically, how they lead to contractions in economic activity, we need to examine the factors
that cause them.

Six categories of factors play an important role in financial crises:

1. Asset market effects on balance sheets

2. Deterioration in financial institutions’ balance sheets
3. Banking crisis

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4. Increases in uncertainty
5. Increases in interest rates
6. Government fiscal unbalances

1. Asset Market Effects on Balance Sheets.

The state of borrowers’ balance sheets has important implications for the severity of
asymmetric information problems in the financial system.

- Stock Market Decline

A sharp decline in the stock market is one factor that can cause a serious deterioration in
borrowing firms’ balance sheets. In turn, this deterioration can increase adverse selection and
moral hazard problems in financial markets and provoke financial crisis. A decline in the
stock market means that the net worth of corporations has fallen, because share prices are the
valuation of a corporation’s net worth. The decline in net worth makes lenders less willing to
lend because the net worth of a firm plays a role similar to that of collateral. When the value
of collateral declines, it provides less protection to lenders meaning that losses on loans are
likely to be more severe. Because lenders are now less protected against the consequences of
adverse selection, they decrease their lending, which in turn causes investment and aggregate
output to decline. In addition, the decline in corporate net worth as a result of a stock market
decline increases moral hazard by providing incentives for borrowing firms to make risky
investments, as they now have less to lose if their investments go sour. The resulting increase
in moral hazard makes lending less attractive – another reason why a stock market decline
and the resultant decline in net worth leads to decreased lending and economic activity.

- Unanticipated Decline in the Price Level

In economies with moderate inflation, which characterizes most industrialized countries,
many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or
more. In this institutional environment, unanticipated declines in the aggregate price level
also decrease the net worth of firms. Because debt payments are contractually fixed in
nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’
liabilities in real terms (increases the burden of the debt) but does not raise the real value of
firms’ assets. The result is that net worth in real terms (the difference between assets and
liabilities in real terms) declines. A sharp drop in the price level therefore causes a substantial
decline in real net worth for borrowing firms and an increase in adverse selection and moral
hazard problems facing lenders. An unanticipated decline in the aggregate price level thus
leads to a drop in lending and economic activity.

- Unanticipated Decline in Value of the Domestic Currency

Because of uncertainty about the future value of the domestic currency in developing
countries (and in some industrialized countries), many nonfinancial firms, banks and
governments in developing countries find it easier to issue debt denominated in foreign
currencies rather than in their own currency. This can lead to a financial crisis in a similar
fashion to an unanticipated decline in the price level. With deb contracts denominated in
foreign currency, when there is an unanticipated decline in the value of the domestic
currency, the debt burden of domestic firms increases. Since assets are typically denominated
in domestic currency, there is a resulting deterioration in firms’ balance sheets and a decline
in net worth, which then increases adverse selection and moral hazard problems along the
lines just described. The increase in asymmetric information problems leads to a decline in
investment and economic activity.

- Asset Write-Downs

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 Asset price declines also lead to a write-down of the value of the assets side of the balance
sheets of financial institutions. This deterioration in their balance sheets can also lead to a
contraction of lending.

2. Deterioration in Financial Institutions’ Balance Sheets

Financial institutions, particularly banks, play a major role in financial markets because they
are well positioned to engage in information-producing activities that facilitate productive
investment for the economy. The state of banks’ and other financial intermediaries’ balance
sheets has an important effect on lending. Suppose financial institutions suffer deterioration
in their balance sheets and so have a substantial contraction in their capital. They will have
fewer resources to lend, and lending will decline. The contraction in lending then leads to a
decline in investment spending, which slows economic activity.

3. Banking Crisis
If the deterioration in financial institutions’ balance sheets is severe enough, they will start to
fail. Fear can spread from one institution to another, causing even healthy ones to go under.
Because banks have deposits that can be pulled out very quickly, they are particularly prone
to contagion of this type. A bank panic occurs when multiple banks fail simultaneously. The
source of the contagion is asymmetric information. In a panic, depositors, fearing for the
safety of their deposits (in the absence of or with limited amounts of deposit insurance) and
not knowing the quality of banks’ loan portfolios, withdraw their deposits to the point that the
banks fail. When a large number of banks fail in a short period of time, there is a loss of
information production in financial markets and a direct loss of banks’ financial
intermediation. The decrease in bank lending during a banking crisis decreases the supply of
funds available to borrowers, which leads to higher interest rates. Bank panics result in an
increase in adverse selection and moral hazard problems in credit markets. These problems
produce an even sharper decline in lending to facilitate productive investments and lead to an
even more severe contraction in economic activity.

4. Increases in Uncertainty
A dramatic increase in uncertainty in financial markets, due to perhaps to the failure of a
prominent financial or nonfinancial institution, a recession, or a stock market crash, makes it
hard for lender to screen good from bad credit risks. The resulting inability of lenders to solve
the adverse selection problem makes them less willing to lend, which leads to a decline in
lending, investment and aggregate economic activity.

5. Increases in Interest Rates

Individuals and firms with the riskiest investment projects are those who are willing to pay
the highest interest rates. If increased demand for credit or a decline in the money supply
market drives up interest rates sufficiently, good credit risks are less likely to want to borrow
while bad credit risks are still willing to borrow. Because of the resulting increase in adverse
selection, lenders will no longer want to make loans. The substantial decline in lending will
lead to a substantial decline in investment and aggregate economic activity. Increases in
interest rates also play a role in promoting a financial crisis through their effect on cash flow,
the difference between cash receipts and expenditures. A firm with sufficient cash flow can
finance its projects internally, and there is no asymmetric information because it knows how
good its own projects are. An increase in interest rates and therefore in household and firm
interest payments decreases their cash flow. With less cash flow, the firm has fewer internal
funds and must raise funds from an external source, say, a bank, which does not know the
firm as well as its owners or managers. Because of this increased adverse selection and moral

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 hazard, the bank may choose not to lend firms, even those with good risks, the money to
undertake potentially profitable investments. Thus when cash flow drops as a result of an
increase in interest rates, adverse selection and moral hazard problems become more severe –
again curtailing lending, investment, and economic activity.

6. Government Fiscal Imbalances

In emerging market countries, government fiscal imbalances may create fears of default on
government debt. As a result, demand from individual investors for government bonds may
fall, causing the government to force financial institutions to purchase them. If the debt then
declines in price (which will occur if a government default is likely) financial institutions’
balance sheets will weaken and their lending will contract. Fears of default on the
government debt can also spark a foreign exchange crisis in which the value of the domestic
currency falls sharply because investors pull their money out of the country. The decline in
the domestic currency’s value will then lead to the destruction of the balance sheets of firms
with large amounts of debt denominated in foreign currency. These balance sheet problems
lead to an increase in adverse selection and moral hazard problems, a decline in lending, and
a contraction of economic activity.

8. Discuss the key causes of the recent global financial crisis according to Henry (2009).

Refer to reading on One Huge Minsky Moment.

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