What Can an Abstract Macroeconomic Model, Such as the IS-LM Model, Tell us about the Links between Financial and Real Production activity in an Economy?

At a higher income level of Y  , the demand for money will be greater at each interest rate.  From the new money demand schedule LL  , we see that the equilibrium interest rate is now r  .  Point E  in figure (b) illustrates that the combination r  and Y  also leads to money market equilibrium.  With a higher income, tending to increase the quantity of money demanded, and a higher interest rate, tending to reduce the quantity of money demanded, the quantity of money demanded remains in line with the unchanged quantity supplied.

The LM schedule is obtained by joining all the points in figure (b).

The LM schedule slopes upwards.  With a higher income level it also requires a higher interest rate to eliminate any money demand and maintain money market equilibrium with an unchanged money supply.

An increase in the domestic money supply can cause the LM schedule to shift to the right, because for a given rate of interest the increased supply of money will only be held if there is an increase in income which leads to a rise in transaction demand.  A depreciation of the exchange rate will lead to a rise in the aggregate price index, as it implies a rise in the price of imports.  This means that the real money balances will be reduced and there will be a resulting increase in the demand for money that can only be eliminated by reducing the transactions demand for money implying a lower level of income and a leftward shift of the LM schedule.

The IS-LM model allows us to study both markets for goods and money on the same diagram.  

Figure 3

Figure 3, above, shows all the points on the IS schedule where the goods market is in equilibrium and all the points on the LM schedule where the money market is also in equilibrium.  It is only at point E that both markets are in equilibrium.               “Goods and money markets interact to determine the level of equilibrium interest rate r* and the equilibrium income Y*.”

Point A on the IS schedule, in figure 3, illustrates that the interest rate is r  and that the level of income is Y  .  The combination r  and Y  lead to goods market equilibrium, however, at an interest rate of r  , an income level of Y  is required

for the money market to be in equilibrium, at B on the LM schedule.  With interest rate at r  , the income level at Y  is too low for money market equilibrium to occur.  With such a low income level, the quantity of money demanded is also too low to match the given quantity of money supply.  Therefore, with an excess supply of money, a cut in interest rates is required to achieve the money supply target.  This process continues until interest rates drop to r*.  At this level, aggregate demand and income have risen sufficiently to increase money demand enough to lead to equilibrium in the money market, as well as the goods market.

If the interest rate is at r  , the income Y  that is required for goods market equilibrium at point C is greater than the income Y  that is required for equilibrium in the money market at point D.   Therefore, with income too high to allow money market equilibrium to occur, there is an excess demand for money, causing interest rates to rise.  As before, this process continues until interest rates rise to r* and income rises to Y*, and both markets are in equilibrium.  

The IS-LM model can be used to illustrate how fiscal policy and monetary policy can be employed to alter the level of national income.  

If the economy starts at equilibrium, E  , an increase in the money supply, shifts the LM schedule to the right, LM  , resulting in a rise in national income and a fall in interest rates.  

Figure 4

The initial position, E  , is at the intersection of the IS  schedule and the LM  schedule.  The resulting increase in expenditures, (which is caused by low interest rates and associated with higher investment), would, through the multiplier effect, tend to lead to national income of Y  .  An excess demand for final output will also lead to an increase in goods prices.  As prices rise, the real money supply falls and there are also effects due to a rise in relative price of domestic goods.  These shift the IS and LM schedules back slightly to the left to a point A. (The shifted curves are not shown because they are so close to IS  and LM ).

Now, we can observe the effect of a fiscal policy expansion.  Once again, the economy starts at full equilibrium, E  , where interest rates are at r* and national income is at Y*.  An increase in government spending will result in a rightward shift of the IS schedule.  This increase also creates an increase in aggregate demand, which in turn rises the price level.  The new IS  and LM  schedules are drawn to incorporate the effects of this initial rise in the price level.  The increase in government expenditure increases the interest rate, from r* to r  .  This rise in the interest rate reduces investment, so government spending crowds out investment.  Initially the combination of national income and the interest rate moves from E  to Y  .

Figure 5

In the long run, wealth effects and higher domestic prices shift the IS schedule to IS  and the fall in the real money supply shifts the LM schedule to LM  .  Thus, the

long-run effect of a fiscal expansion is a permanently higher interest rate, r2  , at point Z, which crowds out investment and a higher price level which could crowd out consumption, through wealth effects,  and net exports, through a rise in domestic prices relative to foreign prices.  

In developed countries, decisions to invest, in capital projects, are often taken separately from decisions to save.  It is a general feature of developed economies that a large proportion of saving is not used directly by the saver, but is made available to investors elsewhere.  One of the roles of a financial system is described as the channelling of fund from economic agents with a financial surplus (lenders) to those with a financial deficit (borrowers).  Borrowing is most often used to finance investment however, some agents will borrow to finance a deficit that has arisen not from investment but from an excess of consumption over income.  

A financial intermediary is an organisation that operates in the financial system, linking lenders and borrowers or savers and investors.  Intermediation is the role of financial  institutions in channelling savings and other deposits by lenders to borrowers.  Financial intermediaries such as commercial banks and building societies accept deposits from individuals and businesses and use these funds to make loans to creditworthy customers.  An intermediary’s profit is the difference between interest rates paid for deposits and interest rates on loans.

‘Intermediary effects’ allocates capital resources to earn an average yield much higher than under self-finance.  This financial intermediary raises the marginal product of capital for each capital intensity.

Two different types of intermediation are, firstly, a ‘distributive’ or ‘brokerage’ function whereby the economic role of the intermediary is to facilitate the transfer of ownership of existing financial assets.  The second type of intermediary is those who issue contracts, which modify the attributes of the financial securities, which pass between the borrower and the lender.

Where financial intermediation is performed by a depository financial institution and where the sector is sufficiently competitive so that there are no monopoly profits in financial intermediaries, the wealth owners rate of return is given by;

r=Y f k - c

where Y fk  is the marginal product of capital when investment is financed, c is the real unit cost of finance per period and r is the deposit rate.

Lewis J. Spellman recognises 3 impacts of financial intermediaries;

1. A better allocation of investment (Allocation effect).
2. Increased desire to hold financial wealth per unit of output (Intermediation effect).
3. Separation of the rate of return on capital earned by firms and the rate of deposit earned by the holders of financial assets (Cost effect).

The more efficient the financial intermediary, in terms of lower unit financial costs, the greater will be the equilibrium capital intensity.

The financial system can influence the capital intensity and output by achieving an allocation of capital resources that place productive resources with the most

efficient producers and therefore, alters the aggregate production function of the economy.

There is a wide range of financial intermediaries in the UK, including, commercial banks, building societies, insurance companies and pension funds.

There are many benefits of intermediaries; firstly, the presence of information costs undermines the ability of a potential lender to find the most appropriate borrower, in the absence of intermediation.  There are four types of information costs; search costs exist whenever there is a contract between two parties.  Transactors and transactees have to search out, obtain information about, select, meet and negotiate with other parties to a contract. Verification costs also exist because before money is loaned out lenders must verify the accuracy of information being provided by the borrower.  Asymmetric information between borrower and lender will give rise to adverse selection, which will cause inefficient allocation in markets.  Monitoring costs are also created because once a loan is negotiated, the activities of the borrower must be monitored, to ensure it is possible to distinguish between legitimate and unsound reasons for a borrower being unable to meet a payment.  Enforcement costs are carried by contracts, in any contract, either of the parties to the contract may breach its conditions, and the injured party has to take action to either enforce the contract or seek compensation in the event of breach of contract.

Another benefit of financial intermediaries is, provided that the institution keeps some proportion of those funds it receives in liquid form, and provided that depositors do not wish to withdraw deposits at once, depositors can have access to their funds,  even though the majority of funds have been lent for a long period of time.  The advantage to the borrower is the availability of long-term loans, even though, perhaps, no one wishes to lend for a long period.  This is known as maturity transformation.

A benefit for lenders is that the institutions can pool lots of small deposits which taken separately would be unattractive to borrowers.  These deposits can earn a rate of interest from being lent, which would not have been possible before.  This is a plus-point for borrowers as they can borrow large sums of money, even though lenders may not wish to lend large sums.  By operating on a large scale, the financial intermediaries can reduce risk for both parties by incurring the risk themselves.  Institutions also reduce risk by their ability to diversify.  They can do this by lending to a wide variety of people and organisations in such a way that an adverse event is likely to effect only a small proportion of loans.  They can also diversify their sources of funds, so that a difficulty in raising funds from one source can be offset from elsewhere.

“Diversification is one of the characteristics of financial intermediaries that tends to benefit from economies of scale.”

To put the role of financial intermediaries in simple terms, is to say that, intermediaries are making funds available (to lenders and borrowers) cheaply, readily and with a minimum of risk.

                                                                                                                                                                                                                                                                                                                                                                   

What Can an Abstract Macroeconomic

Model, Such as the IS-LM Model, Tell us

about the Links between Financial and Real

Production activity in an Economy?  What

are the Range of Financial Intermediaries

existing in the UK and what are the Benefits

of Financial Intermediaries?

Bibliography

1. Collins Dictionary of Economics, 3rd Edition, C. Pass, B. Lowes and L. Davies, 2000, Harper Collins.
2. Domestic and International Banking, M.K. Lewis and K.T. Davies, 1987, Philip Allan.
3. Economics, 6th Edition, D. Begg, S. Fischer and R. Dornbusch, 2000, McGraw-Hill.
4. International Finance, 2nd Edition, K. Pilbeam, 1998, Macmillan Press.
5. Modern Banking in Theory and Practice, S. Heffernan, 1996, John Wiley & Sons.
6. Money and Finance in Economic Growth and Development, Volume 8,     R.I. McKinnon, 1976, Marcel Dekker.
7. An Introduction to Positive Economics, 8th Edition, R. Lipsey and K. Chrystal, 1995, Oxford University Press.
8. The Economics of Money, Banking and Finance, P. Howells and K. Bain, 1998, Prentice Hall.
9. The UK Financial System, 3rd Edition, M. Buckle and J. Thompson, 1998, Manchester University Press.

 Lecture Notes, Banking and Finance, 05/10/2001 and 19/10/2001.

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