In practice, however, the money multiplier approach has several problems.
Even if reserve ratios do only change in a predictable way, the very fact that only a very small number of predictable ratios is used (in terms of parsimononious structure of the model an advantage), these are unlikely to completely capture all portfolio adjustments and behavioural interactions. If one wanted to include those in the system, the complexity would rise considerably which would increase the informational costs to the system. The model has very small informational content. Factors affecting the determinants of high-powered money may be endogenous to the system and not as assumed given by an exogenous amount of H (possible dynamic portfolio adjustment of the authorities). Taking H as exogenous may obscure the problems the monitary authorities are facing in practice. The EU-type (Hansen, 1973) equation of the public sector deficit is given by: , where OMO are operations in marketable debt, NMD transactions of non-marketable debt, MAT funds to pay off maturing debt, ECF the total finance accomodating external currency flows. Rearranged this gives the following equation for the change in high-powered money:
. PSD and MAT are outside the control of the authorities. NMD and ECF are inversely related to interest rate differentials. This implies that to achieve a desired level of H, the authorities need to offset by inducing people to purchase OMOs. However, with uncertainty about the real yield on asset holdings, the public will only plan over a short-run horizon, i.e. the market demand will be influenced by expectations. With relative stability expectations will not deviate too much from current levels, i.e. there will be at least some certainty about longterm prices and rates. With sudden changes in the system, large fluctuations are nevertheless possible. The greater the uncertainty and instability of interest rates, the less will authorities be able to control the money stock by OMO. Furthermore, it is difficult to forecast private sector response to OMOs due to the strength of competition for money from the rest of the economy. Banks compete for funds from the public. Lower yield differentials favour public debt which in turn forces the authorities to increase rates to restrain monetary expansion. However, the extent of rates responding to competition depends on the interest rate elasticity of loan demands. Lags in response to rate changes may further complicate the adjustment and effcient targeting.
Furthermore, the model does not capture any problems associated with the money stock as a target of the authorities (which measure for money, broad, narrow; “Goodhart’s law” suggesting that as soon as a certain money stock is targeted financial intermediaries will search for broader concepts to avoid controls). The variables do not say anything about the behavioural process behind quantitative adjustments.
In sum, the true problems the authorities are facing are not really recognised in the simple multiplier approach. This suggests that it should only used with caution in determining the money supply. The value of the multiplier arising out of the simple identities used is irrelevant if the critical factors for the monetary authorities are disregarded. These are: (1) the interest rate elasticity of demand for advances, (2) the public sector deficit size, (3) the elasticity of substitution of foreign to domestic assets in an open economy under a fixed exchange rate regime and the extent of exchange rate fluctuations in a floating regime and (4) the market reactions to OMO. This implies that a combination of the relevant statistics should be used in determining the money supply rather than relying on the money multiplier model.
- Why may rationing arise in credit markets and what are the implications for the working of these markets?
Macroeconomic Models usually model financial markets despite their complexity and sophistication by just two variables: the money stock and the interest rate. In this respect the financial markets are treated no differently than other complex markets such as the labour market. However, recent advances in the literature have thrown doubt on whether the interest rate alone does adequately reflect the links between financial markets and the rest of the economy. It is argued that the availability of credit and the quality of balance sheets are important determinants of the rate of investment and that the money stock is not a key quantity in the determination of the price level and output, in part because it is endogenous and in part because the financial system is itself sufficiently flexible to generate as much inside money as might be needed to finance any given level of activity.
Arguments centre on the theory of imperfect information. Capital markets are assumed to not only intermediate in a mechanical way between savers and investors but in addition deal with a variety of problems that arise from asymmetric information about investment projects between borrower and lender. These informational problems shape capital market institutions and debt instruments and affect the way in which policy actions are transmitted to the goods market. It is therefore important to recognise these informational complications in order to assess the role of credit in the business cycle and in the transmission of monetary policy to the economy.
In the following I will outline why credit may be rationed and what the implications for credit markets are.
If credit is rationed, then it is possible that the interest rate is not a reliable indicator of the impact of financial variables on aggregate demand. Baltensperger (1978) defines credit rationing as the situation when “some borrower’s demand for credit is turned down, even if this borrower is willing to pay all the price and non-price elements of the loan contract”. Price element in this respect is the interest rate whereas non-price elements are collateral requirements. There appear two types of credit rationing. Type 1 credit rationing occurs when an individual cannot borrow as much as he or she wants at the going interest rate. Type 2 credit rationing occurs when, among identical borrowers, some who wish to borrow are able to do so, while others cannot (Keeton, 1979).
Most obviously, credit rationing follows when there are interest rate ceilings, this is called disequilibrium credit rationing. It results because of institutional restrictions. Imposed credit rationing of this type has been very common in most industrialised countries in the time after the Second World war and the 1980s (“window guidance” in Japan, the pre-1971 credit ceilings and the “corset” in the UK, encadrement du credit in France etc.) and appeared mostly in the form of lending quotas. The effect of this type of rationing is to make the supply curve vertical. Credit rationing results if banks collectively maintain interest rates at lower than profit maximising levels. In the longer term the credit controls on the already cartelised banking system provoked a combination of credit rationing, higher margins and loss of incentives for greater efficiency and therefore pushed financial flows to be diverted to other uncontrolled channels (“disintermediation”) in the form of intercompany trade credit or commercial paper, fringe banks and uncontrolled finance houses etc. During the last years the increasing world wide competition with the development of multinational company and banks networks combined with the change in societal attitudes towards relatively uncontrolled free markets has led to the abolishment of most direct credit control systems.
The underlying motivation for credit controls was to indirectly control the interest rate, i.e. to have a quick and effective means to maintain lower rates particularly in times of crisis. Other arguments for credit rationing at the micro-level are: (1) a higher time discount rate of private borrowers than the social rate, so that it was feared that scarce credit would be absorbed by consumption instead of profitable investment, (2) as a source of revenue to the government by forcing banks to take up government debt at lower interest rates, (3) to direct credit to socially more desirable projects (necessary because of diverting underlying equilibrium prices.
However, it has been shown that credit rationing may also occur as a phenomenon even in the absence of controls. Jaffee and Modigliani (1969) distinguish between disequilibrium and equilibrium rationing. Disequilibrium rationing occurs when lenders are slow to adjust the interest rates that they charge on loans as external conditions change. This may appear when interest rates are set by a cartel or a market leader or when lenders set limits on their exposure to counter-parties. Changes in the credit-worthiness of these counter-parties most often induce limit changes instead of actual rate changes.
Rationing may occur also as an equilibrium phenomenon after full adjustment to a static point has taken place.
Two main reasons have been advanced for lenders to ration credit rather than raise interest rates to clear markets:
- Moral hazard. When the contract between lender and borrower is a debt contract that allows for bankruptcy, the lender increases the incentive of the borrower to undertake risky investments by raising the interest rate. The increased risk of bankruptcy may actually reduce the lender’s expected return when the interest rate rises. This would not be a problem if the lender could observe and control the type of project undertaken by the borrower.
- Adverse selection. Similarly, again assuming that the contract between lender and borrower is a debt contract, lenders may prefer to ration credit rather than to raise the interest rate because more risk averse individuals drop out of the borrowing pool as the interest rate rises. The less risk averse the borrower, the more likely is the borrower to choose risky projects that increase the chance of bankruptcy. This problem would not occur if the lender had full information about the type of project to be undertaken by the borrower.
Stiglitz and Weiss (1981) build a model of credit rationing based on adverse selection.
Suppose a continuum of entrepreneurs each having an indivisible investment project requiring initial investment K. Each entrepreneur has an endowment W<K, i.e. has to borrow K-W=B. The projects have the same returns but differ in risk. A project succeeds with probability pi. Success is denoted by RiS, failure by Rf. Thus,
The key assymmetry of information is that though the entrepreneur know his probability of success, the banks does not. Further, in the absence of mechanisms to sort individuals into probability classes, the bank potentially makes loans to all who are willing to borrow at the posted rate. It it should decide to ration credit, it cannot do so in a way that discriminates high-risk from low-risk borrowers among those willing to borrow.
With risk neutral banks and entrepreneurs the expected return respectively is:
Where p is the cutoff probability at which customers come to the bank for loans.
When an entrepreneur decides whether to borrow, a key feature of the payoff to the investor is that it is decreasing in the probability of success, pi. Hence, high-risk investors are willing to pay more for a loan. This is the basic source of the credit-rationing result. It depends on the fact that the contract between the borrower and the bank is a debt contract. Gale and Hellwig (1985) show that if it is costly to monitor the state of nature, the optimal contract takes the form of debt. By having the borrower make a fixed payment independent of the state of nature for good outcomes, the contract saves on expected monitoring costs.
If investors have the alternative of holding their wealth, W, in a safe asset that yields a rate of return ρ. They will want to borrow so long as . Given this and the definition of above, the higher the interest rate, r, the riskier is the marginal project, that project for which the entrepreneur is indifferent between undertaking the investment project and putting his wealth into the safe asset. This implies that dp/dr<0; that is, the probability of success of the marginal project declines as the interest rate increases.
The use of the very restricted form of debt contract in this model raises the issue of the robustness of the credit-rationing result. Bester (1985) suggests the use a sorting device in form of different debt contracts so that borrowers effectively self-select into different equilibrium contracts.
The term rationing automatically implies nonoptimality. De Meza and Webb (1987) show that if, in the Stiglitz-Weiss model, the supply of funds to the bank is nondecreasing in the rate of return, there is too little investment at the credit-rationed equilibrium, i.e. an interest subsidy could restore the first-best allocation. They also show that with a backward-bending supply of funds to the banking system, there will be overinvestment at the credit-rationed equilibrium.
However, Williamson (1986) shows that credit-rationing may also be optimal in preventing overinvestment in risky projects. Mankiw (1986) presents a model in which the allocation of credit is nonoptimal in the absence of credit rationing. He shows that an increase in the interest rate may destroy the market equilibrium (financial collapse). This leads to nonoptimal allocation of investment, i.e. government intervention to prevent market collapse may be socially justified.
