Manchus

China was being ruled by the Manchu dynasty from the 17th century. Initially their rule had ushered in prosperity but it was soon accompanied by economic stagnation. This fit in with the cyclical theory of alternate periods of boom and bust, an inherent trait of Confucian philosophy. The Chinese were living in obscurantism with little contact with the West. The Chinese economy was self-sufficient and relatively more prosperous than the West in the 18th century, when the winds of change that would sweep down outdated technology had begun to emerge in Asia.
The Western countries traded with China for tea, silk and other items in exchange for the very little they could offer. They had an adverse balance of trade vis-à-vis China till the latter part of the 18th century, but this trade was very profitable as it became a major source of revenue for the exchequer of the Western nations, and was re-exported all over the world culminating in huge profit. Notwithstanding such success the West had a burning desire to penetrate the vast Chinese market. The product that brought untrammeled success to the British was opium. Opium was grown in British India, packed in countless crates and smuggled into China. This ultimately altered the balance of trade dramatically in favor of the British within a few decades and wreaked havoc on Chinese society as opium had an inelastic demand like salt and food.
Opium resulted in an incessant outflow of Chinese silver to the British and distorted the Chinese domestic silver-copper dual currency resulting in inflation and devaluation of the Chinese currency. The economic, social and human landslide of China finally woke up the rulers who enacted laws to stop the importation of opium. However, these laws were flouted by the British with impunity. Such circumstances eventuated in the outbreak of a major naval conflict between Britain and China, which ended in a humiliating loss for China. Subsequently a debilitating treaty was thrust upon China. This treaty became known as the Treaty of Nanking and became the first of a series of unequal treaties that encroached upon China’s economic sovereignty and reduced imperial China to the status of vassalage.
This is the backdrop in which China survived the major part of the ninth century and the first half of the twentieth century. The enforced agreements crippled the Chinese economy. The major territorial areas of China were still ruled by the Manchus but for practical purposes they were puppets in the hands of their western masters. They had to pay massive tributes to the western nations and were forced to administer policies, which greatly benefited the western countries at the cost of China. Western exports were allowed duty-free into China, including opium. Chinese exports were heavily taxed in the Western nations. China had to seek permission for enacting its domestic policies from the Western powers that often had no interest in seeing China modernize. Besides, Chinese wealth was being swept away by the floods of tumultuous Western currents. Some parts of China were under the direct rule of the Western powers that thoroughly exploited the economy and fostered policies, which solely benefited them.
China had very little scientific, technological and financial muscle to modernize its industries and armed forces. Besides, Chinese society was under the spell of Confucianism, which looked down upon merchant class and had created an atmosphere in which the Chinese mercantile and entrepreneurial spirit was stifled. China was living under a rent-seeking bureaucratic feudal class, which smothered the growth of the merchant community. In the latter half of the ninth century reforms were initiated by the Qing dynasty but was half-hearted and minimal. Western science and technology and manpower were incorporated in the experiment but the Westerners supplied them with obsolete, substandard technology and inferior manpower, which kept Chinese industry and military backward.
On top of that the centrifugal forces periodically manifested themselves in violent movements, which further hurt, the ruling class and the economy.
Ultimately the Qing dynasty was overthrown but it gave way to a period of provincial warlordism, which was marked by stagnation and corruption. This was succeeded by the Kuomintang who was stooges of Western capitalism and followed the Manchus in their obeisance to the Westerners. The Kuomintang’s corruption and brutality further exacerbated the situation. The Western powers had themselves developed very little industry and financial institutions to fuel the economy. Therefore, it can be safely concluded that under Western tutelage China’s development was obstructed.

Rajeet Guha

The Great Depression

There is a broad consensus among scholars that the cataclysmic event called the Great Depression occurred in 1929. It reared its ugly hood with the crashing of the New York Stock Exchange in Wall Street. It lasted well into the next decade, ravaging the lives of millions of people on its way. It was undoubtedly one of the worst economic downturns in the history of capitalism. The stubborn perseverance of the Great Depression wreaked havoc on large segments of society. The ranks of the unemployed began to soar in numbers. A large section of the middle class lost their savings and was reduced to a state of penury. At this time lots of businesses failed and stocks of companies became worthless scraps of paper. Many banks shut down their operations during this period. The plague soon spread to other parts of the Western capitalist world. The combination of disastrous policies, outmoded and harsh international agreements, creeping pessimism and mistrust, insufficient demand and a surfeit of overproduced goods created the Great Depression one of the longest and most severe recessions in the evolution of capitalism. It was ultimately the inevitability of World War 2 that proved to be the panacea for the vicious and unending cycle and misery of the Great Depression. In this paper I will analyze the nature and intensity of the Great Depression and the impact it had on people’s lives. I will also make an attempt to unravel the causes of the Great Depression by synthesizing the various arguments into a single coherent theory.
The Great Depression in the United States was largely the result of changes in economic institutions that lowered the normal or steady state market hours per person over 16. The difference in steady-state hours in 1929 and 1939 is over 20 %. The market hours did not return to their steady-state due to changes in labor market institutions and industrial policy actions. This is exemplified by steady-state market hours returning to normal in France but not in the U.S.
The stock market crash resulted in the devaluation of wealth and disruption of the banking system. This explains the intensity of the crisis. The stock market collapse created pessimism in the business and smothered investment. Financial markets collapsed because of the institutional distortions created by the treaty of Versailles.
Fisher and Robbins have argued that the depression was the inevitable result of the unstable credit structure of the twenties. There was a dangerous circle of obligations and risks epitomized by the loans that the U.S. had made to England, France during the war and for which they demanded back payment. But in order to pay back the loans the Allies depended on Germany’s war reparations but Germany was already in a mess.
Under the Dawes Plan of 1924 the U.S. loaned funds to GB, France and Germany but in 1929 they suddenly cut back on funds. The demise of the gold standard in international trade and demands that Germany make reparations payments in gold created a net gold flow into the United States that led to a veritable explosion of credit. Extremely unstable credit arrangements emerged in the twenties and once the crash came, the banking system quickly collapsed. Thus, excessive credit and speculation coupled with a weak banking network caused the Great Depression. The stock market crash resulted in a decrease in purchasing power and left the economy saddled with excess capacity and inadequate demand.
Some people say that market saturation had taken place in industry especially in residential construction. Some people say that there had been an increase in the tax rates and that is what caused aggregate demand to decrease. There was a decline in farm incomes during the twenties. Some people assert that the New Deal’s industrial codes raised labor costs and material input prices, thus negating, thus negating whatever monetary stimulus existed. The 1936-37 recession was dubbed the “Roosevelt recession”.
Some blamed that the private sector moved too quickly in the mid 1930s in raising prices. As a result by 1937 consumers increasingly resisted higher prices as they sought to liquidate the large debt incurred earlier in the decade and to maintain the savings in uncertain times. The average propensity to consume subsequently fell and a recession took hold. Some writers like Paul Sweezy have argued that during the 1920s the distribution of national income became increasingly skewed lowering the economy’s overall propensity to consume.
Others such as Kindleberger, Arthur Lewis have focused on the shift in the terms of trade between primary products and manufactured goods due to the uneven development of the agricultural and industrial nations. The change in the terms of trade created a credit crisis in world markets during the bad crop yields of 1929 and 1930. At the same time that agricultural economies were losing revenue because of poor harvests and declining world demand, the developed economies were contracting credit for the developing nations and imposing massive trade restrictions such as America’s Hawley-Smoot tariff of 1930. As the agricultural nations went into the slump the industrialized countries lost a major market for their output.
Price rigidity inhibited the recovery of both final product demand and investment demand. After the crash of 1929, prices became increasingly inflexible due to the concentrated structure of American industry and the impact of labor unions. These sticky prices further limited the already constrained power of consumers.
Secondly noncompetitive pricing predominated in the capital goods sector, meaning producers were less willing to buy new plants and equipments.
Schumpeter argued that the major cycles of economic activity had reached their nadir in the Great Depression. According to him in the United States and Europe development during the nineteenth century and early twentieth century took the form of a series of surges in output, capital and labor followed by periods of retarded growth. Each period of retardation in the rate of growth of output culminated in a protracted depression in which business cycle recoveries were disappointing and failing to lift the economy
Stagnation theorists agreed that stagnation involved a decrease of the rate of growth of heavy industries and of building activity and the slowing down of the rate of growth of the total quantity of production, employment and usually of population. Some people focused on the decline of new technologies while others focused on the shrinkage of investment outlets as the rate of population growth fell.
Steindl argued that long-run tendencies toward capital concentration, inherent in capitalistic development over time led to a lethargic attitude toward competition and investment. The emergence of concentrated markets prevented the utilization of excess capacity that is required for an economic revival. Price inflexibility in concentrated industries is intensified during depressions. Firms revenues tend to be jeopardized in a slump that price reduction seems unfeasible. There may even be incentives to raise prices in order to compensate for reduction in sales. In a sector where the squeezing out of competitors is relatively easy, large declines in demand will result in the reduction of profit margins for each firm as prices are cut.
By contrast, in a concentrated market, profit margins will tend to be inelastic in the face of lowered demand, as prices remain the same. In such circumstances where price reductions do not compensate for declines in the rate of growth and thus companies tend to reduce their rate of capacity utilization. Reductions in capacity utilization imply not only decreases in national income but also increase in unemployment. In the presence of underutilized capacity, firms will be increasingly disinclined to undertake any net investment. A cumulative process is thereby established wherein a decline in the rate of growth, by generating reductions in the rate of capacity utilization will lead to a further decline in the rate of expansion as net investment is reduced.
Individual firms by believing that decreases in their own investment will alleviate their own burden of excess capacity, merely intensify the problem economy-wide. The higher profit margins secured by large firms indicate an increasingly skewed distribution of output that when combined with the reluctance of firms to invest generates a rising aggregate marginal propensity to save. The potential for recovery is thus barred.
According to Marxists crises are possible and inevitable due to the unplanned nature of the capitalist system. According to them forces that delay a crisis only tend to intensify it. Capitalism leads to uneven development of the economy and in order to adjust to get back into sync there is forcible adjustment, which is the economic crisis itself. The initial maladjustment is reflected in changes in the profit rate. The form of these changes can vary depending on the objective encountered.
Capitalist competition is aggressive, resulting in invasion of old markets, creating new ones, introducing new technologies and management strategies. This results in capitalist accumulation. Competition even exists among banks in supplying credit. This leads to aggregate over-investment and over accumulation. In this process individual capitalists push down wages in order to cut costs and compete in the market thereby causing underconsumption causing a depression in the profit rate and lowering capacity utilization. Combined with excessive debt and capacity utilization this will create a depression. According to Kindleberger and other Keynesians, the U.S. failed to fulfill the role of a hegemonic power. This created instability.
The U.S. Federal Reserve’s attempts in 1928 and 1929 to raise interest rates to discourage the speculative demand for company stocks as a rise in interest reduces the speculative demand for money as people tend to buy bonds rather than sell them. The increase in interest rate decreased the investment demand for producer goods leading to a drop in production of producer goods. There was therefore retrenchment and the fear of being thrown out in these industries decreased the demand for consumer goods as well. The increase in interest rates also reduced consumption as people tended to save more. The decrease in the price level or deflation reduced aggregate supply and contracted production in the short-run but aggregate demand decreased faster because of a decrease in consumption and investment. The decrease in aggregate demand resulted in a further fall in price. With deflation setting in and prices falling rapidly, investors decided that they would delay investment as in a deflation, money tomorrow is worth more than money today resulting in more profits in the future investment than current investment. The failure of businesses resulted in their inability to pay back the loans leading to bank closures and the wiping out of people’s life savings. This cast doubt on the credit system and therefore there was a lack of funds for investment.
Milton Friedman and Anna Schwartz believed that the Depression due to blunders in monetary policy. A range of evidence points that at the market peak forty percent stock market values were pure air. Prices were above stock market for unrealistic optimism. Federal Reserve initially raised interest rates by making borrowing money for stock speculation difficult and costly. However, in 1927 Federal Reserve lowered the interest rates and created easy-money policies and expanded the boom for two more years. The Federal Reserve contracted the money supply continually thereby pushing up interest rates continually. At that time interest rates were hiked up to discourage gold outflows from U.S. to other countries as every country was then on the gold standard.
The major economists of the day like Schumpeter, Hayek and Robbins believed that liquidation of the economy would be the panacea for the depression. They believed that propping up aggregate demand through govt. spending (printing money) would lead to inflation. Fiscal Orthodoxy and balanced budgets led to a reduction in aggregate demand thereby leading to a reduction in wages and prices. This led to further deflation. In a deflation the collateral value goes down and therefore banks stop giving credit. Countries without massive gold reserves could not even lower interest rates as this would lead to massive gold outflow and domestic investors would invest abroad. Additional credit could not be injected as this would lead to higher imports and balance of payments deficit. The countries that abandoned the gold standard recovered faster.
The Keynesian explanation of the Great Depression can be found in the decrease of aggregate demand. The boom in the automobile and radio industries and residential construction propelled growth in the 1920s according to this view. The drying up of investment opportunities created a downward shift in aggregate demand. Bad fiscal policy has been attributed the blame for the Great Depression. The increase in taxes and a lackadaisical attitude shown by the govt. towards spending created and lengthened the Depression.
In a nutshell it can be said that the Great Depression resulted from the lowering of working hours, loss of income due to the stock market crash, clinging onto the gold standard, the harsh reparations of the treaty of Versailles, hiking up of interest rates, skewed income distribution, overproduction, tariff barriers, increase in taxes, saturation in residential construction, New Deal’s industrial codes, adverse shift in the terms of trade, lack of an international financial institution, weak banking network, Federal Reserve’s refusal to increase the money supply, sticky prices, noncompetitive pricing, stagnation and tendency towards the concentration of capital in few hands, weak banking system and the quenching up of international credit. The juxtaposition of these factors created a recipe for disaster. The disaster manifested itself in the Great Depression. It was ultimately World War 2, which unfettered the Western capitalist world from the clutches of the Depression.
















Reference:
1) Great Depression and American capitalism – Robert Himmelberg
2) Great Depression and World War 2 – Thomas Cochran
3) The Great Depression – John A. Garraty
4) The World Economy, Money and the Great Depression – Gottfried Haberler
5) World in Depression 1929-39 – Charles Kindleberger
6) A Monetary history of the United States – Milton Friedman & Anna Schwartz


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Rajeet Guha

A.1 The Big Mac Index is synonymous with the Big Mac Purchasing Power Parity. It is grounded in the theory of Purchasing Power Parity (PPP), which adjusts price level differences across countries. The theory of PPP purports that in the long-run market foreign exchange rates will move towards rates that equalize the prices of an identical basket of goods and services across countries exemplified by the prices of burgers across countries. The proponents of PPP point out the drawback in calculating national output at prevailing market foreign exchange rates namely not accounting for the discrepancies in price levels across countries and therefore either understating or hyperbolizing the contribution of GDP of countries to the world output. The adherents of the theory of PPP believe that the law of one price should be incorporated in the calculation of the GDP of countries. They assert that GDP computed at PPP will mirror the true contribution of the country’s economy to world output.

A.2 The Big Mac index is a befitting title. It is founded on the supposition that in the long run market foreign exchange rates will kowtow before the law of one price. The law of one price claims that the prices of goods across countries will converge in the long-run. A corollary that comes out of this is that the prices of Big Mac burgers across countries will be the same in a universally accepted currency such as the dollar. The Big Mac has been used as an example to drive home the strong case for purchasing power parity.

A.3 Certain key insights can be gleaned from the article in the economist titled ‘Food for Thought’. The article rams home the issue of abandoning the estimation of GDP at exchange rates that fail to take into account disparities in price level across countries and endorses the calculation of GDP at purchasing power parity. The advocates of PPP contend that GDP at PPP will reveal the latent size of an economy and its share in the world output pie. They are convinced that there will be a clear-cut picture showing by how much an average consumer in one country is better off in real terms than his counterpart in another country. They also feel that the unearthing of the baffling surge in oil prices lie in the novelty of purchasing power parity. They feel the mind-boggling populous nations of China and India have catapulted the enormous bulge in oil prices. However, the verbose eulogy on PPP is not without a blemish. PPP does have an Achilles heel. It does not hold forth for goods and services that are precluded from the realm of trade.

India DEV

Rajeet Guha

Economic Development: Predictability and Challenge: the Indian Experience

While the last 4 decades have seen the proliferation of theories of development, some of the fundamental issues of growth, elimination of poverty and human development have continued to generate debate and controversy. This essay seeks to investigate these theoretical approaches with reference to India’s development experience. The three major strands of such debate that this essay concerns itself with are: first the different stages of development transformation and their predictability, secondly the key macro economic conditions which act as preconditions for development and finally the link between economic growth and poverty reduction. W.W Rostow in 19 visualized Harrod Domar



More recently, particularly since the nineties a fundamental question that has baffled both economists and political thinkers and practitioners alike is the so called persistent poverty trap in which countries like India find themselves despite registering some of the fastest growth rates in the world since the eighties. While it is true that India like China has succeeded in substantial reduction of poverty, particularly since the seventies, there is no doubt a certain slowing down of poverty reduction discernible in the last decade or so. As a result the growth in per capita income has stagnated despite impressive economic growth. India enjoyed a growth rate of over 6% per year for almost two decades: 1980-2000. The ratio of India’s population below the poverty line fell from 39% in 1987-88 to 25.3% in 1999-2000 in rural areas and from 22.8% to 12.5% in urban areas (Angus Deaton (2001) cited by T.N.Srinivasan in China and India: Growth and Poverty, 1980-2000: www.1.gsb.columbia.edu) In absolute numbers, however, the poor in India still number over 250 million, almost twice as many as in Sub Saharan Africa. A more disaggregated picture shows that the large poor states of India (Uttar Pradesh, Madhya Pradesh, Rajasthan, Orissa etc.) containing 40% of India’s population have lagged behind in reducing poverty since the late 1970s. This has also had its inevitable impact on politics. India’s vibrant democratic polity lent a crushing defeat to the ruling Bharatiya Janata Party (BJP) in 2004 which had been basking in the glow of a near 7% growth rate for two successive years, unprecedented growth in the IT and IT enabled services sectors, rising foreign direct investments and tremendous expansion in outsourcing from the US. Defying all predictions (national and international) this electoral reverse for the ruling right of center political party has been widely explained as a rejection by India’s poor of what was a growth strategy benefiting the middle and upper classes and bypassing the poor. In a sense this political development has once again brought to sharp focus the fundamental question whether economic growth fuelled by free markets, globalization and sound macro economic management can constitute the necessary and sufficient conditions for economic development that enhances the well being of people. But more about this later: in order to understand India and her development experience better we need to go back into history to the dawn of independence.

India was liberated from the yoke of British imperialism in 1947 after a long and arduous non-violent struggle punctuated occasionally with spells of violence. India was a fractured nation in 1947. India adopted the framework of democratic, centralized planning in the incipient development of the country. It will be easier to understand this in a historical context. During the pre-independence era of British India, the govt. had not played an effective role of promoting development and in fact had subjugated the interests of Indian economy to the British imperial interests impoverishing India through skewed trade, heavy taxation and high-handed, illegitimate extortion. The havoc wreaked on the Indian economy by the English East India Company, one of the earliest multinational corporations, in conjunction with neoclassical laissez-faire economics is well known to most Indians. Prior to independence India suffered from devastating famines and stagnation. Hence poverty reduction and national self-reliance were central themes of India’s founding fathers. Keeping this historical perspective in mind, the leaders of India’s Gandhian revolution decided that it was time for the government to play the chief role in the allocation of resources for productive purposes even while operating within a democratic polity guaranteeing private property and a coexisting private sector. Hence, arose the necessity of a central planning agency, which would operate within a democratic framework.
India’s infatuation with Fabian socialism continued far beyond the embryonic stages of development of the country and spanned more than four decades. It was only in 1991 after four decades of state planning that India decided to cast away the fetters on markets. From 1991 till now India has liberated the private sector from regulation and price distortions and embraced globalization as the only alternative in its elusive quest for economic development. India has made modest strides so far in its effort to remove debilitating poverty, illiteracy, unemployment, high infant mortality, severe child malnutrition, a burgeoning population, inadequate healthcare, halfhearted land reforms, lack of social security and blatant discrimination against women. India still has a long way to go.
The First Five Year Plan was from 1951-56. It was a modest one and it was concerned more with the immediate objectives of repairing the damage caused by the Second World War and the Partition. In this plan agriculture and industry were given equal weightage and India exported surplus food to foreign nations. There was considerable investment in transport, power, irrigation, technical education and scientific research in the First Plan. At the end of the first plan India’s per capita income was lower than Egypt, Brazil, Chile, Peru and Yugoslavia. India was ranked 53rd in terms of per capita income for developing countries in the list compiled by the United Nations. The standard of living of large masses of people then was lower than what was indicated by per capita income because of unequal distribution of income and large unemployment and underemployment. In 1955 out of the total working force of 170 million about 8 million were unemployed and about 15 million were underemployed. In 1955 with regard to steel output India was around sixty years to eighty years behind France, Germany, U.K., and U.S.A. As far as education was concerned India was about eighty to hundred years behind all these countries then.
The Second Five Year Plan, christened the Mahalanobis Plan after its architect P.C. Mahalanobis, laid the design for planned economic development in India with a focus on heavy and basic industrialization as the top priority while agriculture and light, consumer goods industries were relegated to a secondary role. The state extended near monopoly of steel, mines including coal, fertilizers, banking and insurance while co-existing with the private sector in other areas such as hotel and tourism, transport, heavy and light engineering etc. In some areas such as agriculture, plantations, jute, cotton the state had no presence at all except to step in when private sector units needed to be bailed out under situations of financial crisis. The state’s policy of centralized planning over resource allocation was played out through an elaborate system of controls and regulations articulated through various licensing regulations and price controls. However, according to Prof. Jagdish Bhagwati the Mahalanobis plan and the controls gripped the economy in a low-level equilibrium trap.
The oil shocks following the West Asian conflict of the 60’s had their toll on the economy. At the end of the 60’s about 50% of India’s population was living in absolute poverty. During the end of the fourth plan and beginning of the fifth plan period, a notable development was the ushering in of the wheat-based green revolution in India which in one go catapulted India from a food deficit nation up to the 60’s dependent on PL 480 food imports from the US to a food surplus nation (based on effective demand) in the late 70’s and 80’s onwards.
19 % of investment in the second plan was devoted to social services like education, health and residential reconstruction. However, in the third plan the share of investment for social services was reduced to 16 %. Expenditure on basic education was curtailed while the share of higher education especially that catering to fields of engineering and medicine was expanded. Till 1965 national income was estimated to have increased by 3.7 % per annum while population increased by 2 % per annum leading to an annual per capita income increase of 1.7 %. Compared to the pre-independence period the achievements were remarkable but they were still inadequate from the point of view of raising the standards of people significantly.
In 1980, at the end of the fifth plan around 40 % of the Indian population lived in absolute poverty. They could not afford the incomes necessary to purchase the minimum calorie-equivalent amounts of food. The incidence of poverty was highest in rural India. More than 70 % of the population lived in rural areas and it was estimated that 40 % to 50 % of the rural population could be designated as absolutely poor that is those who could not afford nutritionally determined minimum food requirements. Although life expectancy at birth had gone up from 33 years in 1950 to 50 years in 1980, it was still lower than other Asian countries. India also had a high infant mortality rate of 121 per thousand in 1980. The adult literacy rate at that point of time was 36 %. Unemployment in 1980 was estimated to be 12 %. There were widespread disparities between the high-income states of Punjab, Haryana, Maharashtra and Gujarat and the low-income states of Bihar, Orissa, Uttar Pradesh, Madhya Pradesh, Assam and Rajasthan. Despite all this, there was a silver lining. India produced more scientific and technical personnel than any other developing country. This was a result of the large investments made by India in the fields of science & technology. According to Jagdish Bhagwati, India had lagged behind China, South Korea, Taiwan, Malaysia, Indonesia, Thailand, Singapore and Sri Lanka in economic growth, provision of services like education and healthcare, and eradication of poverty and income inequality. Population control also seems to have been more effective in these countries where levels of education and healthcare were higher than in India. This is also evinced by the fact that within India itself population growth was lower in states where there were high levels of education and healthcare. This is exactly what happened in the states of Kerala, Gujarat, Maharashtra, Punjab, Tamil Nadu and West Bengal. India’s massive population played a major part in depressing per capita income.

In India the immediate reason for economic reforms was clearly the economic and foreign exchange crisis in 1991 when India was left with enough foreign exchange reserves to last only a fortnight and its international credit rating being severely eroded with the risk of default in interest payment obligation looming in the horizon. The genesis of this crisis however can be traced to the high growth period of the 6th and 7th Five Year Plans when India registered some of the highest growth rates (around 8%), breaking out of the low growth rate trap as it were. These growth rates of the eighties were achieved through an aggressive government led expenditure strategy fuelled by external commercial borrowings and internal borrowings and increase in money circulation. This resulted in major macro economic imbalances: such as gross fiscal deficit of 8.3% in 1991, inflation rate close to 16% in 1991, internal debt amounting to 52.9% of GDP in 1991 and interest charges amounting to 4% of GDP in the same year (working out to 20% of total government expenditure). (Nirupam Bajpai and T. Jain 1996). The Government of India in 1991 had to pledge gold to obtain foreign exchange in 1991 adding to national humiliation.
Reform was therefore inevitable. Foreign direct investment in India had to focus more on getting its macro economic essentials right and stabilized with stringent internationally imposed time bound targets to achieve. Being crisis induced, the first phase of reforms was on macro economic stabilization efforts including getting the fiscal deficit in check, removing price distortions through the reduction of subsidies and changing the exchange rate polices. The second phase of reforms was directed at increasing factor productivity by slowly dismantling the elaborate system of industrial licensing etc., which had for long stifled the economy. It also saw the gradual removal of restrictions on imports and high tariff regimes, with focus on boosting exports. A major aspect of this third phase was also in the withdrawal of controls on foreign investment and foreign equity participation. Taxation reforms and reform of interest rates have also followed. The third phase of reforms aimed at liberalizing the labor markets by allowing grater mobility and flexibility has got mired in lack of consensus and the power of trade unions. Trade liberalization has also been part of this phase involving compliance with WTO obligations regarding patents on intellectual property, lowering of tariffs etc. This phase has also been grappling with reforms in the insurance sector allowing for foreign equity participation and withdrawal of government from a wide variety of areas where the private sector and the markets could have performed with far greater efficiency. The latter includes the hotel and tourism industry, the steel industry, the textile sector, the electricity sector etc. Public sector and disinvestments have not been easy with consensus building proving to be extremely difficult.
There have been many satisfactory results from the Indian reform process. Inflation has been brought down to 4-5 %, the foreign exchange reserves are today a staggering $75 billion, GDP growth has been a steady 5.6 % since 1980, external commercial borrowings, external assistance, IMF loans etc. have gone down very substantially. Foreign direct investment has also been growing: FDI flow in 2004 was $8 billion. India’s institutional framework in terms of democracy, functioning courts, free press, good information, efficient stock markets and property rights are amongst the country’s greatest assets. Yet other indicators still lag. Unlike China and South Korea, India has not seen major growth in per capita GDP. At a literacy rate of about 65% India still has the largest number of illiterate people (about 250 million) in the world and the largest number of people in absolute poverty of any country in the world. The East Asian Countries, even in the post financial crisis period have a much lower incidence of poverty and better social indicators than India. Indonesia which was the hardest hit by the financial crisis has a literacy rate of 80% and poverty incidence of less than 20% (World Bank: India:. Policies to Reduce Poverty and Accelerate Sustainable Development: http://wbIn1018.worldbank.org ) in 1998.

Although in the case of both India and China poverty reduction in the last two decades have been accompanied by acceleration of growth rates, it is clear that a direct causal-effect relationship between growth and poverty reduction would be tantamount to an economic oversimplification. As Professor T.N. Srinivasan argues (ibid) “the three endogenous outcomes growth, poverty and inequality are together determined by exogenous factors including the existence and functioning of institutions most importantly the markets for goods, services and particularly for labor and capital, domestic and external policies pursued, endogenous behavioral responses to policies and opportunities of individuals, households and enterprises as well as any constraints on the responses such as on mobility of goods and factors.” One example is that the poor in India and China are largely rural and heavily dependant on agriculture either as landless laborers or small and marginal farmers. Therefore if the pattern of growth followed is one that only expands non-agricultural urban activities, such growth could bypass the poor, unless such growth creates demand for domestic agricultural output or can pull such labor out of agriculture into non-agricultural activities. The effect of growth on poverty would be determined by the elasticity of growth on poverty reduction in the sector in which growth occurs. This is amplified if we pursue the China-India comparison a little further. As Srinivasan states there is evidence to suggest that in 1980, barely two years after Deng Xiao Ping abandoned the Maoist path, the per capita incomes of the two countries were comparable. Both economies had high growth during 1980-2000 but while China’s average per capita income grew at an average of 9% per year, India’s was a mere 4% per year. By 2000 China’s per capita income was nearly 70% higher than that of India. China’s rural poverty declined by 85% between 1978 and 1998 while that of India declined by less than 50% (Srinivasan ibid). According to sources cited by Professor Srinivasan the differences in reform and growth processes along with differences in savings and investment rates contributed to these differences in growth and poverty outcomes of the two countries making Chinese growth faster and more pro-poor. China reformed agriculture while Indian reforms are yet to be extended to agriculture thus, although always in the private sector, stands isolated from world markets, riddled with government interventions and burdened by the absence of land reforms particularly in the poorer states. Further India’s reservation (till recently) of the labor-intensive sectors such as garments, leather products to the small-scale sector prevented the full exploitation of globalization by these sectors. China on the other hand increased its share of world exports of labor-intensive products, while India lost this opportunity. In addition in both the countries there have been regional disparities in the growth patterns. In India phenomenal success in software development and export has been confined to a few cities in the South (Bangalore and Hyderabad) and West (Bombay).

As Professor Amartya Sen and Jean Dreze argue (India: Development and Participation, New Delhi, OUP 2002) although “in comparative international perspective the Indian Economy has done reasonably well in the period following the economic reforms initiated in the early nineties, … relatively high aggregate economic growth coexists with the persistence of endemic deprivation and deep social failures”. Professor Sen’s seminal contribution to development economics has been marked by two points of departure linking development strategies first to the ends of development and secondly to an investigation of the means to reach such ends. In this approach he goes beyond the conventional economic ends such as high growth, sound balance of payments etc. to human well being and entitlements and secondly from conventional economic means such as savings, investment etc. to the so called social side of economic operations, viz., human capabilities. He illustrates his analysis by comparing the experiences of India and China and argues that the vastly superior performance of China should be traced to its pre-reform achievements in the communist era through sustained investments in the development of human capability. He illustrates this with reference to comparisons in the spheres of life expectancy, basic education, basic health, gender equality and fertility. In every sphere China’s performance far exceeds that of India (see tables).


Region Population (millions) Infant Mortality Rate
Orissa 31.7 124
Madhya Pradesh 66.2 117
Uttar Pradesh 139.1 97

Region Population (millions) Adult literacy rate (female/male)
Rajasthan 44 20 / 55
Bihar 86.4 23 / 52
Uttar Pradesh 139.1 25 / 56

Countries 1960 1980 1992
India 28 36 50
South Korea 71 93 97
Thailand 68 86 94
China n.a. 69 80

State Population(Millions) (1991) Female life expectancy Male life expectancy Death rate (0-4 age group) Total fertility rate
Kerala 29.1 74.4 68.8 4.3 1.8
Himachal Pradesh 5.2 n.a. n.a. 19.3 3.1
Maharashtra 78.9 64.7 63.1 16.3 3
Tamil Nadu 55.9 63.2 61 16.1 2.2
Punjab 20.3 67.5 65.4 17 3.1
Gujarat 41.3 61.3 59.1 23.3 3.1
West Bengal 68.1 62 60.5 20.6 3.2
Karnataka 45 63.6 60 23.6 3.1
Assam 22.4 n.a. n.a. 32.4 3.5
Haryana 16.5 63.6 62.2 23 4
Orissa 31.7 54.8 55.9 39 3.3
Andhra Pradesh 66.5 61.5 59 21.3 3
Madhya Pradesh 66.2 53.5 54.1 44.5 4.6
Uttar Pradesh 139.1 54.6 56.8 35.6 5.1
Bihar 86.4 58.3 n.a. 22.8 4.4
Rajasthan 44 57.8 57.6 30.9 4.6

State Population (million)1991 Female – male ratio (1991) Literacy rate in 7+ age group, 1991 (Female) Literacy rate in 7+ age group, 1991 (male)
Kerala 29.1 1.036 86 94
Himachal Prade 5.2 .976 52 75
Maharashtra 78.9 .934 52 77
Tamil Nadu 55.9 .974 51 74
Punjab 20.3 .882 50 66
Gujarat 41.3 .934 49 73
West Bengal 68.1 .917 47 68
Karnataka 45 .960 44 67
Assam 22.4 .923 43 62
Haryana 16.5 .865 41 69
Orissa 31.7 .971 35 63
Andhra Pradesh 66.5 .972 33 55
Madhya Pradesh 66.2 .931 29 58
Uttar Pradesh 139.1 .879 25 56
Bihar 86.4 .911 23 52
Rajasthan 44 .910 20 55

State Rural literacy (female) 10-14 age group (1987-88) Rural literacy (male) 10-14 age group(1987-88) Incidence of poverty (head-count ratio)(Rural) Incidence of poverty (head-count)(Urban)
Kerala 98 98 44 44.5
Himachal Pradesh 81 95 24.8 3.3
Maharashtra 68 86 54.2 35.6
Tamil Nadu 71 85 51.3 39.2
Punjab 69 76 21 11.2
Gujarat 61 78 41.6 38.8
West Bengal 61 69 57.2 30.6
Karnataka 56 74 42.3 45
Assam 78 83 53.1 11.4
Haryana 63 87 23.2 18.3
Orissa 51 70 65.6 44.5
Andhra Pradesh 42 66 31.6 40
Madhya Pradesh 40 68 49.8 46
Uttar Pradesh 39 68 47.7 41.9
Bihar 34 59 66.3 56.7
Rajasthan 22 72 41.9 41.5

Category Uttar Pradesh Kerala
% of female rural children 12-14 who have never been enrolled in school 68 % 1.8 %
% of male rural children 12-14 who have never been enrolled in school 27 % 0.4 %
% of recent births preceded by an ante-natal check-up 30 % 97 %
% of births taking place in medical institutions 4 % 92 %
No. of hospital beds per million persons 340 2418
Proportion of villages with medical facilities 10 % 96 %
Proportion of population receiving subsidized cereals from public distribution system 3 % 87 %
Proportion of children aged 12-23 months who have not received any vaccination 43 % 11 %

Country Infant Mortality Rate (1960) Infant Mortality Rate (1981) Infant Mortality Rate (1991)
India 165 110 80

Country Life Expectancy (1960) Life Expectancy (1981) Life Expectancy (1991)
India 44 53.9 59.2
State Fertility rates in 1979 Fertility rates in 1991
Kerala 3 1.8
Tamil Nadu 3.5 2.2

Money1

Rajeet Guha

A.1 Money is any item that people are generally willing to accept in exchange for goods,

services and financial assets such as stocks or bonds. It is anything that acts like money. These days paper money acts like money. Earlier in the past coins of gold, silver and copper were used as money. Knife money, ring money, cigarettes, tobacco, beaver pelts, wampum, shells, bags of barley or wheat closed with the sovereign’s seal stamped on it to guarantee weight. Salt was also used as money.
Money has several functions. First money functions as a medium of exchange. This means that people who trade goods and services and financial assets are willing to accept money in exchange for these items. It saves the cost of bartering goods. Money has other important functions. It can be used as a store of value. Money could be held for future use without loss of value in the meantime. Money also functions as a unit of account, which means that people maintain their financial accounts by using money to value goods, services and financial assets. Americans keep their accounts in dollars while Japanese keep theirs in Japanese yens while the English keep theirs in pound sterling. Money also serves as a standard of deferred payment. People agree to loan contracts that call for future repayment in terms of money.
Money has several characteristics. First it must be durable. It needs to last over time. Raw fish can’t be used as money. It must be divisible into small amounts. It must have small denominations. It should be neither too abundant nor scarce. In case it is scarce then interest rates and the cost of making money would go up. If it were too abundant then everybody would be a billionaire. Sea shells or dirt can’t be used as money. It must be portable. It must have a high value to weight ratio. It must be recognizable. Everyone must know that it is money. It must be standardizable. It must be a known purity and it must be hard to counterfeit.
Money has an internal contradiction. It has a use-value and an exchange value. Use value refers to money’s intrinsic worth as a commodity. Exchange value refers to the value or price that money fetches in the market.
The two costs involved in making transactions are transactions costs and waiting costs. These two costs make up the total costs of conducting transactions. The transactions costs refers to the physical amount of time it takes place for the transaction to take place. Waiting costs refer to the cost of waiting for the seller after he has sold his good to the buyer to be offered an acceptable good in exchange.
An economy would prefer to use money instead of a non-monetary system because of reduced transactions and waiting costs. The total costs of conducting transactions are greatly reduced by a monetary economy. It is diagrammatically expressed in Fig. 1. A monetized economy does not require a double coincidence of wants like barter. It does not require a direct exchange of wants. It saves us from bartering which is extremely inefficient and expensive. Besides it becomes complicated and cumbersome in case where an economy produces vast amount of goods as it becomes difficult to keep track of innumerable prices where prices is given by the formula:
No. Of prices = N (N-1) / 2 where N denotes the number of goods.
Fiat money will generally be preferred to commodity money such as specie, gold coins and, money backed by a commodity standard such as the gold standard. It will be preferred as interest rates cannot be raised in a commodity standard and there is a limit to amount of social expenditure conducted by the govt. for the public as it would lead to inflation and decrease the quantity of gold redeemable to the public when public debt has to be paid. The economy where a commodity standard backs money or an economy that has commodity money would also be prone or sensitive to fluctuations in the price or quantity of gold in the economy. In contrast to this fiat money has none of these problems. Besides transactions and waiting costs are the least in using fiat money than in any other system.
Money is responsible for the modern world because in the absence of a durable, portable, divisible, scarce, recognizable standard of exchange it would be impossible to conduct the enormous, infinite and continuous, non-stop transactions of the world with such rapidity on a global scale without money. The transactions costs, waiting costs and the number of prices to keep track of would be too high for exchange of goods and services to take place.
A.3 Money is defined as a universal equivalent according to the Marxist conception of money. However, in order to come to such a hypothesis one must define a commodity. A commodity is a product, which is the private property of a private agent or individual and which is bargained in the process of exchange over other commodities. This is how the distribution system of products works in a capitalist economy where privately owned commodities are exchanged for a profit.
According to Marx commodities have a dual nature. It has a use-value or can directly be used or consumed by the owner, which is its first aspect. The second aspect is that the commodity can be exchanged for other commodities in the market. This exchangeability for other products is its exchange-value. Exchange-value can often be and often is different from use value. Exchange value or value refers to the price of a commodity in neoclassical economics.
Therefore if exchange-value is different from use value and if the commodity’s intrinsic worth or use-value does not determine its exchange-value or value or price, then there must be some common factor, which determines its exchange value. It was the great Adam Smith, the father of economics, who proposed that exchange-value is determined by labor expended in a commodity. Thus was born the labor theory of value. The labor theory of value was subsequently enriched and refined by Ricardo, and then Karl Marx. According to Marx, only the abstract, simple, socially necessary labor time determines the exchange value or simply value or price which is manifested as money necessary to purchase the commodity in a market. Money is an expression of this value in a commodity and it is different and specific to every commodity. Money is an expression of this value alienated or separated from any particular commodity. The money value added of the mass of commodities newly produced and exchanged in an economy constitutes the total value added of all newly produced commodities. According to Marx simple barter expresses the accidental/ elementary form of value such as 20 yards of linen = 1 coat. Linen expresses its value in the coat. The coat is passive. It is the material in which the linen expresses itself. The value (exchange value) of the linen is expressed by the material of the coat (1 yard of linen = 1 / 20 of a coat). The linen is in a relative position and the coat is in a equivalent position. The coat is a particular equivalent for the linen. The elementary form of value quickly develops into the expanded form of value in which one commodity is equated to the whole range of other commodities, each of them in turn expressing its value. This change corresponds to a change in perspective from an individual exchange to a consideration of the whole system of commodity exchange. Marx expresses the expanded form of value as 20 yards of linen = 1 coat = 10 pounds of tea = 1 / 2 ton of iron. In this form, the value of linen is mirrored in all other commodities. Therefore 20 yards of linen is the universal exchange value or money as it is the general equivalent measure of the value of all other commodities. Thus money is embodied in the barter system. This general equivalent form brings us very close to the general / money form of value. When some commodity or abstract unit of account becomes socially accepted as the general equivalent and is commonly used as a measure of the value of all commodities and thereby becomes money such as for example 2oz. Of gold = 20 yards of linen = 1 coat = 10 lbs. Of tea = 1 / 2 ton of iron. Thus 2 oz. Of gold is commodity money, which is the universal equivalent, or value that expresses itself in all other products.
A.4 Let us assume that an economist is stranded on an island with 100 non-perishable pineapples with two months to survive on the island. He charts out his consumption possibilities. He could either consume 100 pineapples in the first month and nothing in the second month or nothing in the first month and 100 in the second month or he could opt for any combination on the consumption possibilities line (Fig. 2) such as 50 in the first month and 50 in the second. The economist, however, is trained to think in terms of utility and indifference curves. He moves away from the realm of reality for a moment and thinks of three combinations among which he would be indifferent, as they would yield the same satisfaction or utility. The three points that belong to the set of indifference curve 1in Fig. 3 are (70,40), (40,60) and (20,90) where the first point in a pair denotes pineapples consumed in the first month and the second point denotes pineapples consumed in the second month. The law of diminishing marginal utility makes the indifference curve convex.
The economist then imagines what would happen if he could consume 10 extra pineapples in the first month without giving up any pineapples in the second month. This would tantamount to a higher indifference curve 2 and therefore greater utility and happiness. The economist then imagines a hypothetical situation where he could consume 10 less pineapples in the first month without any compensatory increase in the second month. This would lead to an indifference curve 0 which is below indifference curve 1 and therefore yields least utility. All these 3 indifference curves can be graphed in Fig. 4
The economist snaps out of his reverie about hypothetical indifference curves. Nevertheless his daydream has helped him to figure out how to decide. In Fig. 5 he draws the consumption possibilities line and the three indifference curves. The points A’’, B’’, C’’ on indifference curve 0 and B on indifference curve 1 are all attainable. The point B on indifference curve 1 is at a higher utility than at any point on indifference curve 0. A is his optimal choice. Combinations on indifference curve 2 are not attainable. The economist notes that at point B the slope of the indifference curve is equal to the slope of the consumption possibilities line, which is 1(1 pineapple must be given up in the first month to obtain 1 pineapple in the second month). However, the economist also discovers that for every two pineapples saved (not consumed) planted in the first month will yield three pineapples in the second month. He then draws his production opportunities set where he can either consume 100 pineapples in the first month or he can plant 100 pineapples in the first month and get 150 pineapples in the second month. The economist’s production opportunities set represents his extended consumption opportunities set. The slope of his production opportunities set is 2/3. The slope of the production opportunities set represents the rate of exchange of first month pineapple consumption for second month pineapple consumption. The reciprocal of this rate of exchange is 3/2, which is the rate of second month pineapple consumption for first month pineapple consumption. He draws these graphs in Fig.6
The economist realizes that he can use and save pineapples in the present to create pineapples in the future. Therefore pineapples function as capital goods besides consumption goods. Economists refer to the amount of output yielded by a unit of capital as the marginal product of capital, which is 3/2.
In fig. 7 the economist draws his original consumption possibilities set as well as his production / new consumption possibilities set along with indifference curve 1 and indifference curve 2. The point B’ on indifference curve 2 will yield greater satisfaction or utility or happiness than any point on indifference curve 1 because it is on a higher indifference curve. At B’ the indifference curve 2 is tangent to the new consumption / production possibilities set where the optimal combination is (50,75) or eat 50 pineapples in the first month, save 50 pineapples and plant them in the first month which would give 75 apples in the second month. Instead if he had not planted the 50 pineapples and merely saved them for the second month then only 50 pineapples would be available for the second month. The total return from saving is therefore 25 pineapples. The rate of return from saving is the total return from saving divided by the total number of pineapples saved that is 25 / 50 or 0.5 or 50 %. The rate of return from saving or the rate of interest is 50 %. This is how interest rates are determined through personal preferences as manifested via indifference curves in the island model.
A.5 The risk structure of interest rates refers to the relationship among yields on financial instruments that have the same maturity but differ on the basis of liquidity, default risk and tax considerations. Default risk is the risk or chance that an individual or a firm that issues a financial instrument may be unable to honor its obligations to repay the principal and / or interest payments. The default risk of U.S. treasury securities is virtually zero. The default risk of corporate bonds is much higher. The amount by which the corporate bond rate exceeds the Treasury Bond rate because of greater default risk is the risk premium. Default risk clearly is an important consideration in bond purchases. Two predominant institutions that rate the risks of bonds are Standard & Poor’s & Moody Investor’s Services. Two of these bonds are investment grade securities (bonds with relatively low risk) and junk bonds (bonds with relatively high default risk). Another reason that corporate bond rates exceed interest rates on U.S. treasury bonds of identical maturities is that traders regard corporate bonds as less liquid financial instruments than Treasury securities. This is because the secondary market for treasury securities is well developed while the secondary market for corporate bonds is not well developed. The higher corporate bond rate compensates for the less liquidity of corporate bonds. There is also a liquidity premium that accounts in part for the difference in interest rates between two bonds with identical maturities. Junk bonds have higher interest rates than investment-grade securities because they are less liquid and therefore contain a liquidity premium.
The island model was unable to account for these issues because:
1) In the island model the principal on pineapples can’t go bad. Therefore, his investment on pineapples cannot go bad in the island. Therefore, there is no risk of investment going down. Yield of a bond may go down dramatically in the real world but in this case yield will not go down in the island. Secondly, there is no choice or portfolio diversification as he can only eat pineapples for an extended period whereas in the real world there is a lot of diversification and there is competition between the different instruments, which determine the price of these instruments. Thirdly there was a specific time span of his investments maturing after the end of the first month. In the real world the time span of bonds and shares is much longer. There is unlimited liquidity in the island. Therefore, there is no liquidity premium. The question of risk has not been factored here. Therefore, there is no risk premium.

Uncertainty

Carefully explain why uncertainty over deposit levels is a big deal for banks?

Banks are clearly the oldest and most important financial market intermediary which brings the potential borrowers and lenders together, provides liquidity that drives the economy and provides the medium of exchange. We know a bank can be defined as a type of financial institution that originates loans as well as maintains deposits for account holders that are federally insured.
Although the type of services offered by a bank depends upon the type of bank and the country, services provided usually include: directly taking deposits from the general public and issuing checking and savings accounts; lending out money to companies and individuals; cashing checks, facilitating money transactions such as wire transfers and cashiers checks; issuing credit cards, ATM, and debit cards and online banking. Clearly the one common thread which runs through all these functions is the ability of banks to make liquidity available most immediately on demand and other times as expeditiously as possible. Therefore at a basic level the continued and assured availability of deposits is a critical component of the bank’s liquidity and any uncertainty regarding deposits is necessarily of concern to banks.
A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a securities market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits. The one event which can severely impair a bank’s reputation and can therefore create a run on the bank is the bank’s inability even if temporarily to repay a depositor to withdraw his/her deposit or a portion thereof. Depositor panic psychology has been seen far too often to result in bank failures under such circumstances. That is why uncertainties related to deposit levels, even if misconceived, are danger signals which banks take very seriously.
Therefore there are provisions in every country for Bank reserves which are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy. Some governments (or their central banks) restrict the proportion of a bank's balance sheet that can be lent out, and use this as a tool for controlling the money supply. Even where the reserve ratio is not controlled by the government, a minimum figure will still be set by regulatory authorities as part of banking supervision.
The traditional bank has an inherent susceptibility to crisis, in that it borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, or more precisely incorrectly price the interest rates of those loans, and lose more money than they have.

Money

A.9a) Keynesian monetary policy can stimulate the economy. This happens in a sequence of events. This will be elucidated in the following lines:
The Federal Reserve controls monetary policy. It can boost the economy through expansionary monetary policy. It can embark on a policy of open market purchases at a given price level. This will increase the nominal quantity of non-borrowed reserves in the banking system from NBR1 to NBR2. We know that the demand for total depository institution reserves depends negatively on the federal funds rate. The supply of total depository institution reserves is perfectly federal funds rate inelastic and is determined solely by the Federal Reserve. The rise or increase in nonborrowed reserves shifts the supply of total depository institution reserves to the right while the demand for total depository institution reserves remains the same. This induces a decline in the Federal Reserve funds rate.
Financial market traders will interpret the Federal Reserve’s policy actions as one that is intended to bring about a long-lasting reduction in the equilibrium federal funds rate, then the expectations theory of the term structure of interest rates indicates that the federal funds yield curve must shift downward as the expected federal funds rate for future days and weeks decrease. As long as the risk structure of interest rates remains unchanged, this also induces a downward shift in the treasury securities yield curve. Thus, the longer term interest rates relevant to business investment decisions decreases to r2.
The decline in longer-term interest rates has a huge impact. Desired investment spending is very sensitive and very elastic to interest rates. Thus, a drop in interest rates will lead to more demand for loans by businesses to invest in producer and consumer goods and will provide an incentive to individuals to consume more and save less and will fuel an increase in both transactions and speculative demand and also expansion of credit as more and more people will want to take loans to buy houses, cars or for getting education.
The increase in investment spending as well as consumption will lead to an increase in aggregate demand and a consequent increase in equilibrium real national output and national income. Exports will also be boosted by a fall in interest rates as goods can be exported cheaper. Thus, we will see a virtuous cycle in which the economy will be booming.
The classical economists and their modern incarnates who advocate the theory of rational expectations dispute the Keynesian monetary policy prescription. The rational expectations school believes that people (workers, consumers) are essentially rational and cannot be fooled. They believe that people generally do not experience money illusion.
However, there can be rare exceptions. They believe that in most circumstances people can anticipate the effects of monetary policy correctly. It is only in rare cases that they do not anticipate the effects of monetary policy. Keynesian monetary mechanism revives the economy only when people cannot anticipate the effects of monetary policy and experience money illusion and are fooled into thinking that their real wage has risen whereas their nominal wage has risen due to an increase in the price level while their real wage remains unchanged. All this is due to an increase in real non-borrowed reserves as the Federal Reserve embarks on open-market purchases bringing about decreases in federal funds rate, which later translates into a decrease in interest rates boosting investment, consumption and exports. All this increases aggregate demand and leads to an increase in the price level, which leads to an increase in the demand for labor and a nominal wage increase.
Workers get fooled into believing that their real wage has risen and therefore increase their supply of labor, thus increasing the supply of output. Thus, the economy is propelled forward when workers cannot anticipate the effects of monetary policy.
b) However, the new classical economists argue that in most cases Keynesian monetary policy will fail to revive the economy. They assert that people will not have money illusion and will correctly anticipate the effects of monetary policy. They are convinced that the only thing expansionary monetary policy by the Federal Reserve will do is that it will lead to inflation with no change in output and no change in employment. Thus, even the unemployment rate will be unaffected. The mechanism explained in the following lines will explain how Keynesian monetary policy will fail.
When the Federal Reserve engages in expansionary market operations then there is an increase in the supply of non-borrowed reserves to NBR2 that leads to a fall in the federal funds rate and later manifests itself as a drop in interest rates. The drop in interest rates boosts investment, consumption and exports thereby increasing aggregate demand leading to an increase in the price level as the classical economists believe that prices are always flexible and adjust quickly to market forces. Workers correctly predict the increase in price level. People therefore anticipate that their real wage will fall. Workers therefore cut back on the supply of labor to firms and thus output supply curve to firms decreases and shifts to the left and firms produce less output at the new price level P2 than what should have been produced. The output produced is the same as that in the previous lower price level. Thus, output does not change. There is only inflation. Thus, Keynesian monetary policy fails to revive the economy in this situation.

A.7 The development of an innovation like digital cash will affect the process of determining the quantity of money in circulation namely money supply. It will become imperative to redefine monetary aggregates. Digital cash will function as a medium of exchange and will thus be included in M1. M2 and M3 include M1 and thus will also incorporate digital cash.
Digital cash can be denoted as DC. M1 will now be expressed as a sum of currency (C), transactions deposits (D) and digital cash (DC). The public’s desired holdings of digital cash relative to transactions deposits can be denoted as dc, so DC = dc * D. Again C = c * D, where c is the holding of currency relative to transactions deposits. Thus, M1 can be written as:
M1 = C + D + DC
M1 = c * D + D + dc * D
M1 = D (c + 1 + dc)
M1 money multiplier = M1 / MB
= D (c +1 + dc) / (RR + ER + C)
= D (c + 1 + dc) / D (rrd + e + c)
= (c + dc + 1) / (rrd + e + c)
This expression indicates that other things being equal, the widespread use of digital cash – the addition of the factor dc and an increase in its value as more and more people adopt digital cash – increases the money supply M1 and the money multiplier M1 / MB. The inclusion of dc in the money multiplier raises the value of the numerator, thereby pushing up the value of the multiplier. This happens because if people hold digital cash on smart cards, personal computers or other devices, then an increase in reserves in the banking system induces an expansion effect on the volume of transactions deposits and consequently on transactions deposits.

Non-Depository Institutions

Rajeet Guha

A.1 Non-depository institutions are institutions that do not issue checkings and savings deposits. They provide a broad array of financial services. Some of them are securities market institutions that specialize in intermediating risks in securities markets while others known as insurance companies insure individuals and firms against risks of future losses. Pension funds offer pension plans that provide retirement security income to workers. Financial institutions called finance companies make loans to individuals and firms that commercial banks, savings banks and credit unions might deem uncreditworthy. Mutual funds provide specialized portfolio management skills.
Securities market institutions : When business firms issue new shares of stock or offer to sell new bonds, these firms and those who contemplate buying their securities face two asymmetric information problems. One stems from adverse selection. Some firms that issue new securities may have an incentive to do so because they are strapped for cash and teetering on the edge of financial disaster. Those considering buying new stocks or bonds recognize this possibility and need to be able to identify creditworthy firms. The firms recognize this and need a way to signal their creditworthiness to potential purchasers of their securities. Securities market institutions such as investment banks and securities brokers and dealers provide this signal by intermediating firms’ securities.
Securities market institutions also assist in minimizing moral-hazard problems that arise when firms that are successful in raising funds via security issues might have an incentive to misuse those funds. By monitoring the performances of issuing firms, these institutions assure stock and bond holders that the firms maintain their creditworthiness. This ensures that the shares of stock or the bonds of issuing firms remain liquid instruments that retain the risk characteristics that they possessed when the firms first issued them.
Investment banks guarantee that the issuing firm will receive a specified minimum price per share of stock or per bond.
Brokers offer a range of financial services including consultations about financial instruments to buy or sell and other financial planning advice.
Some broker-dealers are members of stock exchanges that are responsible for preventing wide swings in stock prices. They do this by adding to or reducing their own holdings of stock to counteract major changes in demand or supply conditions. Investment banks by and brokers by making sensible investments save the public from channeling their funds into risky propositions. Investments in reliable companies provide people with a ready source of liquidity and provide information about which companies are likely to succeed.
Insurance companies are institutions that specialize in trying to limit adverse-selection and moral hazard problems arising from insurance against future losses. The policies that they issue are promises to repay the policyholder if such a future loss occurs. In return insurance companies receive premiums from policyholders and it is from these premiums that payments are made to policyholders who experience losses.
Insurance companies design their policies to reduce the extent of problems that they face in light of asymmetric information. That is because the people who apply for insurance know much more about their risks of loss than do insurance companies, and those who receive insurance can do the most to limit the risks of such losses.
Insurance companies seek to reduce the adverse-selection problem by restricting the availability of insurance. Insurance companies will not sell every available policy to every individual. For instance suppose, that an individual learns that he is inflicted with an illness for which there is no cure. The individual then will want to purchase life insurance for the protection of his wife and children. If the insurer would permit such a person to buy such a policy, then the insurer would be taking on a 100 percent probabability of a claim that would amount to more than the premiums it would collect from that individual. No insurance company could stay in business if it made such policies to everyone. Insurers also deal with the adverse-selection problem by limiting how much insurance an individual or firm can buy. To reduce their exposures to losses from policies taken out by applicants who may know they have life-shortening conditions, insurers typically place limits on the dollar amount of coverage that individuals may purchase. In addition insurance companies typically require policyholders who purchase large life insurance to undergo blood tests or physical exams.
Insurance policies also restrict the behavior of policyholders. These provisions are intended to reduce the extent of moral-hazard problems that insurers face. Limiting the amount of insurance can reduce the extent of moral hazard problems. For example if a company that operates agricultural grain-elevators could insure them for more than they are worth then it would have little incentive to operate the elevators safely by keeping flammable liquids away. Thus the risks would increase and so would the insurer’s chances of making payments on losses. Hence insurers typically limit policy coverages to the maximum possible losses that policyholders could incur. One key weapon against moral-hazard problems is an insurance company’s ability to cancel insurance because of bad behavior by a policyholder. Most insurance policies include a clause threatening cancellation if the policyholder develops a record of reckless behavior after the policy has been issued. Insurance companies also combat moral-hazard problems by offering policies with deductible and coinsurance features. A deductible is a fixed amount of loss that a policyholder must pay before the insurance company must provide payments. Coinsurance is a feature that requires the policyholder to pay a fixed percentage of any loss above the specified deductible. Insurance companies thus reduce or eliminate the risk of families who have lost their breadwinners spending their days as paupers. They also provide people with damage-repair liquidity.
Pension funds have proliferated over the years as they have become popular savings vehicles for people. Pension funds exist because of increased longevity of people and because people can’t work throughout their lives but still need a permanent source of income for old-age. Pension funds also carry tax benefits. They provide retired people with liquidity. It also saves them from the risk of spending their old age in penury. They remove the element of uncertainty.
Finance companies propel the economy forward. They lend money to individuals and business that are of insufficient size or creditworthiness and thereby moves the businesses, economy and people forward. They facilitate in the running of small businesses by extending loans to them. Finance companies specialize in offering financial services to individuals. Consumer finance companies make loans enabling individuals to purchase durable goods such as home appliances or furniture or to make improvements to existing homes. Sales finance companies make loans to individuals planning to purchase items from specific retailers or manufacturers. They provide individuals and businesses with liquidity.
Mutual funds have proliferated in recent years due to the interest rates on large-denomination financial instruments outstripping interest rates at depository institutions. Mutual funds also provide risk diversification by investments in a variety of companies. By being transparent they provide information to the public. They also provide the investors with a ready source of liquidity. They also reduce uncertainty in returns.

A.4 Financial markets are a place where financial assets are bought and sold and they play a crucial role in financing and investments. The financial system comprises those who need money and those who have money to lend. Those who have money to lend are called Surplus Spending units (SSUs) and those that need money are called Deficit Spending Units (DSUs). At a fundamental level the market needs financial intermediaries who can bring the two together by borrowing money from savers and lending to borrowers. Banks are the oldest of such financial intermediaries.
Money is what drives the world. Money is the most liquid asset of an entrepreneurial economy and as Keynes explains everybody demands money either because (a) they have expenditure plans to finance (b) are in uncertainty about what the future holds and therefore need to be reassured by the availability of money to finance any unforeseen expenditure and (c) need to engage in speculative ventures to increase earning from money. Interest is the reward that people demand for inducement to part with liquidity. It is this combination of transactions, precautionary and speculative motives that makes the demand for liquidity so strong.
Banks fulfill this essential need: they provide liquidity. Every time customers withdraw money from an automated teller machine or write a check, they rely on the bank’s liquidity provision function. In fact in terms of liquidity there is very little difference between a demand deposit that an investor holds and a line of credit extended to a firm. Both products require the bank to pay the client money on demand. Therefore it bank provides liquidity on both sides of the balance sheet — to both depositors and borrowers.
Bank intermediation also contributes towards the lowering of transaction costs involved in bringing SSUs and DSUs together. The existence of banks obviates the need to transact business moving from door to locating SSUs and DSUs. Institutional intermediation ensures this. Banks also provide through their most liquid assets, money, the media for exchange. Specialization among institutional intermediaries such as banks reduces transaction costs for both lenders and borrowers.
A major reason for the existence of banks is that they specialize in handling asymmetric information problems in the financial markets. Unlike any other market for goods and services, in this market information about potential lenders with surplus funds and potential borrowers of such funds is not readily available. This is not to say that money markets did not function before institutionalized banks came into being. Individual moneylenders and pawnshop owners possessed the information and brought the two together. However given the growing complexity of our financial needs the existence of specialized institutions willing to incur the costs of such information search and its management using economies of scale is crucial to a well functioning economy.
Banks also contribute towards the spreading of risks. At a basic level by allocating a pool of savings among a diversified portfolio of assets of loans and securities they spread the risks and in the process they reduce risks for depositors and of course as mentioned earlier increase liquidity for lenders.
The other major function banks perform is to fund so called “complex, illiquid positions”. Historically, this has taken the form of making term loans to borrowers who are "difficult" credits. By virtue of their past relationships with client firms, banks know more about their future prospects, as well as about alternative uses for the firms’ assets. Consequently, they can lend more than other less-knowledgeable lenders. Once again this is something which only institutional intermediation, institutional memory and institutional relationships make possible. It is only institutional intermediation that can take such risks with confidence and thus meet the liquidity requirements of a wide variety of DSUs. Also, the bank’s specific lending skills and knowledge have to be brought into play when the bank wants to coax repayment. As a result, the loans are hard to sell to other potential lenders without similar skills or knowledge. Consumers turn to banks for safe and for short- and long-term credit. Large and small businesses rely on banks for payment processing, short-term credit, and backup credit lines. And governments rely on the banking system to conduct payments, distribute currency, safeguard tax receipts, and to serve as a conduit for monetary policy.
Before we conclude we also need to touch upon another type of bank which like commercial banks as described above, also fulfills some essential functions which are key to the functioning of the economy. These are the central banks. The central bank controls the money supply within the national boundaries. In Britain, the central bank is called Bank of England, in Japan is the Bank of Japan, and in the United States the Federal Reserve. The central bank regulates, supervises, and is responsible for policies concerning money. Thus, it has a central role in regulating money inflation in the domestic economy, which, also, has an enormous impact on the economy's performance. The following are the accepted tasks of a central bank: 1) controlling the money supply 2) clearing checks 3) supervising and regulating banks 4) maintaining and circulating currency 5) maintaining national reserves of gold and foreign currencies.
Finally the banking industry plays a major role as the primary vehicle in implementing monetary policies and despite the rise of non-banking institutions (such as mutual funds, housing and finance companies etc.) this role remains unchallenged in most countries. . Most central banks seek to achieve their objectives through some form of interest rate management. Control over short-term interest rates is achieved in every case by manipulating the supply of central bank reserves available to satisfy banks' demand for reserves. Banks' demand for reserves is similarly influenced by central banks either directly by setting reserve requirements or indirectly by allowing only banks to access the payment system and then setting the rules regarding the management of their central bank accounts.
In summary therefore although non banking financial institutions are today rising faster than ever and while the difference between banks and such institutions is being blurred by the latter venturing into roles earlier played by banks exclusively such as deposit offers, the basic functions of banks in making credit available, in providing safe investment choices (deposits) for households, and in processing payments remain as relevant today as ever. They are at the heart of the financial system and the economy overall no matter who performs them: banks or non-banks.

A.3 Money moves the world. In our quest to satisfy endless human demands for goods and services in the modern world, money as the universal medium of exchange is crucial for human existence. The financial market consists of those who have surplus money and those who don’t. The market needs financial intermediaries who can bring the two together by borrowing money from savers and lending to borrowers.
There are broadly two types of intermediaries: depository and non-depository. Depository institutions are those that take in deposits and make loans. As we know banks are the most important depository financial intermediary which makes liquidity available where it is needed, lowers information search costs and reduces transaction costs bringing together those who need money with those who have surplus money.
A Bank can be defined as a type of financial institution that originates loans as well as maintains deposits for account holders that are federally insured. As depository institutions banks are generally considered full-service financial institutions because they offer a wide variety of services: checking and ATM debit accounts, savings accounts, dedicated savings accounts for retirement or college tuition, credit cards, auto loans, personal loans, business loans and mortgage loans which are secured by real estate.
The most common and the earliest form of bank is the commercial bank. This started as a business bank serving the interests of business. It used its own notes and made commercial loans.
Savings unions and thrifts
A non-bank or a non-bank bank, is a financial institution that provides banking services without meeting the legal definition of a bank, i. e. one that does not hold a banking license. Operations are, regardless of this, still exercised under financial supervision. Non-bank institutions frequently acts as suppliers of loans and credit facilities, however they are typically not allowed to take deposits from the general public and have to find other means of funding their operations such as issuing debt instruments.
Non-banks are ordinary intermediaries. It is an institution, which offers services similar to those of banks but not subject to the usual banking regulations. Although thy do not accept deposits the way banks do, many of them offer their customers NOW accounts which function like conventional checking accounts but because of prior notice provisions do not technically give the depositor a legal right to withdraw on demand. Others even offer conventional checking accounts, but avoid classification as banks by limiting their extension of commercial credit to the purchase of money market instruments such as certificates of deposit and commercial paper.
Non Banks also act as a conduit between those with funds to lend and those in need of funds. By pooling the funds of investors from whom they borrow, they can then lend in various amounts and periods. For their service they charge a fee, usually in the form of periodic interest payments. Their borrowing and lending increases the total credit market debt but has no direct effect on the money supply. Non-banks simply intermediate the transfer of funds from the bank accounts of the original investors to the bank accounts of the ultimate borrowers.

Bank Lending vs. Non-Bank Lending
Banks play a key role in the monetary system, yet their lending now accounts for less than 20% of the total credit market debt in the US. Most of the lending is done through non-bank financial institutions such as finance companies, mortgage companies, insurance companies, pension funds, and investment banks. Non-banks cannot accept demand deposits, and therefore play no direct role in the payment system. But they provide a variety of financial products and compete quite successfully with banks for lending opportunities.
Non-banks usually borrow short-term at low rates to lend longer term at higher rates. That means a non-bank must be able to roll over its short-term debt at favorable rates. It must also be able to borrow on short notice to manage any cash flow problem. For that reason it must maintain an excellent credit rating, or it may not be able to borrow at all.
Bank Lending
Banks are not ordinary intermediaries. Like non-banks, they also borrow, but they do not lend the deposits they acquire. They lend by crediting the borrower's account with a new deposit, and then if necessary borrowing the funds needed to meet the reserve ratio requirement. The accounts of other depositors remain intact and their deposits fully available for withdrawal. Thus a bank loan increases the total of bank deposits, which means an increase in the money supply. When the loan is paid off, the money supply decreases.
A net increase in bank lending results in a shortage of reserves needed by the banking system, which only the Fed can supply. In order to maintain control of the Fed funds rate, i.e. the interest rate on overnight loans between banks, the Fed must provide the funds as required. It does so by purchasing Treasury securities from the public.
Bank lending has no effect on a bank's own capital. But bank lending is limited by the capital ratio requirement set by the Fed. If a bank has sufficient capital, it can expand its balance sheet by issuing more loans. However if it is not holding excess reserves, it will have to acquire more in order to meet the reserve ratio requirement. Banks therefore actively seek new deposits. Of course they prefer deposits on which they pay no interest, like ordinary checking accounts. They also seek savers and investors who will buy their term deposits at a low interest rate relative to their own lending rate.

A.6 The traditional bank has an inherent susceptibility to crisis, in that it borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, or more precisely incorrectly price the interest rates of those loans, and lose more money than they have.
The fundamental rationale for regulation of banks is that banking industry, more than any other industry suffers from an inherent opaqueness is in its operations. They are like black boxes where money goes in and goes out but it is extremely difficult for the outside world to understand the risks taken in this process of intermediation between surplus spending units (SSUs) and deficit spending units (DSUs). Because banks are opaque, runs and failures of some banks can impact upon the entire banking industry. The riskier and more inefficient ones can infect all and lead to a collapse of the entire industry as past experience has shown. Conversely if banks were as transparent as other firms, runs on riskier banks would not induce failures of safe banks and the role of outside regulation would become redundant and inefficient. The market would then regulate what the regulators now try to achieve. Fully transparent banks would borrow at open market rates that fairly reflected their risks.
However the reality is that to some extent opacity is almost intrinsic to banks. Given the intermediation role that banks play with limited control over how businesses to which they lend are run, points to a fundamental source of risk in the banking industry. As Guthman points out: “Probably in no other field involving such large public interests is there more uncertainty for the investors than in banking… because of the difficulty in valuing such a large and mixed lot of loans” and other assets. Primary among bank assets are loans to smaller, more opaque borrowers also referred to as the raison d etre for Banks (D. Diamond 1984, “Financial Intermediation and Delegated Monitoring: Review of economic Studies). Lending to opaque borrowers may lead to opaque banks. This makes it extremely difficult to evaluate bank loan quality and therefore the true value of its assets.
Again given the intermediary role of banks between SSUs and DSUs, the depositors are completely blind about what happens to their money and the nature of risks their money is exposed to. It is this combination of opaqueness inherent to banking and the consequent risks to depositors and the entire banking industry and the difficulties that the market faces to ensure efficiency of lending and borrowing within such opacity that underscores the need for regulation.
The other inherent need for regulation of banks arises from the nature of their assets. The typical balance sheet structure of banks features a sizable volume of highly liquid liabilities--those that can be withdrawn at par on demand such as balances in checking accounts--in combination with a portfolio of generally longer-term assets that often are difficult to sell or borrow against on short notice. It is probably fair to say that there is considerable agreement among central bankers and other economic policymakers that this unique balance sheet structure creates an inherent potential instability in the banking system. Rumors concerning an individual bank's financial condition--even if ill-founded--can spark a run by depositors and other creditors that may force the bank to unload assets at fire sale prices and, in extreme situations, suspend payment on withdrawal requests. Especially if the distressed institution is large or prominent, the panic can spread to other banks, with potentially debilitating consequences for the economy as a whole. Most countries with private banking systems have experienced episodes of bank panics to some degree, and in the United States, such panics occurred with some frequency in the late nineteenth century and was a major factor exacerbating the Great Depression of the 1930s.
Therefore while institutional regimes differ, most countries have established safeguards against banking panics that rest on three basic pillars--some form of deposit insurance (explicit or implicit), a program of banking supervision and regulation, and an institution that can act as lender of last resort.
However from every regulation comes a change in behavior and excessive bank regulations can actually harm the industry. Therefore what is important is a careful balance which does not destroy the innovation and risk taking entrepreneurial spirit of banks.
History of Regulation

A.5 Banks are clearly the oldest and most important financial market intermediary, which brings the potential borrowers and lenders together, provides liquidity that drives the economy and provides the medium of exchange. We know a bank can be defined as a type of financial institution that originates loans as well as maintains deposits for account holders that are federally insured.
Although the type of services offered by a bank depends upon the type of bank and the country, services provided usually include: directly taking deposits from the general public and issuing checking and savings accounts; lending out money to companies and individuals; cashing checks, facilitating money transactions such as wire transfers and cashiers checks; issuing credit cards, ATM, and debit cards and online banking. Clearly the one common thread which runs through all these functions is the ability of banks to make liquidity available most immediately on demand and other times as expeditiously as possible. Therefore at a basic level the continued and assured availability of deposits is a critical component of the bank’s liquidity and any uncertainty regarding deposits is necessarily of concern to banks.
A bank raises funds by attracting deposits, borrowing money in the inter-bank market, or issuing financial instruments in the money market or a securities market. The bank then lends out most of these funds to borrowers. However, it would not be prudent for a bank to lend out all of its balance sheet. It must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits. The one event which can severely impair a bank’s reputation and can therefore create a run on the bank is the bank’s inability even if temporarily to repay a depositor to withdraw his/her deposit or a portion thereof. Depositor panic psychology has been seen far too often to result in bank failures under such circumstances. That is why uncertainties related to deposit levels, even if misconceived, are danger signals that banks take very seriously.
Therefore there are provisions in every country for Bank reserves that are typically kept in the form of a deposit with a central bank. This is called fractional-reserve banking and it is a central issue of monetary policy. Some governments (or their central banks) restrict the proportion of a bank's balance sheet that can be lent out, and use this as a tool for controlling the money supply. Even where the reserve ratio is not controlled by the government, a minimum figure will still be set by regulatory authorities as part of banking supervision.
The traditional bank has an inherent susceptibility to crisis, in that it borrows short term and lends leveraged long term. The sum of deposits and the bank's capital will never equal more than a modest percentage of the loans the bank has outstanding. Even if liquidity is not a concern, if there is no run on the bank, banks can simply choose a bad portfolio of loans, or more precisely incorrectly price the interest rates of those loans, and lose more money than they have.
Therefore as Jan Kregel put it “banks are… profit maximizers with liquidity preferences” (Kregel, Jan, “Constraints on the expansion of output and employment: real or monetary” Journal of Post Keynesian Economics Winter 1984-85). As Keynes explained liquidity preference was a theory of choice between holding money idle (say in deposit liabilities or deposits in the central bank) and holding loans: the interest rate being the means to equalize the “attractions” of both. The interest rate is the reward for parting with liquidity. This needs some explanation. Although money is the most liquid of assets of an entrepreneurial economy, most of it is in any case constituted by banks’ own liabilities (deposits and supply of reserves by the central banks). Why then would they have a liquidity preference, viz., care about whether there is any uncertainty regarding liquidity? (On Bank’s’ Liquidity Preference: Fernando J. Cardim de Carvalho: http://www.ie.ufrj.br/moeda/pdfs/on_banks_liquidity_preference.pdf) Why then would deposit uncertainty be a big deal for banks it is they who collectively determine liquidity in the market? This is the theoretical conundrum that Gary A. Dymski seeks to explain in his work in this area.
As Dymski explains, banks are obliged to supply liquidity immediately on demand even while making loans, which are its source of profit by depleting its liquidity. As he says, “The more credit banks create to satisfy loan demand, the fewer funds are available for redistribution to meet depositor’s demand for liquidity (Dymski, G., “A Keynesian theory of bank behavior”, Journal of Post Keynesian Economics, Summer 1988). In some sense bankers are always trying to weigh between profitability and liquidity and this evaluation is profoundly affected by uncertainties on both sides, viz., deposit uncertainty and uncertainty regarding profitability. In terms of deposit uncertainty, it is not so much a problem of the entire banking industry taken as a whole because the amount of demand deposits is largely a result of the banking industry’s decision to extend loans and therefore is for the banking industry that determines the amount of liquidity available in the market. However when it comes to individual banks there are major concerns regarding deposit uncertainty because a bank could never be sure as to when and to what extent its deposits might be diverted to some other bank, thus severely eroding its ability to meet depositors liquidity demands. Realistically however, banks do not satisfy their liquidity preference only by shoring up its reserves (the only exception being the great depression) when banks showed what Friedman refers to as ‘absolute liquidity preference’. Keynes therefore explains this as not so much an issue of how much to lend and how much to keep in reserve as for banks to carefully weigh what proportion of its loans can be made in relatively less liquid forms (Some forms of loan are considered more liquid than others: example: short term consumer loans are more liquid than long term investment loans) and how to guard against deposit erosion. The individual bank’s decision as to how much liquidity it would keep, by sacrificing higher earnings (generally the more illiquid an asset is the higher the interest rate) would depend on its assessment of the risks of its depositors wanting to cash those deposits and other liquid assets.
In other words banks also engage in liability management and not just asset management, to reduce uncertainties. Thus a typical balance sheet composition of a bank would contain on the asset side different kinds like: Cash, Treasury Bills, Bills of Exchange, Inter-bank loans, Loans to customers etc., while on the liability side the portfolio would comprise Demand deposits, Time deposits and Inter Bank Borrowing. This represents a trade off between interest rates and safety on both sides, but interest rates on the liability side measure directly how much the bank is willing to pay to reduce the possibility of being surprised by an untimely demand for payment from its lenders, including depositors. This is how banks typically manage deposit uncertainty.