Money, Banking, and Finance Chapter 11

Why Do We Fail to Learn From Past Mistakes?

Speculative bubbles form for psychological and economic reasons

• Psychological reasons
• faith or “blind optimism”
• herd behaviour
• Economic reasons
• easy credit
• borrowing for purchases of stocks or real estate
• inflation of a financial bubble

How Exactly Are All These Possibilities of Bank-Based and Non-Bank-Based Finance Linked to the Macroeconomy?

Finance is crucial to realize investment plans of firms

• no savings have to be collected prior to the investment undertaking
• banks can create deposit money by extending loans with “the stroke of a pen”
• investment plans depend on banks and non-banks willingness and ability to provide funds to firms and households

Figure 11.2 Credit and Aggregate Demand

Aggregate Expenditure
Credit Volume
Less financialized economy
More financialized economy

• A larger amount of credit disbursed tends to lead to more aggregate demand: Money is usually borrowed by households and firms to finance spending on consumer goods, residential properties or new equipment.

• However, the more finalized an economy, the more of the credit goes into non-productive activities without an impact on aggregate demand. For a financialized economy, therefore, the Credit-AE-curve is further to the left.

The International Aspect of Finance: Cross-Border Trading of Financial Assets

• Some invest in foreign assets because of good performance of – for example – a Japanese car company
• Others invest abroad to speculate on changes in the exchange rate
• Trading financial assets across borders means that one country borrows and another country acquires claims

What to Take Home (I)

• Hyperinflation comes from running the printing press
• Deflation is a fall in aggregate price levels
• Money is a store of value, a medium of exchange, and a unit of account
• Economists differentiate between commodity money and fiat money
• Commercial banks make profits through collecting deposits and investing in a portfolio of loans as well as miscellaneous securities
• Deposit money is created when banks make loans

What to Take Home (II)

• Nonbank financial institutions are not subject to banking regulation
• Economies became financialized
• Irrational speculative real estate or asset price rises are called bubbles
• Finance is crucial to realize investment plans of firms