Credit Markets and Financial Intermediation: Study Notes

Credit Markets

Introduction to Credit Markets

Credit markets are a fundamental component of the macroeconomy, facilitating the flow of funds from savers to borrowers. They determine the allocation of resources, the cost of borrowing, and the return to saving, all of which are central to economic growth and stability.

• Credit Market: The marketplace where borrowers (such as entrepreneurs, businesses, home buyers, and students) obtain funds from savers.

• Borrowers: Economic agents who seek to borrow funds for investment or consumption.

• Principal: The amount of money borrowed or lent.

• Interest Rate: The cost of borrowing, expressed as a percentage of the principal.

What is the Credit Market?

Key Terms and Definitions

• Nominal Interest Rate (i): The annual cost of a $1 loan, not adjusted for inflation.

• Total Interest Payments: The total amount paid in interest over the life of the loan.

Formula:

$\text{Total interest payments} = i \times L$

where $L$ is the loan amount.

Example Table: Calculating Total Interest Payments

Total Loan Amount	Nominal Interest Rate	Total Interest Payments
$20,000	1%	$200
$20,000	5%	$1,000
$20,000	10%	$2,000
$20,000	50%	$10,000

Real Interest Rate and the Fisher Equation

• Real Interest Rate (r): The inflation-adjusted cost of borrowing, reflecting the true cost in terms of purchasing power.

• Fisher Equation: Relates the nominal interest rate, real interest rate, and inflation rate.

$r = i - \pi$

• $r$ = real interest rate

• $i$ = nominal interest rate

• $\pi$ = inflation rate

Example Table: Calculating Real Interest Rate

Nominal Interest Rate	Rate of Inflation	Real Interest Rate
1%	2%	-1%
5%	2%	3%
10%	2%	8%
50%	2%	48%

Decision-Making: Nominal vs. Real Interest Rate

• Borrowers and lenders base their decisions on the real interest rate, as it reflects the true cost or return after accounting for inflation.

• Optimizing agents compare the real value of what they repay to what they borrowed.

Credit Demand

Credit Demand Curve

The credit demand curve shows the relationship between the real interest rate and the quantity of credit demanded by borrowers.

• Quantity of Credit Demanded: The amount of loans borrowers are willing to take at a given real interest rate.

• Credit Demand Schedule: A table showing quantities demanded at various real interest rates.

• Credit Demand Curve: A downward-sloping curve, indicating that higher real interest rates reduce the quantity of credit demanded.

Why is the credit demand curve downward sloping?

• As the real interest rate increases, borrowing becomes more expensive, reducing the number of profitable investment opportunities and thus the quantity of credit demanded.

Sensitivity: The steepness of the curve reflects how sensitive borrowers are to changes in the real interest rate.

Shifts in the Credit Demand Curve

• Changes in perceived business opportunities (e.g., firms buying more capital equipment).

• Changes in household preferences or expectations (e.g., households become nervous about job security).

• Changes in government policy (e.g., changes in the budget deficit).

Example: If firms expect higher future profits, the credit demand curve shifts right (increases).

Credit Supply

Credit Supply Curve

The credit supply curve shows the relationship between the real interest rate and the quantity of credit supplied by savers.

• Quantity of Credit Supplied: The amount of funds that savers are willing to lend at a given real interest rate.

• Credit Supply Schedule: A table showing quantities supplied at various real interest rates.

• Credit Supply Curve: An upward-sloping curve, indicating that higher real interest rates increase the quantity of credit supplied.

Motives for Saving:

• Retirement

• Bequests (for children)

• Large purchases (house, car, etc.)

• Starting a business

• Precautionary savings ("rainy day" fund)

Effect of Real Interest Rate:

• Higher real interest rates generally encourage more saving, as the reward for saving increases.

• However, for some, higher rates may allow them to save less to reach a target amount (income effect), but typically the substitution effect dominates, leading to more saving.

Shifts in the Credit Supply Curve

• Changes in household saving motives (e.g., due to expectations or demographics).

• Changes in firms' saving motives (e.g., retained earnings).

Example: If households become more concerned about the future, the credit supply curve shifts right (increases).

Credit Market Equilibrium

Determination of Interest Rate and Quantity

The equilibrium in the credit market is where the credit supply and credit demand curves intersect. This determines both the equilibrium real interest rate and the total quantity of credit in the market.

• Equilibrium Real Interest Rate ($r^*$): The rate at which the amount of credit supplied equals the amount demanded.

• Equilibrium Quantity of Credit ($Q^*$): The total amount of loans exchanged at the equilibrium rate.

Example: If the government increases its budget deficit, the credit demand curve shifts right, raising the equilibrium real interest rate and increasing the quantity of credit.

Banks and Financial Intermediation

Role of Banks and Financial Intermediaries

Banks and other financial intermediaries connect savers and borrowers, facilitating the efficient allocation of resources in the economy.

• Types of Financial Institutions: Banks, asset management companies, hedge funds, private equity funds, venture capital funds, and the shadow banking system.

Bank Balance Sheets

• Assets: What the bank owns (e.g., reserves, cash equivalents, long-term investments).

• Liabilities: What the bank owes (e.g., demand deposits, short-term borrowing, long-term debt).

• Stockholders' Equity: The difference between total assets and total liabilities; represents the value to shareholders.

Balance Sheet Equation:

$\text{Total Assets} = \text{Total Liabilities} + \text{Stockholders' Equity}$

Example Table: Simplified Bank Balance Sheet

Assets	Liabilities and Stockholders' Equity
Reserves: $74B Cash Equivalents: $274B Long-term Investments: $1,453B	Demand Deposits: $X Short-term Borrowing:$Y Long-term Debt: $Z Stockholders' Equity:$W
Total Assets: $1,801B	Total Liabilities + Stockholders' Equity: $1,801B

Additional info: Actual values for liabilities and equity would be specified in a full balance sheet.

Functions of Banks

• Identifying Profitable Lending Opportunities: Screening borrowers and selecting the best loan applications.

• Maturity Transformation: Converting short-term liabilities (deposits) into long-term assets (loans).

• Risk Management: Diversifying assets and transferring risk to stockholders and, in extreme cases, to the government (via deposit insurance).

Maturity and Risk Transformation

• Maturity: The time until a debt must be repaid. Deposits are short-term (withdrawable at any time), while loans are long-term.

• Risk: Banks manage risk by holding diversified portfolios, but systemic events (e.g., financial crises) can still cause widespread losses.

Bank Insolvency and Deposit Insurance

• Insolvency: Occurs when a bank's liabilities exceed its assets.

• FDIC Insurance: Protects depositors up to $250,000 per account, transferring risk to the government if a bank fails.

• Resolution: The FDIC may shut down the bank or transfer it to new ownership to protect depositors.

Example Table: Bank Balance Sheet Before and After Loss

Scenario	Assets	Liabilities	Stockholders' Equity
Before Loss	$11B	$10B	$1B
After $1B Loss	$10B	$10B	$0B
After $3B Loss	$8B	$10B	-$2B (insolvent)

Bank Failures

Historical Waves of Bank Failures

• Four major waves in U.S. history:

  1. 1919-1928: Rural bank failures (~6,000 banks).

  2. 1929-1939: Great Depression (~9,000 banks).

  3. 1986-1995: Savings and loan crisis (~3,000 banks).

  4. 2007-2009: Financial crisis (several large institutions, e.g., Lehman Brothers).

• Counting failures can be misleading; the collapse of a large bank can have greater systemic impact than many small failures.

• Post-crisis reforms require large banks to submit "living wills" and hold more equity.

Summary

• The credit market matches borrowers (credit demand) and savers (credit supply).

• Equilibrium determines the real interest rate and the quantity of credit.

• Banks and financial intermediaries play key roles in identifying lending opportunities, transforming maturities, and managing risk.

• Banks become insolvent when liabilities exceed assets, but deposit insurance protects depositors.