Following the American Psychological Association’s Guidelines
INTRODUCTION
Monetary policy implemented by the central banks aims at influencing directly the financial markets to create a stable monetary environment in the economies. The economies fluctuate over time with peaks and troughs. The globalization has created a large world economy which includes the connected country economies, and any crisis emerging in a country spreads to the other countries’ economies quickly. The crisis creates vulnerable economies, and the economy managements of the countries have to intervene to recover from the crisis. The global crises have severe results for economies and individuals, and they also can create disequilibrium in the monetary values such as inflation, interest rates, financial market prices etc.
The central banks, to decrease the negative effects of the global crises, implement monetary policy by using the monetary policy tools. Recently, the Federal Reserve has started buying the government papers to increase the interest rate, and attract the capital back to the U.S.. This policy created a shock in the financial markets.
In this essay we will analyze the paper “Risk-Taking Channel of Monetary Policy: A Global Game Approach” by Stephen Morris and Hyun Song Shin. The authors develop a game theory model to analyze the relationship between the FED and the agents in the financial markets.
SUMMARY OF THE ARTICLE
The article explores impact of the monetary shocks as a result of the monetary policy implemented by the FED over the asset management sector. There are typical actors in the financial markets who make decisions of making financial investments by buying or selling the assets. Some of those actors are more risk-averse and some of them are risk-taking agents. When a new monetary policy implementation is realized, these actors make a decision to take their position as a response to the monetary policy. The FED creates a vision for the future and announces it to the agents in the market. Therefore, the agents can make their best decisions, and the uncertainty in the market becomes less. However, there is another important fact influencing the markets: expectations. Expectations are basically what the agents in the market assume about the future. Understanding of expectations is important for the economy management. The FED might use all the tools to influence the financial markets; however, it is possible that the FED cannot create the desired influences on the market, because the agents’ expectations in the market might transform the desired influence of the monetary policy into an unexpected and undesired ex-post result. Thus, the FED should be able to anticipate the expectations to ensure that the monetary policy reaches the desired goals, in another word; a well developed expectation management is a necessity for the FED.
There are two groups analyzed in the study: Risk-neutral asset managers and risk-averse households. They are in the same environment under the same conditions. The asset managers use their customers’ funds to make profit in the financial markets, and the households have two options: managing their financial resources by themselves or hiring an asset manager to invest their financial resources. There are long term and short term investment papers in the market. The long term papers pay only once at the terminal date. The long term asset is a risky zero coupon bond. The short term asset is floating rate money market fund or bank account. The article analyzes the response of the two types to a monetary shock as a result of a new monetary policy implementation. The article finds out that the monetary policy is a very powerful in the economy, and the lower interest rates and the commitment to the lower interest rates in the long run compress the risk premiums and stimulates the real economy activity. Thus the FED might be able to create a long term economic stimulation by implementing the appropriate monetary policy. The paper also analyzes what other risks might occur which might prevent the desired situation in the long run through analyzing the possible responses from the agents in the financial markets.
INDICES AND ECONOMIC CALCULATIONS IN THE ARTICLE
In this section, three indices and one calculation used in the paper will be defined and discussed.
Premium risk
Premium risk is an important definition for the financial investors. This term basically is the return from a financial asset exceeding the return from a risk-free market asset like government bond. The professional investors would like to create a lower-risked financial investment portfolio, thus they need to create a secure portfolio with higher profit providing financial assets. The most secure way for the investors is to invest in the government bonds, because at the terminal date the government guarantees a payment and the strongest and the most trustable institution in a country. Investing in a government bond means guaranteeing a certain amount of income at the terminal date. However, investors would like to make more profit than this, thus any asset giving the same amount of the income with the government bonds is not the one worth investing in it. An asset which might be accepted as an investment opportunity should be promising a higher income than the risk-free assets’ incomes. If the risk premium is positive, then it is worth investing in this asset and taking some risk. Otherwise investing in the risk-free assets is the rational choice.
Financial Asset Prices
Financial assets are created by the financial institution to gather money. As known, the financial sector collects money from people and it creates a volume of credit for the investments in the economy. In another word, it helps the economy by redistributing the financial resources into the more efficient investment areas, thus the financial resources become active inside the economy and they finance the efficient investments. Financial assets are the tools to collect the financial resources from the economy. The financial assets are official papers where there is a price and the annual return amount on them. They might be providing interest or profit from investments. These assets have a nominal and a market value or price. The nominal price is the written price on the official paper, and the market price is the price determined in the market. Many of the financial assets are sold and bought in secondary markets. The demand and the supply of these assets determine the price in a free market environment. The market price for the financial assets is a sign for the investors. The market price is one of the most important information for the agents in the market. It basically summarizes all influences on the asset as a result of the dynamics in the market.
Interest rate
Interest is an important macroeconomic variable that all the agents in the economy watch. The simple definition of the interest rate is a promised return for borrowing financial resources to the other agents in the economy. All the agents interested in investments follow the interest rate level in the economy. Interest gain is a profit that an investor takes very low risk and no effort is required to spend the interest gain. Therefore, if an investor is willing to invest in risky assets or in risky physical investments, the return from this investment should be more than the market interest rate. In another word, the interest gain is the shadow price for all other investments, because when one uses the financial resource for other risky investments, the interest gain is to be lost.
Interest rate is important for the whole agents in the economy. In the modern world, the financial services are developed. The developed financial tools provide better opportunities for people for consuming and investing. Even a person cannot afford consumption or investment, the new developed financial instruments might it make possible for people. The price of these tools is the interest rate. When the interest rate is low, it is better for people and an economy where expenditures of consumption and investment are the engine of the economy. The high interest rates are not desired in the modern developed economies, because it might cause a decrease in the expenditures and it creates a barrier for the investments.
Consequently, the interest rate, productivity of an economy and welfare level of people in a country is interactive facts, and in the economy articles, the interest rate is used as an important variable.
Utility Function and Constraints of Real World
Utility function is one of the most important functions in the economy articles. Any paper related to the personal decision making process uses the utility function. The utility function is a function explains us how a person gets utility by consuming or investing. For example, in this article, the authors define two different person type and they define their utility functions. The utility functions show us what things a person is sensitive to. By using and transforming the utility function by using the mathematical operations, economists can develop models explaining economic facts. In analyzing an investor decision making process, a utility function for a person can be developed taking the sensitivity to the risk perception and the time into consideration. From this point, an economist can find the conditions for utility maximization; derive the relative prices for the assets for an investor, and much other information.
While using the utility function in the economic modeling, another important set of equations are important: the constraints. The utility function shows us the desires of a person, and there exist some barriers in the real world. Therefore a person cannot succeed to reach all his desires because of these constraints. For example, budget constraint, limited time constraint, geographical constraints, etc. Budget constraint is used in many economy articles. As we know a person can make a certain amount of income, and he cannot spend more than this income. Land is also limited; any utility depended on the quantity of land is to be limited. More examples can be given about constraints. Constraints can be defined as equalities or inequalities. For optimizing problems in the economy science, the utility function is used together with the constraints.
ECONOMIC PRINCIPLES USED IN THE ARTICLE
Interest rate level in an economy and financial asset price relation
Interest rate is a parameter for all kind investments and it is also related to the financial asset pricing. Many theories are developed on pricing the financial assets like Capital Asset Pricing Model (CAPM), Intertemporal CAPM, and many others. In these models, different kinds of interest rates are used: the risk-free assets’ interest rate, nominal interest rate, market interest rate, interest rates announced by the central banks, etc. While determining the price of a financial asset, these interest rates play a role. For instance, the risk-free financial interest rate is base information for investors.
The financial assets are some official papers proving that a person invested in it by paying the nominal price on the paper, and he will get paid a certain amount at a terminal point in time. If the paper depends on an interest gain, then a certain interest ratio is written on the paper. The price and the interest rate written on the paper are the nominal price and the nominal interest rate. These papers are traded in secondary markets, and people can sell these papers to third party people before the terminal time. The nominal rate on the paper does not change; however, the interest rate in the economy might change. While a person buys and keeps an asset, the market interest rate will change, and this situation will create alternative costs or gains for the asset holder. For instance, if the market interest rate increased, then the investor could get an asset with a higher interest rate; however, he holds a paper with a lower interest rate, he loses the opportunity to gain more. Also if he wants to sell the asset with lower interest rate, the buyer might offer a lower price than the nominal price. Therefore, the price of the paper goes down in the secondary market. When the interest rate goes up, then the asset will have a higher interest rate and the price of the paper in the market will go up. Basically, the market interest rate and the price of an asset in the secondary market are negatively correlated. This relation is included in the model in the article, although there is no explicit explanation in the text.
Risk tolerance and utility
Risk tolerance is the parameter showing that how much an investor is risk-lover, or risk-averse, or risk neutral. This parameter help economists categorize the investors as risk-taking, or risk-averse, risk neutral. Risk-lover investors are interested in taking higher risks to make higher profits, and the risk-averse investors prefer making lower gain by taking lower risk.
As we explained in the previous section, the utility function explains us how an investor or a person makes decision; therefore the risk-related behavior has to be reflected into the utility function. The authors in the mentioned article at the beginning of the essay take the risk tolerance parameter into the utility function. There is negative sign in front of the risk tolerance parameter, and the risk tolerance parameter is in the denominator. In the paper, there is no numerical limit is defined for the risk tolerance parameter; however, in many other economy articles, it is taken as between 0 and 1. Thus, if we assume that the risk tolerance parameter is between 0 and 1, then while the risk tolerance increases close to 1, the utility will be increasing, and vice versa.
Forming expectation about interest rate in the long run depending on the information gathered
The paper defines two kind of person type: asset manager and regular person. These two types have different characteristics and different aims while investing. The asset manager is a person who collects other people’s financial resources, and makes investments by using them. A regular person only invests by using his financial resources.
As we know, any investor in the market forms some expectations. Expectations are not some random ideas; they are some decisions made upon the information gathered by a person. Thus, we expect that something might happen or might not happen due to the information we have. The information asymmetry between people might create some advantages for the person with more information, and some disadvantages for the person with less information. This situation is analyzed in the article. The asset manager is a person who is able to collect better information respectively; therefore he can make better decisions than a regular person. Also we can claim that he can manage other people’s expectations.
METHODOLOGY USED IN THE ARTICLE
This paper uses a special utility function for investors, and analyzes the influence of the monetary shocks on the investors’ decision making processes. An investor cares the risk premium; in another word, an investor cares if it is worth taking risk for an investment and the criteria value for this is how the return from an investment is higher than the return from the risk-free assets. The paper includes this idea and the return from the risk-free assets and the return from the other assets are included in the model.
The paper also analyzes the interaction between the market interest rate and the price of the assets. A monetary shock changes the interest rates, and indirectly it influences the price of the assets.
Consequently, the article develops a risk-taking channel for the asset managers. The monetary shock changes the risk premiums, and then that reflects to the interest rates in the market. The asset managers are important people, and their reactions to the monetary shock can shape the behavior, or the expectations of other people. Another important fact that this article finds out that the policies aiming at creating or keeping a stability in the financial markets cannot be thought separate from the monetary policies for stimulating the economy, or for different goals.
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