Search

This study revisits and tests empirically the Portfolio Theory of Inflation (PTI), which analyzes how the effectiveness of macroeconomic policy in open and globally financially integrated economies is influenced by global investor decisions (Bossone, The portfolio theory of inflation and policy (in)effectiveness, 2019). The PTI shows that when an economy is heavily indebted and is perceived by the market to be poorly credible, investors hold it to a tighter intertemporal budget constraint and policies aimed to stimulate output growth dissipate into domestic currency depreciation and higher inflation, with limited or no impact on output, or with lower output and lower inflation. On the other hand, markets afford highly credible economies much greater space for effective and noninflationary macro policies. The study leads to a very basic advice: policymakers of an internationally highly integrated economy should keep public liabilities (the stock of both central bank money and public debt) at low levels: the larger the liabilities, the higher the degree of surrender of the country's national policy sovereignty to external forces and interests.

Questo studio pone le fondamenta dell’ “Approccio Contabile” (“Accounting View”) alla moneta. Sulla base dei principi di Ragioneria Generale riconosciuti internazionalmente, lo studio argomenta che le monete emesse dallo stato e dalla banca centrale non costituiscono debito e che nei regimi di riserva frazionaria soltanto una quota della moneta emessa dalle banche commerciali pu essere considerata quale debito. Lo studio chiarisce come il signoraggio associato all’emissione di queste monete debba essere contabilizzato nei bilanci delle istituzioni emittenti ed esamina le implicazioni di ci`o per la corretta comprensione della moneta. Il nuovo approccio fa luce su argomenti quali la vera natura del capitale della banca centrale, le monete delle banche commerciali e quelle digitali. Da esso si derivano nuovi metodi di stima del signoraggio e si applicano al caso del Regno Unito (per il quale esistono stime recenti). I risultati rivelano che il signoraggio, in particolare quelle estratto dalle banche commerciali, un fenomeno quantitativamente rilevante. This study lays the foundations of the Accounting View" of money. Using inter national accounting principles, the study argues that state and central bank monies are not debt, and that in fractional reserve regimes only a share of commercial bank money can be regarded as debt. The study determines how the seigniorage associated with the issuance of these monies should be accounted for in the financial statements of the issuing institutions, and examines what this implies for the correct understanding of money. The new view throws light into such issues as the true nature of central bank capital, commercial banks, and digital currencies. Drawing on it, new measurements of seigniorage are derived and applied to the case of the UK (for which recent estimates exist). The results reveal that seigniorage, in particular that extracted by commercial banks, is a quantitatively relevant phenomenon.

The Portfolio Theory of Inflation (PIT) proposed in this study investigates the role of global financial markets in determining the effectiveness of macroeconomic policy in open and fully financial integrated economies. The PIT adopts a modified version of the portfolio balance approach to exchange rate determination and incorporates intertemporal optimal choices from global investors. These investors allocate resources across national economies based on local investment opportunities and policy credibility: when a country's credibility is low, they hold its economy to a tighter intertemporal budget constraint and the issuance of what they deem as "excess" public sector liabilities causes the country's currency to depreciate and inflation to rise due to a large exchange rate pass-through, with limited or no impact on output. On the other hand, high credibility creates space for effective and noninflationary macro policies but, if such space is abused, credibility gets dissipated and higher inflation reflects such dissipation.

This study analyzes the emergence of secular stagnation as the consequence of a rise in the preference for liquidity. Such a rise is caused by a persistent set of pessimistic expectations. This study also investigates the effectiveness of a broad range of demand-management policies in dealing with secular stagnation. To obtain these results, this study uses a model where agents derive utility from holding assets of different degrees of liquidity. In this environment, rational expectations interact with changes in market sentiment, to produce secular stagnation.

An international cooperative effort has been focused on the need to reduce financial fragility and systemic risks in global financial markets. Work is proceeding in three different areas: enhancing financial market transparency, improving the international financial architecture, and strengthening financial systems. Strengthening financial systems (the focus of this paper) means cooperating to promote principles and sound practices for financial stability through development of well-functioning financial systems and market discipline. Financial sector reform and development is much more than setting rules, articulating standards, approving legislation, and creating new institutions. All are important but ultimately behavior must be changed if there is to be meaningful and lasting financial reform. For that reason, this paper emphasizes the role of incentives to induce appropriate behavior. Developing countries have made important progress toward improved financial supervision in the past few years. Reforming financial sectors is a lengthy and complex process of institution building and incentive reorientation, whose success requires full ownership of, and participation in, the process by society and its government.

In this brief, Biagio Bossone of the International Monetary Fund evaluates narrow banking from the perspective of modern theories of financial intermediation. These theories portray the status quo banking system as a solution to otherwise intractable problems of imperfect information, risk, and even moral hazard. The system's characteristic coupling of liquid liabilities with illiquid assets - seen by some as an undesirable mismatch - in fact contributes greatly to the efficiency of the economy. Bossone argues that these efficiency gains outweigh the disadvantages associated with the existing legal framework.

Over the past 70 years, a proposal to narrow the scope of banks has emerged more and more frequently in financial debates and research. Narrow banking would prevent deposit-issuing banks from lending to the private sector and restrict nonbank intermediaries from funding investments with demand deposits. Proponents of narrow banking defend it as a step toward greater financial stability and efficiency. This study reviews the literature on the subject, contrasts the concept of narrow banking with contemporary banking theories, and evaluates the potential effects of narrow banking on finance and the real economy. The study also delineates an empirical exercise to estimate the costs of bank narrowness and draws policy conclusions based on those estimates.

Over the past decades, finance theory has contributed significantly to understanding banks and identifying what qualifies them to be special financial intermediaries. Historically, banks have had a comparative advantage in certain functions - such as providing liquidity and payment services and supplying credit and information - which competition, technological change, and institutional development have increasingly eroded. And the spread of e-money could deal a blow to conventional banking, generating entirely new ways of doing finance. After integrating his examination of money, production, and investment, the author argues that banks remain special in that they lend claims on their own debt and the public accepts the debt claims as money. His study shows the banks and nonbank financial intermediaries perform complementary functions essential to the economy. Risk reduction policies in payment systems, banking asset allocation, and the deposit market affect the economy's tradeoff between risk and efficiency and the cost of generating resources to finance production. As possibilities for global communications expand, trust will matter more than ever, and banks and other financial intermediaries will be in a good position to bridge gaps in trust when it comes to creating money and intermediating funds.

In any economic environment where decisions are decentralized, agents consider the risk that others might unfairly exploit informational asymmetries to their own disadvantage. Incomplete results, especially, lies at the heart of financial transactions in which agents trade real claims for promises of future real claims. Agents thus need to invest considerable resources to assess the trustworthiness of others with whom they know they can interact only under conditions of limited and asymmetrically distributed information. Thinking of finance as the complex of institutions and instruments needed to reduce the cost of trading promises among anonymous individuals who do not fully trust each other, the author analyzes how incomplete trust shapes the transaction costs in trading assets, and how it affects resource allocation and pricing decisions from rational, forward-looking agents. His analysis leads to core propositions about the role of finance and financial efficiency in economic development. He recommends areas of financial sector reform in emerging economies aimed at improving the financial system's efficiency in dealing with incomplete trust. Among other things, the public sector can improve trust in finance by improving financial infrastructure, including legal systems, financial regulation, and security in payment and trading systems. But fundamental improvements in financial efficiency may best be gained by eliciting good conduct through market forces.

In an economy where decisions are decentralized and made under conditions of uncertainty, the financial system can be seen as the complex of institutions, infrastructure, and instruments that society adopts to minimize the costs of trading promises when agents have incomplete trust and limited information. Building on a microeconomic general equilibrium model that portrays such fundamental financial functions, the author shows that, in line with recent empirical evidence, the development of financial infrastructure stimulates greater and more efficient capital accumulation. He also shows that economies with more developed financial infrastructure can more easily absorb exogenous shocks to output. The results call for addressing a crucial issue in the sequencing of reform in the financial sector: early in development, banks provide essential financial infrastructure services as part of their exclusive relationships with borrowers. Further economic development requires that such services be provided extrinsically to the bank-borrower relationship, clearly at the expense of bank rents. There may be a compelling discontinuity to financial sector development in that banks need to be supported early in development but to be"weakened"later - at the expense of bank rents - to foster further development. The important question for policy is when and how to generate and manage this discontinuity so that it is not forced on society by costly and traumatic events such as bank failures.

The author analyzes the financial system's role in economic growth and stability, addressing several core policy issues associated with financial sector reform in emerging economies. He studies finance's role in the context of a circuit model, with interacting rational, forward-looking, heterogeneous agents. He shows finance to essentially complement the price system in coordinating decentralized intertemporal resource allocation choices made by agents operating with limited information and incomplete trust. He discusses the links between finance and incentives for efficiency and stability in the context of the circuit model. He also identifies incentives and incentive-compatible institutions for reform strategies for financial sectors in emerging economies. Among his conclusions: 1) Circuit theory features important methodological advantages to analyze the role of finance, and to assess structural weaknesses of financial systems under different institutional settings and in different stages of economic development. 2) Incentives for prudence and honesty can protect the stability of the circuit by directing private sector forces unleashed by liberalization. In particular: a) Financial institutions should be encouraged to invest in reputational capital. b) Governments should complement the creation of franchise value by strengthening supervision and by adopting a regulatory regime based on rules designed to align the private incentives of market players with the social goal of financial stability. c) Safety nets to reduce systemic risk should minimize the moral hazard from stakeholders by limiting risk protection and by making the cost of protection sensitive to the risk taken. d) Governments should encourage self-policing in the financial sector. e) Where information and trust are scarce, there is a potential market for them, and governments can greatly improve incentives for optimal provision of information. f) Governments should strengthen the complementarity between the formal and the informal financial sectors. Emphasizing incentives is not to deny the importance of good rules, capable regulators andsupervisors, and strong enforcement measures. It is to suggest that the returns on investments to set up rules, institutions, and enforcement mechanisms can be greater if market players have an incentive to align their own objectives with the social goal of financial stability.