Intermediation and cost determinants of large bank liability composition

A (translog) profit function is estimated for an aggregate of large U.S. money center banks over 1970–1975. Estimates of liability substitution elasticities and own price elasticities of demand are obtained and contrasted with results from earlier, partial equilibrium studies. Statistical analyses led to the rejection of two commonly held propositions in banking: (1) that the aggregation of all bank debt (to obtain a debt/equity ratio) is valid, and (2), that asset structure can be ignored when liability composition is being determined. A mixed, full information maximum likelihood estimation technique was used in estimation.     

Does money matter in developing economies? Some evidence from the Solow estimator

Building on the Solow seminal approach for estimating the output elasticity of money stock and on Startz's (1984) implementation of it, this article explores the role of money in the production process in Kuwait, Saudi Arabia, and the United Arab Emirates. Due to lack of necessary data on interest rates in these countries, we use alternative measures of credit constraints as proxies. In contrast to Startz's conclusion for the U.S., our empirical results systematically reveal significant output elasticities of money in each of the three developing countries under study. This is consistent with the neoclassical monetary theory and its incorporation of real money balances as an important input in the production function. Moreover, as the McKinnon-Shaw hypothesis contends, money appears to be complementary to physical capital in the three developing countries. Hence, policy-makers must not hinder the development of their money (financial) markets if they desire to promote economic growth.     

The effects of relative price changes on the household's demand for money

In examining the economic response to changes in the rate of inflation, models of the demand for money have traditionally assumed that all prices change equiproportionately. This paper alternatively examines the effect on the demand for money of relative price changes. The analysis develops a choice theoretic framework of household behavior by combining a utility maximization framework with the inventory approach to the transactions demand for money. A significant result of the analysis is that the net effect of a change in relative prices on the household's money holding depends on the purchase frequencies and price elasticities of the relevant commodities.     

Investor biases in Japan: Another pathology of Keiretsu

We examine how keiretsu-related institutional investors behave in the Japanese stock market relative to other investor categories for the period from 1985–1998. Based on the agency problem hypothesis for the general bias of institutional investors and the relational distance hypothesis for the unusual bias of keiretsu-affiliated money managers, this paper finds that keiretsu-affiliated money managers over-invest not only in large firms, but also in imprudent firms. The group affiliation of Japanese domestic money managers may drive their portfolio decisions towards financially weak group member firms at the expense of their client investors. Identifying the conditions for this rescue type of investment, we illustrate a rather weak corporate governance foundation of institutional money management in Japan.     

Can banks individually create money out of nothing? — The theories and the empirical evidence

This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".     

Are there economies of scale in the demand for money by firms? Some panel data estimates

We estimate elasticities of scale in the demand for money by firms using firm level panel data from Spain, the UK, and the US. This elasticity is one for Spain and the UK but smaller for the US. We find that the errors in the money demand equations contain two terms that are correlated with sales. Firstly, a permanent firm effect that captures differences in technological sophistication. Secondly, a measurement error in sales, which becomes relevant when relying on changes in sales to account for fixed effects. Failure to control for these correlated unobservable terms results in important biases in the estimated sales elasticities.     

A lost century in economics: Three theories of banking and the conclusive evidence

How do banks operate and where does the money supply come from? The financial crisis has heightened awareness that these questions have been unduly neglected by many researchers. During the past century, three different theories of banking were dominant at different times: (1) The currently prevalent financial intermediation theory of banking says that banks collect deposits and then lend these out, just like other non-bank financial intermediaries. (2) The older fractional reserve theory of banking says that each individual bank is a financial intermediary without the power to create money, but the banking system collectively is able to create money through the process of ‘multiple deposit expansion’ (the ‘money multiplier’). (3) The credit creation theory of banking, predominant a century ago, does not consider banks as financial intermediaries that gather deposits to lend out, but instead argues that each individual bank creates credit and money newly when granting a bank loan. The theories differ in their accounting treatment of bank lending as well as in their policy implications. Since according to the dominant financial intermediation theory banks are virtually identical with other non-bank financial intermediaries, they are not usually included in the economic models used in economics or by central bankers. Moreover, the theory of banks as intermediaries provides the rationale for capital adequacy-based bank regulation. Should this theory not be correct, currently prevailing economics modelling and policy-making would be without empirical foundation. Despite the importance of this question, so far only one empirical test of the three theories has been reported in learned journals. This paper presents a second empirical test, using an alternative methodology, which allows control for all other factors. The financial intermediation and the fractional reserve theories of banking are rejected by the evidence. This finding throws doubt on the rationale for regulating bank capital adequacy to avoid banking crises, as the case study of Credit Suisse during the crisis illustrates. The finding indicates that advice to encourage developing countries to borrow from abroad is misguided. The question is considered why the economics profession has failed over most of the past century to make any progress concerning knowledge of the monetary system, and why it instead moved ever further away from the truth as already recognised by the credit creation theory well over a century ago. The role of conflicts of interest and interested parties in shaping the current bank-free academic consensus is discussed. A number of avenues for needed further research are indicated.     

On measuring the nearness of near moneys revisited

In this paper we re-examine the theoretical foundations and empirical estimation of models which incorporate a CES utility function to study the nearness of money substitutes. We show that previous studies using these models have been subject to a number of theoretical and empirical flaws. The result of these flaws has been to overestimate the degree of substitutability between money and near money assets. We show that when these errors are corrected, estimates of substitution elasticities are several times smaller than even those of the most recent studies and therefore are more in line with estimates from more traditional demand for money studies.     

Wage stickiness and the non-neutrality of money: A cross-industry analysis

The paper provides an empirical test of sticky wage models of business fluctuations by focusing on industry level cross-sectional implications that emerge. This breaks the observational equivalence, existing at the aggregate level, between rational expectations, long-term contracting and imperfect information models. The specific implication tested is whether output responses to nominal disturbances (industry Phillips Curve slopes) are inversely related to wage indexation elasticities. The Phillips Curve slopes are found to vary across industries for the Canadian economy, but bear no relationship to indexation elasticities, casting doubt on the role of nominal wage rigidity in generating the observed non-neutrality of money.     

Is Prescott right? Welfare state policies and the incentives to work, learn, and retire

This paper bolsters Prescott’s (Fed. Reserve Bank Minneap. Q. Rev. 28(1):2–13, 2004) claim that high taxes are responsible for lackluster labor market performance in Continental European countries. We develop a life-cycle model with endogenous skill formation, endogenous labor supply, and endogenous retirement. Labor taxation distorts not only labor supply, but also education and retirement decisions. Actuarially unfair pensions further exacerbate labor tax distortions on retirement. Education subsidies can nevertheless cushion the adverse impact of taxation on skill formation. Feedbacks between education, labor supply, and retirement are important. The model is simulated with realistic behavioral elasticities that are consistent with microeconometric evidence. If, besides labor supply, also learning and retirement are endogenous, the uncompensated (compensated) elasticity of the tax base equals 0.46 (0.85), which is more than twice as large as the standard uncompensated (compensated) labor supply elasticity of 0.18 (0.40). Furthermore, life-cycle interactions between education, working, and retirement are quantitatively important and the interactions raise all behavioral elasticities substantially. For example, the uncompensated labor supply elasticity increases with one-half due to life-cycle interactions (to 0.26). We demonstrate that low European labor supply can be fully explained by taxation without relying on unrealistically high labor supply elasticities. Reducing labor market distortions, cutting benefit levels, lowering tax rates, and making (early) retirement actuarially more fair, therefore, boosts labor supply, delays retirement, and stimulates skill formation. In addition, high education subsidies are needed in large welfare states to offset explicit and implicit tax burdens on human capital investment.      

Money and stock prices: Market efficiency and the lag in effect of monetary policy

This paper examines stock market efficiency with respect to money supply data by testing (1) regression models of stock returns on monetary variables and (2) trading rules based on money supply data. The evidence indicates no meaningful lag in the effect of monetary policy on the stock market and that no profitable security trading rules using past values of the money supply exist. Therefore this evidence is consistent with the efficient market model. Current security returns incorporate all information contained in past money supply data and, in addition, appear to anticipate future changes in the money supply. A number of previous studies have concluded that lags exist and can be used in profitable trading rules. Analysis of these studies demonstrates that for a variety of reasons the evidence in these past studies does not sustain such conclusions.     

Financial innovation,new assets,and the behavior of money demand

Two fundamental changes in US banking regulations have affected the behavior of money demand (M1). The first authorized checkable deposit accounts paying explicit interest rates. The second allowed these rates to be market determined. The theoretical literature does not directly address the impact of these events, suggesting that they are primarily an empirical issue. However, the empirical literature has yet to agree on the impact of financial innovation on money demand; for example, several studies report an increase in the elasticity of money demand, several others report a decline. This paper uses a Lancaster-type choice model to analyze formally the expected impact of these two changes on the demand for money. The model derives specific conditions under which (i) the demand for money increases as new assets are introduced and (ii) the impact of either the introduction of new assets or the elimination of interest rate restrictions on the elasticity of money demand.     

The interrelationship between price and output decisions and investment decisions: Microfoundations and aggregate implications

This paper develops a model of firm behavior in which both price and output decisions and investment decisions are made. The model permits an analysis of the dynamics of inventory and capital accumulation on price and output behavior. There are two main results: (1) Short-run price and output levels will differ from long-run levels as desired stocks of inventory and capital diverge from actual levels. (2) The size of the elasticities of price and output to changes in demand and cost variables depends on the speed with which gaps between desired and actual stocks are closed through investment.     

Monetary policy and long-term interest rates: An efficient markets approach

This paper is an application of efficient markets theory to analyze empirically the relationship of money supply growth and long-term interest rates. This approach has the advantage over calier research on this subject in that it imposes a theoretical structure on this relationship that flows easier interpretation of the empirical results as well as more powerful statistical tests on the interest of ascertaining the robustness of the results, many different empirical tests are carried out in this paper, and they uniformly do not support the preposition that increases in the money supply are correlated with declines in long rates.     

Interest rate pass-through in India

The success of the interest rate channel depends upon the size and speed with which retail interest rates respond to changes in policy or money market interest rates. This study estimates the dynamic elasticities of the pass-through of the official monetary policy rate to the money market and retail interest rates in India and examines whether the speed and magnitudes of the pass-through have changed following introduction of the Liquidity Adjustment Facility in 2000. The results show that the speed of adjustment is highest for call rates and lowest for 364-day Treasury Bill yield. The pass-through elasticities with respect to call rate show marginal improvement in the case of deposit and lending rates and worsening in the case of Treasury Bills.     

Inflation and stagflation

This paper reports on the author's theoretical and empirical research which has supported the following propositions. First, the change in the rate of inflation from one year to the next depends upon the growth of the money supply less the current rate of inflation. The current unemployment rate does not significantly affect whether the rate of inflation will rise or fall. If the monetary authorities raise the rate of monetary expansion above the current rate of inflation, the latter will rise regardless of the slack in the economy. Second, the change in the unemployment rate from one year to the next depends upon: (a) the deviation of the current unemployment rate from its equilibrium value and (b) the growth of the money supply less the current rate of inflation. The first effect concerns wage flexibility and the second effect concerns the shift of the aggregate demand (C+I+G) curve.     

Adaptive expectations,rational expectations,and money demand in hyperinflation Germany

In the recent literature Sargent and Wallace (IER, June, 1973) have estimated the demand equation for money in hyperinflation under the restriction that the adaptive formula of Phillip Cagan yields rational inflation expectations in the sense of John Muth. The present paper finds evidence to reject for the Germany case the proposition that adaptive expectations are rational. The procedure employed is basically to overfit the stochastic representation for the inflation rate implied by the ‘adaptive-is-rational’ hypothesis. The paper also puts forward and applies a two-step procedure to estimate the important money demand elasticity in hyperinflation. The procedure returns reasonable results with large estimated standard errors.     

Understanding the risk of leveraged ETFs

The purpose of this paper is to clarify the risks of leveraged ETFs. We do this by showing how to construct a k-times leveraged ETF as a dynamic portfolio in the ETF and a money market account. This construction characterizes the return distribution of the leveraged ETF over any investment horizon. As a corollary, we show that a k-times leveraged ETF will not earn k times the return of the ETF. It differs due to a term involving the ETF’s volatility and the interest paid on the borrowing over the investment horizon.     

Simultaneous effects of clustering and endogeneity on the underpricing difference of IPO firms: A global evidence

This paper provides the first empirical examination of the Entrepreneurial Wealth Losses (EWL) theory in explaining the global underpricing difference while simultaneously accounting for various clustering effects on the endogenous underwriter-underpricing relationship. We carefully evaluate the effect of clustering in standard errors within years, industries, countries, and developed versus developing countries. Employed here is a large global dataset comprising 10,212 IPO-issuing firms from 22 developed and developing countries between 1995 and 2016. Our 2SLS results provide strong evidence relating the existence of dispersion in underpricing in the global IPO market to the three dimensions of the EWL theory. When the degree of ex-ante uncertainty surrounding the time of offering is high, results show that in countries with a high level of IPO underpricing, issuers sell less secondary shares, create less primary shares, and employ less reputable underwriters. After adjusting for the clustering effect, the EWL model fails in cross-country settings and in developing stock markets while it succeeds in developed ones. This is due to the failure to capture the endogenous underwriter reputation-underpricing relationship. We show how ignoring one- and two-way clustering effects in the IPO data influences results. The validity of the EWL model particularly the statistical significance of the endogenous underwriter reputation-underpricing relationship vanishes based on the way we cluster our standard errors. Instead, we uncover conclusive evidence supporting the spinning behavior rationale where prestigious underwriters in developing equity markets burden IPO firms with a hefty underwriting fee. Sequentially, they leave big amounts of money on the table for investors to cash it out at the expense of issuers. Entrepreneurs in developing nations appear not to be concerned by this spinning practice, because they care little about their wealth losses in exchange for securing successful offering. Policy-wise, the paper provides several practical contributions.