The Financial Accelerator and the Flight to Quality - Essay Example

Macro and Micro Economics Q1. (a) The national income accounting identity s that aggregate income earned in an economy is always equal to the aggregate expenditure (Rose, 2010). A closed economy is a hypothetical economic system that does not engage in any foreign trade. From the demand or expenditure side: Y (Total Income) = C (Consumption Expenditure) + I (Investment Expenditure) +G (Government Expenditure) When all accumulated resources in the market are utilized, the aggregate savings (S) becomes equal to aggregate investment (I). The government incurs expenditure for the public and in return earns taxable revenue (T). The case of the current assignment assumes that total government expenditure (G) is equal to its taxable revenue (T). Therefore, the accounting identity can also be explained as: Y = C + S + T (i) Considering the data of Table 1. 12 (Y) = 9 (C) + 2 (S) + G (since T = G) = > G = Y - C - S = 12 – 9 – 2 = 1 £ billion (Total Government Expenditure) Therefore government expenditure (G) as a percentage of GDP (Y) = (1/12)*100 = 8.33 % (ii) Total household savings or capital accumulation as a percentage of GDP = (2/12)*100 = 16.66 % (b) (i) The fluid capital accumulation or savings determines the investable funds supply in an economy. Figure 1: Saving Investment Equilibrium (Source: Rose, 2010) As shown in the above graph, the savings (s) in a closed economy is always given exogenously. The investment in the market (I) is a function of rate of interest (r). The cost of borrowing money in an economy becomes high when the lending rate of interest is elevated. Hence, investments made in the market are adversely related to the lending rate of interest. At equilibrium rate of interest (re), national savings and investment remains equal to each other (S=I) (Baddeley, 2005). Figure 2: Supply Side Change S1 S2 r e r I (r) (Source: Author’s Creation) When the aggregate savings in an economy rise up to 30% of GDP, the investments can be expected to increase (to match savings) only if the lending rate of interest (r) falls below the previous equilibrium rate (re). The new value of savings = 30% of GDP (Y) = 30% of 12 = 3.6 £ billion. Hence, if investments made in an economy are expected to rise as per the increased savings, then the new value of investments would be = 3.6 £ billion. (ii) The supply side policies are implemented in an economy for increasing productivity of its real national output, during a state of recession. These policies help an economy to grow sustainably, without the persistence of inflation (Bernanke, Gertler and Gilchrist, 1996). However, economic growth cannot be successfully achieved solely with the essence of supply side policies. The supply side approach is rendered successful with presence of adequate aggregate demand in the economy. If the housing confidence slumps and the economy suffers from recession, then the individuals desire to save more and spend less. As a result, if the monetary authorities of a country lower interest rate and stimulate investments, then aggregate production related activities will rise, but the output produced will not be sold adequately due to lack of consumers’ demand (Mankiw and Taylor, 2006). (iii) The problems associated with a supply side approach can be resolved with the help of expansionary fiscal policies. These policies will enable the government authorities to stimulate the level of aggregate demand. Such initiatives can be undertaken by the fiscal authorities by way of additional capital spending in the core infrastructure sector, lowering tax rates, improving quality of education and reducing the level of planning controls. (c) (i) Trade surplus is the measure resembling a positive balance of trade in an economy. When the value of exports in a country is more than that of its imports, trade surplus in the current account is experienced (Akerlof and Shiller, n.d.). (ii) The monetary policies of an economy are undertaken by the central banking authorities. The central bank can lower the level of trade surplus in an economy with the essence of contractionary monetary policies (Benford and Burrows, 2013). These policies can be practiced by selling securities through open market operations, increasing the base rate of interest and augmenting cash reveres of the commercial banks. All these practices will lower domestic investment and productivity levels of the economy, thereby reducing its exporting propensity. Lower exports will ultimately reduce trade surplus of the country (Marsh, 2000). (iii) The domestic investors will lower investments made in the market due to the contractionary monetary policy measures. The cost of borrowing money incurred will rise because of increasing base rate, higher reserve ratios and larger supply of securities in the market (BIS, 2005; Brakham and Ward, 2002; Dombret and Tucker, 2012). Q2. (a) The price-earnings ratio evaluates the present share price of a company with respect to that of the peer companies. Here, share price of Nilezon is overvalued as compared to the industry average and that of the other two companies such as, Skybay and Pathos. This fact indicates that Nilezon is providing its investors with higher earnings, which has been satisfactory for last five years. However, if historical P/E ratio of the company is compared with that of the industry, the share prices can be stated as undervalued, given that the industry average is higher. As a result, the share price performance of Nilezon has deteriorated over years, but has performed well in last five years. Two main limitations of this interpretation is that comparing the P/E ratios with that of peer companies is not an efficient measure to draw an conclusion pertaining to undervaluation or overvaluation of shares. Another major limitation is that P/E ratio of the industry cannot be calculated accurately as peer companies may not reveal their actual earnings publicly. (b) The prospective earnings per share are provided for each companies and the industry. In order to estimate the intrinsic value of each company shares, prospective EPS and P/E ratios are considered. The following table presents intrinsic value of the shares: Average P/E ratio Prospective EPS Intrinsic value Nilezon 30 20p 600p Skybay 15 80 1200p Pathos 10 300 3000p From the above table it can be concluded that Pathos has overvalued its share price compared to its peers. According to Efficient Market Hypothesis (EMH), pathos has the ability to beat the market as the share prices are higher than that of the industry. EMH states that it is impossible to beat the market and the stocks are traded at fair value. However, according to the above calculation Pathos has outperformed the market. (c) As per the interpretation and calculation shown above, it can be stated that there is a bubble in the share market. Q3. An economic bubble is a type of economic cycle that is characterized by fast expansion pursued by a contraction. An economic bubble is also known as a speculative, price, market or financial bubble. It is a situation when the asset prices in an economy seem inconsistent with the predictions of future. It is often difficult to study the intrinsic values of assets in the real-life markets. Hence, bubbles are observed in an economy primarily after a sudden fall in the prices of goods and services. Sudden fall in the prices is considered to be a resultant of bubble burst or crash (Snowdon, 2008). Before the crash of an economic bubble, the prices of goods and services in the market are highly volatile in nature. However, bubbles often occur in an economy without the existence of any market speculation, uncertainty or bounded rationality. The exact time for an economic bubble crash can only be forecasted in a probabilistic manner. Economists often evaluate the process of a market bubble through the Markov’s switching model (Shiller, 2003). Certain processes of price coordination or social norms in an economy are also significant causal factors related to economic bubble. It was previously believed that bubbles are beneficial to an economy; but over time, speculative bubbles were seen to cause financial crisis in an economy. Economists claim that monetary and fiscal authorities of a country should try to implement special market recovery policies, following a bubble burst in the market (Baddeley, 2005). Bubbles are primarily found to misallocate the productive resources of an economy to non-optimal stages. They are an outcome of ex-ante market confidence among the economic agents. A speculative bubble burst destroys the productive wealth and generates malaise in an economy. The great depression of 1930 and the severe recession in Japan in 1990 are few adverse consequences of economic bubble burst. Nonetheless, the most recent catastrophic aftermath of a bubble crash can be realized by studying the property bubble phenomenon in certain European countries, which had triggered the global financial crisis and recession in 2008. The two extracts provided in the assignment elaborate on the case of real estate bubble in the U.K. The housing sector bubble was the primal element that had generated the global financial crisis of 2008. Due to certain intrinsic market exuberances, the real estate sector in some European countries such as, Greece, Italy and Spain, was facing constant price bubble due to speculative property trading activities. Finally, failure of many overvalued property projects had carved the way for the global financial crisis, thereby creating severe recession in the European countries. The harmful impacts of this recession have been lowered over time with the essence of special austerity programs undertaken by the fiscal and monetary authorities of these countries (Malkiel, 2007). However, the case studies for the assignment empirically prove that housing market bubble is present in the U.K. economy. This is because the housing construction companies therein are found to extensively bid on the prices of land and increase market valuation by 10% or more (Mazzucato, et al., 2010). Through the Help to Buy Scheme that was introduced by the U.K. public sector authorities, the aggregate demand for newly build homes has considerably increased. The land traders in the U.K. have stated that the aggregate supply of currently constructed homes is relatively less compared to their market demand. Even so, almost six to ten buyers in the country are found to be inclined towards purchasing newly constructed plot. The land traders claim that the housing land of the U.K. is frantic in nature. Hence, excess of housing demand over supply has ultimately increased the price of construction land. The land traders of the U.K. are augmenting the price values of housing lands because they face excessive demand from the house builders. Even so, Mathew Griffith, the director of IPPR, has stated that the house builders will presently undertake lower number of construction projects so as to protect their profit margins (Mazzucato, et al., 2010). The surplus margins earned by the builders are falling due to excessive rise in the price of construction lands. Under such circumstances, industrial housing output in the U.K. will decline in the near future and hopes of the government authorities (to increase housing output) will be subjected to greater market risks. After occurrence of the global financial crisis in 2008, profit margins of the U.K. house builders had increased exponentially. Nevertheless, excessive demand for houses is forcing them to enhance constructions to a greater extent. Soaring prices of construction lands is lowering the builders’ profit margins, thereby compelling them to slow down project developments. The construction land prices in the U.K. are presently seen to rise to the levels as that before the 2008 crisis (Mazzucato, et al., 2010). Then again, before the crisis, the number of credible buyers for the construction land therein was relatively more. According to the case, some researchers reckon that the U.K. housing market is presently under a bubble (Mazzucato, et al., 2010). The prices of construction land in the country are rising and the builders have lowered the service supply. Such problems are believed to persist unless the U.K. government discards the deficit reduction strategy. However, other analysts are of the opinion that the U.K. economy is recovering in reality because of the housing sector boom and debt-fuelled consumers’ demand. This new school of thought believes that financial crisis in 2008 had occurred primarily due to excessive credit facilities offered in the country. These researchers perceive that the debt reduction strategy introduced by fiscal authorities of the U.K. is not irrational, given that such lending operations have helped to increase the house mortgages only by 1% (Mazzucato, et al., 2010). Furthermore, the present amount of money with the U.K. house buyers is lower than that of pre-crisis. Although disposable income thresholds of the consumers is 4% above the level existing before the crisis in 2008, their aggregate spending propensity is 2% lesser than that in the pre-financial stage (Mazzucato, et al., 2010). Considering the empirical outcomes, these researchers claim that the U.K. housing market is not in a bubble. The U.K. economy will not face a recession in the near future because scale and scope of its business-to-business, financial, computing and information technology services are considerably increasing over time. The global financial crisis of 2008 was caused due to excessive credit facilities provided in the market. Nonetheless, an economy can reach a state of stagnation due to very low credit supply. Thus, for achieving a sustainable economic growth in a market, the concerned government and monetary authorities should strategically ensure moderate supply of credit therein. The U.K. economy would have failed to revive from the state of recession, if the ultra-loose monetary policies were not coupled with fund lending and Help to Buy schemes (Mazzucato, et al., 2010). As a result, the myth pertaining to the present housing sector bubble in the U.K. might not hold true to the outcomes of reality. Bubbles are not caused due to excess demand or credit supply in the market. Economic bubbles are rather outcomes of animal spirits or market irrationalities, which over value the asset prices. Reference List Akerlof, G. A. and Shiller, R. J., no date. Animal spirits. Princeton: Princeton University Press. Baddeley, M., 2005. Housing Bubbles, Herds and Frenzies: Evidence from British Housing Markets. University of Cambridge, pp. 1-33. Benford, J. and Burrows, O., 2013. Commercial property and financial stability. [pdf] Quarterly Bulletin. Available at: [Accessed 15 August 2014]. Bernanke, B., Gertler, M. and Gilchrist, S., 1996. The financial accelerator and the flight to quality. The Review of Economics and Statistics, 78(1), pp. 1–15. BIS, 2005. Real estate indicators and financial stability. Monetary and Economic Development, pp. 1-394. Brakham, R. J. and Ward, C. W. R., 2002. Investor sentiment and noise traders: discount to net asset value in listed property companies in the U.K. Journal of Real Estate Research, 18(2), pp. 1-22. Dombret, A. and Tucker, P., 2012. Blueprint for resolving regulation. The Financial Times, 20 May. Mankiw, G. N. and Taylor, M. P., 2006. Microeconomics. Connecticut: Cengage Learning EMEA. Malkiel, B. G., 2007. A random walk down Wall Street. New York: Norton. Mazzucato, M., Lowe, J., Shipman, A. and Trigg, A., 2010. Personal Investment: financial planning in an uncertain world. [pdf] Available at: [Accessed 18 August 2014]. Marsh, D., 2000. The Bundesbank: The bank that rules Europe. London: Mandarin. Rose, A., 2010. National income. [pdf] Berkeley. Available at: [Accessed 15 August 2014]. Snowdon, B., 2008. His and hers economics. [online] Available at: [Accessed 18 August 2014]. Shiller, R. J., 2003. From efficient markets theory to behavioural finance. The Journal of Economic Perspectives, 17(1), pp. 83–104. Read More