Aggregate Income and Aggregate Monetary Expenses - Essay Example

Abstract In the last few decades banks have seen tremendous decrease in average bank interest margins. This trend is best explained in literature using a causality that runs from increased competition in traditional segments to lower margins to new activities. A bank’s business model is measured using a multidimensional proxy of relationship banking activity, exerts a robust, positive effect on interest margins. It is therefore an objective of all banks to come up with a model to maximize their profits without necessarily affecting their customers so much. Introduction Profit expansion infers winning most elevated conceivable measure of benefits amid a given period of time. A firm needs to produce highest measure of benefits by building ideal gainful limit both in the short run and long run relying on different interior and outer variables and strengths. There should be proper balance between short run and long run objectives. In the short run, a firm has it specialized and managerial stipulations while over the long haul, a firm will have sufficient time and adequate chance to make assorted types of alterations and corrections in generation process and in its advertising methods. A benefit expanding firm picks both its inputs and its yields with the sole objective of attaining greatest financial benefits. A firm will dependably look to boost contrast between aggregate income and aggregate monetary expenses Profit maximization In the event that a firm are strictly benefit maximizers they will settle on choices in a marginal way i.e. analyze the marginal profit reachable from delivering one more unit of employing one extra worker. We assume a bank produces an output, namely loans (L j), and uses two inputs, labor and deposits (D j). In addition to loans, on the asset side the bank is expected to hold a certain amount of reserves (R j) with central bank. Liabilities are made up of deposits in addition to exogenous residual, other net liabilities (ONL j). Therefore for a given required reserve ratio (Ԑ j), the balance sheet condition of each bank is + = + - =0 (1) Banks receive revenue from the interest on loans and must pay the interest costs of deposits as well as the real resource costs, mostly wages, of engaging in financial intermediation. They maximize profits (U j), which are defined as the difference between financial revenues and (financial and nonfinancial) costs: = - - , (2) Where il and id are the lending and deposit interest rates, respectively, w is the wage rate; and x is a vector of other variables that affect marginal nonfinancial costs. In this simple formulation there is no uncertainty and the banks choose their level of output to maximize profits. The first order condition for profit maximization is =  + Lj-- =0 (3) Where is the marginal nonfinancial cost of producing loans. The two types of connections in equation (3) are of specific importance. First is the relationship between changes in deposits and loan, which, as indicated by the monetary record condition, is dictated by the required reserve ratio. That is, credit growth is compelled by the amount of reserves banks must hold. ∂dj⁄∂lj =1⁄1 -Ԑj. Second is the relationship between the interest rates and the quality of output (loans) supplied by the bank (∂il /∂Lj, ∂id /∂Lj), which will be controlled by the level of market power subsequent to, in perfect competition individual bank yield will have no impact on costs. Equation (3) may be changed effectively into a relapse mathematical statement clarifying the spread between lending and deposit interest rates, the precise specifications of which will depend on assumptions regarding the cost function and the markets for deposit loans. Below we present the two alternative specifications to be estimated in Section I: a single equation specification and one in which the spread equation is estimated jointly with a demand function. Single equation specification = - (4) Where = 1+ msj •rsj /is the market power indicator in each of the two markets (for deposits and loans), which depends on the interest elasticity of demand (), the market share of bank j in the respective market (msj), and the response of industry supply to changes in the output of bank j (rsj). (For simplicity, we drop the j subscript in the reserve ratio variable Ԑ, which is appropriate when estimating this equation for the aggregate banking system. On the other hand, panel data estimation will require bank-specific interest rates, cost function variables, and reserve ratios.) It can be shown that if market power exists in either of the two markets, the term d /l will be greater than unity. Otherwise, under perfect competition in both markets, this term will be equal to unity. Equation (4) therefore provides a profit-maximizing relationship between the lending interest rate, the deposit rate (adjusted by the rate of financial taxation), and marginal costs. If we assume marginal costs to be a linear function of the wage rate (w), the volume of loans (L), and other factors (x), equation (4) can be written as a regression equation for the lending rate: Il = d0 + d1 + d2 L + d3 w +d4 x (5) d0 =, d1 = , d2 = , d3 = , d4 = Where b0 , b1 , b2 , and b3 are parameters of the marginal cost function. In this specification, d1 outlines the impact of market power in both markets, and will be equal to unity unless market power exists in at least one of the two markets. If both markets for deposits and loans are perfectly competitive, then the interest rate charged on loans will be equal to the marginal cost of producing loans and deposits, that is, In the event that, actually, we expect that one of the markets is perfectly competitive, then the above regression equation will assess the level of market sector control in the remaining market. Hannan and Liang (1993) utilize a comparable methodology concerning U.S. banks. They assume the loan side to be perfectly competitive and therefore set out to estimate market power on the deposit side. A Simultaneous Equation Specification A simultaneous equation approach may also be utilized, as in the Shaffer (1989 and 1993) investigations of market power control in U.s. furthermore Canadian banks. The market for bank deposits is assumed to be competitive, and the slope as opposed to the versatility of the demand curve for the output market (loans) is thought to be consistent. Joint estimation of the demand curve permits the incline parameters to be evaluated and consolidated into the spreadmathematical statement. The demand for bank loans is specified as a linear function of the lending rate (il), income (Y ), and the price of substitutes for bank loans (z l), with certain interaction terms: L = a0 + a1i1 + a2Y + a3zl + a4i1Y + a5 i1zl (6) We then rewrite equation (4) under the assumption of perfect competition in the deposit market (d = 1), and substitute the slope of the demand function (L/il) from equation (6), thus arriving at a regression equation for the spread: Il – = -L+ L + + (7) Equations(6) and (7) may then be evaluated together for the aggregate banking system, yielding evaluations of all demand and marginal cost parameters, and of average market power in the banking system (λ).Note that is equal to the market share times the response indicator (λ= msj • rsj = Lj /L • L/Lj) and is equal to zero in the case of perfect competition, to the inverse of the number of banks (1/N) in the case of a Cournot oligopoly, and to unity in the case of collusion. To identify λ, either a4 or a5 must be nonzero, and to obtain a down-downward sloping demand curve for loans, the estimated values of a1 + a4Y + a5zl must be positive. It can be shown how one can relax the assumption that banks are price takers in the deposit market, thus requiring the estimation of a demand function for deposits. It can be demonstrated how one can unwind the assumption that banks are value takers in the store market, therefore obliging the estimation of an interest capacity for stores. The supposition appeared sensible in the Colombian case, as banks face regular rivalry from other money related mediators that offer similar types of deposits, yet may have a certain measure of market power influence on the loaning side where they do not face as clear as clear a challenge. As Shaffer brings up, if the deposit market is not perfectly competitive, then a finding of market power is still valid, but may be misattributed to the loan market. Estimation results The wage variable is developed as the proportion of total labor costs to employment, the scale variable L was the average monthly stock of loans, and the income variable, Y, was the monthly index of industrial production. Wages, credits, and deposits were taken in genuine terms by flattening the ostensible values by the CPI. The cost of substitutes of bank yield, zl, was the premium rate on 90-day national bank bills. Finally, to incorporate the possible impacts of changes in credit quality, the rate of nonperforming credits was incorporated in the spread equation, reflecting two possible responses by banks. In the first place, as a shift variable x, nonperforming loans would reflect the degree to which bank directors expand operational costs in light of deterioration in credit quality. Second, in the spread mathematical statement the impact of nonperforming credits may express a risk premium charged by banks in response to the financial costs of forgone interest revenue. Therefore, if at least one of these responses is present, we would expect increments in the rate of nonperforming loans to widen the interest spread. Response to a Change in Monetary Policy • An increase in the money supply creates an excess supply of money • The interest rate declines • Investment spending and net exports rise • Aggregate demand rises • The excess supply of money is eliminated • Aggregate output is positively related to the money supply Conclusion The bank exists in an universe of impeccable conviction, no transaction or variables costs, no long-term deposit growth, and competitive loan market. The bank is accepted to augment benefits and at first is thought to be served by optional markets in both government securities and credits. Loan interest always exceeds interest rates on securities and the latter in turn exceed the zero rate of return on cash. Bank maximizes profit as expressed by equation below: Л = + – Subject to Where = bank profits in the period = loans of the bank made at interest rate , = securities of the bank interest rate = cash = deposits = bank capital = fixed costs of servicing bank deposits and capital = fractional deposit reserve requirement References Read More