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Khodadadi F, samsami H. Macroeconomic Effects of Exchange Rate Shock under Fractional and Full Reserve Banking
A DSGE Approach. QJER 2024;
URL: http://ecor.modares.ac.ir/article-18-73973-en.html
URL: http://ecor.modares.ac.ir/article-18-73973-en.html
1- Associate Professor of Economics, Shahid Beheshti University, Tehran, Iran. , fr.khodadadi@gmail.com
2- Assistant Professor of Economics, Shahid Beheshti University, Tehran, Iran.
2- Assistant Professor of Economics, Shahid Beheshti University, Tehran, Iran.
Abstract: (545 Views)
Aim and Introduction
The financial sector has seen considerable growth in many post World War II western economies. The consequences of the Great Financial Crisis of 2007-2009 displayed how large the reach of the industry is, and how actions taken by a few important role players, can harm the general public. It is due to the consequences of the Great Financial Crisis that the notion of reforming the banking sector came about. The call for reform occurred in the 1940s as well, after the Great Crash. It was here that Full Reserve Banking (FRB), the broad term for the proposed banking reform and the subject of this dissertation, originated.
The Great Crash ended a period of expansion and growth in the USA in the 1920s where credit was easily available, and the money supply grew. The subsequent Great Depression was an economic event of unprecedented dimensions (Temin, 2000). The years 1929-1933 held a stock market crash, a banking crisis, and a collapse of commodity prices. Friedman and Schwartz (1963) contended that the primary propagation mechanism of the Depression was the contraction in the US money supply, together with banking panics. There were three banking crises in that short period, and it was the failure of two large banks, the Bank of United States and Caldwell and Company, that caused most of the problem. These banks had undergone rapid credit expansion in the 1920s and collapsed under the pressure of the recession (Temin, 2000: 307). A response to the recession was to say that the root cause was bad banking practice and that stricter regulations should be imposed to prevent future crises. Regulation was introduced in The Glass-Steagall Act (1933) however, a more severe suggestion was that bank deposits should be fully backed by bank reserves, Full Reserve Banking, an approach proposed in the Chicago Plan.
The Chicago Plan was proposed by Henry Simons, Irving Fisher and others, to prevent another crisis. It proposed requiring banks to hold 100 per cent reserves. This would simultaneously curb the possibility of reckless lending, and eliminate the risk of bank runs, thereby eliminating the possibility of another banking crisis.
Over the past years, the nominal capacity of the supply of bank facilities has increased significantly, and the main increase in bank assets has come from the increase in granting facilities. On the liabilities side of the banks' balance sheets, non-governmental sector deposits (due to paying high interest rates to depositors) during the year 2013 to 2022 has increased by 33.6% on average.
Statistical evidence shows that the real sector of the economy has not benefited much from the expansion of the banking network's balance sheet and the allocation of bank resources has not led to economic growth. On the other hand, it can be seen that the liquidity created by the banking system has not been absorbed by the real sector of the economy and its effects have been manifested in nominal variables in the form of price increases or turbulences in the currency market and other assets. The average growth of real GDP (without oil) during the years 2013 to 2022 was about 1.6 percent.
In general, it can be seen that due to the endogenous nature of money, the central bank has not had a significant success in controlling the growth of monetary aggregates through controlling the growth of the monetary base and its components (statistical evidence in recent decades confirms this); So that the credibility of the central bank's monetary policies has been challenged and the economy has been exposed to continuous threats of inflation and monetary and financial instabilities.
Methodology
This study will employ several techniques for gathering data, including a library type, a documentary branch, and the use of databases, such as those of the Central Bank of the Islamic Republic of Iran and the World Bank. Based on the characteristics of the Iranian economy under fractional & full reserve banking, a random dynamic general equilibrium model was developed for the period 1991-2021. Typical econometric methods are also used to evaluate the hypotheses. This has enabled assessing the effects of the exchange rate shock under two scenarios. It should be noted that the models were estimated in the dynare program space under MATLAB software.
Findings
The exchange rate shock has a negative effect on the consumption of the private sector at real prices, probably due to an increase in import prices. This has led to a decrease in the import of goods. Since imports form a part of the consumption for the private sector, therefore, the consumption by this sector decreases by about 0.5 percent. The Exchange rate shock has had a positive effect on the net foreign exchange reserves of the central bank. The growth rate of the monetary base is also affected by the currency shocks. With the increase in the exchange rate, although the central bank first reacts to the inflationary conditions resulting from the currency shocks through the currency reaction function and reduces the base monetary growth rate, but this situation is not very durable and finally the monetary base growth rate will increase by about 0.4 percent.
If these resources enter the banking system, due to the 100 percent reserve, it has led to the crediting of the banks, and as a result, inflation and final costs have decreased. But in fractional reserve banking, banks create money by attracting deposits, which in turn creates money by them. As a result of this jump, inflation and the final cost will increase.
The exchange rate shock also increases inflation because with the increase in the nominal growth rate of the exchange rate, the marginal cost of each import unit increases and finally the country's inflation increases by 0.7 percent.
Discussion and Conclusion
The purpose of this research is to investigate the effects of exchange rate impulse on the macroeconomic variables of Iran's economy in the conditions of partial and full reserve banking. To achieve this goal, a new Keynesian stochastic dynamic general equilibrium model was designed considering fractional and full reserve banking system (FRB). The realities of the Iranian economy are considered, and then the effects of exchange rate shocks under two types of banking are investigated. After determining the input values of the model and estimating the parameters using the seasonal data of Iran's economy during the period of 1991-2022 using the Bayesian estimation method, the results obtained from the simulation of the model variables indicate the validity of the model in describing the fluctuations of the Iranian economy. The results of the model indicate that, as a result of the exchange rate shock, the growth rate of the monetary base and consequently the amount of money is affected. Under full reserve banking, due to the full reserve of deposits, this has led to a lower increase in inflation and final cost. However, in partial reserve banking, due to the less control of the banking system, despite having two tools to control the growth of the monetary base and the nominal exchange rate, it will create higher fluctuations in the inflation rate and other macroeconomic variables. In other words, the study model has been slightly different from the basic model in the face of the currency impulse, both in terms of the amplitude and the length of the fluctuation
The financial sector has seen considerable growth in many post World War II western economies. The consequences of the Great Financial Crisis of 2007-2009 displayed how large the reach of the industry is, and how actions taken by a few important role players, can harm the general public. It is due to the consequences of the Great Financial Crisis that the notion of reforming the banking sector came about. The call for reform occurred in the 1940s as well, after the Great Crash. It was here that Full Reserve Banking (FRB), the broad term for the proposed banking reform and the subject of this dissertation, originated.
The Great Crash ended a period of expansion and growth in the USA in the 1920s where credit was easily available, and the money supply grew. The subsequent Great Depression was an economic event of unprecedented dimensions (Temin, 2000). The years 1929-1933 held a stock market crash, a banking crisis, and a collapse of commodity prices. Friedman and Schwartz (1963) contended that the primary propagation mechanism of the Depression was the contraction in the US money supply, together with banking panics. There were three banking crises in that short period, and it was the failure of two large banks, the Bank of United States and Caldwell and Company, that caused most of the problem. These banks had undergone rapid credit expansion in the 1920s and collapsed under the pressure of the recession (Temin, 2000: 307). A response to the recession was to say that the root cause was bad banking practice and that stricter regulations should be imposed to prevent future crises. Regulation was introduced in The Glass-Steagall Act (1933) however, a more severe suggestion was that bank deposits should be fully backed by bank reserves, Full Reserve Banking, an approach proposed in the Chicago Plan.
The Chicago Plan was proposed by Henry Simons, Irving Fisher and others, to prevent another crisis. It proposed requiring banks to hold 100 per cent reserves. This would simultaneously curb the possibility of reckless lending, and eliminate the risk of bank runs, thereby eliminating the possibility of another banking crisis.
Over the past years, the nominal capacity of the supply of bank facilities has increased significantly, and the main increase in bank assets has come from the increase in granting facilities. On the liabilities side of the banks' balance sheets, non-governmental sector deposits (due to paying high interest rates to depositors) during the year 2013 to 2022 has increased by 33.6% on average.
Statistical evidence shows that the real sector of the economy has not benefited much from the expansion of the banking network's balance sheet and the allocation of bank resources has not led to economic growth. On the other hand, it can be seen that the liquidity created by the banking system has not been absorbed by the real sector of the economy and its effects have been manifested in nominal variables in the form of price increases or turbulences in the currency market and other assets. The average growth of real GDP (without oil) during the years 2013 to 2022 was about 1.6 percent.
In general, it can be seen that due to the endogenous nature of money, the central bank has not had a significant success in controlling the growth of monetary aggregates through controlling the growth of the monetary base and its components (statistical evidence in recent decades confirms this); So that the credibility of the central bank's monetary policies has been challenged and the economy has been exposed to continuous threats of inflation and monetary and financial instabilities.
Methodology
This study will employ several techniques for gathering data, including a library type, a documentary branch, and the use of databases, such as those of the Central Bank of the Islamic Republic of Iran and the World Bank. Based on the characteristics of the Iranian economy under fractional & full reserve banking, a random dynamic general equilibrium model was developed for the period 1991-2021. Typical econometric methods are also used to evaluate the hypotheses. This has enabled assessing the effects of the exchange rate shock under two scenarios. It should be noted that the models were estimated in the dynare program space under MATLAB software.
Findings
The exchange rate shock has a negative effect on the consumption of the private sector at real prices, probably due to an increase in import prices. This has led to a decrease in the import of goods. Since imports form a part of the consumption for the private sector, therefore, the consumption by this sector decreases by about 0.5 percent. The Exchange rate shock has had a positive effect on the net foreign exchange reserves of the central bank. The growth rate of the monetary base is also affected by the currency shocks. With the increase in the exchange rate, although the central bank first reacts to the inflationary conditions resulting from the currency shocks through the currency reaction function and reduces the base monetary growth rate, but this situation is not very durable and finally the monetary base growth rate will increase by about 0.4 percent.
If these resources enter the banking system, due to the 100 percent reserve, it has led to the crediting of the banks, and as a result, inflation and final costs have decreased. But in fractional reserve banking, banks create money by attracting deposits, which in turn creates money by them. As a result of this jump, inflation and the final cost will increase.
The exchange rate shock also increases inflation because with the increase in the nominal growth rate of the exchange rate, the marginal cost of each import unit increases and finally the country's inflation increases by 0.7 percent.
Discussion and Conclusion
The purpose of this research is to investigate the effects of exchange rate impulse on the macroeconomic variables of Iran's economy in the conditions of partial and full reserve banking. To achieve this goal, a new Keynesian stochastic dynamic general equilibrium model was designed considering fractional and full reserve banking system (FRB). The realities of the Iranian economy are considered, and then the effects of exchange rate shocks under two types of banking are investigated. After determining the input values of the model and estimating the parameters using the seasonal data of Iran's economy during the period of 1991-2022 using the Bayesian estimation method, the results obtained from the simulation of the model variables indicate the validity of the model in describing the fluctuations of the Iranian economy. The results of the model indicate that, as a result of the exchange rate shock, the growth rate of the monetary base and consequently the amount of money is affected. Under full reserve banking, due to the full reserve of deposits, this has led to a lower increase in inflation and final cost. However, in partial reserve banking, due to the less control of the banking system, despite having two tools to control the growth of the monetary base and the nominal exchange rate, it will create higher fluctuations in the inflation rate and other macroeconomic variables. In other words, the study model has been slightly different from the basic model in the face of the currency impulse, both in terms of the amplitude and the length of the fluctuation
Article number: 5
Keywords: Full Reserve Banking, Fractional Reserve Banking, Exchange Rate Shock, Dynamic Stochastic General Equilibrium Model
Article Type: Original Research |
Subject:
Macroeconomics and Monetary Economics
Received: 2024/02/22 | Revised: 2025/03/1 | Accepted: 2024/03/28
Received: 2024/02/22 | Revised: 2025/03/1 | Accepted: 2024/03/28
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