Finance the Real Economy

The study of economics aims to explain how economies function as well as how people interact with one another. In spite of its classification as a “social science” and the fact that it is frequently regarded as one of the liberal arts, the practice of modern economics is frequently very quantitative and heavily maths-oriented. Macroeconomics and microeconomics are the two primary subfields that make up the field of economics.

Macroeconomics

The study of the behaviour of the economy as a whole is the focus of macroeconomics, which is a subfield of economics. In the field of macroeconomics, a wide range of phenomena that affect the entire economy are investigated in depth. Some examples of these phenomena include fluctuations in unemployment rates, national income, and gross domestic product (GDP).

The study of economic tendencies, or what is likely to occur in the economy when individuals make certain choices or when the factors of production change, is the focus of the field of microeconomics. Microeconomics, on the other hand, focuses on the more granular factors that influence decisions made by individuals, as well as those made by businesses. Macroeconomics, on the other hand, examines how the economy functions as a whole.

The balance sheet as a channel for the asset price gap and the credit gap

The balance sheet channel explains how a decline in asset prices affects the balance sheets of households and businesses, as well as their solvency and creditworthiness, as well as the potential effects that this may have on consumption and investment. The prices of both financial and real assets have a significant impact on the ability of businesses and households to meet their financial obligations. A summary index is constructed as a result of how the share prices and property prices change in relation to their respective historical trends. This is done with the intention of accounting for variations in the prices of both financial and real assets. As the first step toward the creation of a summary variable, the generation of a gap is performed for both the stock market and the property market. The deviation of the stock market index and the property price index from their trend is what is used to calculate the stock price gap, while the home price gap is calculated by dividing the trend by the deviation. Footnote5 In the second step, the share price gap and the property price gap are combined to create an asset price gap that summarises the development of house and stock prices. The share price gap accounts for twenty percent, while the property price gap accounts for eighty percent. 

‘The value of borrowers’

The value of borrowers’ assets tends to decrease whenever there is a disruption in the economy, whereas the value of their loans remains unaffected. When this occurs, the borrowers’ balance sheets appear to be in much worse shape than they had anticipated, which is the primary reason why they amortise a portion of their liabilities (consolidate their balance sheets). Because of this, the “financial accelerator effect” allows asset prices and credit to mutually support and strengthen one another. We add a credit gap to the list of variables so that we can account for this mechanism and make appropriate adjustments. Both the share price gap and the credit gap are constructed in the same way from a technical standpoint. The credit ratio is established as the initial step in the process (total lending in relation to GDP at current prices). The deviation of the credit ratio from its trend is used to calculate the credit gap, and this value is then divided by the trend.

The interest on treasury bills with a maturity of three months is one channel through which interest rates are expressed.

The value of the currency can also be influenced by monetary policy (exchange rate channel). In the majority of cases, the value of the krona will rise in response to an increase in the repo rate. A stronger exchange rate, also known as an appreciation, makes foreign goods cheaper in comparison to goods produced domestically. This results in an increase in imports, a decline in exports, and a reduction in the amount of pressure exerted by inflationary forces. In addition, a stronger krona has a tendency to reduce the rate of inflation because it makes imported goods and goods that compete with imported goods cheaper. This makes the effect of falling demand’s dampening effect on inflation even stronger. We also factor in the real exchange rate so that we can control for the channel associated with the currency exchange rate.

The interest rate on loans; the primary route for bank capital

The impact that a variety of risks have on the balance sheets and income statements of banks, and ultimately on their pricing behaviour and lending decisions, is referred to as the bank capital channel. As in Karlsson et al. (2009), it is assumed that banks in Sweden operate on a market that is characterised by monopolistic competition and that the lending rate of the banks is set as a markup on their marginal costs. This is the same assumption that was made in Karlsson et al. (2009). Footnote8 Therefore, the lending rate is affected not only by the interest rate that banks themselves are required to pay in order to borrow funds, but also by the interest rate supplement that banks add when lending to their respective customers. According to the findings of a study conducted by Karlsson et al. (2009), what is referred to as credit spread in the academic literature on macroeconomics is made up of a wide variety of different components, each of which is influenced in some way or another by different risks associated with bank operations. In order to analyse the effects that these risks have on the real economy in addition to those that are caused by monetary policy, it is necessary to use lending rates in addition to policy rates in macroeconomic models. This makes it possible to analyse these effects. The interest rate that households and businesses actually pay on their existing loans is incorporated into the lending rate that is used as an indicator. This rate is a combination of the two rates. 

The financial stress index: a measure of uncertainty in the market

The uncertainty channel explains how elevated levels of unpredictability in financial markets can cause consumers to cut back on their spending and boost their savings instead. A “stress index” is a metric that is used to assess the level of unpredictability on financial markets. An index is constructed that is a composite of developments on four markets: the stock market, the currency market, the money market, and the bond market. 

Markets for stocks and currencies are fraught with unpredictability.

There are a few different metrics that can be utilised to quantify the volatility and unpredictability of the stock and currency markets. The level of volatility is one of the most important measurements. There is a class of volatility measures that are prospective in nature due to the fact that they are determined by option prices (e.g. VIX in the USA). However, from a practical econometric standpoint, the fact that long time series are not readily available for these volatility measures is a limitation that should be considered a drawback. Because of this, the actual volatility in the OMX index is used in this paper. This volatility is measured as the standard deviation for the OMX index for the preceding 30 days. In addition, the actual volatility of the Swedish krona to euro exchange rate is used as a stress indicator for the currency market. This volatility is measured as the standard deviation for the prices that have been recorded over the course of the previous 30 days.

Conclusion 

The interest rate channel explains how the real economy is impacted whenever there is a change in the repo rate brought about by the central bank. By adjusting the repo rate, which is the same as adjusting the so-called overnight rate, monetary policy has the ability to influence the interest rate on treasury bills with a maturity of three months.