Asymmetric information

Asymmetric information reflects a view among New Keynesian economists that allows for incomplete markets on account of the fact that principal and agent do not possess the same degree of information about a particular event or state. This perceived infor- mational asymmetry weighs heavily on the New Keynesian credit-channel theory of the monetary policy transmission mechanism, based on the loanable funds view of the rate of interest, whereby the real rate of interest acts as a price-rationing device to equilibrate the supply and demand for loanable funds. New Keynesians acknowledge that the real rate of interest may not perform this equilibrating function when the demand for loanable funds rises beyond certain levels. Lenders may withhold credit to otherwise creditworthy borrowers rather than offering loans at higher rates of interest even if these borrowers would be willing to pay those higher rates. Money neutrality is violated as the predicted link between changes in high-powered money and the money stock is upset. Output and employment are then less than their full-employment counterparts.

Clearing system

A clearing system consists of a series of norms and coordinated processes by which financial institutions systematically collect and mutually exchange data or documents on funds or securities transfers to other financial intermediaries at an agreed place called "clearing house". These procedures can also involve the determination of partici- pants' bilateral and/or multilateral net positions and aim at simplifying the discharge of respective obligations on a net or net net basis in a settlement system. Occasionally, the expression "clearing system" implies a mechanism of multilateral netting by novation and the settlement of the corresponding payments or, imprecisely, the process itself of settling transactions. Since their functioning involves "a moderate stock of solid Money [. . .] [while] a large proportion of both solid and paper Money might be spared" (Seyd, 1871, p. 5) and they naturally aim at "eliminating or reducing cash transfers" (Einzig, 1935, p. 66), clearing systems gained particular success in the nineteenth century.

Corridor and floor systems

A corridor-type (with its floor-type variant) system is an approach to the setting of inter- est rates that an increasing number of central banks have adopted since the mid 1990s. The system has now become the operational framework that most central banks utilize for implementing their strategies on interest rates.

The interest rate policy of central banks consists of a strategy and an operational framework. Strategically, central banks set their desired level for one or more interest rates, based on what they consider adequate in terms of their public policy objectives. Operationally, they use a set of instruments and procedures to effectively steer the chosen interest rates toward the target policy rate. Since the 1990s, the prevailing operational framework for monetary policy implementation is a corridor system. In the 2000s, the central banks of Japan and New Zealand, as well as a number of other central banks in the aftermath of the global financial crisis, have further modified their framework and embraced a floor system.

Credibility and reputation

The issues of credibility and reputation of monetary authorities were introduced by the "New classical economists", in order to develop additional arguments in favour of monetary policy rules and against the use of discretionary policies. Their main goal was to show that an "inflation bias" emerges in cases where monetary policy is discretionary. Monetary authorities are said to be credible if private agents believe in their commit- ment to price stability. Kydland and Prescott (1977) showed that it is in the best interests of central banks to announce a low-inflation policy and then, if private agents believe in the policy announced, to switch to a higher-inflation policy in order to temporarily reduce the rate of unemployment. As a matter of consequence, central banks will have a credibility issue, because rational agents will not believe them.

This credibility issue raised by Kydland and Prescott (1977) can only arise under very restrictive theoretical circumstances: central banks have to make their decision first before private agents can react, the game needs to be a one-shot one, and agents as well as the central bank must have full information and must not cooperate.

Credit bubble

A credit bubble is a sustained and accelerating growth of bank loans relative to the growth of Gross Domestic Product (GDP), which finances a boom in both economic activity and in asset prices. The proposition that this growth of credit adds to demand - especially for financial assets - above and beyond that generated from existing incomes contradicts the "loanable funds" vision of lending in which loans are "pure redistribu- tions" which "should have no significant macroeconomic effects" (Bernanke, 2000, p. 24), as lending simply redistributes spending power from lender to borrower without enhancing aggregate demand. However, in the endogenous-money view, lending enables demand to increase in the aggregate, thus financing a growth in economic activity and rising prices on asset markets. Prior to the global economic and financial crisis that erupted in 2008, the dominant view in economics was that the proposition that "credit bubbles" had any macroeconomic significance was a figment of the imaginations of non- economists. The Modigliani-Miller theorem (Modigliani and Miller, 1958) - the relevant subset of the efficient markets hypothesis - argued for the irrelevance of credit to both the valuation of firms (except for the effect of the tax-deductibility of interest payments) and economic performance. The proposition that there could be a "financial accelera- tor" (Bernanke et al., 1996) gave conventional theory an argument as to how credit could impact on economic activity, but this mechanism relied on agency costs owing to asym- metric information and acted through the price of credit rather than its volume.

Deleveraging

Deleveraging is the process by which either economic units (taken individually) or the economy as a whole get rid of their debts. The most obvious way of carrying this out is by repaying existing debt, which should result in the aggregate stock of debt decreasing. However, while debt may fall in nominal terms, the attempt to deleverage - that is, to repay debts accumulated in the past - can increase the burden of debt in real terms.

According to Fisher (1933), repaying the debt implies a decrease in the means of payment in circulation and therefore a fall in the price level. This logic is based on the quantity theory of money. As a result, this fall would increase the debt in real terms; during a crisis, therefore, the attempt to repay debt would result in a larger debt. This means that if all units simultaneously try to deleverage, a debt deflation could occur, resulting in a self-defeating exercise.

Flow of funds

The flow of funds (or financial account) is a system of accounting that records all finan- cial transactions of an economy. Bookkeeping both the financial stocks and flows, it tracks the sources and uses of funds for each institutional sector and for the economy as a whole. The flow of funds is one of the key instruments in national accounting together with the national income and product account, the national balance sheet, and the input- output matrix. It is one of the primary components of the System of National Accounts (SNA) of the United Nations. First published in 1953, the flow of funds was incorpo- rated within the SNA in 1968.