Exchange-rate targeting

Orthodox economics considers the exchange rate as a nominal anchor against inflation to provide long-run macroeconomic stability (Snowdon et al., 1994). Along with this general position, after the breakdown of the Bretton Woods exchange-rate pegs, it was suggested that a target zone for the exchange rate would benefit from some flexibility and its maintenance would be less demanding than a strict peg (Williamson, 1985; Krugman, 1991).

By contrast, policy makers, especially in developing countries, tend to be more con- cerned with real variables, short-term dynamics and real exchange-rate targeting. In this respect, Chile was one of the first countries to adopt, in 1965, an exchange-rate rule based on purchasing-power parity (PPP), followed by Brazil in 1968. This rule deter- mined the nominal exchange rate that was changed at irregular intervals depending on the inflation-rate differential between Brazil and the United States (Calvo et al., 1995).

Capital flight

The Latin American "lost decade" of the 1980s has been an important case study for researchers. During that period, Latin American governments had great difficulty in servicing their external debt. Argentinean, Brazilian, Bolivian and Peruvian economies experienced both stagnation and hyperinflation, while at the same time the private sector increased its accumulation of foreign-exchange reserves. A very similar situa- tion repeated during the Russian and Argentinean crises of 1997 and 2001. The loans granted by the International Monetary Fund to these governments followed a similar fate: local elites hoarded most of the foreign exchange outside the country. What would have been the fate of Latin America had all that money been available to service external debts? Paradoxical situations like these were the main motivation of the literature on capital flight. (On the relationship between capital flight and Latin American debt crises, see Pastor, 1989.)

The definition of capital flight is an old question that goes back at least to the inter-war period. According to Kindleberger (1937), capital flight is that part of capital outflows motivated by political and economic risk.

Financial literacy

While no universally-accepted definition of financial literacy exists, one that is broad and often cited comes from the United States President's Advisory Council on Financial Literacy (2008, p. 4): "the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial wellbeing." Economists (and other researchers), however, are particularly concerned about two issues regarding financial lit- eracy: (i) how best to improve financial literacy; and (ii) how much of an impact (if any) higher financial literacy rates will have on actual financial behaviour.

One of the most comprehensive studies of Americans' financial knowledge, skills and behaviour comes from the FINRA Investor Education Foundation (2009). They sur- veyed over 28,000 people across the United States in October 2009. The survey included a basic financial literacy test that resulted in a failing average grade (less than 60 per cent). Also, they found that only 35 per cent of households had enough savings to cover three months of expenses (rainy-day funds). 73 per cent of households had at least one credit card, but only 41 per cent of them reported that in the last 12 months they always paid their debts in full. Despite these findings, over two-thirds of people surveyed ranked themselves as highly knowledgeable about personal finance overall.

Collateral

The term "collateral" refers to a tangible asset or a secure financial asset, such as a gov- ernment bond, which is used to guarantee a debt issued by the owner of the asset. The existence of collateral is intended to make the debt less risky, as the creditor has a legal claim on the asset in the case of default by the debtor. As such, collateral is fundamental to the smooth functioning of financial markets.

In this sense, collateral is part of a significant number of lending and borrowing trans- actions undertaken by market participants. For instance, source collateral is provided to investment banks by hedge funds and commercial banks directly, and by other financial market participants such as pension funds and insurers via their custodians (Singh, 2012). While the existence of collateral is crucial to the individual investor, particularly the creditor, collateral also plays an important role in the financial system at the macro- economic level, notably because source collateral is frequently re-pledged, which allows for the creation of collateral chains and hence an interdependent network of lending and borrowing transactions at the aggregate level.

Capital requirements

Capital requirements, also referred to as minimum mandatory capital adequacy require- ments, constitute the cornerstone of banking regulation in advanced and emerging economies. They are designed to ensure that banks and depository institutions more generally hold an adequate amount of capital to withstand losses on their assets during periods of stress. Against this backdrop, minimum capital requirements serve as a buffer to reduce the risk of banks becoming insolvent and thus unable to carry out their activi- ties on an ongoing basis, eventually protecting depositors and taxpayers and fostering the stability of the financial system as a whole. Notice that in order to ensure their solvency and reinforce the confidence of depositors and investors, banks may voluntarily choose to maintain capital adequacy ratios above the regulatory minimum.

Credit creation

The credit creation theory of banking is one of three theories concerning the role of banks in the economy. It maintains that each individual bank is able to provide credit and to issue money out of nothing, without having to have received new reserves first (as by contrast the fractional reserve theory of banking maintains), or without having to have received new deposits first (as the financial intermediation theory of banking maintains). Credit creation is recognized by, among others, Schumpeter (1912), Austrian school authors such as von Mises (1934 [1953]), post-Keynesian authors such as Moore (1988) and Rochon and Rossi (2003), and empirical economists such as Werner (1992, 1997, 2005).

The question about which of the three theories of banking is correct has been disputed for at least 150 years, without ever having been put to a decisive empirical test. This has recently been provided by Werner (2014a; 2014b), whose tests involved borrowing from a bank that offered access to its internal processes and accounting. It was found that both the fractional reserve and the financial intermediation theories of banking are contra- dicted by the empirical facts.

Credit divisor

When the monetary base is endogenous, the direction of causality between that variable and loans or deposits is reversed. Hence, the orthodox concept of the money multiplier (see Phillips, 1920; Cannan, 1921; Crick, 1927) is replaced in most heterodox theories with the credit divisor, a concept developed by Le Bourva (1962 [1992]), a prominent French monetary theorist. As pointed out by Lavoie (1992b), who translated Le Bourva's original 1962 paper into English, the specific phrase diviseur de credit, or "credit divisor", first surfaced in a later article by Lévy-Garboua and Lévy-Garboua (1972, p. 259). Nonetheless, these authors attribute their turn of phrase to a suggestion by Le Bourva (1962 [1992], p. 259) himself.

Le Bourva wrote mostly about "overdraft economies", to wit, systems typified by companies that were always in debt to banks, and banks that were perpetually in debt to the central bank. In such economies, banks supply credit to creditworthy customers on demand at a fixed rate of interest, up to given credit limits. Lavoie (1992a, pp. 174 and 207-10), Renversez (1996) and others have further generalized the divisor concept to a more "financialized" economy.