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Read more about our statistics. Banking services The BIS offers a wide range of financial services to central banks and other official monetary authorities. Read more about our banking services. Latvijas Banka. View all notes Some features of the model, such as the foreign ownership of banks or the absence of domestic monetary policy rules, reflect the specificities of the Lithuanian economy but the main insights are quite general.

The model economy comprises three sectors — households, firms and banks — and engages in economic and financial transactions with the rest of the world see Figure 1. The household sector is completely standard. It consists of an infinitely-lived representative household that values real consumption and leisure and provides labour services to firms which are owned by the household sector.

Capital Markets and Financial Intermediation in The Baltics

The household earns wages and is entitled to the dividend stream of firms. The household does not borrow and is a net saver — all its savings are deposited in a bank, earning a market-determined interest income. Schematic view of the model. This distinction between final and intermediate goods producers is rather artificial and it is just a standard modelling device to ensure that the productive sector as a whole retains some pricing power, governed by demand elasticity parameters.

The final good is homogeneous and can be either consumed or invested. Intermediate goods producers employ labour and capital. They are the owners of physical capital and finance its accumulation from retained earnings and bank loans. Since producers of intermediate goods are monopolistically competitive, they earn non-zero profits, decide on the dividend policy and are set to maximize discounted dividend streams, subject to investment and price adjustment costs. The firm sector is a net borrower and takes loans from the bank. Notably, intermediate firms do not have access to bank deposits but they adjust their outstanding loan balances instead.

Notably, unlike Jakab and Kumhof Jakab, Z. Though banks credit borrowers' accounts with newly created money and, as a result, borrower's deposits increase within a time period , we make a simplifying assumption that the borrower uses all those funds for settlements or debt repayment and the end-of-period balance of the borrower's deposit account is always zero.

Therefore in the formulation of our model the borrower firm is not allowed to have deposits. View all notes.

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A competitive representative bank takes deposits from the household sector, extends loans to firms and intermediates the domestic economy's borrowing from or lending to the rest of the world. The bank is subject to capital requirements and wants to hold a capital buffer above the minimum requirement. The banker wants to maximize the utility derived from the stream of bank dividend payouts, which are consumed abroad. Importantly, bank's deposits are the instrument of both settlement and saving in the economy.

Accounting relationships in the general equilibrium setting ensure that an increase in bank loans results in a contemporaneous rise in deposits accompanied by stronger domestic demand and inflationary pressures. In the remainder of this section we outline the model's building blocks in more technical detail. The representative household obtains utility from consumption and disutility from labour. The household's flow budget constraint states that the household's disposable income, comprised of wage income, dividends and interest income, can be spent on consumption or saved in the form of bank deposits.

Note the timing convention whereby the deposit is determined at the end of the period, as a result of household's saving vs. Also note that the budget constraint is expressed in nominal terms. We do not apply a special notation to distinguish between real and nominal variables, therefore to avoid possible confusion we will explicitly point out which variables are which in the text.

The household maximizes the utility by choosing optimal levels of consumption, labour and deposits. Equation 5 is a standard Euler equation. The firm sector is comprised of competitive producers of final goods and monopolistically competitive intermediate good producers. The homogeneous final goods are produced from intermediate goods and are suitable for both consumption and investment and can be used domestically or exported. The firm decides on the quantities of intermediate goods to maximize its profits. Modelling intermediate goods production is considerably more elaborate.

Producers of intermediate goods act in a monopolistic competition market, they employ capital and labour to produce their products, with the aim of maximizing dividend pay-outs, subject to various constraints. Note again the timing and accounting conventions whereby K j , t denotes the capital stock at the end of period t , and only fully installed capital, i.

Likewise, capital starts to depreciate once it is employed in the production process. It is a logical inclusion from the accounting perspective but, in modelling terms, it is also necessary in order to ensure that the firm's balance sheet Equation 9 remains balanced as prices change.

In our model, we take account of the financial structure of the firm sector and this ensures that the institutional environment is rich enough to enable us to track economic and financial flows between sectors and ensure the model's internal consistency at the macro level. On the other hand, the profit function in Equation 11 may not be immediately recognizable in the context of DSGE modelling.


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Moreover, the nominal capital gains term in the profit function has little to do with real shareholder value. Therefore we postulate that firms are more concerned about the discounted dividend pay-outs as their optimization objective. Comparing to the profit formulation in Equation 11 , we can immediately see that the dividend pay-out is a cash-flow concept, as one has to exclude non-cash items such as depreciation expenses or unrealized capital gains but add such cash flows as borrowing from banks. The important insight from this simple analysis is that DSGE models can incorporate a reasonably high level of institutional detail and the gap between business accounting principles and the DSGE accounting framework is not necessarily very significant.

Before putting together the firm's optimization problem formally, we introduce one more financial constraint. Expressions for partial derivatives of adjustment costs are provided in the equation list in Appendix 4. Hereafter we refer to intermediate producers or the production sector as a whole simply as firms. Note that the final good producers are simply used as a modelling device to ensure that the productive sector as a whole retains some pricing power.

The financial sector in the model consists of a representative competitive foreign-owned bank. Assuming that bank dividends are non-negative, the bank may accumulate equity only from retained earnings; thus, external equity financing is assumed away for simplicity. The model in its present form does not incorporate credit risk.

For this reason, the model does not provide an explanation as to why a significant share of bank financing comes in the form of equity financing. Furthermore, in the competitive equilibrium, profits, and thereby the value of equity, would naturally go to zero. In order to institute positive bank equity we exogenously impose a Basel-style minimum capital requirement and also assume a financial cost inversely related to the capital buffer in excess of the minimum requirement.

Note that the specification of the bank profit function implies that today's profits are determined by yesterday's decisions. This reflects the inherently intertemporal nature of finance but in the absence of credit risk the timing choice does not materially change the optimizing and forward-looking banker's problem. Notably, other authors apply varying interest timing conventions, depending on their analytical objectives e.

1. Introduction

Gerali et al. Bank portfolio allocation: The impact of capital requirements, regulatory monitoring, and economic conditions. Journal of Financial Services Research , 20 1 , 33 — The logarithmic cost function is well defined and yields a negative value when the argument, i. It should be said that this formulation is a simplification suitable for the case with no credit risk and actual bank failures because it simply does not allow bank capital to go below the required minimum as that would result in infinitely large financial cost to the bank.

Closing small open economy models. Journal of International Economics , 61 1 , — It is assumed that banks are owned by an impatient foreign household who receives dividends and spends them on consumption abroad. The banker equates the marginal rate of substitution between dividends today and tomorrow to the relative price of dividend pay-outs.

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Thus, withholding dividend pay-outs for one period spares the bank from paying alternative financing cost r D t to depositors and also reduces the marginal financial cost associated with a thin capital buffer. Notably, the larger the capital buffer gets, the more inclined the banker becomes to pay out the dividends, all else being constant. Equation 27 establishes that bank's capital buffers are increasing along with an increasing interest rate margin. Equation 28 governs demand for foreign debt.

Foreign debt is positive when the difference between deposit rates and the risk-free foreign rate is sufficiently large, in other words, when foreign borrowing is relatively cheap. All else being equal, the lower risk-free foreign rate naturally implies stronger demand for bank's borrowing from abroad.

Equation 29 is simply a variant of the basic national accounting identity, or decomposition of the gross domestic product net of lost output by expenditure approach. Equation 30 is the simplified balance-of-payments identity, which states that the combined current and capital account, comprised of net exports and net financial income from abroad in this simple economy, must equal the financial account, or in this case simply the change in foreign debt.

Derivation of the well-known macroeconomic identities from sectoral balance sheets and budget constraints is economically important in that it confirms the micro-macro consistency of the model and helps to draw parallels with the empirical analysis of integrated economic and financial accounts see Section 3. Finally, we need one more equation to identify the price level and close the model. As was mentioned above, the standard closure using the Taylor rule is not appropriate for a small member state of a monetary union, in which the monetary policy does not actually react to changes in that specific economy.

Monetary and financial policies in emerging markets. Manuscript available. Also, consumption negatively affects net exports through imports channel. This completes the model. A full list of model equations is presented in Appendix 4. The model design captures two potentially very different financing mechanisms.

One is related to household's decision to allocate existing purchasing power between consumption and financial saving and the other one is linked to bank's willingness to create new purchasing power. The two decisions jointly determine the supply of credit to the economy and greatly affect the economic dynamics as will be shown in a later section. The whole process could be schematically visualized with the help of the analytical integrated economic and financial accounts table.