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The revenue that rental firms generate by renting out capital goods is the real rental
rate R/P. The rental firm bears three costs of capital:

 It must pay interest i on the loan used to buy the capital good.
 The price of capital PK can change during the renting out of the capital good

and this could be a loss for the rental firm
 The capital good tears down over time, called depreciation, while being rented

out. The rate of depreciation is δ.

These combine to determine the cost of capital:
Cost of capital = iPK – ΔPK + δPK

By assuming that the price of the capital good rises with the price of other goods
(inflation), we can write it as a function of the real rather than nominal interest rate.
We then rewrite it as the real cost of capital, the cost of capital measured in a unit of
the economy’s output.

Real Cost of Capital = (PK/P)(r + δ)

The Determinants of Investment
Rental firms can decide to buy new capital goods or not. They do this if it is profitable
to do so. Because we earlier derived the relation between the real rental price and the
marginal product of capital for which production firms want to rent capital, we can
substitute this to find the profit rate of rental firms:

Profit Rate = MPK - (PK/P)(r + δ)
If the profit rate is positive given a level of capital stock, then rental firms will want to
increase the capital stock. We now have the relation between the incentive to invest
(profit rate) and the increase in the capital stock given by the net investment function
In():

ΔK = In(MPK - (PK/P)(r + δ))
We now also see that the theoretical separation between rental and production firms
is not necessary, since we only use the cost of capital and the marginal product of
capital. Both can be associated solely with production firms. We now find the
investment function, which is the net investment function adjusted for depreciation
(since the depreciated capital goods also need to be replaced):

I = In + δK
We now see why a lower interest rate increases investment: it decreases the cost of
capital. We can also find the steady state level of the capital stock by setting profit to
zero, which is equivalent to setting revenue equal to cost of capital:

MPK = (PK/P)(r + δ)

Taxes and Investment
Two examples of taxes that are important for investment are:

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 Corporate income tax, a tax on corporate profits. If corporate profits are
defined the way we have, then such a tax will not have any effects on the level
of investment.

 Investment tax credit, a reduction to the amount of taxes a firm has to pay
based on the amount spent on capital goods.

The Stock Market and Tobin’s q
A stock is a share in the ownership of a firm, and the stock market is the market of
such shares. Tobin’s q is defines as follows:

q = Market Value of Installed Capital / Replacement Cost of Installed Capital
It gives information about whether investment is profitable. If q >1 then investment is
profitable, but if q<1, it is not. This is similar to the neoclassical model, because the
stock market value is a representation of profitability (MPK), and the replacement cost
of capital is similar to the cost of capital. Tobin’s q effectively measures the same
thing. An advantage of Tobin’s q is that the stock market value is easily measurable,
and is therefore often used as an economic indicator that predicts investment
fluctuations.

Alternative Views of the Stock Market
There is a debate among economists about whether stock market fluctuations are
rational. There are roughly two positions:

 The efficient market hypothesis says that because 1) every stock in the stock
exchange is monitored by professional portfolio managers, and 2) the stock is
valued by supply and demand of the market, it must be the case that the stock
is valued fairly, because otherwise, investors would flock to purchase or sell the
stock, correcting its market price. According to this theory the market price
reflects al information in the market.

 Keynes on the other hand said that the stock market price does not reflect its
actual value, but what people think other people think is the actual value.
Because this is a very uncertain and hectically changing estimate, the market
price will fluctuate very strongly away from its actual value.

Financing Constraints
If a firm has a profitable investment opportunity, this does not necessarily mean that
it can undertake it, because the firm may face financing constraints, which are limits
on the amount of capital they can raise in financial markets. Financing constraints for
firms are similar to borrowing constrains for consumers.

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17.2. Residential Investment

Residential investment is investment in increasing the stock of houses.

The Stock Equilibrium and the Flow Supply
In order to understand residential investment a model has been developed that
contains two elements:

 The (stock) supply and demand for the stock of houses.
 The (flow) supply of new housing.

It is the market for the stock of houses that determines the real price of housing PH/P.
However the supply of houses is fixed in the short run. If the real price of houses is
larger than the cost of building houses then firms have an incentive to invest in
housing. We see that if the housing demand shifts upward, then the incentive to
invest in housing will increase. This is summarized in the graph:

The interest rate is a determinant of housing investment, because if the interest rate
is high, the cost of paying a mortgage is higher.
17.3. Inventory Investment

Inventory investments are usually only 1% of GDP, but during a recession it is usually
more than half of the decline in spending. Therefore it is on the one hand
insignificant, but for the study of economic fluctuations it is very important.

There are four reasons for inventory investments:

 Production smoothing. There are often fluctuations in sales over time. For
some firms more is sold in weekends than in week days, or more in the summer
than in the winter. However it is often more efficient to produce the same

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amount of a good in each period, so therefore inventory is developed in low-
sale periods, in order to sell them in high-sale periods.
 Inventories as a factor of production. For some firms it is more efficient to
hold inventories than to produce just-in-time. For example, it saves
transportation costs for supermarkets to hold large amounts of inventories as
opposed to shipping in new stocks every day.
 Stock-out avoidance. The exact level of sales in a given period is uncertain,
therefore it is better for firms to have more in stock than is expected to be
sold, in case sales are unexpectedly high, in order to prevent running out.
 Work in process. For some goods, the production process requires that
products are developed in parts. The different components of that good are
often held in stock for a period of time and counted as inventory investment.

The relation between the real interest rate and inventory investment is simple: when
the real interest rate rises, holding inventories becomes more costly, so firms move
more to just-in-time production.
17.4. Conclusion

There are three important conclusions to be made from this chapter.

 All three investment types are inversely related to the real interest rate
 The investment function depends on a wide range of influences
 Investment spending is highly volatile over the business cycle.

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18. Alternative Perspectives on
Stabilization Policy

In Part VI of the book, three different macroeconomic topics will be discussed that
move away from the models developed here, either by critiquing their results or by
approaching different aspects that they omit.
In this chapter, certain perspectives will be outlined that critique the policy advices
developed using the (primarily Keynesian) AS-AD model.

18.1. Should Policy Be Active or Passive?

There is a debate over whether the government should try to actively stabilize the
economy in response to exogenous shocks.

We have assumed throughout chapters 10 and 14 that it is possible for the
government to respond to shocks to the economy, so that if there i.e. a supply shock,
the government should stabilize the shock with fiscal and/or monetary policy. This
idea is a relatively recent idea that started to gain support after the great depression.
However not all economists agree that this should be done, and we address some of
their arguments here.

Lags in the Implementation and Effects of Policies
Some economists argue that stabilization policy is not feasible because there are time
lags associated with these policies, so that stabilization policy will be too slow to
respond to be effective. There are two types of time lag associated with stabilization
policy:

1. Inside lag. This is the time it takes between the exogenous shock to the
economy and the response of the government to enact stabilization policies.

2. Outside lag. This is the time it takes for the policy to take effect in the
economy.

Monetary policy has much shorter inside lag than fiscal policy, at least in the U.S. and
Europe, because the government needs to first pass the policy decision through the
legislature, and go through the political process, whereas the central bank can decide
to change the interest rate/money supply overnight.
However, monetary policy does have an outside lag of about half a year, because it
takes time for firms to respond to the interest rate change by writing new contracts
and setting up new projects.
There are however certain policies, called automatic stabilizers, that don’t require an
explicit policy change by the government, but stimulate or depress the economy

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automatically in case of a shock. For example, the income tax system automatically
reduces taxes in a depression because incomes go down.

The Difficult Job of Economic Forecasting
Because of the time lags associated with stabilization policies, it is required to forecast
the economy in order to respond to shocks in time. However, economic forecasting is
incredibly difficult, so one argument against stabilization policy is that the government
should not even try to do it, because it will only do more harm than good.

Ignorance, Expectations, and the Lucas Critique
The economist Robert Lucas formulated what came to be known as the Lucas
critique. The critique is that the models developed in this book make the wrong
predictions about the effects of stabilization policy because they do not take into
account the change in expectations that are the result of these policies. If a policy
tries to stabilize a shock, but people see this policy coming, their expectations will
change such as to reduce the effect of the policy. Some economists conclude from
this critique that policy evaluation is too hard to really make stabilization policy
effective.

The Historical Record
Apart from theoretical arguments about the effectiveness of stabilization policy,
economists have also looked at the effectiveness of specific stabilization policies in
history. However the historical record is not perfectly clear on this, because it is often
too difficult to determine the cause of a recession.
18.2. Should Policy Be Conducted by Rule or by Discretion?

A second debate topic on stabilization policy is about the question whether policy
should be conducted by rules that are stated beforehand, or whether the policy
should be left to the discretion of policymakers.

There are multiple aspects to this debate which we will go through step by step.

Distrust of Policymakers and the Political Process
One question related to this debate is whether policymakers can be ‘trusted’ with the
discretion of choosing policies at their will, rather than by rule. There are generally
two arguments why they should not be:

 They are incompetent. This argument says that politicians do not have the
competence to assess economic problems and their necessary solutions.

 They are opportunistic. This argument says that the objectives of policymakers
are not the same as those of the public. For example some say that it is
the political business cycle that determines stabilization policy rather than the

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economic business cycle. This means that politicians choose to stimulate the
economy just before the elections in order to increase their chance of re-
election

The Time Inconsistency of Discretionary Policy
Discretionary policy is more flexible than rule-based policy, but this does mean that it
is subject to the problem of time inconsistency, which goes as follows: The
policymakers will want to announce in advance what their policy is going to be (for
example when stabilizing inflation, they will want to announce this so that it has the
least effect on output), however, when the public has formed these expectations, they
will have an incentive to enact policies that stimulate output in the short run, simply
because the public did not expect it. This however has a long run negative effect
because it will cause the public not to believe the announcements of the
policymakers, which makes the stabilization policy less effective.
This is an argument why the government should enact policy by rule rather than by
discretion, because a policy by rule is not subject to this time inconsistency.

Rules for Monetary Policy
Even if we agree on the idea that there should be a policy rule rather than policy
discretion, there remains the question of what that policy rule should be. There are
three main proposed policy rules for monetary policy:

 The monetarist proposal is that the central bank should keep the money supply
growing at a steady rate. This is based on the hypothesis that changes in the
money supply are the cause of most large economic fluctuations.

 Another proposal is GDP targeting, which states that the central bank should
target the nominal level of GDP, a target that changes over time to take
account of long-run growth.

 A third proposal is inflation targeting, which means that the central bank
announces a target for the level of inflation (usually around 2%), and adjusts
the money supply and interest rate to achieve this target.

All three of these policy rules target nominal variables. This is because it is hard to
measure the true real variable of something and hard to measure for example the
natural rate of unemployment, even though real variables are more indicative of
actual economic performance.

There are two further institutional observations to be made about the practice of
monetary policy.

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 In practice, even if central banks use a policy rule, there is also some room for
discretion

 There is a relation between central bank independence, the lack of influence
that politicians have over the central bank, and low levels of inflation. This has
caused many economists to propose that central banks should be independent
institutions.

18.3. Conclusion: Making Policy in an Uncertain World

The main conclusion that can be drawn from this chapter is that our knowledge of
what the most effective policies are is still very incomplete. There is not yet a clear
answer to the debates in this chapter.

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19. Government Debt and Budget Deficits

The main theories about government debt are the traditional view, which is
consistent with the models introduced in this book, and the Ricardian view, which
critics this view and reaches a different conclusion. Debt is still a controversial
subject in economics.

This chapter introduces a subject of macroeconomics that has been neglected by our
models: Debt. The models in this book contain the option for the government to run a
fiscal deficit, but do not address the effect this has on the level of sovereign debt. This
issue is addressed in this chapter. First the context and measurement of government
debt is addressed. Then the two most important theories of government debt are
explained, and finally we address some alternative perspectives on debt.

19.1. The Size of the Government Debt

The government debt increases in periods where the government is running a deficit,
and decreases when it is running a surplus.

We begin with the context of government debt, focusing primarily on the U.S. The
government debt is usually expressed as a percentage of GDP. Besides this being
more indicative than the absolute level, this also allows easy comparisons between
countries. Countries have a variety of debt-to-GDP ratio’s ranging from Switzerland
with 0.4 % to Greece with 133.1 %.
There are two main events that usually cause a significant increase in the level of
government debt:

 Wars: They cost a lot of money and the short run consideration of winning the
war usually trumps the long run consideration of keeping debt low.

 Economic crises: Taxes decrease as GDP decreases, and government
expenditures sometimes increase as part of stabilization policy, causing a fiscal
deficit and an increase in debt.

The U.S. and Europe also face the future problem of an aging population because this
means more retired workers and therefore a smaller labour force to be used in
production and it means a higher level of social security expenditures. This may cause
a big increase in the level of government debt.
19.2. Problems in Measurement

There are a number of problems with the measurement of government debt, some of
them more controversial than others.

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Before we move on to the theories of debt, we address four problems in measuring
government debt. This is because some economists think that the way government
debt is currently measured does not reflect the extent to which burdens are shifted to
the future or the effect of the debt on the economy.

1. Inflation. This is not a very controversial measurement problem, and it entails
that the nominal level of government debt should be adjusted each year by
inflation to find the real level of debt. This means that if the real level of
government debt is stable, the nominal level should be rising by the rate of
inflation: ΔD = πD.

2. Capital Assets. The government does not just expend money for current use,
but it also expends money to purchase capital goods/assets. Therefore some
economists propose that the government uses capital budgeting, a procedure
that takes into account these assets as well. This means that if the government
purchases a capital good, this will be subtracted from the net level of debt

3. Uncounted Liabilities. Some economists argue that the level of debt is
misleading the way it is currently measured because it does not take into
account certain liabilities. For example the pensions of government workers
will have to be paid to them in the future, and therefore are just like debt, but
they are not counted as such.

4. The Business Cycle. Due to automatic stabilizers addressed in chapter 18, the
budget deficit automatically rises during recessions and decreases during
booms. This is not an unrealistic representation of the deficit, because this
deficit cycle actually occurs, but it nevertheless does not represent policy
changes in the budget deficit. Therefore some economists propose to calculate
a cyclically adjusted budget deficit that is based on estimates of what
government spending and tax revenue would be if the level of output would be
at its natural level.

Few economists deny the existence of these four measurement problems, but not
everyone agrees on how severe the problems are.
19.3. The Traditional View of Government Debt

The traditional view of government debt can be deduced from the models
introduced in this book.

Imagine the effect of a decrease in taxes (keeping G constant). The short run and long
run effects of this can be deduced from the theories in this book.

 In the short run, a reduced tax level increases consumer spending, thereby
stimulating aggregate demand and employment. However the lower level of

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saving causes an increase in the interest rate, thereby decreasing investment,
and a capital inflow, thereby appreciating the currency and depressing net
exports. The effect on debt is that it will rise
 In the long run, the level of saving declines, thereby decreasing the capital
stock, decreasing output and decreasing consumption (since economies are
generally below the golden rule level of capital). The economy would have
larger foreign debt.

19.4. The Ricardian View of Government Debt

The traditional view of debt is criticized by the Ricardian view.

The economist David Ricardo came up with a hypothesis that came to be known
as Ricardian equivalence. It states that consumers are forward-looking and therefore
base their spending not just on current disposable income but also on expected future
disposable income. The consumer reasons that the reduction in today’s taxes must be
paid by an increase in future taxes, so that the consumer’s future income decreases.
The rational forward looking consumer would not respond to the tax cut by increasing
spending, but by increasing saving. This means that net saving is unaffected in both
the short and long run, and that the effects described by the traditional view are not
realized, in short because the traditional view assumes that consumers base their
consumption decision on current income. Note that Ricardian equivalence is a similar
argument to some of those made in chapter 16 about consumer theory.

Consumers and Future Taxes
Defenders of the traditional view argue that consumers are in fact not as forward
looking as the hypothesis of Ricardian equivalence assumes. Here are three
arguments why they are not:

 Myopia. This basically means that people are short-sighted and do not fully
understand the effects of a decrease in taxes, so that they do not realize that
they will have to pay the taxes in the future.

 Borrowing Constraints. This argument means that consumers cannot always
borrow to smooth their consumption, so that there may be consumers who
would like to spend more, but can only do so after the tax cut. This would
mean that the tax cut still has an effect on consumption.

 Future Generations. A third argument is that consumers expect the future taxes
to be paid by future generations rather than by themselves. If we assume that
people are selfish, they will care less about future generations than about
themselves. On the other hand the counter argument to this is that people do
care about future generations, as evidenced by the fact that parents leave
bequests.

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The debate about the validity of the Ricardian view versus the traditional view is
ongoing. At this point there is evidence to support both theories.
19.5. Other Perspectives on Government Debt

With the two theories in mind, we address some debates about government debt.

Balanced Budgets Versus Optimal Fiscal Policy
On the one hand, we would like to run a balanced budget and not have any
government debt, but on the other hand there are three reasons why we would want
to have deficits and surpluses:

 Stabilization. The argument for stabilization is clear from chapters 10 to 14.
 Tax smoothing. Besides stabilizing output, budget deficits and surpluses can also

be used to smooth taxes so that people don’t have large fluctuations in their
disposable income due to the business cycle
 Intergenerational Redistribution. A budget deficit causes a shift in the tax burden
from current to future generations. For example, if the current generation
fights a war. It is only fair that future generations share some of the burden of
that war.

Fiscal Effects on Monetary Policy
some economists argue that if the government has a large public debt, the monetary
authority may try to decrease it by stimulating inflation, thereby decreasing the real
public debt. However in practice this does not happen in developed countries,
because central banks are relatively independent, and the fiscal authority knows that
inflation is not a very good solution to fiscal problems.

Debt and the Political Process
some economists think that the possibility of public debt worsens the political
process. They argue that debt is a way to move the negative effects of their policies
to future politicians, so that a true cost-benefit analysis is not done. This has caused
some economists to argue for a constitutional balanced-budget clause, so that
politicians are forced to bear both the costs and benefits of their policies. Others
oppose this because it makes stabilization harder, or because it is impractical.

International Dimensions
the budget deficit and the level of government debt does not just affect the domestic
economy, but also the relation of the economy to foreign economies. The budget
deficit is namely also related to the trade deficit, which has to effects:

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 High levels of government debt may have the risk of capital flight. This
happens if there is a fear that the government will default on its debt, causing
international investors to take their capital out of the country.

 High levels of debt paid by foreign borrowing may have a negative effect on
the political power of a country in world politics.

19.6. Conclusion

The question of the best policy towards government debt is a complex one that has
many considerations and uncertainties related to it. This is why there are still many
disagreements among economists on what the best policies are.

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20. The Financial System: Opportunities
and Dangers

The financial system is on the one hand a source for economic efficiency, but on the
other hand a possible source for economic instability.

This book has so far neglected to give a complete analysis of the role of the financial
system and instead has focused primarily on the real economy. It has been introduced
in the theories as the market of loanable funds and the money market. For a more
complete study of the financial system you should consult a textbook on that topic,
but here is a brief introduction to the role of the financial system in the macro
economy. We first address the function of the financial system in the economy, and
then we address the macroeconomic ramifications of a crisis in the financial system.

20.1. What Does the Financial System Do?

The financial system has a number of key functions in the economy.

The financial system is a broad term that refers to all the institutions and mechanisms
that channel the loanable funds of savers to the borrowers that need them to invest.

Financing Investment
there is a large variety of mechanisms used to channel funds from savers to
borrowers, and this is one of the most important functions of the financial system.

 Financial markets are markets through which savers can directly provide
resources to investment.
o One financial market is the market for bonds, a representation of a loan
given to a firm by the bondholder. The process of raising funds for
investment by firms through the bond market is called debt finance.
o Another financial market is the market for stocks, shares in the
ownership of a firm. The process of raising funds for investment through
stocks is called equity finance.

 Financial intermediaries are firms that take loans or equity from savers and
invest them in profitable firms that need finance. They allow savers to invest
without them having to study the investments themselves.

Sharing Risk
Another important function of the financial system is to share risk between individuals
in an efficient way. Some people are more risk averse than others. That is they have a

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stronger aversion to taking financial risks. One way to allocate risk among strongly
risk averse and less risk averse individuals is by letting the risk averse individuals hold
bonds, and letting the more risk-tolerant individuals hold equity. This is because the
income gained from equity is much more volatile.
Another way that the financial system does is reduce risk. It does so by giving
investors the option of diversification, the process of buying equity or bonds in many
different firms, so that the risk of one firm failing is spread out over a larger part of
individuals; on average, the firms will do well, and individuals bear less of the risk. One
way to diversify is a mutual fund, a financial intermediary that finances itself with
equities (stocks), and invests the funds into a large set of firms. This allows even small
savers to own a small part of a very large variety of firms.
However, diversification cannot completely remove risk, because there are two types
of risk:

 Systemic risk. These are risks that affect the income of all firms. For example, an
economic recession hurts all firms, not just a specific one. This risk cannot be
removed by diversification.

 Idiosyncratic risk. This is risk that is specific to one firm, such as the risk of the
CEO dying in a plane crash. This risk can be removed with diversification.

Dealing with Asymmetric Information
one problem in finance is the problem of asymmetric information, the situation where
one parties in an economic transaction has more information than the other. There
are two main problems that asymmetric information can cause:

 Adverse selection. An example of this is that if the owner of a firm wants to
raise finance, he usually knows more about the firm than the investor. The
owner will only accept the financing deal if he thinks it is beneficial to him.
Therefore the investor will be weary of the owner accepting the deal, since
that means the owner is likely getting the better part of the deal. The result is
that investors sometimes do not invest in firms, even if the firm has a profitable
investment opportunity.

 Moral hazard. This is the situation when an agent, someone who works for
someone, has more information about his actions than the principal, the person
who the agent works for. In this situation for example, an agent may decide to
spend some of the finance raised on personal consumption rather than
investment.

Fostering Economic Growth
as we saw in the Solow growth model, high saving means high investment, and this
means economic growth. However, the Solow model simplified the analysis by simply
assuming that saving would turn into investment, and that investment would be the

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right type of investment. In fact, unlike in the Solow model, there is more than one
type of capital good; instead there are an uncountable number of possible
investments. One role of the financial system is to look at what the most profitable
investments are and invest in those. Presumably, the financial system does this by
supply and demand which changes different interest rates such that capital moves to
the efficient investments. However the process is not perfect, in part due to the
asymmetric information problems described earlier.
20.2. Financial Crises

Within the AS-AD a financial crisis is one type of exogenous shock.

Chapters 10 to 14 described short run fluctuations by showing the effects of an
‘exogenous shock’. Such an exogenous shock can take many forms. One type of shock
is a financial crisis, a major disruption in the financial system making the process of
moving funds from savers to borrowers less efficient. We first look at how a financial
crisis works, then at possible responses by policymakers, and finally what can be done
to prevent them.

The Anatomy of a Crisis
not all crises are exactly alike, but they all roughly follow the same pattern:

1. Asset-price Booms and Busts. First, there is often a speculative bubble in the
financial markets, an increase in the market price of a financial asset that
doesn’t represent its underlying value. At some point investors see that the
market value is too high for the underlying value, so they sell the asset and the
bubble ‘pops’.

2. Insolvencies at Financial Institutions. Financial institutions hold such assets on
their balance sheets, so when the bubble pops, they suddenly have fewer
assets than before. Because financial firms often use leverage, borrowing funds
to finance investment (discussed in chapter 4), they may suddenly have more
debt than assets, causing them to go bankrupt.

3. Falling Confidence. Because financial institutions now suddenly are heavily
indebted, investors lose confidence in them and take out their capital. This
forces banks and other institutions to stop lending and sell assets. Because
they are forced to sell these assets, this drives down their price, and they sell
them at lower than value. This is called a fire sale.

4. Credit Crunch. Because many financial institutions fail or heavily hold back on
lending, borrowers find it difficult to obtain investment funds even though they
have profitable investment opportunities, and investment spending is
contracted.

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5. Recession. Due to this credit crunch, the overall demand for goods and services
declines. This can be interpreted simply as an investment demand shock to the
aggregate demand curve in the AS-AD model.

6. Vicious cycle. The decrease in aggregate demand reduces income. Besides
reducing consumption spending through the multiplier effect studied in
chapters 10 to 14, this also reduces profits and asset values, thereby causing a
stock market decline and further insolvencies. Thus we go back to step 1 and 2,
and the cycle starts again.

Policy Responses to a Crisis
There are three broad categories of policy responses

 Conventional Monetary and Fiscal Policy. Because one result of a financial crisis
is to shift the investment demand function leftward, a possible response is to
shift the aggregate demand function back to the right by monetary and fiscal
expansions. This is exactly what the U.S. government did after the 2008
recession.

 Lender of Last Resort. Because of lost confidence in financial institutions, people
draw their money back, and banks may not have enough reserves to provide
these withdrawals, even though they are solvent. Such a situation is called
a liquidity crisis. In this case the central bank may choose to take the function
of lender of last resort, by lending to solvent banks with liquidity problems, if
there is no one else to lend to them. The central bank can in this way not only
lend to banks but also to shadow banks, financial institutions that serve similar
functions to banks.

 Injections of Government Funds. It is also possible for the government to directly
inject funds in failing institutions, for example by buying stocks in those
companies. This can cut down or dampen the process of the financial crisis at
step 2.

Policies to Prevent Crises
Rather than responding to a crisis, it is more desirable to prevent the crisis in the first
place. Here are four current topics of debate on improving regulation to prevent
crises.

 Focusing on Shadow Banks. The focus of most regulation of financial firms is on
banks, and less so on other financial institutions, even though some of them
perform similar functions. One proposal is to focus regulation more on these
shadow banks.

 Restricting Size. Another proposal is to restrict the size of financial firms. In the
crisis of 2008, certain banks were so big that if they failed, it would cause

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ripple effects that are too large. Such banks were called ‘too big to fail’. This
proposal tries to prevent such banks from getting too big, so that the
government can let them fail. A counterargument to this is that it would
prevent banks from taking advantage of economies of scale.
 Reducing Excessive Risk Taking. Most financial firms that failed during the 2008
crisis did so because they took excessive risks. Therefore there have been
proposals to prevent banks from taking excessive risks.
 Making Regulation Work Better. There have been many proposals, and some of
them executed, to create new regulatory agencies, or to replace old ones, so
that the regulatory process performs in a smoother and more effective way.

20.3. Conclusion

The financial system is a source of economic efficiency and growth, but it can also be
a source of economic instability. It is hard to find a right balance between these two,
and the debate over the structure of the financial system is not over yet.

The financial system is a source of economic efficiency and growth, but it can also be
a source of economic instability. It is hard to find a right balance between these two,
and the debate over the structure of the financial system is not over yet.

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