Question

Explain in detail the sectoral balances approach to macroeconomic analysis, and its implications for the fiscal balance when the foreign and domestic private sectors both have positive net savings desires. Explain in detail Hyman Minsky’s Financial Instability Hypothesis, using a balance sheet approach. How can stability be destabilising, according to Minsky?

Answer 1

Sectoral financial balances are sectoral analysis, is the framework for macroeconomic analysis. Sectoral balances shows when the government sector has a budget deficit, the non-government sectors (private domestic sector and foreign sector) together must have a surplus, or vice-versa. In other words, if one sector is borrowing, the other sectors taken together must be lending. In this way the fiscal balance shows positive results. In macroeconomics any transactions between the government sector and the non-government sector as a vertical transaction indicates sectoral balances. The sectoral balances approach to macroeconomic analysis considers 3 sectors to show its balance Government sector includes all levels of government and their agencies, private domestic sector considers outcome from all households and firms ( including banks), external sector includes all non-residents private households, firms and governments. All transactions considered under any given period, and the outcome shows the fiscal balance is positive or negative. When the foreign and domestic private sectors both have positive net savings desires the fiscal balance indicates to show positive results too.

Hyman Philip Minsky research provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky’s theory explains how indebtedness can increase in periods of tranquillity as a result of endogenous forces that reduce the desired margins of safety of economic units. Minsky explains gradual reduction in the desired margins of safety is the reason behind the increasing financial fragility that accompanies economic expansion and periods of stability. Increasing fragility makes the macro systems more prone to shocks that reduce the ability of borrowers to repay their debt. Minsky’s balance sheet approach looks at the economy as a system of balance sheets of all its agents and examines stocks of assets and liabilities at a certain period of time. The origins of weak and deteriorating balance sheets in emerging market economies shows its inability of these economies to borrow abroad in their own (domestic) currencies. Weakens balance sheets of firms and the economy brings the country into a financial crisis. Minsky defines the degree of financial fragility by defining three income-debt relations for economic units: hedge, speculative, and Ponzi finance. In hedge financing units, the income flows from operations are enough to fulfill debt commitments outflows in every period.  In speculative finance, the income flows are only enough to meet the interest component of their obligations and they will have to roll over debt because they cannot repay the principal. In Ponzi finance, the income flows from operations are not enough to cover the interest costs of their loans or the repayment of principal. These three step process shows how the markets become more risky as they appear to become more stable. The longer the markets seem to be stable, secure are become more risky and unstable.