Substitution & Income Effects, and the Role of the Bank of Spain

Posted on Nov 3, 2024 in Economy

Substitution Effect

When the price of good X decreases, the budget line shifts, reflecting a change in relative prices. This increases the consumer’s real income. To isolate the substitution effect, we consider two assumptions:

  1. Focus on the change in relative prices.
  2. Neutralize the real income increase from the price drop of good X.

Any line parallel to line CB reflects the change in relative prices, as the slope of the budget line depends solely on them. Line LM meets this condition. Any line passing through point E (initial consumption) represents the same real income. Thus, line LM fulfills both conditions.

Line LM reflects the change in relative prices. The substitution effect (S), the movement from E to I, is solely due to the change in relative prices, making one good relatively cheaper and the other relatively more expensive.

Income Effect

The income effect is the change in demand due to the increase in real income from the lower price of good X. If the consumer initially chooses combination E and finally chooses F, the movement from E to I is the substitution effect, while the movement from I to F is the income effect. The shift from LM to CB, being parallel, indicates no substitution effect, but signifies an income effect due to increased real income.

The Bank of Spain

The Bank of Spain is the leading financial policy authority in Spain, answering to the government and the Ministry of Economy and Finance. The Ministry operates through five bodies:

  1. Directorate-General for Trade Policy and Foreign Investments
  2. Bank of Spain
  3. General Directorate of Treasury and Financial Policy
  4. General Directorate of Insurance
  5. National Securities Market Commission (CNMV)

The Bank of Spain holds significant power due to the size of the financial institutions it oversees and the resources it manages. It defines and implements monetary policy autonomously, in line with its autonomy law.

Within the European System of Central Banks (ESCB) and under the European Central Bank (ECB), the Bank of Spain’s primary functions include:

  1. Defining and implementing monetary policy in the Eurozone to maintain price stability.
  2. Conducting foreign exchange operations and managing official state reserves.
  3. Promoting smooth payment system operations in the Eurozone.
  4. Issuing legal tender banknotes.

According to its autonomy law, the Bank of Spain’s missions are:

  1. Monitoring the solvency and conduct of credit institutions and financial markets.
  2. Promoting the stability and smooth operation of the financial system and national payment systems.
  3. Developing and publishing relevant statistics.
  4. Providing cash and acting as a financial agent for public debt.
  5. Advising the government and producing necessary reports and studies.

Features and Functions of the Stock Exchange

Spain has four official stock exchanges: Madrid, Bilbao, Barcelona, and Valencia. Key features include:

  1. Regulation: Operations are overseen by the CNMV and each exchange’s governing bodies.
  2. Security: Transactions are legally and economically secure.
  3. Transparency: Investors can trade through authorized intermediaries, and prices are publicly available.

The stock exchange plays vital economic functions, connecting savers with businesses seeking funds. Its functions are:

  1. Channeling savings into productive investments, contributing to economic development.
  2. Providing liquidity: Investors can sell securities at market price at any time.
  3. Price discovery: Setting security values through supply and demand.
  4. Information dissemination: Providing information on listed companies through security prices, reflecting the economic and social climate.