Chapters 9-13

Chapter 9
THE FIXED PRICE KEYNESIAN MODEL The Keynesian Critique of the Classical Model Wages, prices and interest may be “sticky,” or inflexible, so that markets may not always clear. The classical model assumed that wages were flexible enough so that labor markets always cleared; the price level was flexible enough so the product market always cleared; and real interest rates were flexible enough so that saving is always equal to investment so that the loanable funds markets cleared. Money illusion may exist. Workers may not have information about price changes in the economy, so that they may not know the actual real wage being paid. Short run fluctuations matter. Keynes believed that small changes in spending could lead to much larger changes in GDP in the economy. Expectations matter. Keynes believed that the expectations of consumers and producers are important in determining the overall level of economic activity. Expenditures matter. Keynes believed that expenditures were the determinant of real GDP in the economy.

Classical model (Say’s Law) → Spending adjusts to output Fixed-price Keynesian Model → Output adjusts to spending Assumptions of the Classical Model Rational self-interest→decisions are made with a purpose. Price level is fixed Interest rates are fixed GDP is equivalent to national income→ Net Factor Income from abroad is equal to zero and so it Capital Consumption Allowance. Consumption spending depends on income Investment, government spending, and exports are fixed Imports are autonomous (fixed) Taxes are equal to zero The Consumption and Saving Functions The consumption function is a model that shows the relationship between consumption spending and disposable income in the economy. C = Consumption spending Y = GDP, measured as either output or income C0 = autonomous consumption spending, the level of subsistence consumption spending when income = 0 b = the marginal propensity to consume, or MPC T = Taxes Yd = Disposable income where Yd = Y – T C = C0 + bYd Consumption spending consists of two components. Autonomics consumption spending is independent of income, and is the amount of consumption spending when disposable income is equal to zero. There is also the part of consumption spending when that increases with disposable income. MPC, or b, is the slope of the consumption function. MPC = ΔC/ΔYd Saving functions describe the relationship between saving and disposable income in the economy. S = –C0 + (1 – b)Yd MPC + MPS = 1 C 1 C b C = Yd

C0 Yd

S

S Yd 1-b Yd0 -C0 1

Aggregate Expenditure Since the Keynesian model focuses on the role of spending in the economy, the concept of aggregate expenditures is crucial to the development of the model as a whole. Aggregate expenditures are just the sum of all the spending in the economy by the different sectors, such as households, firms, governments, and the foreign sector. AE = C + I + G + (X – M) AE = aggregate expenditures C = consumption I = investment G = government spending X = exports M = imports Aggregate expenditure function shows the amount of total spending in the economy at different levels of income. If taxes are equal to zero, disposable income Yd = Y – T → Yd = Y AE = C0 + bY + I + G + (X – M) AE0 ¬= C0 + I + G + (X – M) AE = [AE0] + bY Equilibrium in the Fixed-Price Keynesian Model In the model, output adjusts until it is equal to spending in the economy. In equilibrium, output, or real GDP (Y) must be equal to the amount of spending in the economy (AE). If not, inventories will change, causing firms to adjust their output. Keynesian equilibrium is where output = spending. Y = AE Y = AE Y = AE0 +bY Y – bY = AE0 Y (1 – b) = AE0 Y* = 1/(1 – b) AE0 Equilibrium GDP = spending multiplier * autonomous aggregate expenditures AE Y = AE

AE

AE0

Y0 Y* Y1 Y At Y0, AE > Y, so spending > output. Thus, inventories fall and output increases. At Y1, AE < Y, so spending < output. Thus, inventories increase and output falls. When firms are producing below equilibrium, inventories fall so firms have the incentive to increase output. When firms are producing about equilibrium, inventories rise and firms have the incentive to reduce their output. The Spending Multiplier (not the math part) One person’s spending becomes another person’s income. When a person receives, they will save some, as indicated by the MPS. Extending the Model: Imports and Taxes The import function is similar to the consumption function. M0 represents autonomous import spending, or the amount of import spending when disposable income is equal to zero. d = MPIM (marginal propensity to import) MPIM = ΔM/ΔYd Aggregate Expenditures C = C0 + bYd M = M0 + dYd With both of these, aggregate expenditures becomes; AE = [C0 + I + G + X – M0] + bYd – dYd AE = [AE0] + (b – d) Yd AE = AE0 – (b – d)T + (b – d)Y Vertical intercept slope Equilibrium Lots of math leads to new multiplier formulas. Spending multiplier = 1/((1-b+d)) =1/((1-MPC+MPIM)) ΔY = 1/((1-b+d)) ΔAE0 Thus, an increase in autonomous aggregate expenditures leads to a multiplied increase in real GDP. Note that the multiplier here is smaller than in the simple model where imports are fixed. Tax multiplier = (-b+d)/((1-b+d)) = (-MPC+MPIM)/((1-MPC+MPIM)) ΔY = (-b+d)/((1-b+d)) ΔT Thus, the tax multiplier is less than zero as long as b > d, or the MPC is greater than the MPIM. As long as households consumer more domestic goods than foreign goods out of an increase in income, the tax multiplier will be negative. AE Y = AE AE

AE0

Y0 Y* Y1 Y Y = 1/((1-b+d)) AE0 + (-b+d)/((1-b+d)) T Leakages and Injections There is an alternative method to determine equilibrium in the fixed price Keynesian model besides finding where output is equal to spending in the economy. Another motion of equilibrium is that leakages have to equal injections. Leakages consist of income that households have received but not spend on current domestic output. Injections are sources of spending by other sources of the economy, such as firms, the government, and the foreign sector. Equilibrium; Leakages = injections
S + T + M = I + G + X Income received by households not = Spending by other sources of the spent on current domestic output economy besides households AE Y = AE AE

Y* Y I+G+X, S+T+M S+T+M I+G+X

Y* Y

The Paradox of Thrift In this model, an increase in saving will reduce GDP since an increase in saving means a reduction in consumption spending. With a reduction in consumption spending the economy will see a multiplied decline in real GDP.

AE AE’

S1+T+M S0+T+M

Chapter 10
AGGREGATE DEMAND AND AGGREGATE SUPPLY Aggregate Demand: a model that shows the amount of desired spending that consumers, investors, governments, and the foreign sector are willing and able to purchase at different price levels in the economy. Aggregate Supply: a model that shows the amount of desired output that firms and workers in the economy are willing and able to produce at different price levels. Deriving the Aggregate Demand Curve Assume that the price level is variable & declines from P0 to P1 to P2. As the aggregate expenditure function increases, the equilibrium level of GDP increases. We plot it at different price levels. AE Y = AE AE (P2) AE (P1) AE (P0)

Y0 Y1 Y2 Y P

P0 P1

P2 AD Y0 Y1 Y2 Y Reasons Why the AD Curve is Downward-Sloping The Real Income Effect P →real income → C → AE →Y A decrease in the price level increases the purchasing power of any given amount of nominal income, so real income (or real wealth) increases. With higher real income, households increase their consumption spending, which leads to an increase in aggregate expenditures and a multiplied increase in the equilibrium level of real GDP. The Interest Rate Effect P →money demand → i → AE →Y A decrease in the price level leads to a decrease in the demand for money. If prices are lower, consumers do not need to carry as much cash to make purchases. If consumers carry less cash, then more funds can be deposited into savings at banks. With more funds to lend, banks will reduce interest rates to encourage more borrowing. Interest rates are the price of money. The International Trade Effect P →domestic prices → X → AE →Y A decline in the price level means that American products become relatively cheaper compared to foreign products. The decline in domestic prices leads to an increase in exports as foreigners purchase more American products. The increase in export spending leads to an increase in aggregate expenditures and a multiplied increase in the equilibrium level of real GDP. The Determinants of Aggregate Demand Changes in the price level lead to movements along a given aggregate demand curve. If any variable that affects aggregate expenditures besides the price level, then the aggregate expenditure function will shift up or down, and the aggregate demand will change (increases to the right, decreases to the left). Any variable that causes a change in aggregate expenditures will also cause a change in aggregate demand. Consumption Spending Consumer Income: increases in consumer income lead to increase in disposable income and consumption spending in the economy. Income also effects import spending. Wealth: household wealth is the stock of all assets owned by a household minus its liabilities, or the difference between what is owned and what is owed. Wealth is different from income in that wealth is a stock variable, what you own at a given point in time, while income is a flow variable, what you earn over a given period of time. Expectations: consumer expectations about the future can influence consumption spending today. In particular, expectations of future prices and future income can affect consumption today. The permanent income hypothesis: a model that suggest that consumption spending depends on permanent income, not current income. Demographics: changes in the composition of the population can affect consumption spending in an economy in several ways. There are two important factors; the age distribution and the income distribution. The life cycle hypothesis: the idea that saving tents to be greatest in the middle of a household’s life cycle, with dissaving at the beginning and end of the cycle. Personal Taxes: affect the level of disposable income in the economy. An increase in taxes will reduce disposable income, while a tax cut will lead to an increase in disposable income. Consumption spending moves directly with changes in disposable income. Interest Rates: influence the level of consumption spending on durable goods in the economy. Durable goods are usually defined as goods that last longer than one year, like refrigerators. In sum, an increase in consumption spending leads to an increase in aggregate demand (e.g. a rightwards shift). Investment Spending Investment spending consists of the purchases of capital by firms in the economy. Capital is the machinery, factories, tools and equipment used in the production process. Interest Rates: the cost of borrowed funds influences the cost of investment decisions made by firms. An Investment Function: is a model that shows the relationship between interest rates and investment spending in the economy. As interest rates decline, investment spending increases, and the opportunity cost of the funds used for capital purchases becomes less. As interest rates decease more and more investment opportunities become profitable. Cost of Capital: the cost of capital will influence the ability of firms in the economy to purchase capital. If the cost of capital declines, then capital becomes relatively less expensive compared to labor and firms will hire more capital as a result. Business Confidence: investment spending may also depend heavily on business confidence, or firms’ expectations about the future of the economy and their own profit opportunities. If firms believe that the economy will be prosperous in the future and that their own profits are likely to be high, they are more likely to invest in capital expenditures today. Capacity Utilization: the amount of factory capacity in the economy that is currently being utilized, or how much factory space and time is being used up compared to the maximum that could be used. Business Taxes and Regulations: included in the costs of production for firms in the economy. The more firms have to spend in business taxes or the more resources that are devoted to meeting regulatory requirements, the greater are the costs of production. Technology: is the state of a society’s knowledge and practical arts of industrial and agricultural production. The technology available at the time influences the range of investment opportunities available for firms. Government Fiscal Policy: fiscal policy consists of changes in government spending or taxes to influence some macroeconomic variable. The most common form is expansionary, or actions meant to increase the aggregate demand curve and expand GDP. Monetary Policy: consists of changes in the money supply and interest rates to influence some macroeconomic variable. An increase in the money supply will lead to lower interest rates, which increases investment spending. Social Policy: the public’s attitude toward issues such as poverty, health care,… can have profound effects on the level and growth of government spending. Wars and Natural Disasters: government spending on wars and natural disasters also has effects on aggregate demand. For example, by May 2009, the U.S. government had spent $671 billion, or $341 million per day on the War on Iraq. Net Exports The difference between exports and imports. Aggregate demand will increase with an increase in exports or a decrease in imports, both of which lead to in increase in net exports. Income: increases in household income will lead to an increase in import spending. Foreigners’ Income: incomes earned by foreigners in the rest of the world affect their abilities to purchase U.S. exports. As they earn more income, they gain the purchasing power to buy more products from other countries including the United States. Foreign Prices: influence the relative cost of U.S. goods and services compared to foreign products. Exchange Rates: changes in the value of the dollar, along with changes in the values of other currencies can influence foreign demand for US exports and US demand for foreign imports. Protectionism: is a trade policy that prevents the free flow of goods and services between countries through tariffs or quotas. A tariff is a tax on imports, while a quota is a restriction on the quantity of a product that can be imported into a country. Models of Aggregate Supply The classical aggregate supply curve The fixed-price Keynesian aggregate supply curve The ordinary upward-sloping aggregate supply curve The neo-Keynesian aggregate supply curve The neo-classical aggregate supply curve The Classical Aggregate Supply Curve P AS

YF Y The curve is vertical at the level of full employment GDP for the economy. It is assumed that wages, prices, and interest rates are flexible so that markets always clear and that there is no money illusion. An increase in price level leads to a decrease in real wages and a potential shortage in the labor market. Nominal wages must rise to clear the market. Real GDP remains constant. The Fixed-Price Keynesian Aggregate Supply Curve P

AS

Y Firms and workers are willing and able to produce any level of real GDP at the going price level. If nominal wages and the price level are fixed, then the labor supply curve is horizontal. An increase in labor demand will increase real GDP without any increase in the price level. The Ordinary Upward-Sloping Aggregate Supply Curve P AS

Y Aggregate supply slopes upward was real GDP is increased. As the price level increase, the quantity of desired output that firms and workers are willing and able to produce will also increase. Reasons Why the Aggregate Supply Curve is Upward Sloping Due to the profit motive. Along a given aggregate supply curve resource prices, such as nominal wages and interest rates, are being held constant. As the price level increases, producers in the economy will earn more revenue for each unit of output. The Profit Motive P → profit per unit → units produced →Y As the price level increases, holding resource costs constant the profit per unit of output for the firm will increase. If firms and workers can earn a higher profit per unit of output, they will produce more output and real GDP will increase. In this model, the aggregate supply curve slopes upward. An increase in the price level reduces real wages, but with money illusion workers are not aware of the price increase, and thus willing to increase their labor effort in response to the increase in the quantity of labor demanded by firms. The Determinants of Aggregate Supply Changes in the price level lead to movements along a given aggregate supply curve, or a change in the quantity of aggregate supply. An increase in aggregate supply is a rightward shift of the aggregate supply curve. Resource Prices: the costs of land, labor, and capital are important determinants of aggregate supply. Resource prices help to determine how much firms must change to cover the costs of production, and this they are critical to the overall price level in the economy and how much firms are willing to produce at different price levels. Technology: an increase in technology enables firms to become more efficient so that they can produce more output at any given price level. Business Confidence: when firms have high confidence, they are more likely to invest in improving efficiency and building more capital for the future. Quantity of Resources: as the availability increases, firms can produce more at any price level. Capacity Utilization: percent of factory space being used. as the utilization increases, firms can produce more at any price level. Value of the Dollar: if it falls, US firms will require more to purchase foreign resources. Business Taxes and Regulations: an increase will increase the costs of production and lead to a decrease in aggregate supply. Equilibrium AS

AD

Occurs at the intersection. When price level is too high, there is overproduction, and the price level it reduced. When price level is too low, overcompensation occurs and consumers increase the price level. The Neo-Keynesian Aggregate Supply Curve AS

AD

consists of three ranges depending on how far the economy is from full employment. Keynesian Range: when it is horizontal. Here real GDP is far below full employment. Intermediate Range: the upward sloping part. Firms are willing to increase output only with an increase in the price level. Classical Range: vertical. The economy has reached its limit in terms of resources and technology. The Neo-Classical Aggregate Supply Curves Here there are two distinct curves, one for the short run, and one for the long run. In the short run, wages are fixed and workers in the economy suffer from money illusion. In the long run, wages are flexible and there is no money illusion. LRAS SRAS

Equilibrium occurs at the intersection of demand and supply for the short run curves.

Chapter 11
FISCAL POLICY Fiscal policy is a change in government spending or taxes meant to influence some macroeconomic variable such as real GDP growth, the unemployment rate, or inflation. Automatic Stabilizers Consist of government policies and programs that reduce the volatility of the business cycle by moderating fluctuations in income. Progressive Income Taxes Progressive Tax System: means that average income tax rates increase as income increases, so that high-income people pay a higher percentage of their income in taxes. Proportional Tax System: the average tax rate is constant as income increase. All income classes pay the same percentage. Regressive Tax System: the average tax rate declines as income increases so that the poor pay a higher percentage. Unemployment Insurance Welfare Programs Agricultural Price Supports The Stability of Government Spending These are government programs and policies that stabilize the economy automatically without any active intervention on the part of the government. Discretionary Fiscal Policy Occurs for two reasons; either the government wants to speed up the economy by increasing aggregate demand or it wants to slow down the economy by reducing aggregate demand. Fiscal policy works by influencing the aggregate demand side of the economy. Increases in government spending or tax cuts will increase aggregate demand. The most famous examples are FDR’s New Deal programs, JFK’s 1963 tax cuts, and Lyndon Johnson’s tax increases in 1967. The American Recovery and Reinvestment Act of 2009 This has been the grandest experiment yet in the history of the United States fiscal policy. It has five purposes: “To preserve and create jobs and promote economic recovery.” “To assist those most impacted by the recession.” “To provide investments needed to increase economic efficiency by spurring technological advances in science and health.” “To invest in transportation, environmental protection, and other infrastructure that will provide long-term economic benefits.” “To stabilize State and local government budgets, in order to minimize and avoid reductions in essential services and counterproductive state and local tax increases.” The act distributed funds to various sectors of the economy in the government’s attempt to increase spending and stimulate aggregate demand. Fiscal Policy in the Classical Model In the classical model, expansionary fiscal policy leads to complete crowding out. Any increase in government spending is exactly offset but declines in consumption and investment spending so that there is no effect on aggregate supply. r S r1 r2 Def = G – T

I I + Def

I1 I0=S0 S1 I, S an increase in government spending without any change in taxes creates a deficit that must be financed through the issuance of bonds. As the demand for loanable funds increases real interest rates will rise, leading to decreases in investment and consumption spending. Fiscal Policy in the Fixed Price Keynesian Model Here the aggregate supply curve should be horizontal because the price level is fixed. Y = AE AE’ AE AE0’ AE0 Y* YF Y Vertical → recessionary gap: the increase in aggregate expenditures required to bring the economy to full employment when actual real GDP is less than potential real GDP. Horizontal → GDP gap: the difference between potential real GDP and actual real GDP Inflationary gap: the decrease in aggregate expenditures necessary to return the economy to full employment when actual real GDP is less than potential real GDP. An Increase in Government Spending The spending multiplier for an increase in government spending is equal to 1/((1-MPC+MPIM)). This means that for any GDP gap the change in real GDP that is necessary to restore the economy to full employment is equal to the GDP gap. So the change in government spending is: ΔG = ΔY/(1/((1-MPC+MPIM)).). Recessionary gap = (GDP gap)/(spending multiplier). A change in government spending is the most effective means of implementing fiscal policy in that it leads to the largest increase in real GDP for a given change in the budget deficit. A Decrease in Taxes Government can increase aggregate expenditures through decreasing taxes. ΔT =ΔY/((- MPC + MPIM)/((1-MPC+MPIM)).). Tax multiplier = 1 – spending multiplier. A Balanced Budget Change A balanced budged change occurs when an increase in government spending is exactly matched by an increase in taxes so that the fiscal policy action has no effect on the government budget. If it is balanced, it will remain balanced. Since it is a change in both government spending and taxes, the effects will depend on both of the multipliers: 1/((1-MPC+MPIM))+(- MPC + MPIM)/((1-MPC+MPIM))= (1-MPC+MPIM)/((1-MPC+MPIM))=1. The balanced budget multiplier is equal to 1. An Inflationary Gap If equilibrium real GDP is greater than potential real GDP, then an inflationary gap is said to exist. This is the opposite of a recessionary gap. If the economy is producing above full employment, shortages of resources will begin to push up resource prices and inflation may result. In the fixed-price Keynesian model the government has three options to increase aggregate expenditures and real GDP. It can increase government spending, cut taxes, or conduct a balanced budget change were both government spending and taxes are increased by the same amount at the same time. Fiscal Policy in the Ordinary Aggregate Supply/Aggregate Demand Model The aggregate demand curve is downward sloping, and the aggregate supply curve is upward sloping. In most cases an increase in government spending or tax cuts will lead to an increase in aggregate demand and higher real GDP and prices. There are three ways of financing any increase in government spending: Issuing taxes to pay for the increase in government spending Issuing bonds to borrow the money to pay for the increase in government spending Printing money to obtain the currency necessary for the increase in government spending Printing money often causes hyperinflation An Increase in Government Spending Financed through Issuing Bonds When the government increases, aggregate demand will increase. The extent of the horizontal shift depends on sizes of the government spending increase and the spending multiplier. If an increase in government spending is financed through an increase in the sale of bonds, interest rates may rise and cause a partial crowding out effect. Crowding out is . The effects of tax cuts would be similar graphically. An Increase in Government Spending Financed through a Tax Increase If an increase in government spending is financed through an equal increase in taxes, a balanced budget change results. The net effect of a balanced budget is an increase in real GDP. Supply-Side Economics A.k.a. Reaganomics The idea was the governments could influence the supply side of the economy through income tax cuts and deregulation to help stimulate the economy. It was believed that income tax cuts would increase labor supply by raising after-tax wages. Tax Increases: They believe that a tax increase would lead to a reduction in labor effort and a decrease in the aggregate supply curve. The results were more inflation, and less GDP growth than would occur without the supply-side effects. Tax Cuts: If the government wants to stimulate the economy, supply side economics believed that increases in aggregate supply were superior to increasing aggregate demand since there is less inflationary pressures. In a supply side model, the effects of tax cuts and deregulation will increase the aggregate supply curve. As the aggregate supply curve increases, real GDP will rise and the price level will fall. If the income tax cuts also increase disposable income, then aggregate demand will rise as a result. The Laffer Curve: one of the underpinnings of Reaganomics was the Laffer Curve. Laffer theorized that there must be a relationship between tax revenue an tax rates that for some ranges, cuts in tax rates would increase tax revenue as work effort increased. A Laffer Curve shows that as income tax rates (t) increase, tax revenue (T) first rises and the falls. tax revenue (T) T*

tax rates (t) 0% t* 100% Debts and Deficits: The budget deficit is the difference between government spending and tax revenue for a given year. The national debt is the sum of all funds that the government owes to al of its creditors that has not yet been paid off. The national debt is cumulative. Fiscal Policy in the Neo-Keynesian Model The neo-Keynesian model assumes that there are three ranges of aggregate supply and that aggregate supply become steeped as GDP increases. The effect of an increase in government spending is an increase in aggregate demand, but the effects on GDP and prices depend on where the change occurs on the aggregate supply curve. In the Keynesian range, an increase in aggregate demand will lead to an increase in real GDP but no increase in the price level since the aggregate supply curve is horizontal. In the intermediate range the aggregate supply curve is upward sloping. An increase in aggregate demand raises both real GDP and the price level. Fiscal policy is effective in increase real GDP in this range. In the classical range, when the economy is beyond full employment, the aggregate supply curve is vertical because the economy has reached its limits Real GDP cannot be increased no matter how high the prices are raised. Fiscal Policy in the Neo-Classical Model There are two aggregate supply curves in this model. One in the short run and one in the long run. When the economy starts in a recession, the increase in aggregate demand can bring the economy back to full employment with and increase in the price level and real GDP. However, if the economy starts in full employments, an increase in government spending may lead to a temporary increase in GDP, but in the long run the result is inflation as resource prices increase. Policy Choices in the Neo-Classical Model If the economy is in recession, eventually resource prices will fall. The fall will lead to increase in the short run aggregate supply curve and the economy returns to full employment. When the economy starts in a recession, unemployed resources will place downward pressure on resource prices and aggregate supply will increase. When the economy starts in a recession, the increase in aggregate demand will increase real GDP and the price level. Keynesian economists are willing to sacrifice some inflation for the benefit of having a quicker reaction in unemployment in the economy. This tradeoff is shown in a model called the Phillips curve, which posits an inverse relationship between inflation and unemployment rates.
Chapter 12
MONEY AND BANKING Money Money: is any asset that is generally acceptable in exchange for goods and services or as payment for debt. Liquidity: is the acceptability of an asset as a medium of exchange. Dollar bills are liquid, because we are willing to accept them even though they have no intrinsic value. Functions of Money Medium of Exchange This is the most important function of money. Money helps the economy to run smoothly. Barter: is the direct exchange of one god or service for another good or service. Money eliminates having to barter. Unit of Account Money allows the measurement and comparison of the value of different goods and services. It also reduces the number of relative prices that we all must keep in our heads. Number of relative prices = (N (N-1))/2 So the existence of money makes it easier to think! Money can act as a unit of account because it is standardized. Store of Value Since money is durable, it acts as a store of value. By doing so, it allows the accumulation of wealth to take place. It is much easier to store money than goods and services. It acts as a store of value because it is durable. Standard of Deferred Payment Money also allows debts to be expressed and paid back with items similar in quality to what was borrowed. It acts as a standard of deferred payment because it is fungible. A Brief History of Money Commodity Money The origins of commodity money are lost in antiquity. As far back as can be gone in history, there are examples of commodity money. To function as commodity money, an item should be in limited supply, durable, divisible have value apart from its use as money, portable, and fungible. Coins Flat Money Checks Electronic Money ATMS, credit and debit cards. Frees exchange of time and place.
(He gives a 10 page completely pointless history of money here)

The Impact of Money Without money, trade is more difficult, so people are forced to be more self-sufficient. There is little time for leisure. The government must raise its taxes in-kind through the taking of tribute, or taking a portion of the farmer’s product. It facilitates trade and fosters commerce. Measuring Money Since money is liquidity or acceptability, then money can be measured differently depending on the standard of liquidity that is employed. Because of this, the Fed uses several measures of money to reflect different levels of liquidity in assets. These are known as M1, M2, and M3, called monetary aggregates. As we move from M1 to M2 to M3, the liquidity of assets declines, as more assets are included in the measure of money. M1 M1 = is the most liquid measure of money. + Currency and coins + Checking account deposits + Traveler’s checks and other checkable deposits. M2 M2 is the second measure of money. It includes more assets than M1 so it is a larger measure. M2 = M1 + Small denomination time deposits (< $100,000) (CD’s)] + Savings deposits + Money market deposit accounts + Non-instrumental money market mutual fund shares M3 M3 is the broadest measure of the money supply, in that it includes the most assets and is the largest number of the three. M3 = M2 + Large denomination time deposits (>$100,000) + Institutional money market mutual funds + Repurchase agreements + Term Eurodollars M1 = cash and checks M2 = M1 + personal savings M3 = M2 + institutional savings

The Structure of the Federal Reserve The structure of the Fed mimics that of the US national government, with features such as the separation of power and federalism. Rather than having one central bank, the Fed consists of 12 regional banks spread out throughout the country, much the same way that state power is spread throughout the country. This is meant to avoid a concentration of political and economic power. The President selects the Board of Governors, for fourteen year, staggered terms. The Federal Open Market Committee (FOMC) guides the monetary policy decisions of the Fed, which are implemented by the Federal Reserve Bank of New York. The Federal Reserve System Established in 1913 to provide a pool of reserve funds for member banks. Eve though the Fed was originally meant to prevent runs on banks, without deposit insurance runs continued, reaching a height during the Great Depression. Four main functions; Conducting monetary policy Bank supervision and regulation Maintaining financial stability Providing financial services to the U.S. government, financial institutions, and the public, and operating the nation’s payments system The Structure of the Federal Reserve System The Board of Governors of the Federal Reserve System The most important institution, in that it sets the general direction of monetary policy and it oversees the other parts of the system. It consists of seven members with staggered, 14-year terms. There responsibilities include analyzing current domestic and international economic and financial developments, supervising and regulating Federal Reserve Banks, maintaining the nation payments system, protecting consumers, and conducting monetary policy. The Federal Open Market Committee (FOMC), consists of the Board of Governors, the New York Fed President, and four other Federal Reserve Bank presidents who rotate among themselves. It meets every six weeks to assess the economy and set a direction for monetary policy. The Federal Advisory Council Consists of twelve representatives, one from each of the Federal Reserve Bank Presidents. They meet to advise the FOMC and Board of Governors on issues involving the Federal Reserve Banks. 12 regional (or district) Federal Reserve Banks The US does not have a central bank, but 12 regional “central” banks spread throughout the country. The banks help to diffuse economic power throughout the country, though ironically New York continues to play a special role. Directors As a compromise between those who favoed a central bank controlled by bankers, and those who wanted a central bank molded in the public interest, they came up with three types of directors. Type A Directors: elected by member banks to represent professional bankers. Type B Directors: elected by member banks to represent industry and commercial interests. Type C Directors: appointed by the Board of Governors to represent the public interest. They are not involved in banking. Functions Clearing checks Issuing new currency Withdrawing damaged currency Administering discount loans Evaluating mergers and expansions Acting as a liaison between businesses and the Board of Governors Examining bank holding companies and state member banks Collecting data on local business conditions Conducting economic research for monetary policy Assisting with the implementation of monetary policy The Special Role of the Federal Reserve Bank of New York The New York Fed holds the worlds monetary gold, about $160 billion worth depending on current prices. The New York Fed supervises and regulates some of the country’s largest banks, with about a quarter of all bank assets. The New York Fed is geographically close to Wall Street and the New York Stock Exchange, on Liberty Street in the financial district. Because of its proximity to the bond markets, the New York Fed conducts the day-to-day open market operations of buying and selling bonds to keep the federal funs rate at its target level. The New York Fed is the source of foreign exchange interventions since it houses the Foreign Exchange Desk. The New York Fed is the only Federal Reserve Bank that is a member of the Bank for International Settlements The New York Fed is the only permanent member of the FOMC Member Commercial Banks The number of commercial banks that are members of the Federal Reserve has decline in recent years. This is mainly the result of mergers. The costs of joining the Fed can be high. Some benefits include a guaranteed 6% return on equity invested in the district bank, and the opportunity to cote for Type A and type B directors.

Chapter 13
MONETARY POLICY The Bank Balance Sheet Net worth = Assets – Liabilities Assets = Liabilities + Net Worth Net Worth s known as capital, bank capital, equity capital or equity. Balance Sheet: A record of financial position at a given point in time. It shows the sources and uses of bank funds. Assets: what you own. Property or financial instruments that are subjects to ownership. Liabilities: what you owe. The financial claims on an institution. Bank Capital: a bank’s net worth or equity. A Typical Bank Balance Sheet Assets are listed on the left, while liabilities are put on the right. The two sides must always be equal to each other. The major categories of bank assets include reserves and other cash, securities, loans, and physical capital. Liabilities include checking and saving accounts, time deposit borrowings, and bank capital. Assets Reserves Reserves are the sum of vault cash and funds in a bank’s Federal Reserve account. Reserves are held to provide a cushion for deposit outflows. While reserves do not pay interest, bank are required to hold a certain percentage of their demand deposits in reserve in order to provide liquidity services to their customers. The amount is determined by the reserve ratio. RR = required reserves r = reserve ratio D = demand deposits R = actual reserves ER = excess reserves RR = r * D R = RR + ER, so ER = R – RR Cash Items in Process of Collection These are the proceeds from cash that have been deposited into a bank but not yet cleared. This occurs when a check is deposited into a checking or savings account, and before the check “clears” or when payment is received from the issuing bank The check is still considered an asset because payment is expected in the near future. Deposits at Other Banks Small banks may keep accounts at larger bank in exchange for liquidity services such as check collection, foreign exchange, securities purchases, or correspondent banking. Securities Since banks are not allowed to own stocks, government securities provide an important source of investment income. These include Treasury securities, government agency bonds, state and local municipal bonds, and other bonds such as school districts or transportation districts. They provide a lower return than loans, but are much safer. Loans Almost two-thirds of all bank assets are held in loans. This is because banks are profitable. Bank loans provide the largest source of profits for most financial institutions. The cost of making bank loans however, is a lack of liquidity and a greater default on assets. Other Assets Include mostly physical capital, such as the building, counters, chandeliers, computers, desks… Liabilities Checkable Deposits These allow check to be written to third parties, providing a convenient and safe method for transferring funds. These include demand deposits (checking accounts), NOW accounts (Negotiable Order of Withdrawal). Non-Transaction Deposits These are where checks cannot be written on the account. In return for less liquidity, they pay higher interest. One type is saving accounts, where deposits or withdrawals can be made at any time. A second type is time deposits, or certificates of deposit (CD’s), which have fixed maturity rates, higher interest payments, but substantial penalties for early withdrawal. Negotiable CD’s are CD’s that can be traded in the secondary market, have provided an important source of bank funds. Borrowings Most banks borrow from other banks, the Fed, and corporations. Federal Funds rate: the rate that one bank charges to another for loans from its Federal Reserve account. Discount rate: the rate the Federal Reserve charges directly to banks for discount loans from the Fed’s discount window. Bank Capital Also known as net worth or equity capital, it is the difference between assets and liabilities. It is what the banks owes to the owners of the firm, which is why it is listed as a liability. Bank Operations Banks function to undertake the process of asset transformation. They start with assets with one set of characteristics, such as risk, return, or maturity, and transform them into other assets with a different set of characteristics. Asset Transformation: is the process of taking assets with one set of characteristics and transforming them into assets with a different set of characteristics. Accounting For Bank Transactions We use T – accounts to analyze may types of bank transactions. Deposits $100 deposit into a checking account
Assets Liabilities Reserves + 100 Demand deposits + 100 (vault cash)

$100 deposit of a check drawn on a second bank a checking account
Assets Liabilities Cash items in + 100 Demand deposits + 100 process of collection

Once the check clears, the payment will have been received from the issuing bank. The issuing bank is recorded as:
Assets Liabilities reserves + 100 Cash items in – 100 process of collection

The final position of the bank as a result of a $100 check is:
Assets Liabilities Reserves + 100 Demand deposits + 100 For the second bank, the bank that issued the check, the final position is
Assets Liabilities Reserves – 100 Demand deposits – 100

Money Creation While it is not possible for individuals to create money, it is possible for the banking system as a whole to create money through the process of the lending of excess reserves. The Fed can influence the money creation process through the mechanism of open market operation. If the Fed purchases securities from a bank, then the reserves of the bank increase by the amount purchased. Open Market Operations A common tool of monetary policy is open market operations, or the buying and selling of securities by the Fed to influence the quantity of money in circulation. Open market operations are the sale and purchase of securities by the Fed to influence the quantity of bank reserves. Changes in bank reserves can lead to multiplied changes in the money supply. Open Market Purchase from a Bank Assume that banks hold no time deposits, that the net worth is equal to zero, and that the reserve ratio (r) is .10 (10%) Suppose the Fed buys $200 worth of bonds from “Firstbank.” Once the check clears, Firstbank’s balance sheets will be affected in the following ways:

FIRSTBANK FEDERAL RESERVE BANK
Assets Liabilities Assets Liabilities
Reserves + 200 Securities + 200 Reserves + 200
Securities – 200

An open market purchase from a bank increase reserves by the amount of the purchase. Deriving the Money Multiplier If banks hold no excess reserves, the RR = R So RR = r * D Then D = R/r = (1/r)*R ΔD = ΔR/r Sicnce a change in demand deposits leads to a change in the money supply, then

ΔM = ΔR/r

Tools of Monetary Policy Open Market Operations These affect the money supply by influencing the quantity of reserves held by banks. With an open market purchase, the amount of bank reserves increase. An open market sale causes the opposite effect—the quantity of bank reserves declines. Open market operations are used to maintain a target for the Federal Funds rate. If the Fed anticipates an increase in the demand for reserves in the banking system, it will conduct an open market purchase to increase the supply of reserves to maintain the Federal Funds rate at its target level. The FOMC sets the target for the Federal Funds rate. Lending Facilities Discount Loans: loans that the Fed makes directly to member commercial banks from a lending facility known as the discount window. The discount rate is the rate that the Fed charges for these loans. A decrease in the discount rate will cause an increase in discount loans, as borrowing becomes cheaper. These didn’t happen until 2008. Before that, they only lent to depository institutions. Reserve Requirements A change in the required reserve ratio (r) will lead to a change in the money multiplier. Even though changes in reserve requirements can be powerful tools in changing the money supply, the Fed has been reluctant to use this tool in recent years. Models of Monetary Policy The Cambridge model—The Equation of Exchange Rather than using the value of transactions as the basis for money demand, the Cambridge model uses the value of nominal GDP. Since nominal GDP is much more easily measurable, the Cambridge model of money demand has become the basis for the classical model of the economy. M = quantity of money V = income velocity of money (or just velocity) P = price level Y = real GDP PY = nominal GDP The equation of exchange is given by: M * V = P * Y The Velocity of Money This is the average number of times that a unit of currency must be used in a year for the quantity of money in circulation to be sufficient to purchase the quantity of nominal GP produced in that year. V = ((P*Y))/M This equation states that money must turn over enough times (the velocity) to purchase the quantity of nominal GDP produced. The Demand for Money in the Cambridge Model Demand for money = Md = k * P * Y k is known as the Cambridge k, or the percentage of nominal income that households desire to hold as money. The classical model assumes that k is constant, so V must also be constant. k = 1/V In the classical model, an increase in the money supply leads to an increase in aggregate demand. This shows the idea of money neutrality. Changes in the money supply only affect nominal variables, such as the price level, but not real variables, such as real GDP. The Monetarist Model of Monetary Policy The modern monetarist model still uses the quantity theory, MV=PY, but relaxes the assumptions that velocity and real GDP are constant. If velocity is stable, then a stable rate of growth in real GDP can be achieved through a stable rate of growth in the money supply. They argue that the most important economic variable is the rate of growth of the money supply. M * V (with a squiggle over it) = P * Y Stable monetary growth rule: in order to maintain a stable rate of growth of real GDP, monetary policy makers should maintain a stable rate of monetary growth. To increase real GDP by N% per year, the money supply should be increased by N% per year. The Keynesian Model of Monetary Policy A Keynesian economist would say that velocity and real GDP are not constant or stable, the demand for money plays a greater role in determining real GDP than suggested by the classical model, and that the classical model ignores the effects of interest rates and investment. Money Supply: We assume that the supply of money is fixed by the central bank and is independent of interest rates. The money supply curve is vertical. Money Demand: The motives for holding money are Transactions demand—households demand money for planned purchases. Precautionary demand—households hold money for unplanned purchases. Speculative demand—households hold money to take advantage of changes in the prices of financial assets. F = M + B & ΔF = ΔM + ΔB F = financial wealth M = money B = bonds Bs + Ms = Bd + Md → Bs – Bd = Ms – Md Bs = bond supply Ms = money supply Bd = bond demand Md = money demand

i Ms

Md

M When interest rates are high, households hold more bonds and less money. When they are low vice versa.

Changes in Money Demand: Caused by changes in real income, the price level, and household preferences for holding money. An increase in money demand leads to higher interest rates. To analyze the effects of changes in the money supply we can use the concept of the Keynesian Monetary Policy Transmission Mechanism, which traces through the changes that occur throughout the economy from some initial change in the money supply.

→ → → →

In the Keynesian model, increases in the money supply can be successful in stimulating aggregate demand and real GDP, but as in the other models inflation may result from expansionary monetary policy.