Compare and contrast the strengths and weaknesses of fiscal policy and monetary policy.

To get you started concentrate on two distinct chapters in the Schiller textbook. See chapter 11 for an analysis of the strengths of fiscal policy, with some weaknesses. See chapter 12 for key limitations to fiscal policy. See chapters 13, 14 and 15 to see how monetary policy works, and its benefits. Concentrate on chapter 15 to find the failings and problems with monetary policy.

Hints -- Within your answers, consider the following:

--Identify and summarize the market dynamics involved in both kinds of centrally coordinated policies.

--Who is in charge of these policies, and how do their different multipliers work?

--Given your analysis here and, using your knowledge from ALL of the material we have covered this semester, what are the best ways to solve macroeconomic problems?

CHAPTER Fiscal Policy LEARNING OBJECTIVES After learning about this chapter, you should know LO11-1 LO11-2 LO11-3 LO11-4 LO11-5 How and why the real GDP gap and the AD shortfall differ. The tools of fiscal stimulus and their desired scope. What AD excess measures. The tools of fiscal restraint and their desired scope. How the multiplier affects fiscal policy. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy • The Keynesian theory of macro instability practically mandates government intervention. – If AD is too little, unemployment arises. – If AD is too much, inflation arises. • If the market cannot correct these imbalances, then the federal government must. • Fiscal policy: the use of government taxes and spending to alter macroeconomic outcomes. 11-02 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy II • In this chapter we examine fiscal policy tools. • Core issues are – Can government spending and tax policies ensure full employment? – What policy actions will help fight inflation? – What are the risks of government intervention? 11-03 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Taxes and Spending • The federal government collects nearly $4 trillion a year in tax revenues, nearly half of which comes from individual income taxes. • Less than half of government expenditures go to government purchases of goods and services. • The rest are income transfers – payments to individuals for which no current goods or services are exchanged. 11-04 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy’s Influence • These tax and spending powers can greatly influence AD. • Government can alter AD by – Purchasing more or fewer goods and services. – Raising or lowering taxes. – Changing the level of income transfers. 11-05 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy Goals • First, we will explore fiscal policy’s potential to ensure full employment. • Second, we will explore fiscal policy’s potential to maintain price stability. 11-06 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Stimulus • If a recessionary GDP gap exists, fiscal stimulus could shift the economy back to fullemployment GDP. • Fiscal stimulus: Tax cuts or spending hikes intended to increase AD (shift AD to the right). • AS slopes upward, so an AD shift right will induce price level increases. 11-07 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The AD Shortfall • The fiscal stimulus needed to close the GDP gap must be larger than the gap. • AD shortfall: The amount of additional AD needed to achieve full employment after allowing for price level changes. – It is represented by the distance between point a and point e. – It becomes the fiscal target. 11-08 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Using Government Spending • Increased government spending is a form of fiscal stimulus. • All new government spending will have a multiplied impact on AD. • The multiplier effect will stimulate additional rounds of increased consumer spending. Cumulative increase = Fiscal stimulus + Induced increase (Horizontal shift) in AD in consumption = Multiplier X Fiscal stimulus 11-09 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Desired Fiscal Stimulus • Too little fiscal stimulus? The economy may stay in recession. • Too much fiscal stimulus? This may rapidly lead to excessive spending and inflation. • We can use this formula to estimate how much fiscal stimulus is needed: Desired fiscal stimulus = AD shortfall Multiplier 11-10 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Tax Cuts • The fiscal stimulus can come from inducing increased autonomous consumption or investment spending. • Government can do this by lowering taxes. – Individual income tax cut: disposable income would increase, causing increased consumption spending. – Corporate tax cut: profits would increase, spurring increased investment spending. 11-11 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Tax Cuts II • A tax cut adds no more dollars to the economy. It allows earners to keep more of their current pretax income. • How much additional consumer spending is controlled by the size of MPC. Initial increase in consumption = MPC X Tax cut Cumulative change in spending = Multiplier Initial change in X consumption 11-12 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Tax Cuts III • Since there is no initial new input of spending, a tax cut contains less fiscal stimulus than a government spending increase of the same size. • The initial spending injection can be less than the size of the tax cut. Consumers will save a portion of their increased disposable income. 11-13 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Desired Tax Cut • Too little fiscal stimulus? The economy may stay in recession. • Too much fiscal stimulus? This may rapidly lead to excessive spending and inflation. • We can use this formula to estimate how much of a tax cut is needed to achieve desired fiscal stimulus: Desired tax cut = Desired fiscal stimulus MPC 11-14 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Increased Transfers • Increasing transfer payments raises recipients’ disposable income, and spending increases. • The effect is much like a tax cut since the recipients will save some of the payment. 11-15 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Balanced Budget Multiplier • Spending increases raise expenditures (G), and tax cuts decrease revenues (T); therefore, the budget deficit increases. • If the increase in G and the decrease in T are the same size, the deficit would not grow. • How would this affect AD? – Since the effect of a change in G is greater than the effect of a change in T, AD would shift by the size of the change. – The balanced budget multiplier, therefore, equals 1. 11-16 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Restraint • If an inflationary GDP gap exists, a fiscal restraint could be used to return the economy to full-employment GDP. • Fiscal restraint: Tax hikes or spending cuts intended to decrease AD (shift AD left). • AS slopes upward, so an AD shift left will induce price level decreases. 11-17 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The AD Excess • The fiscal restraint needed to close the GDP gap must be larger than the gap. • AD excess: The amount by which AD must be reduced to achieve full employment after allowing for price level changes. – It is represented by the distance between point Q1 and point Q2. – It becomes the fiscal target. 11-18 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Desired Fiscal Restraint • Too little fiscal restraint? The economy may continue to be inflationary. • Too much fiscal restraint? This may rapidly lead to decreased spending and rising unemployment. • We can use this formula to estimate how much fiscal restraint is needed: Desired fiscal restraint = AD excess Multiplier 11-19 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Budget Cuts • Decreased government spending is a form of fiscal restraint. • Reduced government spending will have a multiplied impact on AD. • The multiplier effect will generate additional negative rounds of decreased consumer spending. Cumulative decrease = Fiscal restraint + (Horizontal shift) in AD = Multiplier x Induced decrease in consumption Initial budget cut (fiscal restraint) 11-20 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Budget Cuts II • Cut government expenditures to initiate a multiplier process to achieve the desired fiscal restraint. • For example, decreased military spending would cause layoffs at defense plants. • Incomes would decrease and consumer spending would also decrease, triggering the negative multiplier rounds. 11-21 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Tax Hikes • The direct effect of a tax hike is reduced disposable income. • People must reduce consumption and saving to pay the added taxes. • This will trigger the negative multiplier effect. • AD will shift to the left. 11-22 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Reduced Transfers • If transfer payments decrease, recipients’ disposable income falls and spending decreases. • The effect is much like a tax hike. • This option is politically unpopular. 11-23 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Guidelines • The goal of fiscal policy is to eliminate GDP gaps by shifting AD. • How much to shift is indicated by the AD shortfall or the AD excess. • The size of the fiscal initiative is equal to the desired shift divided by the multiplier. • What remains is to decide which policy tool to use. 11-24 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Policy Tools 11-25 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Crowding Out • Crowding out: A reduction in private sector borrowing (and spending) caused by increased government borrowing. – Fiscal stimulus funding would most likely be financed by government borrowing. – Less credit becomes available to the private sector, which must reduce its borrowing and spending. – This private sector spending reduction offsets the government spending, reducing the impact of the fiscal stimulus. 11-26 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Time Lags • It takes time to – – – – – Recognize that a problem exists. Develop a policy strategy. Pass the required legislation. Implement the policy. Generate the many steps in the multiplier process. • This might take months. • Other impacts on the economy may have occurred before the impact of the policy takes place. 11-27 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Pork Barrel Politics • Congress members might: – Channel spending to their own districts. – Protect favored projects from cuts. – Steer away from tax hikes or spending cuts before an election. • These political moves can alter the content and timing of fiscal policy. 11-28 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow • The concern about content. • To move out of recession to fullemployment GDP, the primary concern is how much spending (or tax cuts) should be involved. • Another concern is the content of the spending. – Public sector or private sector? – A boost for businesses or more for the needy? 11-29 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow II • Public vs. private –Two camps have emerged: – One camp favors government solutions to problems. – The other camp is concerned about excessively large government and asserts that solutions are better left to the private sector. • If government is divided between the two groups, fiscal policy will be delayed by arguments on these policy issues. 11-30 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow III • The camp favoring government solutions to problem would: – increase government spending to cover an AD shortfall. – hike taxes to cover an AD excess. • The camp that is concerned about excessively large government and thinks that solutions are better left to the private sector would: – cut taxes to cover an AD shortfall. – reduce government spending to cover an AD excess. 11-31 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow IV • Each policy tool would alter the economy’s mix of consumption and investment and cause a different distribution of income. – One side: smaller tax cut for the rich, more tax relief for the poor, and more social programs. – The other side: cut taxes for businesses and entrepreneurs, reduce the size and scope of government programs. 11-32 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow V • There is usually some form of compromise on issues like these. • However, you can expect to continue to see major political conflicts over the differing views of these two sets of politicians in the economy tomorrow. 11-33 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives • LO11-1 Know how and why the real GDP gap and the AD shortfall differ. – The real GDP gap is the difference between existing GDP and fullemployment GDP. – The AD shortfall measures how much cumulative spending is required to move the economy back to fullemployment GDP. 11-34 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives II • LO11-2 Know the tools of fiscal stimulus and their desired scope. – The tools of fiscal stimulus are • Increasing government purchases. • Reducing taxes. • Raising income transfers. – The scope of the stimulus is determined by the AD shortfall divided by the multiplier. 11-35 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives III • LO11-3 Know what AD excess measures. – The AD excess measures how much cumulative reduction in spending is required to move the economy back to full-employment GDP. 11-36 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives IV • LO11- 4 Know the tools of fiscal restraint and their desired scope. – The tools of fiscal restraint are • Decreasing government purchases. • Increasing taxes. • Cutting income transfers. – The scope of the restraint is determined by the AD excess divided by the multiplier. 11-37 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives V • LO11- 5 Know how the multiplier affects fiscal policy. – Initial changes in spending, taxes, or transfer payments begin a cycle in which, for example, an increase in government spending becomes income to another. This income is mainly spent, which becomes income to yet another, etc. – This repetitive cycle generates a multiplier effect. 11-38 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Looking Ahead: Chapter 12 Deficits and Debt After learning about this chapter, you should know; • • • • The origins of cyclical and structural debt. How the national debt has accumulated. How and when “crowding out” occurs. What the real burden of the national debt is. 11-39 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Deficits and Debt LEARNING OBJECTIVES After learning about this chapter, you should know LO12-1 LO12-2 LO12-3 LO12-4 1 2 CHAPTER The origins of cyclical and structural deficits. How the national debt has accumulated. How and when “crowding out” occurs. What the real burden of the national debt is. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Stimulus and the Deficit • A fiscal stimulus package is designed to move the economy out of recession toward full-employment GDP. • Tax cuts or increased government spending, or a combination of the two, increases the size of the budget deficit. • Borrowed funds to finance the stimulus must be paid for in the future by increased taxes or reduced spending, both fiscal restraint tools. 12-02 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fiscal Stimulus and the Deficit II • The core issue in this chapter is to examine the budget consequences of fiscal stimulus. • Specifically, – How do deficits arise? – What harm, if any, do deficits cause? – Who will pay off the accumulated national debt? 12-03 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Budget Effects of Fiscal Policy • Using fiscal policy to solve macro problems implies that federal expenditures and federal receipts won’t always be equal. – In fiscal stimulus, G increases or T decreases. – In fiscal restraint, G decreases or T increases. • Budget deficit: amount by which government spending(G) exceeds government tax revenue(T) in a given time period. Budget deficit = Government spending – Tax revenues > 0 12-04 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Recent History of Budget Deficits • Here are recent budget deficits: In 2007, $ 161 billion In 2008, $ 459 billion In 2009, $1,413 billion In 2010, $1,294 billion In 2011, $1,300 billion In 2012, $1,087 billion In 2013, $ 680 billion In 2014, $ 484 billion In 2015, $ 438 billion In 2016, $ 587 billion • Opinion polls reveal that huge deficits are still near the top of the list of American concerns. 12-05 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Keynes’s View on Budget Deficits • Budget deficits are a routine byproduct of fiscal policy, caused by a fiscal stimulus to increase AD. • The goal of macro policy is not to balance the budget but to move the economy to full-employment GDP. • Keynes: Full employment first, then worry about the deficit. 12-06 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Discretionary vs. Automatic Spending • Discretionary spending: Those elements of the budget not determined by past legislative or executive commitments. • Automatic spending: Those elements of the budget that are a result of decisions made in prior years; said to be “uncontrollable.” • Make up of the budget: – Automatic (uncontrollable): about 80 percent. – Discretionary (controllable ): about 20 percent. 12-07 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Uncontrollable? • Can the president and Congress repudiate prior commitments and enact new legislation? – – – – Reduce Social Security benefits. Refuse to pay interest on the accumulated debt. Terminate projects approved in prior years. Reduce payouts for other social welfare programs. • They would face political consequences in doing so. 12-08 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Automatic Stabilizers • Automatic stabilizer: Federal expenditure or revenue item that automatically responds countercyclically to changes in national income (GDP), like unemployment benefits and income taxes. 12-09 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Automatic Stabilizers II • As a recession begins, unemployment compensation and welfare payments increase and income tax collections decrease, each stimulating economic growth in a small way. • As economic growth returns, unemployment compensation and welfare payments decrease and income tax collections increase, each putting a small restraint on economic growth. 12-10 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Cyclical Deficits • Cyclical deficit: that portion of the budget deficit attributable to short-run changes in economic conditions. • As the economy slows – Tax revenues decline. – Unemployment benefits rise. – Other transfer payments rise. • The cyclical deficit • As the economy grows – Widens when GDP – Tax revenues rise. growth slows or – Unemployment benefits fall. inflation increases. – Other transfer payments fall. – Shrinks when GDP – Interest rates could rise, growth accelerates or increasing debt payments. inflation decreases. 12-11 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Structural Deficits • Structural deficit: federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy. • The structural deficit reflects discretionary fiscal policy decisions. • Therefore, part of the deficit arises from cyclical changes in the economy; the rest is a result of discretionary fiscal policy. 12-12 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is to “Blame” for Deficit Increases? • The impact of cyclical components (automatic stabilizers) and policy initiatives affect the budget at the same time. • According to the CBO, in 2013 the budget deficit decreased by $407 billion due in part to the slow recovery ($2 billion) and the rest due to decreased discretionary fiscal policy ($406 billion). 12-13 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Measuring the Impact of Fiscal Policy • We must focus on changes in the structural deficit, not the total deficit. – Fiscal stimulus is measured by an increase in the structural deficit (or shrinkage in the structural surplus). – Fiscal restraint is gauged by a decrease in the structural deficit (or increase in the structural surplus). 12-14 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Economic Effects of Deficits • Crowding out can occur, especially as the economy gets closer to full employment. – Increased government borrowing to finance a growing deficit reduces the availability of funds for private sector spending. – Thus any increase in government expenditures will be offset by reductions in consumption and investment spending. 12-15 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Economic Effects of Deficits II • Interest rate movements: – An increase in demand for funds will cause the price of borrowing, the interest rate, to rise. – Rising interest rates make it more costly for consumers or businesses to borrow, and they may cut back. – Rising interest rates also increase the borrowing costs of government, leaving less room in government budgets for financing new projects. 12-16 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Economic Effects of Surpluses • If the government runs a surplus, tax revenues are greater than government expenditure, it is a leakage to the circular flow. It is a drag on the economy. • Potential uses for a budget surplus: – – – – Spend it on goods and services. Cut taxes. Increase income transfers. Pay off old debt (“save it”). 12-17 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Economic Effects of Surpluses II • Spending a surplus increases the size of the public sector. • Cutting taxes or increasing income transfers puts money in the peoples’ hands and enlarges the private sector. • Paying off some accumulated debt puts money in the hands of the debt holders: – They buy more goods and services. – Expands the private sector. – Lowers the demand for funds and the interest rates. 12-18 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Accumulation of Debt • The national debt is the accumulation of many years of running budget deficits. – The U.S. Treasury borrows by issuing Treasury bonds to lenders who want a safe investment paying out interest. – When there is a deficit, the national debt increases. – When there is a surplus, the national debt can be pared down. 12-19 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The National Debt • In 2017 the national debt hit $20 trillion, an average of more than $60,000 for every U.S. citizen. • A better indicator is the debt-to-GDP ratio. – Except for the Civil War, this ratio was about 10 percent from 1790 to 1917. – During World War II, it rose to 130 percent. – In 2000 it was about 60 percent. – It is now back above 100 percent. 12-20 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Who Owns the Debt? • The national debt creates wealth for bondholders equal to the liabilities it creates for the U.S. Treasury. • Who are the bondholders (owners)? – Federal agencies (e.g., the Federal Reserve and the Social Security Administration) hold 42% of all outstanding Treasury bonds. – State and local governments hold 3%. – The private sector holds 22%. – Foreigners hold 33%. 12-21 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Why Hold U.S. Government Debt? • Relative to other investments: – They are safe. – There is no question of the debt being repaid. – They pay interest. – Dollar-denominated assets are generally acceptable in world trade. 12-22 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Burden of the Debt • How is the debt usually paid off? • It is usually just refinanced. • Refinancing: the issuance of new debt to pay off debt issued earlier. – When a Treasury bond matures, new funds are borrowed to pay it off. – So the debt remains debt. There is no addition to the debt. Only another deficit adds to the debt. 12-23 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Burden of the Debt II • Where does the Treasury get the funds to service the debt? • Debt service: the interest required to be paid each year on outstanding debt. – Increased interest payments use up taxes collected that no longer can be used for other government expenditures. – Debt servicing is a redistribution of income from taxpayers to bondholders. 12-24 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Burden of the Debt III • Is there an opportunity cost of running up the debt? • Opportunity cost: – Funds spent on government expenditures cannot be used for other (public or private) expenditures. – Resources consumed by a government expenditure cannot be used to produce other goods and services. – The value placed on these forgone goods and services is the opportunity cost, however financed. 12-25 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Real Trade-Offs • Deficit spending changes the mix of output in the direction of more public sector goods, i.e., increasing government power while decreasing private sector power. • The burden of the debt is really the opportunity cost (crowding out) of deficit-financed government activity. 12-26 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Debt and Economic Growth • If deficit-financed government spending crowds out private investment, future generations will bear some of the debt burden: – We will have smaller-than-anticipated productive capacity. – There will be arguments about achieving an optimal mix of output, as the public sector grows at the expense of the private sector. 12-27 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Repayment • What if the U. S. Treasury had to pay off all maturing bonds? • If the U.S. Treasury pays off maturing bonds with taxes, it is a redistribution of income from taxpayers to bondholders. – The heirs of current bondholders receive the payout. – The future taxpayers are hit with the taxes to pay off the maturing bonds. 12-28 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. External Debt • Does selling bonds to foreigners change anything? • Borrowing from foreigners eliminates crowding out. – We get more public sector goods without cutting back on private sector production. – Foreigners get the dollars by selling us more imports than they buy of our exports. – We can consume an amount greater than the domestic-only PPC would allow us to consume. • As long as foreigners are willing to hold U.S. debt, external financing imposes no real cost. 12-29 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. External Debt II • What if foreigners no longer want to hold U. S. debt? • Then they will sell their bonds and hold dollars, which they can use to buy dollar-denominated goods and services, mainly U.S. exports. • External debt will be repaid with exports of real goods and services. 12-30 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Debt Limits • What about imposing a debt limit? • The only way to stop the growth of the debt is to eliminate budget deficits. – Balance the budget (G = T), or – Impose a debt ceiling that is decreased each year until it reaches zero. • Debt ceiling: An explicit, legislated limit on the amount of outstanding national debt. – This leads to compromises on how best to use budget deficits. – Usually, when the debt ceiling is reached, Congress simply increases it. 12-31 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow • Dipping Into Social Security. • When the Treasury receives Social Security funds from payroll deductions, it pays out current retirement benefits and puts the surplus in Treasury securities. – The surplus is due to the huge numbers of baby boomer workers over the past decades. – They are retiring now and the surplus will dwindle. Ultimately it will go into deficit. 12-32 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow II • Congress will have to raise taxes, make big cuts in spending, or reduce Social Security payouts to redeem those Treasury securities. • As the boomers retire, more will go out in Social Security checks than comes in from payroll taxes. 12-33 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow III • Will the age of retirement be changed? • Will the payments to retirees be decreased? • Will the percentage taken from payrolls be increased? • This is a major problem facing Congress and America in the economy tomorrow. 12-34 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives • LO12-1 Know the origins of cyclical and structural debt. – During recessions, automatic stabilizers increase the cyclical deficit. – During expansions, automatic stabilizers decrease the cyclical deficit. – Fiscal stimulus increases the structural deficit. – Fiscal restraint decreases the structural deficit. 12-35 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives II • LO12-2 Know how the national debt was accumulated. – Each year’s federal budget deficit adds to the national debt. – The Treasury Department must issue new debt instruments to meet that year’s expenditures. 12-36 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives III • LO12-3 Know how and when “crowding out” occurs. – Deficit financing of government expenditure may crowd out private investment and consumption by removing available funds. – The risk of crowding out increases as the economy nears full employment. 12-37 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives IV • LO12-4 Know what the real burden of the national debt is. – The real burden of the debt is the opportunity cost of activities financed by the debt. – What activities, private or public, must be forgone when a decision is made to deficitfinance a government project? 12-38 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Looking Ahead: Chapter 13 Money and Banks After learning about this chapter, you should know; • What money is. • What a bank’s assets and liabilities are. • How banks create money. • How the money multiplier works. 12-39 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money and Banks LEARNING OBJECTIVES After learning about this chapter, you should know LO13-1 What money is. LO13-2 What a bank’s assets and liabilities are. LO13-3 How banks create money. LO13-4 How the money multiplier works. 1 3 CHAPTER Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money • In this chapter we examine the role of money in the economy. Specifically – What is money? – How is money created? – What role do banks play in the circular flow of income and spending? 13-02 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is “Money”? • Money is a tool that greatly simplifies market transactions. • No money? Transactions would be made using a barter system. • Barter: the direct exchange of one good for another, without the use of money. 13-03 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What Is “Money”? (cont.) • Money acts as a medium of exchange. Sellers will accept it as payment for goods and services. • Money: anything generally accepted as a medium of exchange. 13-04 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Supply • Anything that serves all the following purposes can be thought of as money: – Medium of exchange: accepted as payment for goods and services (and debts). – Store of value: can be held for future purchases. – Standard of value: serves as a yardstick for measuring the prices of goods and services. 13-05 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Modern Concepts • Cash is obviously money because it fills all three purposes. • Checking accounts perform the same market functions as cash. Debit cards act much like a check, so they are money. • Online payment systems and credit cards do not. They can be a medium of exchange but do not fulfill the other purposes. • The essence of money is not its physical form, but its ability to purchase goods and services. 13-06 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Composition of the Money Supply (M1) • Some bank accounts are better substitutes for cash than others. • M1: cash and transactions accounts. – Transactions accounts include checking accounts and travelers checks. – Money supply (M1): Currency held by the public, plus balances in transactions accounts. – M1 permits direct payment to a third party for goods and services. 13-07 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Composition of the Money Supply (M2) • M2: M1 plus savings accounts, etc. – Savings account balances and money market mutual funds are almost as good a substitute for cash as transactions accounts. – Money supply (M2): M1 plus balances in most savings accounts and money market mutual funds. – M2 must be turned into M1 before it can be used to purchase goods and services. 13-08 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Composition of the Money Supply • Cash is less than half of the M1 money supply. Most of M1 are transactions account balances. • M2 is four times larger than M1. People hold money in M2 accounts because they can earn some interest on these deposits. US Money Supply January 2017 13-09 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Economic Importance of Money • The amount of money available (the size of the money supply) affects consumers’ ability to purchase goods and services. • This directly affects aggregate demand (AD). 13-10 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A Bank’s Assets and Liabilities • Assets – Things of value that the bank possesses. • Liabilities – What the bank is obligated to pay to others. • The assets of a bank always equals its liabilities. 13-11 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Creation of Money • Cash is either printed or coined. But cash is a very small part of M2. • How is the money in transactions accounts and savings accounts created? – These bank accounts are not physical lumps of cash. They are computer data entries. – A few keystrokes can increase or decrease the money in a bank account. 13-12 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Creation of Money II • Banks create money by making loans. – Grant a loan and increase the borrowers’ checking account with a few keystrokes. • The bank’s ability to create money is limited by the Federal Reserve System (the “Fed”). – In this way, the Fed controls the basic money supply. 13-13 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fractional Reserves • Bank reserves: assets held by a bank to fulfill its deposit obligations. • Each bank must maintain required reserves, the minimum amount of reserves a bank is required to hold (and not loan out). • Required reserve ratio: The ratio of a bank’s required reserves to its total deposits. Required reserves = Required reserve ratio x Total deposits 13-14 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Fractional Reserves II • Since the bank must set aside some of its deposits to satisfy its required reserves, it can make loans only on the remainder, called excess reserves – bank reserves in excess of required reserves. Excess reserves = Total reserves – Required reserves • A minimum reserve requirement directly limits deposit creation (lending) possibilities. 13-15 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Changes in the Money Supply • A bank makes a loan, creating money. • The borrower spends the money; the seller deposits it into the firm’s bank account. • That bank now has more excess reserves makes a loan on it, creating more money. • When the new borrower spends the loan, this cycle continues to repeat itself. • Each time a new loan is made, the money supply increases. • There is a multiplier process going on, just like the multiplier process in Chapter 10. 13-16 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Multiplier • Money multiplier: the amount of deposit dollars that the banking system can create from $1 of excess reserves. 1 Money multiplier = Required reserve ratio 13-17 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Multiplier II • The potential of the money multiplier to create loans is summarized in this equation: Excess reserves x Money multiplier = Potential deposit creation • If the required reserve ratio is 0.20, the money multiplier is 5. An initial deposit of $100 has $80 of excess reserves and potentially can create $400 of new deposits. 13-18 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Excess Reserves as Lending Power • If a bank has no excess reserves, it can make no more loans. • Each bank may lend an amount equal to its excess reserves and no more. • The entire banking system can increase the volume of loans by the amount of excess reserves multiplied by the money multiplier. 13-19 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Two Essential Functions of Banks • Banks transfer money from savers to spenders by lending funds held on deposit. • The banking system creates additional money by making loans in excess of required reserves. • Changes in the money supply may in turn alter spending behavior and thereby shift the aggregate demand (AD) curve. 13-20 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Banks in the Circular Flow 13-21 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Constraints on Deposit Creation • Deposits. If people prefer to hold onto cash, the deposit creation process will be severely hindered. • Willingness to lend. If banks are reluctant to take risks in lending, they will not fully lend out their excess reserves. • Willingness to borrow. If borrowers are reluctant to take on more debt, fewer loans will be made. • Regulation. The Fed may limit deposit creation by increasing reserve requirements. 13-22 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow • Are bitcoins tomorrow’s money? • People want a more secure and objective limit to money creation. • Bitcoins could offer that limit. • Bitcoins – electronic creations governed by a computer protocol that will maximize the amount available by 2140. 13-23 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow II • Each bitcoin has a “private key” identifier which you can transfer to another person or firm in payment, without a bank transfer. • Will bitcoins be our “money” in the economy tomorrow? • Problems such as wild fluctuation in its value and its acceptability as payment will have to be overcome. 13-24 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives • LO13-1 Explain what money is. – It is anything generally accepted in exchange that serves as a store of value and acts as a standard of value. – M1 includes cash plus transactions account deposits. – M2 includes M1 plus savings account and other account balances. 13-25 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives II • LO13-2 What are a bank’s assets and liabilities? – A bank’s assets are things of value in its possession. – A bank’s liabilities are what it is obligated to pay out to others. – Assets must always equal liabilities. 13-26 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives III • LO13-3 Describe how banks create money. – Banks create money by making loans using excess reserves. – Each loan becomes a new transactions deposit. – This enables banks to transfer money from savers to spenders. 13-27 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives IV • LO13-4 Demonstrate how the money multiplier works. – As loans are spent, they create deposits elsewhere, making it possible for other banks to make additional loans. – This multiplier effect is controlled by the Fed when it sets the required reserve ratio. The money multiplier is the reciprocal of the required reserve ratio. 13-28 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Looking Ahead: Chapter 14 The Federal Reserve System After learning about this chapter, you should know; • How the Federal Reserve is organized. • The Fed’s major policy tools. • How open market operations work. 13-29 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Federal Reserve System LEARNING OBJECTIVES After learning about this chapter, you should know LO14-1 How the Federal Reserve is organized. LO14-2 The Fed’s major policy tools. LO14-3 How open market operations work. 1 4 CHAPTER Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Federal Reserve System • We examine how the government controls money creation and thus aggregate demand (AD). • The core issues are – Which government agency is responsible for controlling the money supply? – What policy tools are used to control the amount of money in the economy? – How are banks and bond markets affected by the government’s policies? 14-02 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Structure of the Fed • The Fed was created in 1913. • It consists of 12 Federal Reserve banks, which act as the central bank for private banks in their regions and perform the following services: – Clearing checks – Holding bank reserves – Providing currency – Providing loans 14-03 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Structure of the Fed II • The Fed Board of Governors sets monetary policy: the use of money and credit controls to influence macroeconomic outcomes. • There are 7 board members appointed by the President and confirmed by the Senate to serve 14-year terms. Appointments are staggered, to ensure a measure of political independence. • One board member is appointed by the President to serve as chairman for 4 years. 14-04 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Structure of the Fed III • The current Fed chairman is Janet Yellen, her term ends February 2018. • The Federal Open Market Committee (FOMC): – Is responsible for the Fed’s daily activity in financial markets. – meets every four to five weeks to review economic performance and to adjust monetary policy as needed. 14-05 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Monetary Tools • The Fed controls the money supply by using three policy tools: – Reserve requirements. – Discount rates. – Open market operations. 14-06 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Reserve Requirements • Private banks are required to keep a fraction of deposits “in reserve,” either as cash or on deposit at the regional Fed bank. • Banks cannot loan out these required reserves. • By changing reserve requirements, the Fed can directly alter the lending capacity of the banking system. 14-07 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Reserve Requirements II • Increase the reserve requirement and: – The amount of excess reserves decreases. – The money multiplier decreases. – The available lending capacity shrinks. • Decrease the reserve requirement and: – The amount of excess reserves increases. – The money multiplier increases. – The available lending capacity expands. Available lending capacity = Excess reserves x Money multiplier 14-08 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Discount Rate • Private banks earn income by making loans, so they try to fully lend out their excess reserves. • At times, a bank might fall short of satisfying the reserve requirement. – It can borrow excess reserves overnight from another bank and pay interest: the federal funds rate. – It can borrow reserves overnight from the Fed and pay interest: the discount rate. 14-09 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Discount Rate II • If the discount rate is raised, borrowing reserves from the Fed becomes more expensive. – Fewer reserves are borrowed. – Fewer loans are made, decreasing the money supply. • If the discount rate is lowered, borrowing reserves from the Fed becomes less expensive. – More reserves are borrowed. – More loans are made, increasing the money supply. 14-10 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Portfolio Decision • Portfolio decision: the choice of how and where to hold idle funds: cash, savings account, or interest-generating bonds. • Should you keep your idle funds in a savings account or purchase government bonds? • The Fed influences this decision by making bonds more or less attractive. 14-11 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Open Market Operations • This is the principal mechanism to directly alter the reserves of the banking system. • When the Fed buys government bonds from the public, reserves increase, more loans can be made, and the money supply grows. • When the Fed sells government bonds to the public, reserves decrease, fewer loans can be made, and the money supply shrinks. 14-12 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Bond Market • A bond is a certificate acknowledging a debt and the amount of interest to be paid each year until repayment, an IOU. • People buy bonds because they pay interest and are a safe investment. • Yield: the rate of return on a bond. Annual interest payment Yield = Price paid for the bond 14-13 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Bond Market II • Pay $1,000 for a bond that pays out $80 a year, and its yield is 0.08 or 8%. • If its price fell to $900 in the bond market, its yield would increase to 0.089 or 8.9%. • The objective of open market operations is to alter the price of bonds, raising or lowering their yields, to make them more or less attractive as investments. • Lower prices = higher yields. • Higher prices = lower yields. 14-14 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Open Market Activity • The Fed can induce people to buy bonds from them by offering to sell them at a lower price. – The public pays for the bonds and bank reserves fall. – Fewer loans can be made. – The money supply decreases. 14-15 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Open Market Activity II • The Fed can induce people to sell bonds to them by offering to buy them at a higher price. – The Fed pays the public for the bonds and bank reserves rise. – More loans can be made. – The money supply increases (or its growth slows). 14-16 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Quantitative Easing (QE) • From 2009-2011 the Fed bought longterm bonds and mortgage-backed securities. – This injected more reserves into the system. – This increased confidence in the banking system. – This kept interest rates historically low. 14-17 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Fed Funds Rate • The Fed funds rate: The interest rate one bank charges another for an overnight loan of excess reserves. – If the Fed increases reserves by buying bonds, the Fed funds rate falls. – If the Fed decreases reserves by selling bonds, the Fed funds rate rises. • The Fed funds rate is a highly visible signal of Federal Reserve open market operations. 14-18 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Increasing the Money Supply • To increase the money supply, the Fed can: – Lower reserve requirements. – Reduce the discount rate. – Buy bonds in open market operations. 14-19 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Decreasing the Money Supply • To decrease the money supply, the Fed can – Raise reserve requirements. – Increase the discount rate. – Sell bonds in open market operations. 14-20 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Application: The Economy Tomorrow • Banks act as an intermediary, moving money from savers (depositors) to spenders (borrowers). • Entrepreneurs are now finding funding outside of the banks, through peer-to-peer lending or crowdfunding. Over $40 billion in funding in 2016. • Crowdfunding: The financing of a project through individual contributions from a large number of people, typically via an internet platform. 14-21 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives • LO14-1 Describe how the Federal Reserve is organized. – There are 12 regional Federal Reserve banks. – The Board of Governors sets general policy. – The chairman is the spokesperson for monetary policy. – The Federal Open Market Committee (FOMC) implements policy strategy. 14-22 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives II • LO14-2 Identify the Fed’s major policy tools. – The Fed controls the size and growth of the money supply by regulating loan activity of private banks. – The three tools are • Altering the reserve requirement. • Altering discount rates. • Buying or selling government bonds in open market operations. 14-23 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Revisiting the Learning Objectives III • LO14-3 Explain how open market operations work. – When the Fed buys bonds, it pays the seller, and bank reserves increase. More loans can be made, and the money supply grows. – When the Fed sells bonds, the buyer pays the Fed, and bank reserves decrease. Fewer loans can be made, and the money supply shrinks (or grows slower). 14-24 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Looking Ahead: Chapter 15 Monetary Policy After learning about this chapter, you should know; • How interest rates are set in a money market. • How monetary policy affects macro outcomes. • The constraints on monetary policy impact. • The difference between Keynesian and monetarist monetary theories. 14-25 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Monetary Policy LEARNING OBJECTIVES After learning about this chapter, you should know LO15-1 LO15-2 LO15-3 LO15-4 1 5 CHAPTER How interest rates are set in the money market. How monetary policy affects macro outcomes. The constraints on monetary policy impact. The differences between Keynesian and monetarist monetary theories. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Monetary Policy • Control over the money supply is a critical policy tool for altering macroeconomic outcomes. – The quantity of money in circulation influences its value in the marketplace. – Interest rates and access to credit are basic determinants of spending behavior. 15-02 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Monetary Policy II • In this chapter we explore the effectiveness of monetary policy. Specifically, – What’s the relationship between money supply, interest rates, and aggregate demand? – How can the Fed use its control of the money supply or interest rates to alter macro outcomes? – How effective is monetary policy, compared to fiscal policy? 15-03 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Market • Money is a commodity that is traded in a marketplace, the money market. – The money supply is controlled by the Fed and society has demand for money. – The market determines the “price” of money, the interest rate. • At high interest rates, money is expensive to acquire. • At low interest rates, money is cheap to acquire. 15-04 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Market II • Money supply (M1): currency held by the public, plus balances in transactions accounts. • Money supply (M2): M1 plus balances in savings accounts and money market mutual funds. • Money demand: quantities of money the public wants to hold at alternative interest rates. 15-05 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Money Market III • Money demand: If people hold cash as M1, they suffer an opportunity cost: the forgone interest they could have earned. • At low interest rates, the opportunity cost of holding money is low, so people will hold more of it, and vice versa. 15-06 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Demand for Money • Why would people want to hold money, that is, have a demand for money? 1. Transactions demand: Money held for the purpose of making everyday market purchases. 2. Precautionary demand: Money held for unexpected market transactions or for emergencies. 3. Speculative demand: Money held for speculative purposes, for later financial opportunities. 15-07 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money Market Equilibrium Money demand: the quantity of money people are willing and able to hold (demand) increases as interest rates fall, and vice versa. Money supply: since the Fed controls the money supply, it is represented by a vertical line. 15-08 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money Market Equilibrium II • The intersection of money demand and money supply (E1) establishes the equilibrium rate of interest. 15-09 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money Market Equilibrium III If interest rates are higher than equilibrium, there is a money surplus. • People must hold more money as M1 than they want to. • They will move money out of M1 into M2 or other assets (such as bonds). • The interest rate will then fall to E1. 15-10 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money Market Equilibrium IV If interest rates are lower than equilibrium, there is a money shortage. • People must hold less money as M1 than they want to. • They will move money into M1 from M2 or other assets (such as bonds). • The interest rate will then rise to E1. 5 15-11 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Changing Interest Rates • The Fed controls the money supply. • The Fed can use its policy tools to change the equilibrium rate of interest. – By increasing the money supply (causing a surplus), the Fed tends to lower the equilibrium rate of interest. – By decreasing the money supply (causing a shortage), the Fed tends to raise the equilibrium rate of interest. 15-12 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Interest Rates and Spending • Lowering interest rates: a tactic of monetary stimulus, to increase aggregate demand (AD). – Reduce the cost of investment spending. – Reduce the cost of holding inventory. – The investment spending increase will kick off a positive multiplier effect. AD will shift right because of this. 15-13 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Interest Rates and Spending II • Raising interest rates: a tactic of monetary restraint, to decrease aggregate demand (AD). – Increase the cost of investment spending. – Increase the cost of holding inventory. – The investment spending decrease will kick off a negative multiplier effect. AD will shift left because of this. 15-14 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Summary • Goal 1: to stimulate the economy. – An increase in the money supply leads to, – Lower interest rates, which lead to, – An increase in aggregate demand. • Goal 2: to restrain the economy. – A decrease in the money supply leads to, – Higher interest rates, which lead to. – An decrease in aggregate demand. 15-15 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Stimulus • Short- vs. long-term rates. • The Fed has greater influence on short-term rates (that is, the Fed funds rate) than longterm rates (mortgages and installment loans). • Monetary stimulus will be most effective if long-term interest rate changes mirror shortterm rate changes. – If not, the AD increase will be less than hoped for. 15-16 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Stimulus II • Reluctant lenders. – Banks must be willing to increase lending activity. – Banks may pile up excess reserves instead of making loans (this happened 2008-2014). – They worry about their financial well-being. – They worry about not being paid back by weak borrowers. – They worry about how new bank regulations may affect profitability. 15-17 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Stimulus III • Lowering interest rates too far eliminates the opportunity cost of holding M1. The public simply hold the money instead of investing. • This is the liquidity trap: The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some low interest rate. 15-18 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Stimulus IV • Low expectations: – In a recession, firms have little incentive to expand production capability (evident in 2008-2014). – There would be little expectation of future profit, or return on investment (ROI), from new investment. – Consumers may be reluctant to take on added debt when future income prospects are uncertain. 15-19 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Stimulus V • Time lags: – It takes time to develop and implement new investments in response to lower interest rates. – Consumers also may take time to decide to increase their borrowing. – It may take 6 to 12 months before market behavior responds to monetary policy. 15-20 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Policy Constraints: On Monetary Restraint • High expectations: – In a growing economy consumers and businesses may believe that future income and revenue will be sufficient to cover higher interest rates. • Global Money: – Market participants can look outside of US money market for loanable funds in foreign subsidiaries, banks and bond markets. 15-21 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Monetarist Perspective • Keynesians say that changes in the money supply changes in interest rates, which shift AD. • Monetarists say that real output levels are not affected by monetary policy. Only the price level is affected by Fed policy … and then only by changes in the money supply. • So they say monetary policy is not effective for fighting recession, but is a powerful tool for managing inflation. 15-22 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Equation of Exchange • The equation of exchange is: MV = PQ • In this equation, total spending is price level (P) times quantity of output (Q). This spending is financed by the money supply (M) times the velocity of its circulation (V). • Velocity (V): the number of times per year, on average, that a dollar is used to purchase final goods and services. 15-23 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Equation of Exchange II MV = PQ • PQ is the same as nominal GDP. • The quantity of money (M) in circulation and the velocity (V) with which it exchanges hands will always be equal to the value of nominal GDP. • Monetarist view: If M increases, P and/or Q must rise, or V must fall. 15-24 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. The Equation of Exchange III MV = PQ • Monetarists assume V is stable – that is, does not change. • V is a function of how people handle their money and the institutions they use to do so. Neither should change much in the short run. • Thus, total spending (PQ) must rise if money supply (M) grows and velocity (V) is stable, regardless of interest rates. 15-25 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Money Supply Focus • If spending increases when the money supply grows, then the Fed should focus on the money supply, not interest rates. – Fed policy should not be to manipulate interest rates. – Fed policy should focus on the size and growth of the money supply. 15-26 Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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