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+ G, p. 192 Government budget deficit K G - T, p. 192 Equilibrium in an economy with a government: Y K C + I + G, p. 193 Saving/investment approach to equilibrium in an economy with a government: S + T = I + G, p. 194 Government spending multiplier 1 1 - MPC 1 MPS, p. 196 K K Tax multiplier K - MPC MPS, p. 199 Balanced-budget multiplier K 1, p. 199 All problems are available on MyLab Economics. 9.1 GOVERNMENT IN THE ECONOMY Billion Bongos LEARNING OBJECTIVE: Discuss the influence of fiscal policies on the economy. 1.1 Define saving and investment. Data for the simple economy of Newt show that in 2018, saving exceeded investment and the government is running a balanced budget. What is likely to happen? What would happen if the government were running a deficit and saving were equal to investment? 1.2 Expert economists in the economy of Bongo estimate the following: Real output/income Government purchases Total net taxes Investment spending (planned) 1,200 300 300 200 Assume that Bongoliers consume 80 percent of their disposable incomes and save 20 percent. a. You are asked by the business editor of the Bongo Tribune to predict the events of the next few months. By using the data given, make a forecast. (Assume that investment is constant.) b. If no changes were made, at what level of GDP (Y) would the economy of Bongo settle? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 208 17/04/19 4:16 AM c. Some local conservatives blame Bongo’s problems on the size of the government sector. They suggest cutting government purchases by 25 billion Bongos. What effect would such cuts have on the economy? (Be specific.) 1.3 Assume that in 2019, the following prevails in the Republic of Nurd: Y = +200 C = +160 S = +40 I planned = +30 G = +0 T = +0 1 2 Assume that households consume 80 percent of their income, they save 20 percent of their income, MPC = 0.8, and MPS = 0
.2. That is, C = 0.8Yd and S = 0.2Yd. a. Is the economy of Nurd in equilibrium? What is Nurd’s equilibrium level of income? What is likely to happen in the coming months if the government takes no action? b. If +200 is the “full-employment” level of Y, what fiscal policy might the government follow if its goal is full employment? c. If the full-employment level of Y is +250, what fiscal policy might the government follow? d. Suppose Y = +200, C = +160, S = +40, and I = +40. Is Nurd’s economy in equilibrium? e. Starting with the situation in part d, suppose the government starts spending $30 each year with no taxation and continues to spend $30 every period. If I remains CHAPTER 9 The Government and Fiscal Policy 209 constant, what will happen to the equilibrium level of Nurd’s domestic product (Y)? What will the new levels of C and S be? f. Starting with the situation in part d, suppose the government starts taxing the population $30 each year without spending anything and continues to tax at that rate every period. If I remains constant, what will happen to the equilibrium level of Nurd’s domestic product (Y)? What will be the new levels of C and S? How does your answer to part f differ from your answer to part e? Why? 1.4 There has been considerable debate on the impact of high public debt on economic growth. The authors of This Time Is Different, economists Carmen Reinhart and Ken Rogoff claim that there exists a “debt overhang”—a level of public debt beyond which economic growth is negatively affected by excessive government borrowing, though many other economists disagree. Using the OECD database, find the latest data on GDP growth and the level of public debt for Japan, the United States, and Germany. What do these numbers tell you about the “debt overhang” argument? 1.5 Evaluate the following statement: for an economy to be in equilibrium, planned investment spending plus government purchases must equal saving plus net taxes. 1.6 For the data in the following table, the consumption function is C = 800 + 0.6 in the table and identify the equilibrium output. Y - T. Fill in the columns 1 2 Output Net Taxes Disposable Income Consumption Spending Saving Planned Investment Spending Government
Purchases Planned Aggregate Expenditure Unplanned Inventory Change 2,100 2,600 3,100 3,600 4,100 4,600 5,100 100 100 100 100 100 100 100 300 300 300 300 300 300 300 400 400 400 400 400 400 400 1.7 For each of the following sets of data, determine if output will need to increase, decrease, or remain the same to move the economy to equilibrium: a. Y = 1,000; C = 150 + 0.5 ; I = 100; G = 200; Y - T T = 180 b. Y = 1,250; C = 200 + 0.7 T = 240 c. Y = 1,500; C = 400 + 0. = 80; G = 250; ; I = 250; G = 200; T = 150 1 d. Y = 1,500; C = 300 + 0.75 2 Y - T ; I = 200; G = 200; T = 150 1 2 9.2 FISCAL POLICY AT WORK: MULTIPLIER EFFECTS LEARNING OBJECTIVE: Describe the effects of three fiscal policy multipliers. 2.1 Use your answer to Problem 1.6 to calculate the MPC, MPS, government spending multiplier, and tax multiplier. Draw a graph showing the data for consumption spending, planned aggregate expenditures, and aggregate output. Be sure to identify the equilibrium point on your graph. 2.2 Suppose that in your country the marginal propensity to save equals 15 percent of disposable income. When income is null, consumption is C = 150. Further assume fixed government expenditure of G = 100, fixed taxes of T = 80, and investment of I = 50. Calculate the equilibrium level of GDP. Solve for a change in GDP following an increase in expenditure of 20 percent, financed by an increase in taxes by the same amount. What does it tell you about the impact of expenditure that is fully financed by taxation? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 209 17/04/19 4:16 AM 210 PART III The Core of Macroeconomic Theory 2.3 A $1 increase in government spending will raise equilibrium income more than a $1 tax cut will, yet both have the same impact on the budget
deficit. So if we care about the budget deficit, the best way to stimulate the economy is through increases in spending, not cuts in taxes. Comment. 2.4 Complete the following: a. If the tax multiplier is -1, then the marginal propensity to save is _________ the marginal propensity to consume. b. If the government spending multiplier is 8, then the marginal propensity to save equals ______. c. If the marginal propensity to consume is two times the marginal propensity to save, then the government spending multiplier equals _______. d. If the marginal propensity to save is 0.5, then the tax mul- tiplier equals _______. e. If the marginal propensity to save increases by 10 percent, then the government spending multiplier ________. f. If the marginal propensity to consume goes from 0.8 to 0.85, then the tax multiplier _________. g. If the tax multiplier increases (in absolute value) from -1 to -2, this means that the marginal propensity to consume has ______ relative to the marginal propensity to save. h. If the government spending multiplier decreases from 5 to 4, this means that the marginal propensity to save has _______. 2.5 What is the balanced-budget multiplier? Explain why the balanced-budget multiplier is equal to one. 9.3 THE FEDERAL BUDGET LEARNING OBJECTIVE: Compare and contrast the federal budgets of three U.S. government administrations. 3.1 You are appointed secretary of the treasury of Redana, a newly independent country. Its currency is the oban. The new nation began fiscal operations this year, and as of now has no debt. The king wishes to build up an army in case they have to go to war and wishes to spend on the military. The treasury will spend 500,000 obans and taxes will be 400,000 obans. The 100,000-oban difference will be borrowed from the public by selling 50,000 obans’ worth of 1-year bonds paying 2 percent interest. Similarly, the other 50,000 obans will be raised by selling 5-year bonds paying 6 percent interest. The king believes that using the army one year from now will increase taxes by 100,000 obans, balancing the budget. Assuming zero inflation, what will the size of the budget be after five years? 3.2 [Related to the Economics in Practice on p. 204] Excessive and cumulative public deficits might lead to an increase in the debt-
to-GDP ratio, often used to measure the “weight” of public debt on the economy. In 2014, the average debt-to-GDP ratio for OECD countries was 94 percent. Apart from the argument put forward by some economists (refer to Problem 1.4) that excessive public debt levels are detrimental to economic growth, many governments are interested in reducing government debt because they pay interest on their debt and these payments are often an important item in government budgets. Assume that country A has GDP of $500 billion, total government debt of $450 billion, marginal propensity to save of 0.2, and government expenditure of $200, while tax receipts amount to $180. The government has just announced spending cuts of $20 billion next year with no change in taxation. Would a balanced budget and a debt-to-GDP ratio below the OECD average suffice? Why? 9.4 THE ECONOMY’S INFLUENCE ON THE GOVERNMENT BUDGET LEARNING OBJECTIVE: Explain the influence of the economy on the federal government budget. 4.1 Suppose all tax collections are fixed (instead of depen- dent on income) and all spending and transfer programs are fixed (in the sense that they do not depend on the state of the economy, as, for example, unemployment benefits now do). In this case, would there be any automatic stabilizers in the government budget? Would there be any distinction between the full-employment deficit and the actual budget deficit? Explain QUESTION 1 Households in the lowest quintile of the U.S. income distribution have larger marginal propensities to consume than households in the highest quintile. If the government wishes to reduce taxes to stimulate economic output during a recession, which households should it target tax cuts toward? QUESTION 2 An equal-sized increase in government spending and taxes may be considered expansionary or contractionary fiscal policy. What information would you need in order to make this distinction? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 210 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 211 CHAPTER 9 APPENDIX A Deriving the Fiscal Policy Multipliers The Government Spending and Tax Multipliers MyLab Economics Concept Check In
the chapter, we noted that the government spending multiplier is 1/MPS. (This is the same as the investment multiplier.) We can also derive the multiplier algebraically using our hypothetical consumption function: C = a + b Y - T LEARNING OBJECTIVE Show that the government spending multiplier is one divided by one minus the MPC. where b is the marginal propensity to consume. As you know, the equilibrium condition is 1 2 By substituting for C, we get (Y - T) + I + G Y = a + bY - bT + I + G This equation can be rearranged to yield Y - bY = a + I + G - bT Y(1 - b) = a + I + G - bT Now solve for Y by dividing through by (1 − b): Y = 1 (1 - b) (a + I + G - bT) We see from this last equation that if G increases by one with the other determinants of (1 - b). The multiplier is, as before, simply (1 - b), where b is the marginal propensity to consume. Of course, (1 - b) equals the marginal Y (a, I, and T) remaining constant, Y increases by 1 1 propensity to save, so the government spending multiplier is 1/MPS. > We can also derive the tax multiplier. The last equation says that when T increases by $1, dollars. The tax multiplier is MPS. (Remember, the negative sign in the holding a, I, and G constant, income decreases by b -b resulting tax multiplier shows that it is a negative multiplier.) (1 - b), or -MPC (1 - MPC = -MPC 1 - b > 1 2 > 2 > > > The Balanced-Budget Multiplier MyLab Economics Concept Check It is easy to show formally that the balanced-budget multiplier equals one. When taxes and government spending are simultaneously increased by the same amount, there are two effects on planned aggregate expenditure: one positive and one negative. The initial impact of a balancedbudget increase in government spending and taxes on aggregate expenditure would be the increase in government purchases (ΔG) minus the decrease in consumption (ΔC) caused by the tax increase. The decrease in consumption brought about by the tax increase is equal to ∆C = ∆T MPC. initial increase in spending : - initial decrease in spending : = net initial increase in spending ∆G
∆C = ∆T(MPC ) ∆G - ∆T(MPC ) 1 2 In a balanced-budget increase, ∆G = ∆T; so in the above equation for the net initial increase in spending we can substitute ΔG for ΔT. ∆G - ∆G(MPC) = ∆G(1 - MPC) MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 211 17/04/19 4:16 AM 212 PART III The Core of Macroeconomic Theory Because MPS = (1 - MPC), the net initial increase in spending is: ∆G(MPS) We can now apply the expenditure multiplier 1 MPS to this net initial increase in spending: a ∆Y = ∆G(MPS) b 1 MPS = ∆G Thus, the final total increase in the equilibrium level of Y is just equal to the initial balanced increase in G and T. That means the balanced-budget multiplier equals one, so the final increase in real output is of the same magnitude as the initial change in spending. a b LEARNING OBJECTIVE Explain why the multiplier falls when taxes depend on income. ▸▸ FIGURE 9B.1 The Tax Function This graph shows net taxes (taxes minus transfer payments) as a function of aggregate income. CHAPTER 9 APPENDIX B The Case in Which Tax Revenues Depend on Income MyLab Economics Concept Check In this chapter, we used the simplifying assumption that the government collects taxes in a lump sum. This made our discussion of the multiplier effects somewhat easier to follow. Now suppose that the government collects taxes not solely as a lump sum that is paid regardless of income, but also partly in the form of a proportional levy against income. This is a more realistic assumption. Typically, tax collections either are based on income (as with the personal income tax) or follow the ups and downs in the economy (as with sales taxes). Instead of setting taxes equal to some fixed amount, let us say that tax revenues depend on income. If we call the amount of net taxes collected T, we can write T = T0 + tY. This equation contains two parts. First, we note that net taxes (T)
will be equal to an amount T0 if income (Y) is zero. Second, the tax rate (t) indicates how much net taxes change as income changes. Suppose T0 is equal to –200 and t is 1/3. The resulting tax function is T = -200 + 1 3Y, which is graphed in Figure 9B.1. Note that when income is zero, the government collects “negative net taxes,” which simply means that it makes transfer payments of 200. As income rises, tax collections increase because every extra dollar of income generates $0.33 in extra revenues for the government. > Tax function T = T0 + tY = –200 + 1 3Y_ ) 200 +150 +100 +50 0 –50 –100 –150 –200 –250 MyLab Economics Concept Check Aggregate output (income), Y 100 200 300 400 500 600 700 800 900 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 212 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 213 How do we incorporate this new tax function into our discussion? All we do is replace the old value of T (in the example in the chapter, T was set equal to 100) with the new value, 3Y. Look first at the consumption equation. Consumption (C) still depends on dis-200 + 1 posable income, as it did before. Also, disposable income is still Y - T, or income minus taxes. Instead of disposable income equaling Y - 100, however, the new equation for disposable income is > Yd = Y - T Yd = Y - ( -200 + 1 3Y) Yd = Y + 200 - 1 3Y > Because consumption still depends on after-tax income, exactly as it did before, we have > C = 100 + 0.75Y d C = 100 + 0.75(Y + 200 - 1 3Y) Nothing else needs to be changed. We solve for equilibrium income exactly as before, by setting planned aggregate expenditure equal to aggregate output. Recall that planned aggregate expenditure is C + I + G and aggregate output is Y. If we assume, as before, that I = 100 and G = 100, the equilibrium is > Y = C +
I + G Y = 100 + 0.75(Y + 200 - 1 C > 3Y) + 100 + 100 G I y r r This equation may look difficult to solve, but it is not. It simplifies to Y = 100 + 0.75Y + 150 - 25Y + 100 + 100 Y = 450 + 0.5Y 0. 5Y = 450 This means that Y = 450 0.5 = 900, the new equilibrium level of income. Consider the graphic analysis of this equation as shown in Figure 9B.2, where you should note that when we make taxes a function of income (instead of a lump-sum amount), the AE function becomes flatter than it was before. Why? When tax collections do not depend on income, an increase in income of $1 means disposable income also increases by $1. Adding more income does not raise the amount of taxes paid because taxes are a constant amount. Disposable income therefore changes dollar for dollar with any change in income. > When taxes depend on income, a $1 increase in income does not increase disposable income by a $1 because some of the additional $1 goes to pay extra taxes. Under the modified tax function of Figure 9B.2, an extra $1 of income will increase disposable income by only $0.67 because $0.33 of the extra $1 goes to the government in the form of taxes. No matter how taxes are calculated, the marginal propensity to consume out of disposable (or after-tax) income is the same—each extra dollar of disposable income will increase consumption spending by $0.75. However, a $1 change in before-tax income does not have the same effect on disposable income in each case. Suppose we were to increase income by $1. With the lump-sum tax function, disposable income would rise by $1, and consumption would increase by the MPC times the change in Yd, or $0.75. When taxes depend on income, disposable income would rise by only $0.67 from the $1 increase in income and consumption would rise by only the MPC times the change in disposable income, or +0.75 * 0.67 = +0.50. If a $1 increase in income raises expenditure by $0.75 in one case and by only $0.50 in the other, the second aggregate expenditure function must be flatter than the first. MyLab Economics Visit www.pearson.com/mylab/
economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 213 17/04/19 4:16 AM 214 PART III The Core of Macroeconomic Theory ▸▸ FIGURE 9B.2 Different Tax Systems When taxes are strictly lump-sum T = 100 and do not depend on income, the aggregate expenditure 1 function is steeper than when taxes depend on income AE1 AE2 1,300 1,100 900 700 500 300 100 AE as a function 1 _ of Y when T = –200 + 3Y: AE2 = 450 + 0.5Y. AE as a function of Y when T = 100: AE1 = 225 + 0.75Y. 458 MyLab Economics Concept Check 0 100 500 300 Aggregate output (income), Y (billions of dollars) 1,100 900 700 1,300 The Government Spending and Tax Multipliers Algebraically All this means that if taxes are a function of income, the three multipliers (investment, government spending, and tax) are less than they would be if taxes were a lump-sum amount. By using the same linear consumption function we used in Chapters 7 and 8, we can derive the multiplier - T0 - tY + bY - bT0 - btY 2 1 We know that Y = C + I + G. Through substitution we get Solving for Y: Y = a + bY - bT0 - btY + I + G ¯˚˘˚˙ C Y = 1 1 - b + bt a + I + G - bT0 1 This means that a $1 increase in G or I (holding a and T0 constant) will increase the equilibrium level of Y by 2 1 1 - b + bt If b = MPC = 0.75 and t = 0.20, the spending multiplier is 2.5. (Compare this to 4, which would be the value of the spending multiplier if taxes were a lump sum, that is, if t = 0.) Holding a, I, and G constant, a fixed or lump-sum tax cut (a cut in T0) will increase the equi- librium level of income by b 1 - b + bt Thus, if b = MPC = 0.75 and t = 0.20, the tax multiplier
is -1.875. (Compare this to -3, which would be the value of the tax multiplier if taxes were a lump sum.) MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 214 17/04/19 4:16 AM CHAPTER 9 The Government and Fiscal Policy 215 1. When taxes depend on income, a $1 increase in income does not increase disposable income by $1 because some of the additional $1 must go to pay extra taxes. This means that if taxes are a function of income, the three multipliers ( investment, government spending, and tax) are less than they would be if taxes were a lump-sum amount All problems are available on MyLab Economics. APPENDIX B: THE CASE IN WHICH TAX REVENUES DEPEND ON INCOME LEARNING OBJECTIVE: Explain why the multiplier falls when taxes depend on income. 1A.1 Assume the following for the economy of a country: a. Consumption function: C = 50 + 0.85Yd b. Investment: I = 80 c. Government spending: G = 50 d. Disposable income: Yd = Y - T e. Net taxes: T = - 10 + 0.1Y f. Equilibrium: Y = C + I + G Solve for equilibrium income. (Hint: Be very careful in doing the calculations. They are not difficult, but it is easy to make careless mistakes that produce wrong results.) What happens to the economy when the marginal propensity to save increases to 0.2? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M09_CASE3826_13_GE_C09.indd 215 17/04/19 4:16 AM Money, the Federal Reserve, and the Interest Rate In the last two chapters, we explored how consumers, firms, and the government interact in the goods market. In this chapter, we show how the money market works in the macroeconomy. We begin by defining money and describing its role in the U.S. economy. Microeconomics has little to say about money. Microeconomic theories and
models are concerned primarily with real quantities (apples, oranges, hours of labor) and relative prices (the price of apples relative to the price of oranges or the price of labor relative to the prices of other goods). By contrast, as we will now see, money is an important part of the macroeconomy. 10 CHAPTER OUTLINE AND LEARNING OBJECTIVES 10.1 An Overview of Money p. 217 Define money and discuss its functions. 10.2 How Banks Create Money p. 221 Explain how banks create money. 10.3 The Federal Reserve System p. 227 Describe the functions and structure of the Federal Reserve System. 10.4 The Demand for Money p. 229 Describe the determinants of money demand. 10.5 Interest Rates and Security Prices p. 230 Define interest and discuss the relationship between interest rates and security prices. 10.6 How the Federal Reserve Controls the Interest Rate p. 232 Understand how the Fed can change the interest rate. Looking Ahead p. 236 Appendix: The Various Interest Rates in the U.S. Economy p. 240 Explain the relationship between a two-year interest rate and a one-year interest rate. 216216 M10_CASE3826_13_GE_C10.indd 216 17/04/19 12:23 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 217 An Overview of Money You often hear people say things like, “She makes a lot of money” (in other words, “She has a high income”) or “She’s worth a lot of money” (meaning “She is very wealthy”). It is true that your employer uses money to pay you your income, and your wealth may be accumulated in the form of money. However, “money” is defined differently in macroeconomics. 10.1 LEARNING OBJECTIVE Define money and discuss its functions. What Is Money? MyLab Economics Concept Check Most people take the ability to obtain and use money for granted. When the whole monetary system works well, as it generally does in the United States, the basic mechanics of the system are virtually invisible. People take for granted that they can walk into any store, restaurant, boutique, or gas station and buy whatever they want as long as they have enough green pieces of paper, a debit card with a large enough balance in their checking account, or a smartphone with a mobile wallet app. The idea that
you can buy things with money is so natural and obvious that it seems absurd to mention it, but stop and ask yourself: “How is it that a store owner is willing to part with a steak and a loaf of bread that I can eat in exchange for access to some pieces of paper that are intrinsically worthless?” Why, on the other hand, are there times and places where it takes a shopping cart full of money to purchase a dozen eggs? The answers to these questions lie in what money is—a means of payment, a store of value, and a unit of account. A Means of Payment, or Medium of Exchange Money is vital to the working of a market economy. Imagine what life would be like without it. The alternative to a monetary economy is barter, people exchanging goods and services for other goods and services directly instead of exchanging via the medium of money. How does a barter system work? Suppose you want bacon, eggs, and orange juice for breakfast. Instead of going to the store and buying these things with money, you would have to find someone who has the items and is willing to trade them. You would also have to have something the bacon seller, the orange juice purveyor, and the egg vendor want. Having pencils to trade will do you no good if the bacon, orange juice, and egg sellers do not want pencils. A barter system requires a double coincidence of wants for trade to take place. That is, to effect a trade, you have to find someone who has what you want and that person must also want what you have. Where the range of goods traded is small, as it is in relatively unsophisticated economies, it is not difficult to find someone to trade with and barter is often used. In a complex society with many goods, barter exchanges involve an intolerable amount of effort. Imagine trying to find people who offer for sale all the things you buy in a typical trip to the supermarket and who are willing to accept goods that you have to offer in exchange for their goods. Some agreed-to medium of exchange (or means of payment) neatly eliminates the double-coincidence-of-wants problem. Under a monetary system, money is exchanged for goods or services when people buy things; goods or services are exchanged for money when people sell things. No one ever has to trade goods for other goods directly. Money is a lubricant in the functioning of a market economy. A Store of Value Economists have identified other roles for
money aside from its primary function as a medium of exchange. Money also serves as a store of value—an asset that can be used to transport purchasing power from one time period to another. If you raise chickens and at the end of the month sell them for more than you want to spend and consume immediately, you may keep some of your earnings in the form of money until the time you want to spend it. There are many other stores of value besides money. You could have decided to hold your “surplus” earnings by buying such things as antique paintings, or diamonds, which you could sell later when you want to spend your earnings. Money has several advantages over these other stores of value. First, it comes in convenient denominations and is easily portable. Debit cards and phones that provide access to the money in your checking account make money even more convenient. You do not have to worry about making change for a Renoir painting to buy a gallon barter The direct exchange of goods and services for other goods and services. medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services. store of value An asset that can be used to transport purchasing power from one time period to another. M10_CASE3826_13_GE_C10.indd 217 17/04/19 12:23 AM 218 PART III The Core of Macroeconomic Theory Don’t Kill the Birds! In most countries commodity monies were abandoned many years ago. At one point, sea shells and other artifacts from nature were commonly used. One of the more interesting examples of a commodity money is described by David Houston, an ethno-ornithologist.1 In the nineteenth century, elaborate rolls of red feathers harvested from the Scarlet Honeyeater bird were used as currency between the island of Santa Cruz and nearby Pacific Islands. Feathers were made into rolls of more than 10 meters in length and were never worn, displayed, or used. Their sole role was to serve as currency in a complex valuation system. Houston tells us that more than 20,000 of these birds were killed each year to create this “money,” adding considerably to bird mortality. Running the printing presses is much easier. Today, one of the few remaining uses of commodity monies is the use of dolphin teeth in the Solomon Islands. Apparently there is even a problem with counterfeiting as people try to pass off fruit bat teeth as dolphin teeth!2 CRITICAL THINKING 1. Why
do red feather rolls and dolphin teeth make good commodity monies, whereas coconut shells would not? 1David Houston, “The Impact of the Red Feather Currency on the Population of the Scarlet Honeyeater on Santa Cruz,” in Sonia Tidemann and Andrew Gosler, eds., Ethno-Ornithology: Birds, Indigenous Peoples, Culture and Society (London, Earthscan Publishers, 2010), pp. 55–66. 2The Wall Street Journal, excerpted from “Shrinking Dollar Meets Its Match in Dolphin Teeth” by Yaroslav Trofimov. Copyright 2008 by Dow Jones & Company, Inc. Reproduced with permission of Dow Jones & Company, Inc. via Copyright Clearance Center. liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: it is portable and readily accepted and thus easily exchanged for goods. of gasoline. Second, because money is also a means of payment, it is easily exchanged for goods at all times. These two factors compose the liquidity property of money. Money is easily spent, flowing out of your hands like liquid. The main disadvantage of money as a store of value is that the value of money falls when the prices of goods and services rise. If the price of potato chips rises from $1 per bag to $2 per bag, the value of a dollar bill in terms of potato chips falls from one bag to half a bag. When this happens, it may be better to use potato chips (or antiques or real estate) as a store of value. Indeed, there have been times of rising prices when people hoard goods rather than storing money to support their future needs. unit of account A standard unit that provides a consistent way of quoting prices. A Unit of Account Money also serves as a unit of account —a consistent way of quoting prices. All prices are quoted in monetary units. A textbook is quoted as costing $150, not 150 bananas or five pizzas. Obviously, a standard unit of account is extremely useful when quoting prices. This function of money may have escaped your notice—what else would people quote prices in except money? Commodity and Fiat Monies MyLab Economics Concept Check Introductory economics textbooks are full of stories about the various items that have been used as money by various cultures—candy bars, cigarettes (in World War II prisoner-of-war camps), huge wheels of carved stone (on the island of Yap in the South Pacific),
beads (among North American Indians), cattle (in southern Africa), and small green scraps of paper (in contemporary North America). The Economics in Practice box on the preceding page describes the use of bird M10_CASE3826_13_GE_C10.indd 218 17/04/19 12:23 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 219 Items commodity monies used as money that also have intrinsic value in some other use. Items fiat, or token, money designated as money that are intrinsically worthless. legal tender Money that a government has required to be accepted in settlement of debts. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly. feathers as money. These various kinds of money are generally divided into two groups, commodity monies and fiat money. Commodity monies are those items used as money that also have an intrinsic value in some other use. For example, prisoners of war made purchases with cigarettes, quoted prices in terms of cigarettes, and held their wealth in the form of accumulated cigarettes. Of course, cigarettes could also be smoked—they had an alternative use apart from serving as money. In fact, one of the problems with commodity monies, like cigarettes, is that their value may change when demand for them as items of use falls. If no one in prison smoked, the value of the cigarettes would likely fall, perhaps even to zero. Gold represents another form of commodity money. For hundreds of years gold could be used directly to buy things, but it also had other uses, ranging from jewelry to dental fillings. By contrast, money in the United States today is mostly fiat money. Fiat money, sometimes called token money, is money that is intrinsically worthless. The actual value of a $1, $10, or $50 bill is basically zero; what other uses are there for a small piece of paper with some green ink on it? Why would anyone accept worthless scraps of paper as money instead of something that has some value, such as gold, cigarettes, or cattle? If your answer is “because the paper money is backed by gold or silver,” you are wrong. There was a time when dollar bills were convertible directly into gold. The government backed each dollar bill in circulation by holding a certain amount of gold in its vaults. If the price of gold were $35 per ounce, for example, the government agreed to sell one ounce of gold for 35 dollar bills. However, dollar bills
are no longer backed by any commodity— gold, silver, or anything else. They are exchangeable only for dimes, nickels, pennies, other dollars, and so on. The good news here is that the value of this money does not depend on the value of money in another use, as in the case of cigarettes. The harder question is why it has any value at all! The public accepts paper money as a means of payment and a store of value because the government has taken steps to ensure that its money is accepted. The government declares its paper money to be legal tender. That is, the government declares that its money must be accepted in settlement of debts. It does this by fiat (hence fiat money). It passes laws defining certain pieces of paper printed in certain inks on certain plates to be legal tender, and that is that. Printed on every Federal Reserve note in the United States is, “This note is legal tender for all debts, public and private.” Often the government can get a start on gaining acceptance for its paper money by requiring that it be used to pay taxes. Aside from declaring its currency legal tender, the government usually does one other thing to ensure that paper money will be accepted: It promises the public that it will not print paper money so fast that it loses its value. Expanding the supply of currency so rapidly that it loses much of its value has been a problem throughout history and is known as currency debasement. Debasement of the currency has been a special problem of governments that lack the strength to take the politically unpopular step of raising taxes. Printing money to be used on government expenditures of goods and services can serve as a substitute for tax increases, and weak governments have often relied on the printing press to finance their expenditures. An interesting example is Zimbabwe. In 2007, faced with a need to improve the public water system, Zimbabwe’s president, Robert Mugabe, said, “Where money for projects cannot be found, we will print it” (reported in the Washington Post, July 29, 2007). In later chapters we will see the way in which this strategy for funding public projects can lead to serious inflation. It is interesting to ask whether cryptocurrencies like Bitcoin are in fact currency, satisfying the three functions of a currency that we listed. Bitcoins were designed to be a currency, one which could be used anonymously in transactions, which has advantages in some situations. Bitcoin supply was also deliberately limited to avoid the currency debasement problem we described
above. The U.S Treasury refers to cryptocurrencies as virtual currency, while the U.S. Internal Revenue Service calls them assets. In terms of the criteria we have listed, while bitcoins are used as a method of exchange and qualify as currency on that dimension, the value volatility of Bitcoin makes its function as a store of value or a unit of account less clear. Measuring the Supply of Money in the United States MyLab Economics Concept Check We now turn to the various kinds of money in the United States. Recall that money is used to buy things (a means of payment), to hold wealth (a store of value), and to quote prices (a unit of account). Unfortunately, these characteristics apply to a broad range of assets in the U.S. economy M10_CASE3826_13_GE_C10.indd 219 17/04/19 12:23 AM 220 PART III The Core of Macroeconomic Theory in addition to dollar bills. As we will see, it is not at all clear where we should draw the line and say, “Up to this is money, beyond this is something else.” To solve the problem of multiple monies, economists have given different names to different measures of money. The two most common measures of money are transactions money, also called M1, and broad money, also called M2. M1: Transactions Money What should be counted as money? Coins and dollar bills, as well as higher denominations of currency, must be counted as money—they fit all the requirements. What about checking accounts? Checks, too, can be used to buy things and can serve as a store of value. Debit cards provide even easier access to funds in checking accounts, as do smartphones linked to checking accounts. In fact, bankers call checking accounts demand deposits because depositors have the right to cash in (demand) their entire checking account balance at any time. That makes your checking account balance virtually equivalent to bills in your wallet, and it should be included as part of the amount of money you hold, as we have done thus far in our discussion. If we take the value of all currency (including coins) held outside of bank vaults and add to it the value of all demand deposits, traveler’s checks, and other checkable deposits, we have defined M1, or transactions money. As its name suggests, this is the money that can be directly used for transactions—to buy things. M1 K currency held outside banks + demand deposits +
traveler's checks + other checkable deposits M1 at the end of March 2018 was $3,664.3billion. M1 is a stock measure—it is measured at a point in time. It is the total amount of coins and currency outside of banks and the total dollar amount in checking accounts. M1, or transactions money Money that can be directly used for transactions. near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2: Broad Money Although M1 is the most widely used measure of the money supply, there are other measures as well. Although many savings accounts cannot be used for transactions directly, it is easy to convert them into cash or to transfer funds from them into a checking account. What about money market accounts (which allow only a few checks per month, but pay market-determined interest rates) and money market mutual funds (which sell shares and use the proceeds to purchase short-term securities)? These can be used to write checks and make purchases, although only over a certain amount. If we add near monies, close substitutes for transactions money, to M1, we get M2, called broad money because it includes not-quite-money monies such as savings accounts, money market accounts, and other near monies. M2 K M1 + Savings accounts + Money market accounts + Other near monies M2 at the end of March 2018 was $13,918.1 billion, considerably larger than the total M1 of $3,664.3 billion. The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable. For instance, when banks introduced new forms of interest-bearing checking accounts in the early 1980s, M1 shot up as people switched their funds from savings accounts to checking accounts. However, M2 remained fairly constant because the fall in savings account deposits and the rise in checking account balances were both part of M2, canceling each other out. Beyond M2 Because a wide variety of financial instruments bear some resemblance to money, some economists have advocated including almost all of them as part of the money supply. For example, credit cards are used extensively in exchange. Everyone who has a credit card has a credit limit—you can charge only a certain amount on your card before you have to pay it off. One of the very broad definitions of money
includes the amount of available credit on credit cards (your charge limit minus what you have charged but not paid) as part of the money supply. There are no rules for deciding what is and is not money. However, for our purposes, “money” will always refer to transactions money, or M1. For simplicity, we will say that M1 is the sum of two general categories: currency in circulation and deposits. Keep in mind, however, that M1 has four specific components: currency held outside banks, demand deposits, traveler’s checks, and other checkable deposits. M10_CASE3826_13_GE_C10.indd 220 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 221 How Banks Create Money So far we have described the general way that money works and the way the supply of money is measured in the United States, but how much money is available at a given time? Who supplies it, and how does it get supplied? We are now ready to analyze these questions in detail. In particular, we want to explore a process that many find mysterious: the way banks create money. 10.2 LEARNING OBJECTIVE Explain how banks create money. A Historical Perspective: Goldsmiths MyLab Economics Concept Check To begin to see how banks create money, consider the origins of the modern banking system. In the fifteenth and sixteenth centuries, citizens of many lands used gold as money, particularly for large transactions. Gold is both inconvenient to carry around and susceptible to theft. For these reasons people began to place their gold with goldsmiths for safekeeping. On receiving the gold, a goldsmith would issue a receipt to the depositor, charging him a small fee for looking after his gold. After a time, these receipts themselves, rather than the gold that they represented, began to be traded for goods. The receipts became a form of paper money, making it unnecessary to go to the goldsmith to withdraw gold for a transaction. The receipts of the de Medici’s, who were both art patrons and goldsmith-bankers in Italy in the Renaissance period, were reputedly accepted in wide areas of Europe as currency. At this point, all the receipts issued by goldsmiths were backed 100 percent by gold. If a goldsmith had 100 ounces of gold in his safe, he would issue receipts for 100 ounces of gold, and no more. Goldsmiths functioned as
warehouses where people stored gold for safekeeping. The goldsmiths found, however, that people did not come often to withdraw gold. Why should they, when paper receipts that could easily be converted to gold were “as good as gold”? (In fact, receipts were better than gold—more portable, safer from theft, and so on.) As a result, goldsmiths had a large stock of gold continuously on hand. Because they had what amounted to “extra” gold sitting around, goldsmiths gradually realized that they could lend out some of this gold without any fear of running out of gold. Why would they do this? Instead of just keeping their gold idly in their vaults, they could earn interest on loans. Something subtle, but dramatic, happened at this point. The goldsmiths changed from mere depositories for gold into banklike institutions that had the power to create money. This transformation occurred as soon as goldsmiths began making loans. Without adding any more real gold to the system, the goldsmiths increased the amount of money in circulation by creating additional claims to gold—that is, receipts that entitled the bearer to receive a certain number of ounces of gold on demand.1 Thus, there were more claims than there were ounces of gold. A detailed example may help to clarify what might look at first to you like a sleight of hand. Suppose you go to a goldsmith who is functioning only as a depository, or warehouse, and ask for a loan to buy a plot of land that costs 20 ounces of gold. Also suppose that the goldsmith has 100 ounces of gold on deposit in his safe and receipts for exactly 100 ounces of gold out to the various people who deposited the gold. If the goldsmith decides he is tired of being a mere goldsmith and wants to become a real bank, he will loan you some gold. You don’t want the gold itself, of course; rather, you want a slip of paper that represents 20 ounces of gold. The goldsmith in essence “creates” money for you by giving you a receipt for 20 ounces of gold (even though his entire supply of gold already belongs to various other people).2 When he does, there will be receipts for 120 ounces of gold in circulation instead of the 100 ounces worth of receipts before your loan and the supply of money will have increased. People think the creation of money is mysterious, far from it! The creation of money is simply an accounting procedure, among the
most mundane of human endeavors. You may suspect the whole process is fundamentally unsound or somehow dubious. After all, the banking system began when someone issued claims for gold that already belonged to someone else. Here you may be on slightly firmer ground. 1Remember, these receipts circulated as money, and people used them to make transactions without feeling the need to cash them in—that is, to exchange them for gold itself. 2In return for lending you the receipt for 20 ounces of gold, the goldsmith expects to get an IOU promising to repay the amount (in gold itself or with a receipt from another goldsmith) with interest after a certain period of time. M10_CASE3826_13_GE_C10.indd 221 17/04/19 12:24 AM 222 PART III The Core of Macroeconomic Theory Run on the Bank: George Bailey, Mary Poppins, Wyatt Earp Frank Capra’s 1946 classic film, It’s a Wonderful Life, stars Jimmy Stewart as George Bailey, the-salt-of-the earth head of a small town building and loan bank. At one point late in the movie, as a result of some devilry by a competitor, the soundness of Bailey’s bank comes to be questioned. The result? A classic run on the bank, shown in the movie by a mob trying to get their deposits back at the bank window. Stewart’s explanation to his depositors could be straight out of an economics textbook. “I don’t have your money here,” he tells them. “Your money is being used to build your neighbor’s new house.” Just like the goldsmiths of yore, George Bailey’s banks lent out their deposits, creating money. Bailey’s defense against the bank run was easier in a time when people knew their bankers. “What we need now,” Bailey assured us with Jimmy Stewart’s earnest acting, “is faith in each other.” In today’s market, faith in the government is the more typical defense against a bank run. Another cinematic look at bank runs, by the way, comes in Mary Poppins when Tommy, one of Poppins’ two young charges, loudly insists in the middle of the bank where his father works that he wants his tuppence back and the bank won’t give it to him. The result? Another bank
run, British style! Finally, there is Wyatt Earp, in this case a true story. Earp in 1909, near the end of his colorful life, was hired by a bank in Los Angeles. Rumors were out that the bank had loaned more money than it had gold in its vaults. Depositors, we assume not understanding that this is common, were storming the bank to get their money out. Earp was hired to calm things down. His response was different from George Bailey’s. He took empty money sacks from the bank, hired a wagon and driver, drove to a nearby iron works, and filled the sacks with iron slugs about the size of $20 gold pieces. He drove back to the bank, where police were holding back the mob. He announced that he had about a million dollars in the wagon and began unloading the bars into the bank. He told the police to tell the crowd that “any gent who thinks he can find a better Wyatt Earp and some of his buddies were members of the Dodge City Peace Commission in 1883. From left to right (top row): William H. Harris, Luke Short, William Bat Masterson, (bottom row): Charles E. Bassett, Wyatt Earp, Frank McLain, Jerry Hausman bank to put his money into to go and find it. But he’d better be damned careful he don’t get hit over the head and robbed while he’s doing it.” As the bars were being loaded into the bank, the crowd dispersed. CRITICAL THINKING 1. How do Earp’s remarks illustrate the advantages of paper money over gold? Casey Tefertiller, Wyatt Earp: The Life Behind the Legend, John Wiley & Sons, Inc., 1997. Goldsmiths-turned-bankers did face certain problems. Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had in their vaults at any given moment. If the owners of the 120 ounces worth of gold receipts all presented their receipts and demanded their gold at the same time, the goldsmith would be in trouble. With only 100 ounces of gold on hand, people could not get their gold at once. In normal times, people would be happy to hold receipts instead of real gold, and this problem would never arise. If, however, people began to worry about the goldsmith’s financial safety, they
might begin to have doubts about whether their receipts really were as good as gold. Knowing there were more receipts outstanding than there were ounces of gold in the goldsmith’s vault, they might start to demand gold for receipts. This situation leads to a paradox. It makes perfect sense for people to hold paper receipts (instead of gold) if they know they can always get gold for their paper. In normal times, goldsmiths M10_CASE3826_13_GE_C10.indd 222 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 223 could feel perfectly safe in loaning out more gold than they actually had in their possession, but once people start to doubt the safety of the goldsmith, they are foolish not to demand their gold back from the vault. A run on a goldsmith (or in our day, a run on a bank) occurs when many people present their claims at the same time. These runs tend to feed on themselves. If I see you going to the goldsmith to withdraw your gold, I may become nervous and decide to withdraw my gold as well. It is the fear of a run that usually causes the run. Runs on a bank can be triggered by a variety of causes: rumors that an institution may have made loans to borrowers who cannot repay, wars, failures of other institutions that have borrowed money from the bank, and so on. As you will see later in this chapter, today’s bankers differ from goldsmiths—today’s banks are subject to a “required reserve ratio.” Goldsmiths had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold. The Economics in Practice box on page 222 describes several fictional bank runs, along with a description of Wyatt Earp’s role in preventing a real bank run! The Modern Banking System MyLab Economics Concept Check To understand how the modern banking system works, you need to be familiar with some basic principles of accounting. Once you are comfortable with the way banks keep their books, you will see that the process is not so dissimilar to the world of the goldsmith. A Brief Review of Accounting Central to accounting practices is the statement that “the books always balance.” In practice, this means that if we take a snapshot of a firm—any firm, including a bank—at a particular moment in
time, then by definition: Assets - Liabilities K Net Worth or Assets K Liabilities + Net Worth Assets are things a firm owns that are worth something. For a bank, these assets include the bank building, its furniture, its holdings of government securities, cash in its vaults, bonds, stocks, and so on. Most important among a bank’s assets, for our purposes at least, are the loans it has made. A borrower gives the bank an IOU, a promise to repay a certain sum of money on or by a certain date. This promise is an asset of the bank because it is worth something. The bank could (and sometimes does) sell the IOU to another bank for cash. Other bank assets include cash on hand (sometimes called vault cash) and deposits with the U.S. central bank—the Federal Reserve Bank (the Fed). As we will see later in this chapter, federal banking regulations require that banks keep a certain portion of their deposits on hand as vault cash or on deposit with the Fed. A firm’s liabilities are its debts—what it owes. A bank’s liabilities are the promises to pay, or IOUs, that it has issued. A bank’s most important liabilities are its deposits. Deposits are debts owed to the depositors because when you deposit money in your account, you are in essence making a loan to the bank. The basic rule of accounting says that if we add up a firm’s assets and then subtract the total amount it owes to all those who have lent it funds, the difference is the firm’s net worth. Net worth represents the value of the firm to its stockholders or owners. How much would you pay for a firm that owns $200,000 worth of diamonds and had borrowed $150,000 from a bank to pay for them? The firm is worth $50,000—the difference between what it owns and what it owes. If the price of diamonds were to fall, bringing their value down to only $150,000, the firm would be worth nothing. We can keep track of a bank’s financial position using a simplified balance sheet called a T-account. By convention, the bank’s assets are listed on the left side of the T-account and its liabilities and net worth are on the right side. By definition, the balance sheet always balances, so that the sum of the items on the left side of the T-account is equal
to the sum of the items on the right side. The T-account in Figure 10.1 shows a bank having $110 million in assets, of which $20 million are reserves, the deposits the bank has made at the Fed, and its cash on hand (coins and currency). run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. Federal Reserve Bank (the Fed) The central bank of the United States. reserves The deposits that a bank has at the Federal Reserve bank plus its vault cash on hand. M10_CASE3826_13_GE_C10.indd 223 17/04/19 12:24 AM 224 PART III The Core of Macroeconomic Theory ▸▸ FIGURE 10.1 T-Account for a Typical Bank (millions of dollars) The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits) and net worth. Assets Liabilities Reserves Loans Total 20 90 110 100 10 110 Deposits Net worth Total required reserve ratio The percentage of its total deposits that a bank must keep as cash or reserves at the Federal Reserve. excess reserves The difference between a bank’s actual reserves and its required reserves. MyLab Economics Concept Check Reserves are an asset to the bank because it can go to the Fed and get cash for them, the same way you can go to the bank and get cash for the amount in your savings account. Our bank’s other asset is its loans, worth $90 million. Why do banks hold reserves/deposits at the Fed? There are many reasons, but perhaps the most important is the legal requirement that they hold a certain percentage of their deposit liabilities as reserves. The percentage of its deposits that a bank must keep as reserves is known as the required reserve ratio. If the reserve ratio is 20 percent, a bank with deposits of $100 million must hold $20 million as reserves, either as cash or as deposits at the Fed. To simplify, we will assume that banks hold all of their reserves in the form of deposits at the Fed. On the liabilities side of the T-account, the bank has deposits of $100 million, which it owes to its depositors. This means that the bank has a net worth of $10 million to its owners (+110 million in assets - +100 million in liabilities = +10 million net worth
). The net worth of the bank is what “balances” the balance sheet. Remember that when some item on a bank’s balance sheet changes, there must be at least one other change somewhere else to maintain balance. If a bank’s reserves increase by $1, one of the following must also be true: (1) Its other assets (for example, loans) decrease by $1, (2) its liabilities (deposits) increase by $1, or (3) its net worth increases by $1. Various fractional combinations of these are also possible. The Creation of Money MyLab Economics Concept Check Like the goldsmiths, today’s bankers can earn income by lending money out at a higher interest rate than they pay depositors for use of their money. In modern times, the chances of a run on a bank are fairly small, and even if there is a run, the central bank protects the private banks in various ways. Therefore, banks if they choose to can make loans up to the reserve requirement restriction. A bank’s required amount of reserves is equal to the required reserve ratio times the total deposits in the bank. If a bank has deposits of $100 and the required ratio is 20 percent, the required amount of reserves is $20. The difference between a bank’s actual reserves and its required reserves is its excess reserves: excess reserves K actual reserves - required reserves When a bank’s excess reserves are zero, it can no longer make loans. Why is this? When a bank makes a loan, it creates a demand deposit for the borrower. That demand deposit, in turn, requires reserves to back it up, just like the other deposits in the bank. With excess reserves at zero, and no new cash coming in, the bank has no way to reserve against the new deposit. An example will help to show the connection between loans and excess reserves more generally. Assume that there is only one private bank in the country, the required reserve ratio is 20 percent, and the bank starts off with nothing, as shown in panel 1 of Figure 10.2. Now suppose dollar bills are in circulation and someone deposits 100 of them in the bank. The bank deposits the $100 with the central bank, so it now has $100 in reserves, as shown in panel 2. The bank now has assets (reserves) of $100 and liabilities (deposits) of $100. If the required reserve ratio is 20 percent,
the bank has excess reserves of $80. How much can the bank lend and still meet the reserve requirement? For the moment, let us assume that anyone who gets a loan keeps the entire proceeds in the bank or pays them to M10_CASE3826_13_GE_C10.indd 224 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 225 Panel 1 Panel 2 Panel 3 Assets Liabilities Assets Liabilities Assets Liabilities Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 Loans 400 500 Deposits MyLab Economics Concept Check ▸▴ FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy In panel 2, there is an initial deposit of $100. In panel 3, the bank has made loans of $400. someone else who does. Nothing is withdrawn as cash. In this case, the bank can lend $400 and still meet the reserve requirement. Panel 3 shows the balance sheet of the bank after completing the maximum amount of loans it is allowed with a 20 percent reserve ratio. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 original deposit, now in reserves, plus $400 in loans (which are made as deposits) equals $500 in deposits. With $500 in deposits and a required reserve ratio of 20 percent, the bank must have reserves of $100 (20 percent of $500)—and it does. The bank can lend no more than $400 because that is all its $100 of reserves will support, given its initial deposit. Another way to see this is to recognize that the bank originally had $80 in excess reserves. That $80 would support $400 in new deposits (loans) because 20% of $400 equals the $80 excess reserve figure. The $400 in loans uses up all of the excess reserves. When a bank has no excess reserves and thus can make no more loans, it is said to be loaned up. Remember, the money supply (M1) equals cash in circulation plus deposits. Before the initial deposit, the money supply was $100 ($100 cash and no deposits). After the deposit and the loans, the money supply is $500 (no cash outside bank vaults and $500 in deposits). It is clear then that when loans are converted into deposits, the supply of money will increase. The bank whose T-accounts are presented in
Figure 10.2 is allowed to make loans of $400 based on the assumption that loans that are made stay in the bank in the form of deposits. Now suppose you borrow from the bank to buy a personal computer and you write a check to the computer store. If the store also deposits its money in the bank, your check merely results in a reduction in your account balance and an increase to the store’s account balance within the bank. No cash has left the bank. As long as the system is closed in this way—remember that so far we have assumed that there is only one bank—the bank knows that it will never be called on to release any of its $100 in reserves. It can expand its loans up to the point where its total deposits are $500. Of course, there are many banks in the country, a situation that is depicted in Figure 10.3. As long as the banking system as a whole is closed, it is still possible for an initial deposit of $100 to result in an expansion of the money supply to $500, but more steps are involved when there is more than one bank. To see why, assume that Mary makes an initial deposit of $100 in Bank 1 and the bank deposits the entire $100 with the Fed (panel 1 of Figure 10.3). All loans that a bank makes are withdrawn from the bank as the individual borrowers write checks to pay for merchandise. After Mary’s deposit, Bank 1 can make a loan of up to $80 to Bill because it needs to keep only $20 of its $100 deposit as reserves. (We are assuming a 20 percent required reserve ratio.) In other words, Bank 1 has $80 in excess reserves. Bank 1’s balance sheet at the moment of the loan to Bill appears in panel 2 of Figure 10.3. Bank 1 now has loans of $80. It has credited Bill’s account with the $80, so its total deposits are $180 ($80 in loans plus $100 in reserves). Bill then writes a check for $80 for a set of shock absorbers for his car. Bill wrote his check to Penelope’s Car Shop, and Penelope deposits Bill’s check in Bank 2. When the check clears, Bank 1 transfers $80 in reserves to Bank 2. Bank 1’s balance sheet now looks like the top of panel 3. Its assets include reserves of $20 and loans of $80; its liabilities are $100 in deposits.
Both sides of the T-account balance: the bank’s reserves are 20 percent of its deposits, as required by law, and it is fully loaned up. M10_CASE3826_13_GE_C10.indd 225 17/04/19 12:24 AM 226 PART III The Core of Macroeconomic Theory Bank 1 Bank 2 Bank 3 Panel 1 Panel 2 Panel 3 Assets Liabilities Assets Liabilities Assets Liabilities Reserves 100 100 Deposits Reserves 100 Loans 80 180 Deposits Reserves 80 80 Deposits Reserves 80 Loans 64 144 Deposits Reserves 20 Loans 80 Reserves 16 Loans 64 100 Deposits 80 Deposits Reserves 64 64 Deposits Reserves 64 Loans 51.20 115.20 Deposits Reserves 12.80 Loans 51.20 64 Deposits Summary: Loans Bank 1 Bank 2 Bank 3 Bank 4 80 64 51.20 40.96 Deposits 100 80 64 51.20 Total 400.00 500.00 MyLab Economics Concept Check ▸▴ FIGURE 10.3 The Creation of Money When There Are Many Banks In panel 1, there is an initial deposit of $100 in Bank 1. In panel 2, Bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on Bank 1 (panel 3) and deposited in Bank 2 (panel 1). The process continues with Bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500. Now look at Bank 2. Because Bank 1 has transferred $80 in reserves to Bank 2, Bank 2 now has $80 in deposits and $80 in reserves (panel 1, Bank 2). Its reserve requirement is also 20 percent, so it has excess reserves of $64 on which it can make loans. Now assume that Bank 2 loans the $64 to Kate to pay for a textbook and Kate writes a check for $64 payable to the Manhattan College Bookstore. The final position of Bank 2, after it honors Kate’s $64 check by transferring $64 in reserves to the bookstore’s bank, is reserves of $16, loans of $64, and deposits of $80 (panel 3, Bank 2). The Manhattan College Bookstore deposits Kate’s check in its account with Bank 3. Bank 3 now has excess reserves because it has added $64 to its reserves.
With a reserve ratio of 20 percent, Bank 3 can loan out $51.20 (80 percent of $64, leaving 20 percent in required reserves to back the $64 deposit). As the process is repeated over and over, the total amount of deposits created is $500, the sum of the deposits in each of the banks. The banking system can be looked at as one big bank therefore, the outcome here for many banks is the same as the outcome in Figure 10.2 for one bank.3 The Money Multiplier MyLab Economics Concept Check In practice, the banking system is not completely closed—there is some leakage out of the system, as people send money abroad or even hide it under their mattresses! Still, the point here is that an increase in bank reserves can lead to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. Do not confuse the money multiplier with the spending multipliers we discussed in the last two chapters. They are not the same thing. money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. 3If banks create money when they make loans, does repaying a loan “destroy” money? The answer is yes. M10_CASE3826_13_GE_C10.indd 226 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 227 In the example we just examined, reserves increased by $100 when the $100 in cash was deposited in a bank and the amount of deposits increased by $500 ($100 from the initial deposit, $400 from the loans made by the various banks from their excess reserves). The money multiplier in this case is +500 +100 = 5. Mathematically, the money multiplier can be defined as follows:4 > money multiplier K 1 required reserve ratio In the United States, the required reserve ratio varies depending on the size of the bank and the type of deposit. For large banks and for checking deposits, the ratio is currently 10 percent, which makes the potential money multiplier 1.10 = 10. This means that an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system. >
It is important to remember that the money multiplier is derived under the assumption that banks hold no excess reserves. For example, when Bank 1 gets the deposit of $100, it loans out the maximum that it can, namely $100 times 1 minus the reserve requirement ratio. If instead Bank 1 held the $100 as excess reserves, the increase in the money supply would just be the initial $100 in deposits (brought in, say, from outside the banking system). We return to the question of excess reserves later in this chapter. The Federal Reserve System We have seen how the private banking system can create money by making loans. However, private banks are not free to create money at will. We have already seen the way that their ability to create money is governed by the reserve requirements set by the Fed. We will now examine the structure and function of the Fed. Founded in 1913 by an act of Congress (to which major reforms were added in the 1930s), the Fed is the central bank of the United States. The Fed is a complicated institution with many responsibilities, including the regulation and supervision of about 6,000 commercial banks. The organization of the Federal Reserve System is presented in Figure 10.4. The Board of Governors is the most important group within the Federal Reserve System. The board consists of seven members, each appointed for 14 years by the president of the United States. The chair of the Fed, who is appointed by the president and whose term runs for four years, usually dominates the entire Federal Reserve System and is sometimes said to be the second most powerful person in the United States. The Fed is an independent agency in that it does not take orders from the president or from Congress. The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. These districts are indicated on the map in Figure 10.4. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system in their districts and report to the Board of Governors on local economic conditions. U.S. monetary policy is formally set by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Fed’s Board of Governors; the president of the New York Federal Reserve Bank; and on a rotating basis, four of the presidents of the 11 other district banks. The FOMC sets goals concerning interest rates, and it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell
government securities. (We discuss the specifics of open market operations later in this chapter.) 10.3 LEARNING OBJECTIVE Describe the functions and structure of the Federal Reserve System. Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. 4To show this mathematically, let rr denote the reserve requirement ratio, like 0.20. Say someone deposits 100 in Bank 1 in Figure 10.3. Bank 1 can create 100(1 - rr) in loans, which are then deposits in Bank 2. Bank 2 can create 100(1 - rr) (1 - rr) in loans, which are then deposits in Bank 3, and so on. The sum of the deposits is thus 100 multiplier. 3 1 + (1 - rr) + (1 - rr)2 + (1 - rr)3 + c. The sum of the infinite series in brackets is 1/rr, which is the money 4 M10_CASE3826_13_GE_C10.indd 227 17/04/19 12:24 AM 228 PART III The Core of Macroeconomic Theory 12 Regional Banks and Districts (District numbers in parentheses) (9) Minneapolis San Francisco* (12) (10) Kansas City * Hawaii and Alaska are included in the San Francisco district. (11) Dallas Cleveland (1) (2) (3) Boston New York Philadelphia Board of Governors Richmond Chicago (7) (4) St. Louis (5) (8) Atlanta (6) Board of Governors Federal Open Market Committee (FOMC) 12 Federal Reserve Banks • Seven governors with 14-year terms are appointed by the president. • One of the governors is appointed by the president to a 4-year term as chair. The Board of Governors, the president of the New York Federal Reserve Bank, and on a rotating basis, four of the presidents of the 11 other district banks. Nine directors each: six elected by the member banks in the district and three appointed by the Board. Directors elect the president of each bank. Monetary policy directives Regulation and supervision
Open Market Desk New York Federal Reserve Bank about 6,000 commercial banks MyLab Economics Concept Check ▸▴ FIGURE 10.4 The Structure of the Federal Reserve System Functions of the Federal Reserve MyLab Economics Concept Check The Fed is the central bank of the United States. Central banks are sometimes known as “bankers’ banks” because only banks (and occasionally foreign governments) can have accounts in them. As a private citizen, you cannot go to the nearest branch of the Fed and open a checking account or apply to borrow money. As we will see shortly, the Fed is responsible for monetary policy in the United States, but it also performs several important administrative functions for banks. These functions include clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves.5 In addition, it is often involved in intercountry negotiations on international economic issues. Clearing interbank payments works as follows. Suppose you write a $100 check drawn on your bank, the First Bank of Fresno (FBF), to pay for tulip bulbs from Crockett Importers of Miami, Florida. How does your money get from your bank in Fresno to Crockett’s bank in Florida? The Fed does it. Both FBF and Banco de Miami have accounts at the Fed. When Crockett Importers receives your check and deposits it at Banco de Miami, the bank submits the check to the Fed, asking it to collect the funds from FBF. The Fed presents the check to FBF and is instructed to 5Foreign exchange reserves are holdings of the currencies of other countries—for example, Japanese yen—by the U.S. government. We discuss exchange rates and foreign exchange markets at length in Chapter 19. M10_CASE3826_13_GE_C10.indd 228 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 229 lender of last resort One of the functions of the Fed: it provides funds to troubled banks that cannot find any other sources of funds. 10.4 LEARNING OBJECTIVE Describe the determinants of money demand. debit FBF’s account for the $100 and to credit the account of Banco de Miami. Accounts at the Fed count as reserves, so FBF loses $100 in reserves, and Banco de Miami gains $
100 in reserves. The two banks effectively have traded ownerships of their deposits at the Fed. The total volume of reserves has not changed, nor has the money supply. This way of clearing interbank payments allows banks to shift money around virtually instantaneously. All they need to do is wire the Fed and request a transfer, and the funds move from one computer account to another. Besides facilitating the transfer of funds among banks, the Fed is responsible for many of the regulations governing banking practices and standards. For example, the Fed has the authority to control mergers among banks, and it is responsible for examining banks to ensure that they are financially sound and that they conform to a host of government accounting regulations. As we saw previously, the Fed also sets reserve requirements for all financial institutions. An important responsibility of the Fed is to act as the lender of last resort for the banking system. As our discussion of goldsmiths suggested, banks are subject to the possibility of runs on their deposits. In the United States, most deposits of less than $250,000 are insured by the Federal Deposit Insurance Corporation (FDIC), a U.S. government agency that was established in 1933 during the Great Depression. Deposit insurance makes panics less likely, but the Fed stands ready to provide funds to a troubled bank that cannot find any other sources of funds. The Fed is the ideal lender of last resort for two reasons. As a nonprofit institution whose function is to serve the overall welfare of the public, the Fed has an interest in preventing catastrophic banking panics such as those that occurred in the late 1920s and the 1930s. The Fed also has an essentially unlimited supply of funds with which to help banks facing the possibility of runs since as we shall see, it can create reserves at will. These administrative and regulatory functions of the Fed are important, but its central function is to help manage the macroeconomy by setting the interest rate. To see how this process works we need to add a discussion of the demand for money to our analysis, which we turn to now. The Demand for Money Think about the financial assets of a household. Some of those assets are held in what we have called in this chapter M1 money, cash and checking accounts offering little or no interest, but great convenience in use. One can access these accounts by withdrawing money, but also by using a debit card or smartphone connected to a checking account. Other assets likely held by a household include interest-bearing savings accounts and securities which are less convenient to use, but do earn interest
. In this section we consider how households think about dividing their assets between these two broad categories. What determines how much money people choose to hold? As we have seen, one of the major functions of money is as a means of exchange, to facilitate transactions. We have already discussed the transactions use of money. Convenience in transactions is an obvious motive for people to hold some money, rather than keep all their assets in a harder-to-use savings account. In this section we consider what determines how much money people choose to hold. We will assume in this discussion that money as we are defining it earns no interest. It can take the form of either cash or deposits in non-interest-bearing checking accounts. Note that if debit cards or cell phones are used to pay for items in stores, deposits in checking accounts are needed to back this up. So “money” is being used for these kinds of payments. Consider a simple example of how the decision to hold money versus an interest-bearing instrument might work. We will also assume for simplicity that there is only one form other than money in which financial assets can be held, namely in a “savings account,” which earns interest. Say at the end of the month the firm you work for deposits $5,000 in your checking account. If you leave the deposits in your checking account, you earn no interest. If you move some or all to your savings account, you earn interest on the amount moved. How much should you move? The gain from moving is the interest you earn on the amount moved. The constraint is that you may need the deposits in your checking account to support your transactions, via checks, debit card, or smartphone. The deposits in your checking account support your transactions. The more of your assets you move to your savings account, the more often you will have to move deposits back to your checking account as it is drawn down by your transactions. M10_CASE3826_13_GE_C10.indd 229 17/04/19 12:24 AM 230 PART III The Core of Macroeconomic Theory ▸▸ FIGURE 10.5 The Demand for Money The quantity of money demanded (Md) depends negatively on the interest rate because the opportunity cost of holding money decreases as the interest rate falls. An increase in transactions (P * Y) shifts the money demand curve to the right. Md after increase in P * Y Md before increase in % 14 13 12 11 10 MyLab Economics Concept
Check Money, M We thus have a typical economic trade-off here. You gain interest by moving checking account deposits to your savings account, but the more you move, the more often you will have to move some back, which is costly in time. How much should you move? Here is where the interest rate plays a key role. The higher the interest rate, the more costly it is to keep deposits in your checking account. If the interest rate is close to zero, as it has been for a number of years, you earn very little by moving deposits to your savings account, so there is little reason to do so. There is a time cost of moving deposits back and forth, and there is no reason to bear this cost if you are earning practically nothing on your savings account. On the other hand, if the interest rate rises, the opportunity cost of keeping deposits in your checking account rises, and you should move some of the deposits to your savings account. The higher the interest rate, the more deposits you should keep on average in your savings account, other things being equal. Or, put another way, the higher the interest rate, the less on average you should hold in the form of money in your checking account. The amount of money you should hold thus depends negatively on the interest rate. Again, this is because a high interest rate means the opportunity cost of holding money is high because of the interest lost by not moving deposits to your savings account. You trade off convenience against an interest rate. The amount of money you want to hold obviously also depends on the size of your transactions. The more you spend in a given period, the more deposits on average you will want to have in your checking account, other things being equal. If you hold very little in your checking account relative to the size of your transactions, you will need to spend more time moving deposits from your savings account to your checking account, which is costly. To summarize, the demand for money depends positively on the size of total transactions in a period and negatively on the interest rate. In what follows we will use nominal income P * Y as the measure of transactions, where P is the aggregate price level—the GDP deflator—and Y is real output—real GDP. Figure 10.5 shows the demand for money schedule. The schedule slopes down because, as just discussed, the demand for money rises as the interest rate falls. The figure also shows that the demand for money curve shifts to the right as P * Y increases because of the increase in
transactions. The relationship between money demand and the interest rate will be an important part of our story of monetary policy and the Fed. 10.5 LEARNING OBJECTIVE Define interest and discuss the relationship between interest rates and security prices. Interest Rates and Security Prices Before we discuss how the Fed controls the interest rate, we need to briefly digress and consider the relationship between interest rates and security prices. In our discussion thus far we have described the way in which households choose between holding money and holding their assets in interest-bearing securities or accounts. Interestbearing securities are issued by firms and the government seeking to borrow money. Short-term M10_CASE3826_13_GE_C10.indd 230 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 231 Professor Serebryakov Makes an Economic Error In Chekhov’s play Uncle Vanya, Alexander Vladimirovitch Serebryakov, a retired professor, but apparently not of economics, calls his household together to make an announcement. He has retired to his country estate, but he does not like living there. Unfortunately, the estate does not derive enough income to allow him to live in town. To his gathered household, he thus proposes the following: Omitting details, I will put it before you in rough outline. Our estate yields on an average not more than two percent, on its capital value. I propose to sell it. If we invest the money in suitable securities, we should get from 4 to 5 percent, and I think we might even have a few thousand roubles to spare for buying a small villa in Finland. This idea was not well received by the household, especially by Uncle Vanya, who lost it for a while and tried to kill Professor Serebryakov, but no one pointed out that this was bad economics. As discussed in the text, if you buy a bond and interest rates rise, the price of your bond falls. What Professor Serebryakov does not realize is that what he is calling the capital value of the estate, on which he is earning 2 percent, is not the value for which he could sell the estate if the interest rate on “suitable” securities is 5 percent. If an investor in Russia can earn 5 percent on these securities, why would he or she buy an estate earning only 2 percent? The price of the estate would have to fall until the return to the investor was 5 percent.
To make matters worse, it may have been that the estate was a riskier investment than the securities, and if this were so, a return higher than 5 percent would have been required on the estate purchase to compensate the investor for the extra risk. This would, of course, lower the price of the estate even more. In short, this is not a scheme by which the professor could earn more money than what the estate is currently yielding. Perhaps had Uncle Vanya taken an introductory economics course and known this, he would have been less agitated. CRITICAL THINKING 1. What would happen to the value of the estate if the interest rate on the securities that Professor Serebryakov is talking about fell? securities are usually called “bills,” and long-term securities are usually called “bonds.” Both types of securities work in similar ways. To induce lenders to buy these securities and provide funds, borrowers promise not only to return the funds borrowed at some later date, but also to pay interest. For our discussion we will look at a 10-year U.S. Treasury security, a government bond. Bonds are issued with a face value, typically in denominations of $1,000. They also come with a maturity date, which is the date the borrower agrees to pay the lender the face value of the bond. A bond also specifies a fixed dollar payment that will be paid to the bondholder each year. This payment is known as a coupon. Say that on January 2, 2018, the U.S. Treasury issued a 10-year bond that had a face value of $1,000 and paid a coupon of $20 per year. The bond was sold on this date in the bond market. The price at which the bond sold would be whatever price the market determined it to be. Say that the market-determined price was in fact $1,000. (The Treasury when issuing bonds tries to choose the coupon to be such that the price that the bond initially sells for is roughly equal to its face value.) The lender would give the Treasury a check for $1,000, and every January for the next 10 years the Treasury would send the lender a check for $20. Then on January 2, 2028, the Treasury would send the lender a check for the face value of the bond—$1,000—plus the last coupon payment—$20—and that would square all accounts. In this example the interest rate that the lender receives each year
on his or her $1,000 investment is 2 percent. In return for the $1,000 payment the lender receives $20 each year, or 2 percent of the market price of the bond. M10_CASE3826_13_GE_C10.indd 231 17/04/19 12:24 AM 232 PART III The Core of Macroeconomic Theory Suppose that just before the government put its bond on the market, many other, identicallooking bonds were offered to lenders with coupons of $30, face values of $1,000, and maturity of 10 years. Also, suppose that these bonds were selling for $1,000. Could the Treasury still sell its bond? The answer is yes, but at a lower price. What would that price be? The other securities are offering lenders 3 percent interest, so the Treasury will have to do the same. With a coupon value fixed at $20, the only way to raise the interest rate to the required 3 percent is to lower the price of the bond. The market price of the bond will be less than $1,000. A key relationship that we can see from this example and that we will use later in this chapter is that market-determined prices of existing bonds and interest rates are inversely related. When the Treasury (or a firm) issues a bond, the face value, coupon, and maturity are set. This means that the market price of the bond will change as market interest rates change. When interest rates rise, prices of existing bonds fall. We will use the inverse relationship between interest rates and bond prices as we explore monetary policy post 2008 near the end of the next section. We turn now to put money supply and money demand together to look at how monetary policy works through the Fed. How the Federal Reserve Controls the Interest Rate Tools Prior to 2008 MyLab Economics Concept Check Traditionally the Fed had three tools available to it to control the interest rate via changing the money supply: open market operations, changing the reserve requirement ratio, and changing the discount rate that banks pay to the Fed to borrow reserves. Consider again Figure 10.2. We see in this figure that if commercial bank reserves increase by $100 with a reserve requirement ratio of 20 percent, bank loans can increase by $400, with the money supply increasing by $500 ($400 in loans plus the initial $100 in reserves). This calculation assumes that no excess reserves are held. So one way the Fed can increase the money supply is by simply increasing reserves
. How does the Fed do this? Its principal tool is to buy U.S. Treasury securities from the banks, which the banks hold. These securities do not count as reserves when held by the banks. If the Fed buys $100 in securities from a bank, it credits the bank with $100 in reserves. The bank’s reserves have gone up by $100, so it can make loans of $400, thus increasing the money supply by $500. (We are assuming a single-bank economy, but the analysis goes through with many banks, as in Figure 10.3.) Conversely, if the Fed sells $100 in securities, the bank’s reserves go down by $100 (the securities are paid for by the bank by a debit to the bank’s reserves), and loans must be decreased by $400, thus decreasing the money supply by $500. This buying and selling of government securities by the Fed is called open market operations. Prior to 2008, when essentially no excess reserves were held by banks, it was the main way in which the Fed changed the money supply. Deposits in Figure 10.2 can also be increased if the reserve requirement ratio is lowered. We have already seen this in our discussion of the creation of money. If the reserve requirement ratio were 10 percent rather than 20 percent, loans of $900 could be made, thus increasing the money supply (deposits) to $1,000. Conversely, if the reserve requirement ratio were increased, loans would have to fall and thus the money supply (deposits) would fall. In the period before 2008, when banks rarely held excess reserves, changing the reserve requirement ratio was another tool the Fed could use to change the money supply, although it used this tool infrequently. Banks also have the option to borrow reserves from the Fed, which they did now and again prior to 2008. Borrowed reserves are counted as reserves that can back loans, so when there is an increase in borrowed reserves, there is an increase in the money supply as banks increase their loans. Banks pay interest on the borrowed reserves, called the discount rate, and so a third way the Fed can increase the money supply is to lower the discount rate, inducing banks to borrow more and thus expand loans. Conversely, the Fed can raise the discount rate, inducing banks to pay back some of their borrowed reserves and thus contract loans. This third tool to change the money supply, changing the discount rate, was also infrequently used. 10
.6 LEARNING OBJECTIVE Understand how the Fed can change the interest rate. open market operations The purchase and sale by the Fed of government securities in the open market. discount rate The interest rate that banks pay to the Fed to borrow from it. M10_CASE3826_13_GE_C10.indd 232 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 233 How do these tools give the Fed the ability to control the interest rate? We have just seen that when no excess reserves are held, the Fed can change the money supply through one of the three tools, the main tool being open market operations. The Fed can thus set the value of the money supply, the quantity of money, at whatever it wants. Assuming that the money market clears, which it does in practice, we can combine the demand for money schedule in Figure 10.5 with the money supply that the Fed chooses to determine the equilibrium value of the interest rate. This is done in Figure 10.6. Given the quantity of money that the Fed chooses to supply, the interest rate can simply be read off the money demand schedule. A value of M0 leads to an interest rate of r0 in the figure. Figure 10.6 also shows that if the Fed increases the money supply, from M0 to M1, the interest rate falls from r0 to r1. So any change in the money supply that the Fed might make leads to a change in the interest rate, with the magnitude of the interest rate change depending on the shape of the money demand function. Prior to 2008 the preceding discussion would be the end of the story. Banks essentially held no excess reserves, and the Fed engaged in open market operations to change the money supply and the interest rate. This channel for monetary policy changed in 2008, as the Fed responded to the financial crisis. Expanded Fed Activities Beginning in 2008 MyLab Economics Concept Check In March 2008, faced with many large financial institutions simultaneously in serious financial trouble, the Fed began to broaden its role in the banking system. No longer would it be simply a lender of last resort to banks, but it would become an active participant in the private banking system. How did this change come about? Beginning in about 2003, the U.S. economy experienced rapidly rising housing prices, in what some called a “housing bubble.” Financial institutions began issuing mortgages with less oversight, in some cases to households with poor credit ratings (so
-called subprime borrowers). Some households bought homes they could not afford based on their incomes, expecting to eventually “cash in” on the rising housing prices. Regulation, by the Fed or other federal or state agencies, was lax, and many financial firms took very large risks. When housing prices began to fall in late 2005, the stage was set for a financial crisis. Financial institutions, even large ones, began to experience very large losses, as home owners began defaulting on their loans, setting off a chain reaction that many people thought threatened the economic system. The Fed responded to these events in a number of ways. In March 2008 it participated in an attempted bailout of Bear Stearns, a large financial institution, by guaranteeing $30 billion of Bear Stearns’ liabilities to JPMorgan. On September 7, 2008, it participated in a government takeover of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which at that time owned or guaranteed about half of the $12 trillion mortgage market in the United States. On September 17, 2008, the Fed loaned $85 ▸◂ FIGURE 10.6 The Equilibrium Interest Rate Given a value of the money supply that the Fed chooses, the equilibrium interest rate can be read off of the money demand schedule. If the Fed increases the money supply from M0 to M1, the interest rate falls from r0 to r1 r0 r1 M d M0 M1 Money, M MyLab Economics Concept Check M10_CASE3826_13_GE_C10.indd 233 17/04/19 12:24 AM 234 PART III The Core of Macroeconomic Theory billion to the American International Group (AIG) insurance company to help it avoid bankruptcy. In mid-September, the Fed urged Congress to pass a $700 billion bailout bill, which was signed into law on October 3. In the process of bailing out Fannie Mae and Freddie Mac, in September 2008 the Fed began buying securities of these two associations, called “federal agency debt securities.” More remarkable, however, is that in January 2009 the Fed began buying mortgage-backed securities, securities that the private sector was reluctant to hold because of their perceived riskiness, and long-term government bonds. By September 2012 the Fed was buying mortgage-backed securities and long-term government bonds to the tune of $85 billion per month. This practice ended in November 2014. Most of these
purchases ended up as an increase in excess reserves of commercial banks, as we will see in the next section. As is not surprising, there has been much political discussion of whether the Fed should have regulated financial institutions more in 2003–2005 and whether its subsequent active role in the system was warranted. Whatever one’s views, it is certainly the case that the Fed has taken a much more active role in financial markets since 2008. The Federal Reserve Balance Sheet MyLab Economics Concept Check The expanded Fed activities we have just described can be seen clearly by examining the way in which the Fed’s balance sheet changed during the period after 2008. Although the Fed is a special bank, it is similar to an ordinary commercial bank in that it has a balance sheet that records its asset and liability position at any moment of time. The balance sheet for April 11, 2018, is presented in Table 10.1. On April 11, 2018, the Fed had $4,431 billion in assets, of which $11 billion was gold, $2,413 billion was U.S. Treasury securities, $4 billion was federal agency debt securities, $1,754 billion was mortgage-backed securities, and $291 billion was other. Gold is trivial. Do not think that this gold has anything to do with money in circulation. Most of the gold was acquired during the 1930s, when it was purchased from the U.S. Treasury Department. Since 1934, the dollar has not been backed by (is not convertible into) gold. You cannot take a dollar bill to the Fed to receive gold for it; all you can get for your old dollar bill is a new dollar bill.6 Although it is unrelated to the money supply, the Fed’s gold counts as an asset on its balance sheet because it is something of value the Fed owns. U.S. Treasury securities are the traditional assets held by the Fed. These are obligations of the federal government that the Fed has purchased over the years. As we discussed previously, when banks hold no excess reserves the buying and selling of Treasury securities (open market TABLE 10.1 Assets and Liabilities of the Federal Reserve System, April 11, 2018 (Billions of Dollars) Assets Liabilities Gold U.S. Treasury securities Federal agency debt securities Mortgage-backed securities All other assets Total 11 2,413 4 1,754 249 4,431 Currency in circulation Reserve balances (about 133 required) U.S. Treasury deposits All other liabilities and net worth Total 1,641 2,129
370 291 4,431 Source: Federal Reserve Statistical Release, Factors affecting Reserve Balances, Board of Governors of the Federal Reserve System. MyLab Economics Real-time data 6The fact that the Fed is not obliged to provide gold for currency means it can never go bankrupt. When the currency was backed by gold, it would have been possible for the Fed to run out of gold if too many of its depositors came to it at the same time and asked to exchange their deposits for gold. If depositors come to the Fed to withdraw their deposits today, all they can get is dollar bills. The dollar was convertible into gold internationally until August 15, 1971. M10_CASE3826_13_GE_C10.indd 234 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 235 operations) is the way the Fed affects the money supply and the interest rate. Before the change in Fed behavior in 2008, almost all of its assets were in the form of U.S. Treasury securities. For example, in the ninth edition of this text, the balance sheet presented was for October 24, 2007, where total Fed assets were $885 billion, of which $780 billion were U.S. Treasury securities. The new assets of the Fed (since 2008) are federal agency debt securities and mortgage-backed securities. These were both zero on the October 24, 2007, balance sheet, although it is now the case that the Fed has unwound almost all of its holdings of federal agency debt, where the current holdings are just $4 billion. Of the Fed’s liabilities, $1,641 billion is currency in circulation, $2,129 billion is reserve balances, $370 billion is U.S. Treasury deposits, and $291 billion is other. The Fed acts as a bank for the U.S. government, and so U.S. Treasury deposits are held by the U.S. government at the Fed. When the government needs to pay for something like a new aircraft carrier, it may write a check to the supplier of the ship drawn on its “checking account” at the Fed. Similarly, when the government receives revenues from tax collections, fines, or sales of government assets, it may deposit these funds at the Fed. Currency in circulation accounts for about 37 percent of the Fed’s liabilities. The dollar bill that you use to buy a pack of gum is clearly an asset from your point of
view. Because every financial asset is by definition a liability of some other agent in the economy, whose liability is the dollar bill? The dollar bill is a liability—an IOU—of the Fed. It is, of course, a strange IOU because it can only be redeemed for another IOU of the same type. It is nonetheless classified as a liability of the Fed. Reserve balances account for about 48 percent of the Fed’s liabilities. These are the reserves that commercial banks hold at the Fed. Remember that commercial banks are required to keep a certain fraction of their deposits at the Fed. These deposits are assets of the commercial banks and liabilities of the Fed. What is remarkable about the $2,129 billion in reserve balances at the Fed is that only about $133 billion are required reserves. The rest— about $2 trillion—are excess reserves, reserves that the commercial banks could lend to the private sector if they wanted to. The existence of these excess reserves complicates our story of the Fed’s operations. Tools After 2008 MyLab Economics Concept Check After 2008 we see that we are no longer in a world of zero excess reserves. Indeed, excess reserves on April 11, 2018, were about $2 trillion, which is considerably above zero! What does this do to the Fed’s ability to change the money supply and the interest rate? Between 2008 and the end of 2015, the Fed kept the short-term interest rate close to zero. It began increasing the short-term interest rate in December of 2015. How did the Fed do this? Not through the traditional tools of open market operations, reserve requirement ratio, and discount rate. Consider open market operations. Prior to 2008 the Fed would sell government securities, which would decrease reserves, contract bank loans, drive down the money supply, and thus increase the interest rate. With the existence of excess reserves, however, if the Fed sold government securities, the securities would mostly be bought by the banks with their excess reserves. Bank reserves would decrease, but with ample excess reserves remaining no contraction in bank loans is needed. Look at Table 10.1. If the Fed sold $1 trillion in U.S. Treasury securities, there would be a fall in U.S. Treasury securities of $1 trillion and a fall in Reserve balances of $1 trillion. Both Fed assets and liabilities would be lower by $1 trillion, but there would be no change in the interest rate! Banks would now have $1 trillion less in reserves, but still have roughly
$1 trillion in excess reserves. Just swapping Treasury securities for reserves does not change the interest rate. For the same reason, changing the reserve requirement ratio would also be useless: the banks are well over the requirement. The tool that the Fed now uses to raise the short-term interest rate is to increase the rate it pays to banks on their reserves. Beginning in the post-2008 period, the Fed began paying interest on bank reserves. (Indeed, this may help to explain why banks began holding reserves rather than lending them out.) If the Fed increases the rate it pays on bank reserves, this will increase the interest rate on short-term U.S. Treasury securities. Suppose the Fed raises the rate it pays M10_CASE3826_13_GE_C10.indd 235 17/04/19 12:24 AM 236 PART III The Core of Macroeconomic Theory on bank reserves by 0.25 percentage points. What effect does this have on the short-term U.S. Treasury securities market? With some simplification, the story is roughly as follows. Banks hold both reserves and Treasury securities. Before the Fed increased the rate paid on bank reserves, the interest rates on reserves and short-term Treasury securities were roughly the same. After the Fed’s move, the interest rate on reserves is initially 0.25 points higher. This higher rate induces banks to try to sell their now unattractive securities to the Fed. If the Fed does not buy, then the securities will be sold on the bond market, causing their price to change. As we saw in the previous section, when the price of a security falls, the interest rate rises, so with security prices falling, the interest rate on the securities rises. The new equilibrium will be where the interest rate on the securities is also 0.25 points higher. The interest rate on short-term Treasury securities can thus be changed by the Fed simply increasing the rate it pays on bank reserves. This requires no change in the Fed’s balance sheet. Finally, we should add that when the Fed changes the short-term interest rate, this also changes longer-term interest rates. This is briefly explained in the appendix to this chapter. The appendix also discusses some of the key interest rates in the U.S. economy. Although in the text we are primarily focusing on one interest rate, denoted r, in practice there are many. Looking Ahead This has been a long chapter, but for future analysis we really only need one point, namely
that the Fed has the ability to control the short-term interest rate. Before 2008 it did this primarily through open market operations, and it now does this by changing the rate it pays banks on their reserves with the Fed. S U M M A R Y 10.1 AN OVERVIEW OF MONEY p. 217 1. Money has three distinguishing characteristics: (1) a means of payment, or medium of exchange; (2) a store of value; and (3) a unit of account. The alternative to using money is barter, in which goods are exchanged directly for other goods. Barter is costly and inefficient in an economy with many different kinds of goods. 2. Commodity monies are items that are used as money and that have an intrinsic value in some other use—for example, gold and cigarettes. Fiat monies are intrinsically worthless apart from their use as money. To ensure the acceptance of fiat monies, governments use their power to declare money legal tender and promise the public they will not debase the currency by expanding its supply rapidly. 3. There are various definitions of money. Currency plus demand deposits plus traveler’s checks plus other checkable deposits compose M1, or transactions money— money that can be used directly to buy things. The addition of savings accounts and money market accounts (near monies) to M1 gives M2, or broad money. 10.2 HOW BANKS CREATE MONEY p. 221 4. The required reserve ratio is the percentage of a bank’s deposits that must be kept as reserves at the nation’s central bank, the Federal Reserve. 5. Banks create money by making loans. When a bank makes a loan to a customer, it creates a deposit in that customer’s account. This deposit becomes part of the money supply. Banks can create money only when they have excess reserves—reserves in excess of the amount set by the required reserve ratio. 6. The money multiplier is the multiple by which the total supply of money can increase for every dollar increase in reserves. The money multiplier is equal to 1/required reserve ratio. 10.3 THE FEDERAL RESERVE SYSTEM p. 227 7. The Fed’s most important function is controlling the shortterm interest rate. The Fed also performs several other functions: it clears interbank payments, is responsible for many of the regulations governing banking practices and standards, and acts as a lender of last resort for troubled banks that cannot find any other sources of
funds. The Fed also acts as the bank for the U.S. government. 10.4 THE DEMAND FOR MONEY p. 229 8. The demand for money depends negatively on the interest rate. The higher the interest rate, the higher the opportunity cost (more interest forgone) from holding money and the less money people will want to hold. An increase in the interest rate reduces the quantity demanded for money, and the money demand curve slopes downward. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 236 17/04/19 12:24 AM 9. The demand for money depends positively on nominal income. Aggregate nominal income is P # Y, where P is the aggregate price level and Y is aggregate real income. An increase in either P or Y increases the demand for money. 10.5 INTEREST RATES AND SECURITY PRICES p. 230 10. Interest rates and security prices are inversely related. If market interest rates rise, prices of existing bonds fall. CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 237 when they borrow from the Fed), and (3) engaging in open market operations (the buying and selling of already-existing government securities). To increase the money supply, the Fed could create additional reserves by lowering the discount rate or by buying government securities, or the Fed could increase the number of deposits that can be created from a given quantity of reserves by lowering the required reserve ratio. To decrease the money supply, the Fed could reduce reserves by raising the discount rate or by selling government securities or it could raise the required reserve ratio. 10.6 HOW THE FEDERAL RESERVE CONTROLS THE INTEREST RATE p. 232 11. Prior to 2008 the Fed had three tools to control the money supply: (1) changing the required reserve ratio, (2) changing the discount rate (the interest rate member banks pay 12. In the post-2008 period large quantities of excess reserves have been held by banks. The Fed is now paying interest on these reserves. When the Fed wants to raise interest rates it does so by increasing the interest rate it pays on bank reserves barter, p. 217 commodity monies, p. 219 currency debasement, p. 219 discount rate, p. 232 excess reserves,
p. 224 Federal Open Market Committee (FOMC), p. 227 legal tender, p. 219 lender of last resort, p. 229 liquidity property of money, p. 218 M1, or transactions money, p. 220 M2, or broad money, p. 220 medium of exchange, or means of payment, p. 217 Open Market Desk, p. 227 open market operations, p. 232 required reserve ratio, p. 224 reserves, p. 223 run on a bank, p. 223 store of value, p. 217 unit of account, p. 218 Federal Reserve Bank (the Fed), p. 223 fiat, or token, money, p. 219 money multiplier, p. 226 near monies, p. 220 Equations: M1 K currency held outside banks + demand deposits + traveler>s checks + other checkable deposits, p. 220 M2 K M1 + savings accounts + money market accounts + other near monies, p. 220 Assets K Liabilities + Net Worth, p. 223 Excess reserves K actual reserves - required reserves, p. 224 Money multiplier K 1 required reserve ratio, p. 227 P R O B L E M S All problems are available on MyLab Economics. 10.1 AN OVERVIEW OF MONEY LEARNING OBJECTIVE: Define money and discuss its functions. 1.1 [Related to the Economics in Practice on p. 218] It is well known that cigarettes served as money for prisoners of war in World War II. Do an Internet search using the key word cigarettes and write a description of how this came to be and how it worked. 1.2 As king of Medivalia, you are constantly strapped for funds to pay your army. Your chief economic wizard suggests the following plan: “When you collect your tax payments from your subjects, insist on being paid in gold coins. Take those gold coins, melt them down, and remint them with an extra 10 percent of brass thrown in. You will then have 10 percent more money than you started with.” What do you think of the plan? Will it work? 1.3 Why aren’t money market accounts included in M1 alongside demand deposits? Explain in your own words using the definitions of M1 and M2. 1.4 After suffering two years of staggering hyperinflation, the African nation of Zimbabwe officially abandoned its currency, the Zimbabwean dollar, in April 2009 and made the U.S. dollar its official currency. Why would anyone
in Zimbabwe be willing to accept U.S. dollars in exchange for goods and services? 1.5 In March 2018, the word “cryptocurrency” was added to the Merriam-Webster dictionary, defined as “any MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 237 17/04/19 12:24 AM 238 PART III The Core of Macroeconomic Theory form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units.” The most common cryptocurrency is Bitcoin, although a number of alternative coins (altcoins), like Ethereum, Litecoin, Dogecoin, etc., have also emerged recently. Do these cryptocurrencies qualify as money based on the description of what money is in the chapter? 1.6 Suppose you’re studying abroad for a year and your parents have sent a lump sum payment of $12,000 to your savings account in your new country of residence. They want you to transfer equal sums each month to your new checking account, which you have just started. How will these transactions affect M1 and M2 in your new country of residence? How will these be affected at the end of your stay abroad? 10.2 HOW BANKS CREATE MONEY LEARNING OBJECTIVE: Explain how banks create money. 2.1 For each of the following, determine whether it is an asset or a liability on the accounting books of a bank. Explain why in each case. – Cash in the vault – Demand deposits – Savings deposits – Reserves – Loans – Deposits at the Federal Reserve 2.2 In the spring of 2018, China’s central bank, People’s Bank of China, announced that it would cut the reserve requirement ratio from 17 percent to 16 percent. This was expected to release ¥1,300 billion of additional liquidity into the banking system. How large was the monetary base initially? 2.3 Do you agree or disagree with each of the following state- ments? Explain your answers. a. When the Treasury of the United States issues bonds and sells them to the public to finance the deficit, the money supply remains unchanged because every dollar of money taken in by the Treasury goes right
back into circulation through government spending. This is not true when the Fed sells bonds to the public. b. The money multiplier depends on the marginal propen- sity to save. 2.5 You are given this account for a bank: Assets Liabilities Reserves Loans $1,200 6,800 $8,000 Deposits The required reserve ratio is 10 percent. a. How much is the bank required to hold as reserves given its deposits of $8,000? b. How much are its excess reserves? c. By how much can the bank increase its loans? d. Suppose a depositor comes to the bank and withdraws $500 in cash. Show the bank’s new balance sheet, assuming the bank obtains the cash by drawing down its reserves. Does the bank now hold excess reserves? Is it meeting the required reserve ratio? If not, what can it do? 2.6 Suppose Ginger deposits $12,000 in cash into her check- ing account at the Bank of Skidoo. The Bank of Skidoo has no excess reserves and is subject to a 4 percent required reserve ratio. a. Show this transaction in a T-account for the Bank of Skidoo. b. Assume the Bank of Skidoo makes the maximum loan possible from Ginger’s deposit to Thurston and show this transaction in a new T-account. c. Thurston decides to use the money he borrowed to purchase a sail boat. He writes a check for the entire loan amount to Gilligan’s Seagoing Vessels, which deposits the check in its bank, the Paradise Bank of Kona, Hawaii. When the check clears, the Skidoo Bank transfers the funds to the Paradise Bank. Show these transactions in a new T-account for the Skidoo Bank and in a T-account for the Paradise Bank. d. What is the maximum amount of deposits that can be cre- ated from Ginger’s initial deposit? e. What is the maximum amount of loans that can be cre- ated from Ginger’s initial deposit? 2.7 [Related to the Economics in Practice on p. 222] In the digital age, customer preference for conducting business online versus patronizing a traditional brick-and-mortar location has grown rapidly in many industries, including banking. According to a recent report published by Allied Market Research, online banking is expected to reach a global market size of almost $30 million by 2026, up from
$7.3 million only 10 years earlier. Briefly explain how the growth in online banking could affect the timing and severity of a bank run. 10.3 THE FEDERAL RESERVE SYSTEM *2.4 Suppose that as a result of a grave economic crisis, a country’s citizens’ trust in the financial system in general and the central bank in particular rapidly deteriorates. Consequently, more and more cash payments end up being stashed away in personal home safes, rather than being transferred to savings or checking accounts. How would this change the money supply in that country? LEARNING OBJECTIVE: Define the functions and structure of the Federal Reserve System. 3.1 The United States is divided into 12 Federal Reserve districts, each with a District Bank. These Districts and the locations for the District Bank in each region are shown in Figure 10.4. Do some research to find out why the districts are divided as they are, why the District Banks are located MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 238 17/04/19 12:24 AM in the 12 cities shown in Figure 10.4, and why so many districts are located in the Eastern portion of the United States. 10.4 THE DEMAND FOR MONEY LEARNING OBJECTIVE: Describe the determinants of money demand. 4.1 Paul Krugman, a recipient of the Bank of Sweden Nobel Memorial Prize in Economics, famously depicted the economic situation in Japan in the 1990s as a “liquidity trap”, whereby interest rates were so low that Japanese consumers were willing to hold additional liquidity without CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 239 5.2 Interest rates in Turkey were relatively stable at 8 percent from 2015 through April 2018 but were increased to 17.75 percent in June of that year for two months. Higher interest rates increase the cost of borrowing and discourage firms from borrowing and investing. They also have an effect on the value of the bonds (private and government) outstanding in the economy. How would such a drastic increase in the interest rates have impacted the price of Turkish bonds? Explain briefly but clearly why the value of bonds changes when interest rates change. 5.3 In 2016, Italy, which is a highly indebted nation,
sold 50-year bonds at a yield of 2.8 percent, and buyers were given access to 5 billion euros in the form of these bonds. Would you consider this a risky investment? Why? Md 10.6 HOW THE FEDERAL RESERVE CONTROLS THE INTEREST RATE LEARNING OBJECTIVE: Understand how the Fed can change the interest rate. 6.1 In the Republic of Doppelganger, the currency is the ditto. During 2018, the Treasury of Doppelganger sold bonds to finance the Doppelganger budget deficit. In all, the Treasury sold 80,000 ten-year bonds with a face value of 1,000 dittos each. The total deficit was 80 million dittos. The Doppelganger Central Bank reserve requirement was 16 percent and in the same year, the bank bought 10 million dittos’ worth of outstanding bonds on the open market. All of the Doppelganger debt is held by either the private sector (the public) or the central bank. a. What is the combined effect of the Treasury sale and the central bank purchase on the total Doppelganger debt outstanding? On the debt held by the private sector? b. What is the effect of the Treasury sale on the money supply in Doppelganger? c. Assuming no leakage of reserves out of the banking system, what is the effect of the central bank purchase of bonds on the money supply Money, M changing their interest rates expectations. What happens to the money demand curve in such a situation? Why does monetary policy fail to lower interest rates? Explain with the help of a graph. 4.2 Explain why there is a negative relationship between the amount of money you should hold and the interest rate. 10.5 INTEREST RATES AND SECURITY PRICES LEARNING OBJECTIVE: Define interest and discuss the relationship between interest rates and security prices. 5.1 [Related to the Economics in Practice on p. 231] The Economics in Practice states that the capital value of Professor Serebryakov’s estate is not the value for which he could sell the estate if the interest rate on “suitable” securities is higher than the average yield from the estate. What would happen to: a. the value of the estate if the interest rate on “suitable” securities rose? b. the value of the estate if investment in the estate was suddenly viewed as being less risky than investment in the
securities? c. the yield on the securities if the securities were suddenly viewed as being more risky than was previously thought? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 239 17/04/19 12:24 AM 240 PART III The Core of Macroeconomic Theory 6.2 The Federal Reserve stopped increasing its stockpile of bonds in 2014, a policy called quantitative easing, and by 2018 it had started to let around $40 billion worth of bonds mature without replacing them. This policy, as can be inferred, is called quantitative tightening. Why do you think the Fed has started to engage in quantitative tightening? What impacts would it have on the market for stocks and bonds? 6.3 In 2018, several European countries were faced with the problem of increasing inflation. At the same time, unemployment was low, which led to an increase in real wages. If the European Central Bank (ECB) wanted to cut inflation, which of the following would do it? Explain your answer. a. Decrease the required reserves ratio b. Increase the interest rate c. Sell government bonds 6.4 Suppose in the Republic of Sasquatch that the regula- tion of banking rested with the Sasquatchian Congress, including the determination of the reserve ratio. The Central Bank of Sasquatch is charged with regulating the money supply by using open market operations. In September 2018, the money supply was estimated to be 84 million yetis. At the same time, bank reserves were 12.6 million yetis and the reserve requirement was 15 percent. The banking industry, being “loaned up,” lobbied the Congress to cut the reserve ratio. The Congress yielded and cut required reserves to 12 percent. What is the potential impact on the money supply? Suppose the central bank decided that the money supply should not be increased. What countermeasures could it take to prevent the Congress from expanding the money supply? 6.5 What are the three traditional tools central banks can use to control the interest rate via changing the money supply? Briefly describe how the central bank can use each of these tools to either increase or decrease the money supply QUESTION 1 Money serves three common functions: a means of payment, a store of value, and a unit of account. How well do cryptocurrencies, such as Bitcoin, provide these functions
? QUESTION 2 In this chapter, you learned that the money multiplier is calculated as one divided by the required reserve ratio. This definition implicitly assumes that banks are not holding excess reserves. Would the existence of excess reserves lead the money multiplier to be smaller or larger? CHAPTER 10 APPENDIX LEARNING OBJECTIVE Explain the relationship between a two-year interest rate and a one-year interest rate. The Various Interest Rates in the U.S. Economy MyLab Economics Concept Check Although there are many different interest rates in the economy, they tend to move up or down with one another. Here we discuss some of their differences. We first look at the relationship between interest rates on securities with different maturities, or terms. We then briefly discuss some of the main interest rates in the U.S. economy. The Term Structure of Interest Rates MyLab Economics Concept Check The term structure of interest rates is the relationship among the interest rates offered on securities of different maturities. The key here is understanding issues such as these: How are these different rates related? Does a two-year security (an IOU that promises to repay principal, plus interest, after two years) pay a lower annual rate than a one-year security (an IOU to be repaid, with interest, after one year)? What happens to the rate of interest offered on one-year securities if the rate of interest on two-year securities increases? Assume that you want to invest some money for two years and at the end of the two years you want it back. Assume that you want to buy government securities. For this analysis, we restrict your choices to two: (1) You can buy a two-year security today and hold it for two years, at which time you cash it in (we will assume that the interest rate on the two-year security is 3 percent per year), or MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 240 17/04/19 12:24 AM CHAPTER 10 Money, the Federal Reserve, and the Interest Rate 241 (2) you can buy a one-year security today. At the end of one year, you must cash this security in; you can then buy another one-year security. At the end of the second year, you
will cash in the second security. Assume that the interest rate on the first one-year security is 2 percent. Which would you prefer? Currently, you do not have enough data to answer this question. To consider choice (2) sensibly, you need to know the interest rate on the one-year security that you intend to buy in the second year. This rate will not be known until the second year. All you know now is the rate on the two-year security and the rate on the current one-year security. To decide what to do, you must form an expectation of the rate on the one-year security a year from now. If you expect the one-year rate (2 percent) to remain the same in the second year, you should buy the two-year security. You would earn 3 percent per year on the two-year security but only 2 percent per year on the two one-year securities. If you expect the one-year rate to rise to 5 percent a year from now, you should make the second choice. You would earn 2 percent in the first year, and you expect to earn 5 percent in the second year. The expected rate of return over the two years is about 3.5 percent, which is better than the 3 percent you can get on the two-year security. If you expect the one-year rate a year from now to be 4 percent, it does not matter much which of the two choices you make. The rate of return over the two-year period will be roughly 3 percent for both choices. We now alter the focus of our discussion to get to the topic we are really interested in—how the two-year rate is determined. Assume that the one-year rate has been set by the Fed and it is 2 percent. Also assume that people expect the one-year rate a year from now to be 4 percent. What is the two-year rate? According to a theory called the expectations theory of the term structure of interest rates, the two-year rate is equal to the average of the current one-year rate and the one-year rate expected a year from now. In this example, the two-year rate would be 3 percent (the average of 2 percent and 4 percent). If the two-year rate were lower than the average of the two one-year rates, people would not be indifferent as to which security they held. They would want to hold only the short-term one-year securities. To find
a buyer for a two-year security, the seller would be forced to increase the interest rate it offers on the two-year security until it is equal to the average of the current one-year rate and the expected one-year rate for next year. The interest rate on the two-year security will continue to rise until people are once again indifferent between one two-year security and two one-year securities. Let us now return to Fed behavior. We know that the Fed can affect the short-term interest rate, but does it also affect long-term interest rates? The answer is “somewhat.” Because the two-year rate is an average of the current one-year rate and the expected one-year rate a year from now, the Fed influences the two-year rate to the extent that it influences the current one-year rate. The same holds for three-year rates and beyond. The current short-term rate is a means by which the Fed can influence longer-term rates. In addition, Fed behavior may directly affect people’s expectations of the future short-term rates, which will then affect long-term rates. If the chair of the Fed testifies before Congress that raising short-term interest rates is under consideration, people’s expectations of higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long-term interest rates. Types of Interest Rates MyLab Economics Concept Check The following are some widely followed interest rates in the United States. Three-Month Treasury Bill Rate Government securities that mature in less than a year are called Treasury bills, or sometimes T-bills. The interest rate on three-month Treasury bills is probably the most widely followed short-term interest rate. Government Bond Rate Government securities with terms of one year or more are called government bonds. There are one-year bonds, two-year bonds, and so on, up to 30-year bonds. Bonds of different terms have different interest rates. The relationship among the interest rates on the various maturities is the term structure of interest rates that we discussed in the first part of this Appendix. Federal Funds Rate Banks borrow not only from the Fed but also from each other. If one bank has excess reserves, it can lend some of those reserves to other banks through the federal MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-
time data are marked with. M10_CASE3826_13_GE_C10.indd 241 17/04/19 12:24 AM 242 PART III The Core of Macroeconomic Theory funds market. The interest rate in this market is called the federal funds rate—the rate banks are charged to borrow reserves from other banks. The federal funds market is really a desk in New York City. From all over the country, banks with excess reserves to lend and banks in need of reserves call the desk and negotiate a rate of interest. Account balances with the Fed are changed for the period of the loan without any physical movement of money. This borrowing and lending, which takes place near the close of each working day, is generally for one day (“overnight”), so the federal funds rate is a one-day rate. It is the rate on which the Fed has the most effect through its open market operations. Commercial Paper Rate Firms have several alternatives for raising funds. They can sell stocks, issue bonds, or borrow from a bank. Large firms can also borrow directly from the public by issuing “commercial paper,” which is essentially short-term corporate IOUs that offer a designated rate of interest. The interest rate offered on commercial paper depends on the financial condition of the firm and the maturity date of the IOU. Prime Rate Banks charge different interest rates to different customers depending on how risky the banks perceive the customers to be. You would expect to pay a higher interest rate for a car loan than General Motors would pay for a $1 million loan to finance investment. Also, you would pay more interest for an unsecured loan, a “personal” loan, than for one that was secured by some asset, such as a house or car, to be used as collateral. The prime rate is a benchmark that banks often use in quoting interest rates to their customers. A very low-risk corporation might be able to borrow at (or even below) the prime rate. A less well-known firm might be quoted a rate of “prime plus three-fourths,” which means that if the prime rate is, say, 5 percent, the firm would have to pay interest of 5.75 percent. The prime rate depends on the cost of funds to the bank; it moves up and down with changes in the economy. AAA Corporate Bond Rate Corporations finance much of their investment by selling bonds to the public. Corporate bonds are classified by various bond dealers according
to their risk. Bonds issued by General Motors are in less risk of default than bonds issued by a new risky biotech research firm. Bonds differ from commercial paper in one important way: Bonds have a longer maturity. Bonds are graded in much the same way students are. The highest grade is AAA, the next highest AA, and so on. The interest rate on bonds rated AAA is the triple A corporate bond rate, the rate that the least risky firms pay on the bonds that they issue All problems are available on MyLab Economics. APPENDIX 10: THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY LEARNING OBJECTIVE: Explain the relationship between a twoyear interest rate and a one-year interest rate. Provide an explanation for the extreme differences that you see. Specifically, comment on (1) the fact that rates in 1980 were much higher than in 1993 and (2) the fact that the long-term rate was higher than the short-term rate in 1993 but lower in 1980. 1A.1 The following table gives three key U.S. interest rates in 1980 and again in 1993: 1980 (%) 1993 (%) Three-month U.S. government bills Long-term U.S. government bonds Prime rate 11.39 11.27 15.26 3.00 6.59 6.00 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M10_CASE3826_13_GE_C10.indd 242 17/04/19 12:24 AM The Determination of Aggregate Output, the Price Level, and the Interest Rate In the last three chapters we have been exploring the key elements of the macroeconomy one element at a time. In Chapters 8 and 9 we looked at how the output level in the economy is determined, keeping the interest rate and the price level fixed. In Chapter 10 we turned our attention to the interest rate, holding output and the price level fixed. We are now ready to bring together these key pieces of the economy—output, the price level, and the interest rate. This chapter and the next one will give you the ability to think about the key issues policy makers face in trying to manage the economy. We will see how the output level is determined. We will see what forces push the overall price level up, creating inflation, in an economy.
By the time you finish these two chapters, we hope you will be much better able to understand what lies behind many of the current policy debates in the United States. As we complete the story in this chapter, we will focus on the behavior of two key players in the macroeconomy: firms, who make price and output decisions, and the Federal Reserve (the Fed), which controls the interest rate. We begin with the price and output decisions of firms, which will be summarized in an aggregate supply curve. 11 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 11.1 The Aggregate Supply (AS) Curve p. 244 Define the aggregate supply curve and discuss shifts in the short-run AS curve. 11.2 The Aggregate Demand (AD) Curve p. 247 Derive the aggregate demand curve and explain why the AD curve is downward sloping. 11.3 The Final Equilibrium p. 253 Explain why the intersection of the AD and AS curves is an equilibrium point. 11.4 Other Reasons for a DownwardSloping AD Curve p. 254 Give two additional reasons why the AD curve may slope down. 11.5 The Long-Run AS Curve p. 254 Discuss the shape of the long-run aggregate supply curve and explain longrun market adjustment to potential GDP. 243 M11_CASE3826_13_GE_C11.indd 243 17/04/19 12:25 AM 244 PART III The Core of Macroeconomic Theory 11.1 LEARNING OBJECTIVE Define the aggregate supply curve and discuss shifts in the short-run AS curve. aggregate supply The total supply of all goods and services in an economy. aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. The Aggregate Supply (AS) Curve Aggregate supply in an economy. The is the total supply of goods and services aggregate supply (AS) curve shows the relationship between the aggregate quantity of output supplied by all the firms in an economy and the overall price level. To understand the aggregate supply curve, we need to understand something about the behavior of the individual firms that make up the economy. Consider a situation in which all prices, including the price of labor (wages), simultaneously doubled. What would we expect to see happen to the level of output produced by the firms in this economy? Likely nothing. With all prices doubling, all costs double as well. In effect a firm is in exactly
the same position it was in before the doubling. If wages and prices are both rising, firms get more for their products and pay proportionately more for workers and other inputs. The AS curve in this case would be vertical. Product prices would increase, but firms would not increase output because it would not be profitable to do so. Indeed, as we will see later in this chapter, many economists think this describes reasonably well the long-run relationship between the aggregate price level and aggregate output, arguing that given enough time, price adjustments across all inputs and outputs will fall into line. We will have more to say about this long-run situation a bit later in the chapter. Suppose, on the other hand, that wages and prices do not move in tandem. What do we expect the firms in our macroeconomy to do? If wages respond more slowly to a demand change than do product prices, firms will increase output as product prices rise and the profitability of output increases. Here the AS curve will have an upward slope, rather than being vertical. Many economists believe that in the short run wages do respond more slowly than prices, particularly at some points in the business cycle, and that the short-run AS curve in fact slopes up. Before looking further at the shape of the AS curve, it is worth pointing out that the AS curve is not the sum of individual supply curves. First, we note that imperfectly competitive firms, who make up a substantial part of the economy, do not have individual supply curves. Firms choose both output and price at the same time. To derive an individual supply curve, we need to imagine calling out a price to a firm and having the firm tell us how much output it will supply at that price. We cannot do this if firms are also setting prices. What this means is that you should not think of the AS curve as being the sum of individual supply curves. If individual supply curves do not exist, we certainly can’t add them together! So if the AS curve is not the sum of individual supply curves, what is it? The AS curve shows what happens to the aggregate price level and aggregate output as aggregate demand rises and falls. The AS curve traces out aggregate output and aggregate price level points corresponding to different levels of aggregate demand. Although it is called an aggregate supply curve, it is really misnamed. It is better thought of as a “price/output response” curve—a curve that traces out the price decisions and output decisions of all firms in the economy
under different levels of aggregate demand. Aggregate Supply in the Short Run MyLab Economics Concept Check Consider what happens in an economy when there is a shift in the aggregate demand curve coming from, for example, an increase in government spending. How much, if at all, does the price level increase? How much does output increase? The shape of the AS curve (or price-output response curve) tells us the answer to these questions. The steeper the curve, the more the price level will rise with the demand increase; the flatter the curve, the more the output will rise with the demand increase. Most economists believe that, at least for a period of time, an increase in aggregate demand will result in an increase in both the price level and output. Many economists also believe that how much a demand increase affects the price level versus output depends on the strength of the economy at the time the demand increase occurred. In other words, the AS curve changes its shape as the economy approaches its capacity level. Figure 11.1 shows a curve reflecting these ideas. At low levels of aggregate output—for example, when the economy is in a recession— the aggregate supply curve is fairly flat. The price level increases only slightly when demand increases. At high levels of output—for example, when the economy is experiencing a boom— the AS curve is vertical or nearly vertical. Here, output increases very little following a demand increase and the price level does most of the work. M11_CASE3826_13_GE_C11.indd 244 17/04/19 12:25 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 245 D C AS ◂◂ FIGURE 11.1 The Short-Run Aggregate Supply Curve In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, Y, the curve is vertical. 0 Y Aggregate output (income), Y MyLab Economics Concept Check Why an Upward Slope? In our discussion so far, we noted that if all prices— including wages—move simultaneously, the AS curve will be vertical. All demand increases will be absorbed by price changes alone. A key determinant of whether the short run AS curve slopes up or is vertical is whether wages are “sticky,” moving more slowly than other prices
. With sticky wages, demand increases occur without proportional wage increases and so firms’ marginal cost curves do not shift proportionally. Here increases in prices make output increases more attractive. The empirical evidence suggests that wages do in fact lag prices, that they are slower to change. We discuss in Chapter 13 various reasons that have been advanced for why wages might be sticky in the short run. Looking at the AS curve shows us why the stickiness of wages and the timing of wage responses are so important. Absent these sticky wages, the economy’s response to demand increases by the government, for example, will be price increases without any increase in real output. We should add a word of caution at this point. It may be that some of a firm’s input costs are rising even in the short run after the aggregate demand increase has taken place because some of a firm’s inputs may be purchased from other firms who are raising prices. For example, one input to a Dell computer is a chip produced by Intel or AMD. The fact that some of a firm’s input costs rise along with a shift in the demand for its product complicates the picture because it means that at the same time there is an outward shift in a firm’s demand curve, there is some upward shift in its marginal cost curve. In deriving an upward-sloping AS curve, we are in effect assuming that these kinds of input costs are small relative to wage costs. It is the combination of sticky wages and the large fraction of those wages in firm costs that give us an upward-sloping short-run AS curve. Why the Particular Shape? Notice the AS curve in Figure 11.1 begins with a flat section and ends with a more-or-less vertical section. Why might the AS curve have this shape? It should not surprise you that the shape of the AS curve reflects economists’ views on when in an economy we might expect wages to be most and least sticky. Consider the vertical portion first. At some level the overall economy is using all its capital and all the labor that wants to work at the market wage. The economy is running full tilt. At this level (Y), increased demand for output can be met only by increased prices and similarly for increased demand for labor. Neither wages nor prices are likely to be sticky at this level of economic activity. What about the flat portion of the curve? Here we are at levels of output that are low relative to historical levels. Many firms are likely to have
excess capacity in terms of their plant and equipment and their workforce. With excess capacity, firms may be able to increase output from A to B without a proportionate cost increase. Small price increases may thus be associated with relatively large output responses. We may also observe relatively sticky wages upward at this point on the AS curve if firms have held any excess workers in the downturn as a way to preserve worker morale or for other reasons. M11_CASE3826_13_GE_C11.indd 245 17/04/19 12:26 AM 246 PART III The Core of Macroeconomic Theory Shifts of the Short-Run Aggregate Supply Curve MyLab Economics Concept Check The AS curve shows how a change in aggregate demand will affect the overall price level and output. We have seen that the answer to whether the price level or output is more affected depends on where we are on the AS curve, or how the economy is doing at the time of the change. Now we can think about how other features of the economy might affect, or shift, the position of the AS curve. What does a rightward shift of the AS curve mean? A rightward shift says that society can get a larger aggregate output at a given price level. What might cause such a shift? Clearly, if a society had an increase in labor or capital, the AS curve would shift to the right because the capacity of the economy would increase. Also, broad-based technical changes that increased productivity would shift the AS curve to the right by lowering marginal costs of production in the economy. With lower marginal costs, firms in the economy are willing to produce more for a given price level. Recall that the vertical part of the short-run AS curve represents the economy’s maximum (capacity) output. This maximum output is determined by the economy’s existing resources, like the size of its labor force, capital stock, and the current state of technology. The labor force grows naturally with an increase in the working-age population, but it can also increase for other reasons. Since the 1960s, for example, the percentage of women in the labor force has grown sharply. This increase in the supply of women workers has shifted the AS curve to the right. Immigration can also shift the AS curve. We discuss economic growth in more detail in Chapter 16. We have focused on labor and capital as factors of production, but for a modern economy, energy is also an important input. New discoveries of oil or problems in the production of energy can also shift the
AS curve through effects on the marginal cost of production in many parts of the economy. Figures 11.2(a) and (b) show the effects of shifts in the short-run AS curve coming from changes in wage rates or energy prices. This type of shift is sometimes called a cost shock or supply shock. Oil has historically had quite volatile prices and has often been thought to contribute to shifts in the AS curve that, as we will shortly see, contribute to economy-wide fluctuations. AS1 AS0 MyLab Economics Concept Check AS0 AS1 cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve Aggregate output (income), Y Aggregate output (income), Y a. A decrease in aggregate supply b. An increase in aggregate supply A leftward shift of the AS curve from AS0 to AS1 could be caused by an increase in costs—for example, an increase in wage rates or energy prices. A rightward shift of the AS curve from AS0 to AS1 could be caused by a decrease in costs—for example, a decrease in wage rates or energy prices or advances in technology. ▴◂FIGURE 11.2 Shifts of the Short-Run Aggregate Supply Curve M11_CASE3826_13_GE_C11.indd 246 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 247 The Aggregate Demand (AD) Curve The AS curve in Figure 11.1 shows us all possible combinations of aggregate output and the price level consistent with firms’ output and price decisions. But where on the curve will an economy be? To answer this question we need to consider the demand side of the economy. In this section we will derive an aggregate demand (AD) curve. This curve is derived from the model of the goods market in Chapters 8 and 9 and from the behavior of the Fed. We begin with the goods market. 11.2 LEARNING OBJECTIVE Derive the aggregate demand curve and explain why the AD curve is downward sloping. Planned Aggregate Expenditure and the Interest Rate MyLab Economics Concept Check We know from Chapter 8 that planned investment depends on the interest rate. What does this tell us about the relationship between planned aggregate expenditure (AE) and the interest rate? Recall that planned aggregate expenditure is the sum of consumption, planned investment, and government purchases. That is, AE K C + I
+ G We know that there are many possible levels of planned investment, I, each corresponding to a different interest rate. When the interest rate rises, planned investment falls. Therefore, a rise in the interest rate (r) will ‘ceteris paribus’ lead to a fall in total planned spending (C + I + G) as well.1 Figure 11.3 shows what happens to planned aggregate expenditure and output when the interest rate rises from 3 percent to 6 percent. At the higher interest rate, planned investment is lower; planned aggregate expenditure thus shifts downward. Recall from Chapters 8 and 9 that a fall in any component of aggregate spending has an even larger (or “multiplier”) effect on output. When the interest rate rises, planned investment (and thus planned aggregate expenditure) falls and equilibrium output (income) falls by even more than the fall in planned investment. In Figure 11.3, equilibrium output falls from Y0 to Y1 when the interest rate rises from 3 percent to 6 percent. We can summarize the effects of a change in the interest rate on the equilibrium level of output in the goods market. The effects of a change in the interest rate include: ■■ A high interest rate (r) discourages planned investment (I). ■■ Planned investment is a part of planned aggregate expenditure (AE). ■■ Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of in- come falls. ■■ Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment I0 – I1 C + I0 + G (for r = 3%) C + I1 + G (for r = 6%) ◂◂ FIGURE 11.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure and Equilibrium Output An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate expenditure and thus reduces equilibrium output from Y0 to Y1. 458 0 Y1 Y0 Aggregate output (income), Y MyLab Economics Concept Check 1When we look in detail in Chapter 16 at the behavior of households in the macroeconomy, we will see that consumption spending (C) is also stimulated by lower interest rates and discouraged by higher interest rates. M11_CASE3826_13_GE_C11.indd 247 17/04/19 12:26 AM 248 PART III The Core of Macroeconomic Theory ◂�
� FIGURE 11.4 The IS Curve In the goods market, there is a negative relationship between output and the interest rate because planned investment depends negatively on the interest rate. Any point on the IS curve is an equilibrium in the goods market for the given interest rate shifts IS right IS IS curve Relationship between aggregate output and the interest rate in the goods market. MyLab Economics Concept Check Aggregate output (income), Y Using a convenient shorthand: rc S I T S AET S YT r T S Ic S AEc S Yc This relationship between output and the interest rate is summarized in Figure 11.4. This curve is called the IS curve. Any point on the IS curve is an equilibrium in the goods market for the particular interest rate. The lower the interest rate, the more planned investment we have and the higher will be aggregate output. Equilibrium also means that planned investment equals saving, hence the IS notation. As we note in Figure 11.4, an increase in government spending will shift the IS curve to the right. For any given interest rate, an increase in G increases planned aggregate expenditure, AE, and thus Y in equilibrium. (Remember that AE = C + I + G.) This shift in the IS curve is shown in Figure 11.5. If for a given interest rate, an increase in G increases output from Y1 to Y2, this is a shift of the IS curve from IS1 to IS2. The Behavior of the Fed MyLab Economics Concept Check The IS curve shows the relationship between the interest rate and output. When the interest rate is high, planned investment is low, so all else equal output is low. When the interest rate is low, planned investment is high, so output is high. But where on the curve is the actual economy? To answer this question we need to know the level of the interest rate. We know from Chapter 10 how the Fed controls the interest rate. Every six weeks, the Federal Open Market Committee (FOMC) meets. This committee is headed by the chair of the Fed, currently Jerome Powell. The FOMC decides on the value of the interest rate (the exact rate it sets is called the “federal funds” rate). The FOMC usually announces the interest rate value at 2:15 p.m. eastern time on the day it meets. This is a key time for financial markets around the world. At 2:14 p.m., thousands of people are staring at their computer screens waiting from word on
high. If the announcement is a surprise, it can have large and immediate effects on bond and stock markets. How does the Fed decide on what interest rate value to choose? The Fed’s stated mission is “to foster the stability, integrity and efficiency of the nation’s monetary, financial and payment systems so as to promote optimal macroeconomic performance.”2 The Fed’s main goals in achieving optimal macroeconomic performance are high levels of output and employment and a low rate of inflation. From the Fed’s point of view, the best situation is a fully employed economy with a low inflation rate. The worst situation is stagflation—high unemployment and high inflation. In fact, the Humphrey-Hawkins Full Employment Act of 1978 mandated the Fed to aim for full employment and price stability, and when the bill was sunsetted in 2000, the expectation was that the Fed would continue to aim for full employment and price stability. In virtually all current announcements concerning the interest rate, the Fed makes reference to these two goals. 2Board of Governors of the Federal Reserve System, “Government Performance and Results Act planning Document, page 9 M11_CASE3826_13_GE_C11.indd 248 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 249 ◂◂ FIGURE 11.5 Shift of the IS Curve An increase in government spending (G) with the interest rate fixed increases output (Y), which is a shift of the IS curve to the right. Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the economy. G y r0 IS1 IS2 Y1 Aggregate output (income), Y Y2 MyLab Economics Concept Check The Fed examines data on the current state of the economy, particularly output and inflation, and also considers the likely future course of the economy. In this setting, the Fed faces some hard choices. It knows—as we do from the IS curve in Figure 11.4—that increasing the interest rate will result in lower output, while reducing the interest rate will result in higher output. So one factor the Fed uses to choose the interest rate value is whether it believes output to be too low, too high, or about right. But we know that the Fed also cares about inflation. If the Fed finds inflation higher than it wishes, it will raise the interest rate, other things being equal
, and vice versa if it finds inflation lower than it wishes. The discussion so far has focused on output and inflation as the two main inputs into the Fed’s interest rate decision. But the Fed is not just a mechanical calculator. The Fed chair brings to the FOMC meeting his or her own considerable expertise about the working of the economy. Janet Yellen and Ben Bernanke, the two most recent former Fed chairs are both distinguished researchers. Yellen also had experience running the San Francisco Fed. The current chair, Jerome Powell, served on the Fed for several years before becoming chair and has had high level experience both in government and in the private financial sector. Most of the other members of the FOMC have extensive experience in business and economics. As the Fed thinks about its interest rate setting, it considers factors other than current output and inflation. Levels of consumer confidence, possible fragility of the domestic banking sector, and possible financial problems abroad, say a potential euro crisis, may play a role in its interest rate decision. For our purposes we will label all these factors (all factors except output and inflation) as “Z” factors. These factors lie outside our model, and they are likely to vary from period to period in ways that are hard to predict. If we put all of this together, we can describe the interest rate behavior of the Fed by using a simple linear equation, which we will call the Fed rule: r = aY + bP + gZ Describing the Fed rule via an equation will allow us to incorporate Fed behavior formally into the AS/AD model we are building.3 It is, of course, only an approximation as to how the Fed actually behaves. 3The Fed rule used here differs somewhat from that advocated for teaching purposes by David Romer, “Keynesian Macroeconomics without the LM Curve,” Journal of Economic Perspectives, 14, Spring 2000, 149–169. First, the left-hand side variable is the nominal interest rate (r) rather than the real interest rate advocated by Romer. The Fed does in fact set the nominal rate at each FOMC meeting, so the use of the nominal rate is more realistic and easier to understand for students. Second, the price level, not the rate of inflation, is used in the rule. The AS/AD model is a static model. Introducing inflation brings in dynamics, which complicates the analysis. P is used here instead of the change in P. The insights still hold
, and the story is much simpler. Third, the nominal interest rate is used in the (real) goods market in the determination of planned investment. Again, this is an approximation to avoid dynamics, and the insights still hold. The research of one of the authors (Fair) actually supports the use of the nominal rate in the goods market. The results suggest that people (both consumers and investors) respond more to nominal rates than to real rates. Also, the left-hand side variable in Fair’s price equation in his U.S. macroeconometric model is the (log) price level rather than the rate of inflation. This equation is consistent with the discussion behind the AS curve, where the two decision variables of a firm are taken to be the firm’s price level and level of output, not the change in the price level and level of output. M11_CASE3826_13_GE_C11.indd 249 17/04/19 12:26 AM 250 PART III The Core of Macroeconomic Theory Central Bankers: Does Personality Matter? Federal Reserve, Mario Draghi at the European Central Bank, Raghuram Rajan at the Reserve Bank of India, and Mark Carney at the Bank of England are examples of “superstar” central bankers endowed by the financial press with the capacity to significantly influence monetary policy effectiveness. In particular, central bankers’ education, training, and professional background seems to matter enormously. But is this really true? In a recent study2, two economists looked at the claim that “superstar” central bankers, such as those mentioned above, make an impact on economic performance. Comparing “superstars” with “average” central bankers (as defined by the financial press), the authors found that outstanding personalities at the helm of central banks indeed make a difference and can particularly obtain a better trade-off between inflation and unemployment through a positive effect on the confidence of various economic agents. 1Stanislaw, Joseph and Yergin, Daniel, “The Commanding Heights: The Battle for the World Economy”, 1998. 2Neuenkirch, Matthias and Tillmann, Peter, “Does a Good Central Banker Make a Difference?”, Universität Trier Research Paper in Economics n.8/13, 2014. After being sworn in as Chairman of the U.S. Federal Reserve Board in 1979, Paul Vocker told a journalist in
an informal encounter that he was “boring”, and that “it’s the job of all central bankers to be as boring as possible.”1 Three decades and a global financial crisis later, being boring does not seem to be a requisite to be a good central banker any more. On the contrary, the personality of central bankers is more than sufficiently scrutinized. Janet Yellen at the What does this equation tell us? We will assume that the three coefficients, α, β, and γ, are positive. When output is high, all else equal, the Fed favors a higher interest rate then it would in a low-output economy. Likewise, when the price level is high, all else equal, the Fed favors a higher interest rate then it would when price stability is not a problem. High interest rates will thus be associated with high output and price levels. Positive coefficients tell us that the Fed “leans against the wind.” That is, when output and/or the price level are high, the Fed sets a high interest rate to try to rein the economy in. Note that we are using the price level, P, as the variable in the rule. In practice, the Fed cares about inflation, which is the change in P, rather than the level of P, and we are approximating this by using just the level of P. Z in the rule stands for all the factors that affect the Fed’s interest rate decision except for Y and P. Since we have taken γ to be positive, the factors in Z are defined to be such that a high value of a factor makes the Fed inclined to have a high interest-rate value, other things being equal. Strong consumer confidence, for example, might be a Z factor, reinforcing the Fed’s belief that the economy is doing well on the output side. In 2015, it is clear that concerns about the economy in Europe and China had an influence on Fed interest rate-setting behavior; this would be included as a Z factor. We are now ready to add the Fed rule to our model. Figure 11.6 adds the Fed rule to the IS curve from Figure 11.4. The line depicting the Fed rule in the graph shows the relationship between the Fed’s choice of the interest rate and aggregate output, holding the price level and the Z factors constant. The slope is positive because the coefficient α in the Fed rule is positive: When output is high, the interest rate that the Fed
sets is high, other things being equal. The intersection of the IS curve and the Fed rule determines the equilibrium values of output and the interest rate. At this point there is equilibrium in the goods market and the value of the interest rate is what the Fed rule calls for. Figure 11.6 shows the equilibrium values of output and the interest rate for given values of government spending (G), the price level (P), and all factors in Z. Suppose the government decides M11_CASE3826_13_GE_C11.indd 250 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 251 ◂◂ FIGURE 11.6 Equilibrium Values of the Interest Rate and Output In the Fed rule, the Fed raises the interest rate as output increases, other things being equal. Along the IS curve, output falls as the interest rate increases because planned investment depends negatively on the interest rate. The intersection of the two curves gives the equilibrium values of output and the interest rate for given values of government spending (G), the price level (P), and the factors in Z* Fed rule IS G shifts y IS right y P shifts Fed rule left y Z shifts Fed rule left Y* Aggregate output (income), Y MyLab Economics Concept Check to increase its spending. How do the equilibrium values of the interest rate and output change? Remember that an increase in government spending shifts the IS curve to the right. Figure 11.6 shows the increase in the equilibrium values of both the interest rate and output. Now what happens if instead of a change in government spending, we have an increase in the price level, say from an economy-wide cost shock? Remember that the price level is in the Fed rule—the Fed cares about price stability. The Fed would thus respond to an increase in the price level by raising the interest rate. This means that in Figure 11.6 an increase in the price level shifts the Fed rule to the left—for a given value of output, the interest rate is higher for a higher value of the price level. Finally, if any of the “Z” factors we described increase, like an increase in consumer confidence, this leads the Fed to increase the interest rate, which also shifts the Fed rule to the left in Figure 11.6. Deriving the AD Curve MyLab Economics Concept Check We can now derive the AD curve. The AD curve (like the AS curve) is a relationship
between the overall price level (P) and aggregate output (income) (Y). We know from Figure 11.6 that an increase in P shifts the Fed rule to the left (and has no effect on the IS curve). When the Fed rule shifts to the left along an unchanged IS curve, the new equilibrium is at a higher interest rate and a lower level of output. Be sure you understand why output is lower when P is higher. When P increases, the Fed, according to the rule, responds by raising the interest rate, other things being equal. The higher interest rate has a negative effect on planned investment and thus on AE and thus on Y. This is the relationship reflected in the IS curve. Conversely, a decrease in P shifts the Fed rule to the right, resulting in a new equilibrium with a lower interest rate and higher level of output. There is thus a negative relationship between P and Y in the goods market with the Fed rule, and this is the AD curve. The AD curve is presented in Figure 11.7 shifts AD right Z shifts y AD left AD Aggregate output (income), Y MyLab Economics Concept Check ◂◂ FIGURE 11.7 The Aggregate Demand (AD) Curve The AD curve is derived from Figure 11.6. Each point on the AD curve is an equilibrium point in Figure 11.6 for a given value of P. When P increases, the Fed raises the interest rate (the Fed rule in Figure 11.6 shifts to the left), which has a negative effect on planned investment and thus on Y. The AD curve reflects this negative relationship between P and Y. M11_CASE3826_13_GE_C11.indd 251 17/04/19 12:26 AM 252 PART III The Core of Macroeconomic Theory Central Banks and Price Stability: Which Prices to Look At? Many central banks share the key policy objective of keeping inflation low. For instance, price stability is a core part of the mandate of the Federal Reserve in the United States and the European Central Bank, of which the latter defines price stability as a “year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%.” While the overall objective of price stability is widely shared by central banks, they often differ in terms of the measures of inflation that they use to formulate their monetary policy objectives. While some central banks particularly target overall inflation, others prefer to focus on what is called core inflation. Core
inflation excludes food and energy prices, which are more volatile than other items and may, therefore, mislead policy makers in seeing an inflationary trend where the increase in the price level may have resulted from exogenous shocks with only temporary effects on the economy. Some central banks formally follow an overall inflation target while closely monitoring core inflation. This is the case, for instance, of Chile’s central bank, whose mission is to keep Consumer Price Index inflation at around 3 percent a year, but its annual reports contain extensive analyses of changes in the Consumer Price Index Excluding Food and Energy (CPIEFE). Another problem frequently discussed by economists is whether to include import prices in the indicators used in monetary policy formulation. In particular, some economists argue that central banks should not use a price indicator that includes the prices of goods and services whose production is not affected by domestic monetary policy since imported goods are, by definition, produced abroad. As an alternative, these economists propose the use of production price indexes, such as the GDP deflator. However, this alternative is also problematic as it does not reflect the inflation perceived by consumers when they spend their income. This problem is compounded by the variation of economic situations that countries find themselves in. In emerging market economies, for instance, inflation often reflects Rapid productivity growth in tradable goods industries. Not only is inflation not undesirable in this context, but also the price level indicators used by central banks in advanced industrial countries might not be appropriate for the measurement of inflation necessary to formulate an effective monetary policy. In monetary policy, as in all other areas of economic policy, as far as price indicators are concerned, no size fits all. It is noted in Figure 11.7 that an increase in government spending (G) shifts the AD curve to the right. We can see this from Figure 11.6. When G increases, the IS curve shifts to the right since AE and thus Y are larger for a given value of the interest rate. (Remember that AE = C + I + G.) The new equilibrium for the G increase has a higher interest rate and a higher level of output. The higher level of output means that the AD curve shifts to the right when G increases. It is also noted in Figure 11.7 that an increase in Z shifts the AD curve to the left. Remember that an increase in Z means that the Fed is raising the interest rate, other things being equal: The coefficient γ is positive. We can see why the AD curve shifts to the left when Z increases from Figure 11
.6. When Z increases, the Fed rule shifts to the left in Figure 11.6, which results in a higher interest rate and a lower level of output. The lower level of output means that the AD curve shifts to the left when Z increases. It is important to realize that the AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. To understand why, recall the logic behind a simple downward-sloping household demand curve. A demand curve shows the quantity of output demanded (by an individual household or in a single market) at every possible price, ceteris paribus. In drawing a simple demand curve, we are assuming that other prices and income are fixed. From these assumptions, it follows that one reason the quantity demanded of a particular M11_CASE3826_13_GE_C11.indd 252 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 253 11.3 LEARNING OBJECTIVE Explain why the intersection of the AD and AS curves is an equilibrium point. good falls when its price rises is that other prices do not rise. The good in question therefore becomes more expensive relative to other goods, and households respond by substituting other goods for the good whose price increased. In addition, if income does not rise when the price of a good does, real income falls. This may also lead to a lower quantity demanded of the good whose price has risen. Things are different when the overall price level rises. When the overall price level rises, many prices rise together. For this reason, we cannot use the ceteris paribus assumption to draw the AD curve. The logic that explains why a simple demand curve slopes downward fails to explain why the AD curve also has a negative slope. Aggregate demand falls when the price level increases because the higher price level leads the Fed to raise the interest rate, which decreases planned investment and thus aggregate output. It is the higher interest rate that causes aggregate output to fall. The Final Equilibrium Figure 11.8 combines the AS curve from Figure 11.1 and the AD curve from Figure 11.7. Consider for a moment what these two curves have embedded in them. Every point on the AS curve is one in which firms make output and price decisions to maximize their profits. Every point on the AD curve reflects equilibrium in the goods market with the Fed behaving according to the Fed rule. The intersection
of these two curves is the final equilibrium. The equilibrium values of aggregate output (Y) and the price level (P) are determined. Behind the scenes, equilibrium values of the interest rate (r), consumption (C), and planned investment (I) are determined. The variables that are exogenous to the AS/AD model (i.e., not explained by the model) are government spending (G), the factors in Z, and exogenous costs, like oil prices, that shift the AS curve. Net taxes (T), which have not been discussed in this chapter but are discussed in Chapter 9, are also exogenous. (Net taxes are part of the expanded model of the goods market in Chapter 9.) It is noted in Figure 11.8 that an increase in G shifts the AD curve to the right and that an increase in Z shifts the AD curve to the left. These shifts have already been discussed. The figure also notes that an increase in costs shifts the AS curve to the left. These costs are best thought of as costs like oil prices. The rest of this chapter discusses the AD and AS curves in a little more detail, and then Chapter 12 uses the AS/AD framework to analyze monetary and fiscal policy effects and other macroeconomic issues. Chapter 12 shows the power of the AS/AD model as we use it to analyze a number of interesting and important questions in macroeconomics* AS y G shifts AD right y Z shifts AD left Costs shifts y AS left AD Y* Y Aggregate output (income), Y MyLab Economics Concept Check ▴◂FIGURE 11.8 Equilibrium Output and the Price Level Aggregate output and the aggregate price level are determined by the intersection of the AS and AD curves. These two curves embed within them decisions of households, firms, and the government. M11_CASE3826_13_GE_C11.indd 253 17/04/19 12:26 AM 254 PART III The Core of Macroeconomic Theory 11.4 LEARNING OBJECTIVE Give two additional reasons why the AD curve may slope down. real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level. 11.5 LEARNING OBJECTIVE Discuss the shape of the longrun aggregate supply curve and explain long-run market adjustment to potential GDP. Other Reasons for a Downward-Sloping AD Curve The AD curve slopes down in the preceding analysis because the Fed raises the interest rate when P increases and
because planned investment depends negatively on the interest rate. It is also the case in practice that consumption depends negatively on the interest rate, so planned investment depending on the interest rate is not the only link between the interest rate and planned aggregate expenditure. We noted briefly in Chapter 8 that consumption depends on the interest rate, and we will discuss this in more detail in Chapter 15. The main point here is that planned investment does not bear the full burden of linking changes in the interest rate to changes in planned aggregate expenditure and thus the downward-sloping AD curve. There is also a real wealth effect on consumption that contributes to a downward-sloping AD curve. We noted in Chapter 8 and will discuss in detail in Chapter 15 that consumption depends on wealth. Other things being equal, the more wealth households have, the more they consume. Wealth includes holdings of money, shares of stock, bonds, and housing, among other things. If household wealth decreases, the result will be less consumption now and in the future. The price level has an effect on some kinds of wealth. Suppose you are holding $1,000 in a checking account or in a money market fund and the price level rises by 10 percent. Your holding is now worth 10 percent less because the prices of the goods that you could buy with your $1,000 have all increased by 10 percent. The purchasing power (or “real value”) of your holding has decreased by 10 percent. An increase in the price level may also lower the real value of stocks and housing, although whether it does depends on what happens to stock prices and housing prices when the overall price level rises. If stock prices and housing prices rise by the same percentage as the overall price level, the real value of stocks and housing will remain unchanged. If an increase in the price level does lower the real value of wealth, this is another reason for the downward slope of the AD curve. If real wealth falls, this leads to a decrease in consumption, which leads to a decrease in planned aggregate expenditure. So if real wealth falls when there is an increase in the price level, there is a negative relationship between the price level and output through this real wealth effect. The Long Run AS Curve We derived the short-run AS curve under the assumption that wages were sticky. This does not mean, however, that stickiness persists forever. Over time, wages adjust to higher prices. When workers negotiate with firms over their wages, they take into account what prices have been doing in the recent past. If wages fully
adjust to prices in the long run, then the long-run AS curve will be vertical. We can see why in Figure 11.9. Initially, the economy is in equilibrium at a price level of P0 and aggregate output of Y0 (the point A at which AD0 and AS0 intersect). Now imagine a shift of the AD curve from AD0 to AD1. In response to this shift, both the price level and aggregate output rise in the short run, to P1 and Y1, respectively (the point B at which AD1 and AS0 intersect). The movement along the upward-sloping AS0 curve as Y increases from Y0 to Y1 assumes that wages lag prices. At point B real wages (nominal wages divided by prices) are lower than they are at point A. Now, as wages increase, the short-run AS curve shifts to the left. If wages fully adjust, the AS curve will over time have shifted from AS0 to AS1 in Figure 11.9, and output will be back to Y0 (the point C at which AD1 and AS1 intersect). So when wages fully adjust to prices, the long-run AS curve is vertical. At point C real wages are back to where they were at point A. The price level is, of course, higher. By looking at Figure 11.9, you can begin to see why arguments about the shape of the AS curve are so important in policy debates. If the long-run AS curve is vertical as we have drawn it, factors that shift the AD curve to the right—such as increasing government spending—simply end up increasing the price level. If the short-run AS curve also is quite steep, even in the short run most of the effect of any shift in the AD curve will be felt in an increase in the price level rather than an increase in aggregate output. If the AS curve, on the other hand, is flat, AD shifts can have a large effect on aggregate output, at least in the short run. We discuss these effects of policy in more detail in the next chapter. M11_CASE3826_13_GE_C11.indd 254 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 255 P2 P1 P0 AS (Long run) AS1 (Short run) AS0 (Short run) C A B AD1 AD0 ◂�
� FIGURE 11.9 The Long-Run Aggregate Supply Curve When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Wages respond in the longer run, shifting the AS curve from AS0 to AS1. If wages fully adjust, output will be back to Y0. Y0 is sometimes called potential GDP. 0 Y0 Y1 Aggregate output (income), Y MyLab Economics Concept Check Potential GDP MyLab Economics Concept Check Recall that even the short-run AS curve becomes vertical at some particular level of output. The vertical portion of the short-run AS curve exists because there are physical limits to the amount that an economy can produce in any given time period. At the physical limit, all plants are operating around the clock, many workers are on overtime, and there is no cyclical unemployment. Note that the vertical portions of the short-run AS curves in Figure 11.9 are to the right of Y0. If the vertical portions of the short-run AS curves represent “capacity,” what is the nature of Y0, the level of output corresponding to the long-run AS curve? Y0 represents the level of aggregate output that can be sustained in the long run without inflation. It is sometimes calledpotential output or potential GDP. Output can be pushed above Y0 under a variety of circumstances, but when it is, there is upward pressure on wages. (Remember that real wages are lower at point B than at point A in Figure 11.9.) As the economy approaches short-run capacity, wage rates tend to rise as firms try to attract more people into the labor force and to induce more workers to work overtime. Rising wages shift the short-run AS curve to the left (in Figure 11.9 from AS0 to AS1) and drive output back to Y0. Short-Run Equilibrium Below Potential Output Thus far, we have argued that if the short-run AS and AD curves intersect to the right of Y0 in Figure 11.9, wages will rise, causing the short-run AS curve to shift to the left and pushing aggregate output back down to Y0. Although different economists have different opinions on how to determine whether an economy is operating at or above potential output, there is general agreement that there is a maximum level of output (below the vertical portion of the short-run AS curve) that can be sustained without inflation. What about
short-run equilibria that occur to the left of Y0? If the short-run AS and AD curves intersect at a level of output below potential output, what will happen? Here again economists disagree. Those who believe the AS curve is vertical in the long run believe that when short-run equilibria exist below Y0, output will tend to rise—just as output tends to fall when short-run equilibria exist above Y0. The argument is that when the economy is operating below full employment with excess capacity and high unemployment, wages are likely to fall. A decline in wages shifts the AS curve to the right, causing the price level to fall and the level of aggregate output to rise back to Y0. This automatic adjustment works only if wages fall quickly when excess capacity and unemployment exist. We will discuss wage adjustment during periods of unemployment in detail in Chapter 13. potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. M11_CASE3826_13_GE_C11.indd 255 17/04/19 12:26 AM 256 PART III The Core of Macroeconomic Theory The Simple “Keynesian” Aggregate Supply Curve There is a great deal of disagreement concerning the shape of the AS curve. One view of the aggregate supply curve, the simple “Keynesian” view, holds that at any given moment, the economy has a clearly defined capacity, or maximum, output. This maximum output, denoted by YF, is defined by the existing labor force, the current capital stock, and the existing state of technology. If planned aggregate expenditure increases when the economy is producing below this maximum capacity, this view holds, inventories will be lower than planned, and firms will increase output, but the price level will not change. Firms are operating with underutilized plants (excess capacity), and there is cyclical unemployment. Expansion does not exert any upward pressure on prices. However, if planned aggregate expenditure increases when the economy is producing near or at its maximum (YF), inventories will be lower than planned, but firms cannot increase their output. The result will be an increase in the price level, or inflation Inflationary gap AE3 AE2 AE1 458 0 Y1 YF Y3 P3 P1 0 AS AD3 AD1 AD2 Y1 YF Aggregate output (income), Y 1 C + I + G K AE This view is illustrated in the
figure. In the top half of the diagram, aggregate output (income) (Y) and planned aggregate expenditure are initially in equilibrium at AE1, Y1, and price level P1. Now suppose an increase in government spending increases planned aggregate expenditure. If such an increase shifts the AE curve from AE1 to AE2 and the corresponding aggregate demand curve from AD1 to AD2, the equilibrium level of output will rise from Y1 to YF. (Remember, an expansionary policy shifts the AD curve to the right.) Because we were initially producing below capacity output (Y1 is lower than YF), the price level will be unaffected, remaining at P1. 2 Now consider what would happen if AE increased even further. Suppose planned aggregate expenditure shifted from AE2 to AE3, with a corresponding shift of AD2 to AD3. If the economy were producing below capacity output, the equilibrium level of output would rise to Y3. However, the output of the economy cannot exceed the maximum output of YF. As inventories fall below what was planned, firms encounter a fully employed labor market and fully utilized plants. Therefore, they cannot increase their output. The result is that the aggregate supply curve becomes vertical at YF, and the price level is driven up to P3. The difference between planned aggregate expenditure and aggregate output at full capacity is sometimes referred to With planned aggregate expenditure of AE1 and aggregate demand of AD1, equilibrium output is Y1. A shift of planned aggregate expenditure to AE2, corresponding to a shift of the AD curve to AD2, causes output to rise but the price level to remain at P1. If planned aggregate expenditure and aggregate demand exceed YF, however, there is an inflationary gap and the price level rises to P3. as an inflationary gap. You can see the inflationary gap in the top half of the figure. At YF (capacity output), planned aggregate expenditure (shown by AE3) is greater than YF. The price level rises to P3 until the aggregate quantity supplied and the aggregate quantity demanded are equal. Despite the fact that the kinked aggregate supply curve provides some insights, most economists find it unrealistic. It does not seem likely that the whole economy suddenly runs into a capacity “wall” at a specific level of output. As output expands, some firms and industries will hit capacity before others. CRITICAL THINKING 1. Why is the distance between AE3 and AE2 called an inflationary gap? M11
_CASE3826_13_GE_C11.indd 256 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 257 S U M M A R Y 11.1 THE AGGREGATE SUPPLY (AS) CURVE p. 244 1. Aggregate supply is the total supply of goods and services in an economy. The aggregate supply (AS) curve shows the relationship between the aggregate quantity of output supplied by all the firms in the economy and the overall price level. The AS curve is not a market supply curve, and it is not the simple sum of individual supply curves. For this reason, it is helpful to think of the AS curve as a “price/output response” curve—that is, a curve that traces out the price and output decisions of all firms in the economy under a given set of circumstances. 2. The shape of the short-run AS curve is a source of much controversy in macroeconomics. Many economists believe that at low levels of aggregate output, the AS curve is fairly flat and that at high levels of aggregate output, the AS curve is vertical or nearly vertical. 3. Anything that affects an individual firm’s marginal cost curve can shift the AS curve. The two main factors are wage rates and energy prices. 11.2 THE AGGREGATE DEMAND (AD) CURVE p. 247 4. The IS curve summarizes the relationship between the interest rate and equilibrium output in the goods market. Government spending (G) shifts the IS curve. open market operations to achieve the interest rate value that it wants. 6. Each point on the AD curve is, for a given value of P, an equilibrium in the goods market with the Fed rule. Increases in G shift the AD curve to the right, and increases in Z shift the AD curve to the left. 11.3 THE FINAL EQUILIBRIUM p. 253 7. The final equilibrium is the point of intersection of the AS and AD curves. Determined at this point are equilibrium values of output, the price level, the interest rate, consumption, planned investment, the demand for money, and the supply of money. Exogenous variables (variables not explained by the model) are government spending, the factors in Z, net taxes (used in the next chapter), and cost shocks. 11.4 OTHER REASONS FOR A DOWNWARD-SLOPING AD CURVE
p. 254 8. Consumption as well as planned investment depends on the interest rate. This is another reason for a downward-sloping AD curve. Another reason is that consumption also depends on real wealth. 5. Fed behavior is described by an interest rate rule, the Fed rule. The Fed’s choice of the interest rate value depends on the state of the economy, approximated in the rule by output (Y), the price level (P), and other factors (Z). The Fed uses 11.5 THE LONG-RUN AS CURVE p. 254 9. The long-run AS curve is vertical if wages adjust completely to prices in the long run aggregate supply, p. 244 aggregate supply (AS) curve, p. 244 cost shock, or supply shock, p. 246 Fed rule, p. 249 IS curve, p. 248 potential output, or potential GDP, p. 255 real wealth effect, p. 254 Equations: AE K C + I + G, p. 247 r = aY + bP + gZ, p. 249 P R O B L E M S All problems are available on MyLab Economics. 11.1 THE AGGREGATE SUPPLY (AS) CURVE 11.2 THE AGGREGATE DEMAND (AD) CURVE LEARNING OBJECTIVE: Define the aggregate supply curve and discuss shifts in the short-run AS curve. LEARNING OBJECTIVE: Derive the aggregate demand curve and explain why the AD curve is downward sloping. 1.1 Illustrate each of the following situations with a graph 2.1 In March 2009, the Official Bank Rate (interest rate) in showing short-run aggregate supply: a. A decrease in the size of the labor force b. An increase in available capital c. An increase in productivity as a result of a technological change d. A decrease in the price of oil the United Kingdom was reduced to 0.5 percent, where it stayed for a few years. In August 2016, it was reduced to 0.25 percent. By November 2017, however, the interest rate had started to increase and by August 2018 it was as high as 0.75 percent. What effect did the bank hope the MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M11_CASE3826_13_GE
_C11.indd 257 17/04/19 12:26 AM 258 PART III The Core of Macroeconomic Theory action will have on the economy? Be specific in your answer. What was the hoped-for result on C, I, and Y? 2.2 Some economists argue that the “animal spirits” of inves- tors are so important in determining the level of investment in the economy that interest rates do not matter at all. Suppose this were true, that investment in no way depends on interest rates. a. How would Figure 11.4 be different? b. What would happen to the level of planned aggregate ex- penditure if the interest rate changed? 2.3 The year 2018 saw heightened speculation regarding the European Central Bank increasing key interest rates in the near future, possibly starting with the year 2019. How might this impact aggregate demand? 2.4 Illustrate each of the following situations with a graph showing the IS curve and the Fed rule, and explain what happens to the equilibrium values of the interest rate and output: a. An increase in public spending by the government with the money supply held constant. b. An increase in interest rates by the central bank to offset the effects of a reduction in taxation on prices. c. An increase in the aggregate price level due to a rise in world energy prices. The central bank and the government do not react. d. A decrease in the money supply due to inflationary pressures by the central bank in an attempt to keep the real money supply constant. e. A decrease in public spending by the government with the interest rates held constant by the central bank. 2.5 The AD curve slopes downward because when the price level is lower, people can afford to buy more and aggregate demand rises. When prices rise, people can afford to buy less and aggregate demand falls. Is this a good explanation of the shape of the AD curve? Why or why not? 2.6 In the first few chapters of this book, we introduced the notion of supply and demand. One of the first things we did was to derive the relationship between the price of a product and the quantity demanded per time period by an individual household. Now we have derived what is called the aggregate demand curve. The two look the same and both seem to have a negative slope, but the logic is completely different. Tell one story that explains the negative slope of a simple demand curve and another story that explains the more complex AD curve. 2.7 [Related to the Economics in Practice on
p. 250] In a June 13, 2018 press conference, Fed Chair Jerome Powell announced a 0.25 point increase in the federal funds rate target, to between 1.75 percent and 2.00 percent, the seventh rate hike since late 2015. Powell also indicated that two additional rate hikes were likely before the end of the year. What has happened to the Fed’s target for the federal funds rate since June 2018? Using the Fed rule, explain the Fed’s decision to either change or not change the interest rate. 2.8 [Related to the Economics in Practice on p. 252] Check the Website of your country’s central bank and find the price level indicator that the bank relies on to formulate its monetary policy. Does it differ from the indicators used by the Federal Reserve? How? What is the impact of using other price indexes for the decisions made by the central bank? 11.3 THE FINAL EQUILIBRIUM LEARNING OBJECTIVE: Explain why the intersection of the AD and AS curves is an equilibrium point. 3.1 Illustrate each of the following situations with a graph showing AS and AD curves, and explain what happens to the equilibrium values of the price level and aggregate output: a. A decrease in G with the money supply held constant by the Fed b. A decrease in the price of oil with no change in govern- ment spending c. An increase in Z with no change in government spending d. An increase in the price of oil and a decrease in G 11.4 OTHER REASONS FOR A DOWNWARDSLOPING AD CURVE LEARNING OBJECTIVE: Give two additional reasons why the AD curve may slope down. 4.1 In the tiny island of Pangea, national wealth is broken down as follows: 30 percent is cash in checking and savings accounts, 40 percent is real estate, and 30 percent is stock holdings. Last year, Pangea experienced an inflation rate of 0 percent, real estate prices increased by 7 percent, and stock prices increased by 21 percent. Explain what happened to real wealth within Pangea last year, and how this change in real wealth helps explain the downward slope of the aggregate demand curve. 11.5 THE LONG-RUN AS CURVE LEARNING OBJECTIVE: Discuss the shape of the long-run aggregate supply curve and explain long-run market adjustment to potential GDP. 5.1 The economy of Mayberry is currently in equilibrium at point A on the graph.
Prince Barney of Mayberry has decided that he wants the economy to grow and has ordered the Royal Central Bank of Mayberry to print more currency so banks can expand their loans to stimulate growth. Explain what will most likely happen to the economy of Mayberry as a result of Prince Barney’s actions and show the result on the graph. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M11_CASE3826_13_GE_C11.indd 258 17/04/19 12:26 AM CHAPTER 11 The Determination of Aggregate Output, the Price Level, and the Interest Rate 259 P0 AS (Long run) AS (Short run) A AD 0 Y0 Aggregate output (income), Y 5.2 Two separate capacity constraints are discussed in this chapter: (1) the actual physical capacity of existing plants and equipment, shown as the vertical portion of the shortrun AS curve, and (2) potential GDP, leading to a vertical long-run AS curve. Explain the difference between the two. Which is greater, full-capacity GDP or potential GDP? Why? 5.3 Suppose that the economy of your country is growing at its full potential. Given long years of growth, your country’s consumers have very high expectations regarding the future performance of the economy, and this translates into an abnormally high level of consumer confidence. By using aggregate supply and demand curves and other useful graphs, illustrate how this will affect the equilibrium output. 5.4 Using AS and AD curves to illustrate, describe the effects of the following events on the price level and on equilibrium GDP in the long run assuming that input prices fully adjust to output prices after some lag: a. An increase occurs in the money supply above potential GDP b. GDP is above potential GDP, and a decrease in govern- ment spending and in the money supply occurs c. Starting with the economy at potential GDP, a war in the Middle East pushes up energy prices temporarily. The Fed expands the money supply to accommodate the inflation. 5.5 [Related to the Economics in Practice on p. 256] The Economics in Practice describes the simple Keynesian AS curve as one in which there is a maximum level of output given the constraints of a fixed capital stock and a fixed supply of labor. The presumption is that increases in demand when firms are operating below capacity will result in output increases and
no input price or output price changes but that at levels of output above full capacity, firms have no choice but to raise prices if demand increases. In reality, however, the short-run AS curve isn’t flat and then vertical. Rather, it becomes steeper as we move from left to right on the diagram. Explain why. What circumstances might lead to an equilibrium at a very flat portion of the AS curve? At a very steep portion QUESTION 1 If moderate inflation takes place, and households believe that this increase in the price level is only temporary, they may delay some purchases until the price level falls back to its initial level. This is most commonly observed with durable goods, like washing machines and refrigerators. Would you expect this behavior to shift the Aggregate Demand curve? QUESTION 2 Investments in physical and human capital can increase the value of Potential GDP in the economy. How would you represent this in the Aggregate Demand and Aggregate Supply model? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M11_CASE3826_13_GE_C11.indd 259 17/04/19 12:26 AM 12 Policy Effects and Cost Shocks in the AS/AD Model CHAPTER OUTLINE AND LEARNING OBJECTIVES 12.1 Fiscal Policy Effects p. 261 Use the AS/AD model to analyze the short-run and long-run effects of fiscal policy. 12.2 Monetary Policy Effects p. 263 Use the AS/AD model to analyze the short-run and long-run effects of monetary policy. 12.3 Shocks to the System p. 265 Explain how economic shocks affect the AS/AD model. 12.4 Monetary Policy since 1970 p. 268 Discuss monetary policy since 1970. Looking Ahead p. 270 260 Throughout the two Obama administrations and the early Trump administration, Republicans and Democrats argued vehemently about the overall government budget. Should taxes be raised or lowered? If tax rates are to be changed, should they be personal income tax rates or corporate profit tax rates? Should government spending be raised or lowered? Some of this debate was ideological, as U.S. political leaders differed in questions like how big the government should be. Other debate focused on more economic issues: Was the economy firmly on a growth path or still vulnerable to unemployment problems? Whatever the motivations for particular policies, decisions made in the political
process about taxes and spending have important macroeconomic consequences. The AS/AD model developed in the last chapter is a key tool in allowing us to explore these consequences. M12_CASE3826_13_GE_C12.indd 260 17/04/19 12:27 AM CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 261 12.1 LEARNING OBJECTIVE Use the AS/AD model to analyze the short-run and longrun effects of fiscal policy. Fiscal Policy Effects In Chapter 11, we discussed government spending on goods and services (G) as our fiscal policy variable. But the government also collects taxes and spends money on transfer payments, and these too are an important part of the fiscal policy story. We turn now to look at government spending and taxes using the lenses of the AS/AD model. We will continue in this chapter to use T to denote net taxes, that is, taxes minus transfer payments. A decrease in T has the same qualitative effect as an increase in G. With lower taxes, households have more disposable income and that causes an increase in their consumption. We know from Chapter 9 that the tax multiplier is smaller in absolute value than is the government spending multiplier, but otherwise the economic effect of the two is similar. (You might want to review this material.) A decrease in net taxes, like an increase in G, shifts the AD curve to the right (just not as much because of the smaller multiplier). What happens to the economy when government spending increases or net taxes decrease, thus shifting the AD curve to the right? Key to the answer to this question is knowing where on the AS curve the economy is when this fiscal stimulus is applied. In Figure 12.1, the economy is assumed to be on the nearly flat portion of the AS curve (point A) when we use fiscal policy to shift the AD curve. Here the economy is not producing close to capacity. As the figure shows, a shift of the AD curve in this region of the AS curve results in a small price increase relative to the output increase. The increase in equilibrium Y (from Y0 to Y1) is much greater than the increase in equilibrium P (from P0 to P1). Here an expansionary fiscal policy works well, increasing output with little increase in the price level. When the economy is on the nearly flat portion of the AS curve, firms are producing well below capacity, wages are less likely to increase even with an output increase, and firms will respond to
an increase in demand by increasing output much more than they increase prices. Figure 12.2 shows what happens when stimulus occurs when the economy is operating on the steep part of the AS curve (point B), at a high level relative to its resources. In this case, an expansionary fiscal policy results in a small change in equilibrium output (from Y0 to Y1) and a large change in the equilibrium price level (from P0 to P1). Here, an expansionary fiscal policy does not work well. The output multiplier is close to zero. Output is initially close to capacity, and attempts to increase it further mostly lead to a higher price level. Make sure you understand what is happening behind the scenes in Figure 12.2 when we are on the steep part of the AS curve. The increase in government spending, G, increases the demand for firms’ goods. Because firms are near capacity, raising output is difficult and firms respond by mostly raising their prices. The rise in the overall price level (P) induces action by the Fed because controlling prices is one of its main objectives; the price level is in the Fed rule. Thus, when P rises, the Fed increases the interest rate (r). The higher interest rate lowers planned investment. If total output cannot be increased very much because the economy is near capacity, the interest rate must rise enough to decrease planned investment enough to offset the increase in government spending in the new equilibrium. In this case there is almost complete crowding out of planned investment. Government spending has displaced private investment Gc or T T P1 P0 0 Aœ A Y0 Y1 AS ◂◂ FIGURE 12.1 A Shift of the AD Curve When the Economy Is on the Nearly Flat Part of the AS Curve AD0 AD1 Aggregate output (income), Y MyLab Economics Concept Check M12_CASE3826_13_GE_C12.indd 261 17/04/19 12:27 AM 262 PART III The Core of Macroeconomic Theory ◂▸ FIGURE 12.2 A Shift of the AD Curve When the Economy Is Operating at or Near Capacity P1 P0 0 Gc or T T AS Bœ B AD1 AD0 MyLab Economics Concept Check Aggregate output (income), Y Y0 Y1 What is behind the scenes if there is a decrease in net taxes (T) in Figure 12.2 on the steep part of the AS curve? In this case, consumption demand for firms’ goods increases
(because after tax income has increased). Firms again mostly raise their prices, so P increases, and so the Fed raises the interest rate, which lowers planned investment. If total output is little changed, the interest rate must rise such that the decrease in planned investment is roughly equal to the increase in consumption in the new equilibrium. In this case, consumption rather than government spending crowds out planned investment. Consumption is higher even though output is little changed because after-tax income is higher because of the decrease in T (disposable income, Y–T, is higher). Note that in Figure 12.1, where the economy is on the flat part of the AS curve, there is very little crowding out of planned investment. Output expands to meet the increased demand. Because the price level increases very little, the Fed does not raise the interest rate much, and so there is little change in planned investment. Fiscal Policy Effects in the Long Run MyLab Economics Concept Check We can now turn to look at the long-run effects of fiscal policy. Most economists believe that in the long run wages adjust to some extent to match rising prices. Eventually, as prices rise, we would expect workers to demand and get higher wages. If wages adjust fully, then the long-run AS curve is vertical. In this case it is easy to see that fiscal policy will have no effect on output. If the government increases G or decreases T, thus shifting up the AD curve, the full effect is felt on the price level. Here, the long-run response to fiscal policy looks very much like that on the steep part of the short-run AS curve. So we see that the key question, much debated in macroeconomics, is how fast wages adjust to changes in prices. If wages adjust to prices in a matter of a few months, the AS curve quickly becomes vertical and output benefits from fiscal policy will be short-lived. If wages are slower to adjust, the AS curve might retain some upward slope for a long period and one would be more confident about the usefulness of fiscal policy. Although most economists believe that wages are slow to adjust in the short run and therefore that fiscal policy has potential effects in the short run, there is less consensus about the shape of the long-run AS curve. In an interesting way, economists’ views about how effective fiscal policy can be—whether the government can ever spend itself out of a low output state—is summarized in whether they believe the long-run AS curve is vertical or upward sloping
. Another source of disagreement among macroeconomists centers on whether equilibria below potential output, Y in Figure 11.8 in Chapter 11, are self-correcting (that is, without government intervention). If equilibria below potential output are self-correcting, the economy will M12_CASE3826_13_GE_C12.indd 262 17/04/19 12:27 AM CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 263 12.2 LEARNING OBJECTIVE Use the AS/AD model to analyze the short-run and longrun effects of monetary policy. spend little time on the horizontal part of the AS curve. Recall that those who believe in a vertical long-run AS curve believe that slack in the economy will put downward pressure on wages, causing the short-run AS curve to shift to the right and pushing aggregate output back toward potential output. Other economists argue that wages do not fall much during slack periods and that the economy can get “stuck” at an equilibrium below potential output in the flat region of the AS curve. In this case, monetary and fiscal policy would be necessary to restore full employment. We will return to this debate in Chapter 13. The “new classical” economics, which we will discuss in Chapter 17, assumes that prices and wages are fully flexible and adjust quickly to changing conditions. New classical economists believe, for example, that wage rate changes do not lag behind price changes. The new classical view is consistent with the existence of a vertical AS curve, even in the short run. At the other end of the spectrum is what is sometimes called the simple “Keynesian” view of aggregate supply. Those who hold this view believe there is a kink in the AS curve at capacity output, as we discussed in the Economics in Practice, “The Simple ‘Keynesian’ Aggregate Supply Curve,” in Chapter 11. As we have seen, these differences in perceptions of the way the markets act have large effects on the advice economists give to the government. Monetary Policy Effects Monetary policy is controlled by the Fed, which we are assuming behaves according to the Fed rule described in Chapter 11. The interest rate value that the Fed chooses (r) depends on output (Y), the price level (P), and other factors (Z). The Fed achieves the interest rate value that it wants by setting the interest rate on bank reserves. But how effective is the Fed in
moving the economy as it follows its rule? There are several features of the AS/AD model that we need to consider regarding the effectiveness of the Fed, which we turn to now. The Fed’s Response to the Z Factors MyLab Economics Concept Check We noted in Chapter 11 that the Fed is not just a calculator, responding in a mechanical way to Y and P. The Fed is affected by things outside of our model. Looking at reports of consumer sentiment, the Fed may decide that the economy is more fragile than one might have thought looking at only output and the price level. Or perhaps the Fed is worried about something unfavorable in the international arena. If one of these “Z” factors, as we have called them, changes, the Fed may decide to set the interest rate above or below what the values of Y and P alone call for in the rule. Because Z is outside of the AS/AD model (that is, exogenous to the model), we can ask what changes in Z do to the model. We have in fact already seen the answer to this question in Figure 11.7 in Chapter 11. An increase in Z, like an increase in consumer confidence, may prompt the Fed to increase the interest rate, thus shifting the AD curve to the left. Remember that an increase in Z induces the Fed to set the interest rate higher than what Y and P alone would call for. Similarly, a decrease in Z like a worry about the economy of China or Europe leads to an easing of monetary policy, shifting the AD curve to the right by encouraging more planned investment. In the previous section, we used the fact that G and T shift the AD curve to analyze the effectiveness of fiscal policy in different situations (flat, normal, or steep part of the AS curve). This same analysis pertains to Z. Changes to the interest rate set by the Fed in response to changes in Z also have differential effects depending on where we are on the AS curve. Shape of the AD Curve When the Fed Cares More About the Price Level than Output MyLab Economics Concept Check In the equation representing the Fed rule, we used a weight of a for output and a weight of b for the price level. The relative size of these two coefficients can be thought of as a measure of how much the Fed cares about output versus the price level.1 If a is small relative to b, this means that the Fed has a strong preference for stable prices relative to output. In this case, when the Fed sees a price increase,
it responds with a large increase in the interest rate, thus driving down planned 1Remember that the Fed actually cares about inflation, the change in P, rather than the level of P itself. We are using P as an approximation. Also, the Fed cares about output because of its effect on employment. M12_CASE3826_13_GE_C12.indd 263 17/04/19 12:27 AM 264 PART III The Core of Macroeconomic Theory ◂▸ FIGURE 12.3 The Shape of the AD Curve When the Fed Has a Strong Preference for Price Stability Relative to Output AD MyLab Economics Concept Check Aggregate output (income), Y investment and thus output. In this case, the AD curve is relatively flat, as depicted in Figure 12.3. The Fed is willing to accept large changes in Y to keep P stable. We will return to Figure 12.3 when we discuss cost shocks. The issue of how much weight the Fed puts on the price level relative to output is related to the issue of inflation targeting, which is discussed at the end of this chapter. If a monetary authority is engaged in inflation targeting, then it behaves as if inflation is the only variable in its interest rate rule. What Happens When There Is a Zero Interest Rate Bound? MyLab Economics Concept Check Between 2008 and the end of 2015 short-term interest rates in the United States were close to zero. For all practical purposes, an interest rate cannot be negative. We don’t charge people when they save money or pay them to borrow money. The fact that the interest rate is bounded by zero has implications for the shape of the AD curve, which we will now explore. Let us begin with the Fed rule. Suppose the conditions of the economy in terms of output, the price level, and the Z factors are such that the Fed wants a negative interest rate. In this case, the best that the Fed can do is to choose zero for the value of r. This is called a zero interest rate bound. If Y or P or Z begin to increase, there is some point at which the rule will call for a positive value for r (the interest rate), at which time the Fed will move from zero to the positive value. The fact that the interest rate has remained at roughly zero for many years in the United States suggests that levels of Y, P, and Z may well have called for a negative interest rate for many years. In this case the values of Y, P, and
Z are far below what they would have to be to induce the Fed to move to a positive interest rate in the Fed rule. We will call this case a binding situation. What does Figure 11.6 in Chapter 11 look like in a binding situation? This is shown in Figure 12.4. In this situation the interest rate is always zero, and so equilibrium is just where the IS curve crosses zero. In this binding situation, changes in P and Z do not shift anything (as they did in Figure 11.6) because the interest rate is always zero. In a binding situation the AD curve is vertical, as shown in Figure 12.5. It is easy to see why. In the normal case, an increase in P and Z do not shift the r = 0 line Binding Situation IS MyLab Economics Concept Check Aggregate output (income), Y Y* zero interest rate bound The interest rate cannot go below zero. binding situation State of the economy in which the Fed rule calls for a negative interest rate. ◂▸ FIGURE 12.4 Equilibrium in the Goods Market When the Interest Rate Is Zero. In a binding situation changes in P and Z do not shift the r = 0 line. M12_CASE3826_13_GE_C12.indd 264 17/04/19 12:27 AM CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 265 ◂◂ FIGURE 12.5 The AD Curve in a Binding Situation. In a binding situation the interest rate is always zero AD Y* Aggregate output (income), Y MyLab Economics Concept Check P leads the Fed through the rule to increase the interest rate, which lowers planned investment and thus output. A decrease in P leads to the opposite. In the binding case, the interest rate does not change when P changes (it is always zero), and so planned investment and thus output do not change. For the AD curve to have a slope, the interest rate must change when the price level changes, which does not happen in the binding situation. Note also that changes in Z do not shift the AD curve in a binding situation (unlike the case in Figure 11.7 in Chapter 11). Again, the interest rate is always zero; it does not change when Z changes in a binding situation. You should note that changes in government spending (G) and net taxes (T) still shift the AD curve even if it is vertical. In fact, because there is no crowding out of planned
investment when G increases or T decreases because the interest rate does not increase, the shift is even greater. With a vertical AD curve, fiscal policy can be used to increase output, but monetary policy cannot. You might ask, what if the economy is on the nearly vertical part of the AS curve and a vertical AD curve is shifted to the right of the vertical part? Alas, there would be no intersection anymore. Here the model would break down, but fortunately this is not a realistic case. If the economy is on the nearly vertical part of the AS curve, output and possibly the price level would be high, and it is unlikely the Fed would want a negative interest rate in this case. The AD curve would thus not be vertical. Put another way, a binding situation is unlikely to exist at a high price level. Although for purposes of illustration the AD curve has been drawn as being vertical in Figure 12.5 for all values of P, it is unlikely to be so at high values of P. Shocks to the System Cost Shocks MyLab Economics Concept Check Suppose we have a sudden and severe cold spell that kills off a large fraction of the feeder-fish stock in the world. Or suppose that war breaks out in the Middle East and oil supplies from the region are cut off. How do events like these affect aggregate output and the price level in an economy? When things like this happen, what is the Fed likely to do? The AS/AD model can help guide us through to answers to these questions. The cold spell and the Mideast war are examples of cost shocks, which were introduced in Chapter 11. We chose the examples carefully. In both cases the shock occurred in products that are used as inputs into a wide variety of other products. So a disaster in the fish or oil markets is likely to increase all at once the costs of many firms in many different markets. The AS curve shifts to the left as firms who experience these new costs raise their prices to cover their new higher costs. Figure 12.6 shows what happens to the economy when the AS curve shifts to the left. This leads to stagflation, which is the simultaneous increase in unemployment and inflation. Stagflation is illustrated in Figure 12.6 where equilibrium output falls from Y0 to Y1 (and unemployment rises), and simultaneously the equilibrium price level rises from P0 to P1 (an increase in inflation). The 12.3 LEARNING OBJECTIVE Explain how economic shocks affect the AS/AD model. stagflation A situation
of both high inflation and high unemployment. M12_CASE3826_13_GE_C12.indd 265 17/04/19 12:27 AM 266 PART III The Core of Macroeconomic Theory ◂▸ FIGURE 12.6 An Adverse Cost Shock AS1 AS0 P1 P0 MyLab Economics Concept Check Y1 Y0 Aggregate output (income) (Y) AD reason output falls is that the increase in P leads the Fed to raise the interest rate, which lowers planned investment and thus output. Remember that the Fed rule is a “leaning against the wind” rule, and when the price level rises the Fed leans against the wind by raising the interest rate. We have seen in the previous two sections that when analyzing the effects of changing G, T, and Z, the shape of the AS curve matters. When analyzing the effects of cost shocks, on the other hand, it is the shape of the AD curve that matters. Consider, for example, the case where the AD curve is fairly flat, as in Figure 12.3. This is the case where the Fed puts a large weight on price stability relative to output because they are less concerned about the costs of unemployment. In this case, a leftward shift of the AS curve results in a large decrease in output relative to the increase in the price level. Behind the scenes the Fed is raising the interest rate a lot, lowering planned investment and thus output a lot, to offset much of the price effect of the cost shock. The price level rises less and output falls more than it would if the AD curve were shaped more like the one in Figure 12.6 South African Prices Surge as Cape Town Goes Dry In 2018, South Africa was reeling from a three-year-long drought, the worst in a century. As water levels in dams dropped dangerously to 30 percent, the government declared this drought a national disaster and imposed water restrictions in major cities, mainly Cape Town, leaving the Western Cape with 10 percent of dam reservoir water unsuitable for drinking. The drought caused economic shocks across the country. While agriculture provides only 750,000 jobs and makes up slightly less than 5 percent of South Africa’s GDP, it has indirect links to most other industries. The drought damaged most commercial and staple crops and forced breeders to slaughter cattle, causing a 6.4 percent increase in food prices. Over half of the farmers in the formal labor force lost their jobs. Agricultural growers’ losses in 2018 were estimated at R
10 billion (€0.7 billion). The combined effects of the decline in agricultural exports and the increase in wheat imports are estimated to reduce the trade balance by R20 billion (€1.4 billion). Since the Western Cape accounts for 13.3 percent of overall GDP, growth in 2018 could potentially drop to 0.8 percent from its initial estimate of 1.1 percent. CRITICAL THINKING 1. Why was the South African economy harshly affected by the supply shock caused by the drought even though agriculture comprises a relatively small portion of GDP? M12_CASE3826_13_GE_C12.indd 266 17/04/19 12:27 AM CHAPTER 12 Policy Effects and Cost Shocks in the AS/AD Model 267 cost-push, or supply-side, inflation an increase in costs. Inflation caused by demand-pull inflation Inflation that is initiated by an increase in aggregate demand. An interesting case is when the AD curve is vertical, as in Figure 12.5. Remember that this is the case of a binding situation with a zero interest rate. When the AD curve is vertical and the AS curve shifts to the left, there is no change in output. The only change is a higher price level. In a binding situation the increase in P does not change r (r is still zero), so planned investment is unaffected, and thus output is unaffected. Remember that this story holds only as long as the situation remains binding. At some point if there are large leftward shifts in the AS curve, P will be high enough that the binding situation no longer holds. When this happens, Figure 12.5 is not relevant, and we are back to Figure 12.6. When the price level rises because the AS curve shifts to the left, this is called cost-push, or supply-side, inflation. As we have seen, this is accompanied by lower output. There is thus higher inflation and lower output, or stagflation. Demand-Side Shocks MyLab Economics Concept Check We know from the previous two sections that an expansionary fiscal policy (an increase in G or a decrease in T) and an expansionary monetary policy (a decrease in Z) shifts the AD curve to the right and results in a higher price level. This is an increase in the price level caused by an increase in demand and is called demand-pull inflation. Contrary to cost-push inflation, demand-pull inflation corresponds to higher output rather than lower output. There are other sources of demand
shifts, exogenous to the model, that are interesting to consider. These we can put under the general heading of demand-side shocks. As mentioned in Chapter 5, in the 1930s when macroeconomics was just beginning, John Maynard Keynes introduced the idea of “animal spirits” of investors. Keynes’ animal spirits were his way of describing a kind of optimism or pessimism about the economy which could bolster or hinder the economy. Animal spirits, although maybe important to the economy, are not explained by our model. Within the present context, an improvement in animal spirits—for example, a rise in consumer confidence—can be thought of as a “demand-side shock.” What happens when, say, there is a positive demand-side shock? The AD curve shifts to the right. This will lead to some increase in output and some increase in the price level, how much of each depends on where the economy is on the AS curve. There is nothing new to our story about aggregate demand increases except that instead of being triggered by a fiscal or monetary policy change, the demand increase is triggered by something outside of the model. Any price increase that results from a demand-side shock is also considered demand-pull inflation. Expectations MyLab Economics Concept Check Animal spirits can be considered expectations of the future. Expectations in general likely have important effects on the economy, but they are hard to predict or to quantify. However formed, firms’ expectations of future prices may affect their current price decisions. If a firm expects that its competitors will raise their prices, it may raise its own price in anticipation of this. An increase in future price expectations may thus shift the AS curve to the left and thus act like a cost shock. How might this work? Consider a firm that manufactures toasters in an imperfectly competitive market. The toaster maker must decide what price to charge retail stores for its toaster. If it overestimates price and charges much more than other toaster manufacturers are charging, it will lose many customers. If it underestimates price and charges much less than other toaster makers are charging, it will gain customers but at a considerable loss in revenue per sale. The firm’s optimum price—the price that maximizes the firm’s profits—is presumably not too far from the average of its competitors’ prices. If it does not know its competitors’ projected prices before it sets its own price, as is often the case, it must base its price on what
it expects its competitors’ prices to be. Suppose inflation has been running at about 10 percent per year. Our firm probably expects its competitors will raise their prices about 10 percent this year, so it is likely to raise the price of its own toaster by about 10 percent. This response is how expectations can get “built into the system.” If every firm expects every other firm to raise prices by 10 percent, every firm will raise prices by about 10 percent. Every firm ends up with the price increase it expected. The fact that expectations can affect the price level is vexing. Expectations can lead to an inertia that makes it difficult to stop an inflationary spiral. If prices have been rising and if M12_CASE3826_13_GE_C12.indd 267 17/04/19 12:27 AM 268 PART III The Core of Macroeconomic Theory 12.4 LEARNING OBJECTIVE Discuss monetary policy since 1970. people’s expectations are adaptive—that is, if they form their expectations on the basis of past pricing behavior—firms may continue raising prices even if demand is slowing or contracting. In terms of the AS/AD diagram, an increase in inflationary expectations that causes firms to increase their prices shifts the AS curve to the left. Remember that the AS curve represents the price/output responses of firms. If firms increase their prices because of a change in inflationary expectations, the result is a leftward shift of the AS curve. Given the importance of expectations in inflation, the central banks of many countries survey consumers about their expectations. In Great Britain, for example, a March 2018 survey by the Bank of England found that consumers expected inflation of 3.4 percent for the period 2018–2023. Inflation expectations in England have been in this same range for some years. A similar survey by the Bank of India found consumer expectations of inflation in this period to be in the 8-9 percent range, slightly down from a few years earlier. One of the aims of central banks is to try to keep these expectations low so that expectations of higher prices do not get built in to actual price levels. Monetary Policy since 1970 At the end of Chapter 9, we compared the fiscal policies of the Clinton, Bush, Obama, and early Trump administrations. In this section, we will review what monetary policy has been like since 1970. Remember by monetary policy we mean the interest rate behavior of the Fed. How has the Fed changed the interest rate in response to economic conditions?

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