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an aggregate production function. The Aggregate Production Function An aggregate production functionFunction that relates the total output of an economy to the total amount of labor employed in the economy, all other determinants of production (capital, natural resources, and technology) being unchanged. relates the total output of an economy to the total amount of labor employed in the economy, all other determinants of production (that is, capital, natural resources, and technology) being unchanged. An economy operating on its aggregate production function is producing its potential level of output. Figure 23.6 shows an aggregate production function (PF). It shows output levels for a range of employment between 120 million and 140 million workers. When the level of employment is 120 million, the economy produces a real GDP of $11,500 billion (point A). A level of employment of 130 million produces a real GDP of $12,000 billion (point B), and when 140 million workers are employed, a real GDP of $12,300 billion is produced (point C). In drawing the aggregate production function, the amount of labor varies, but everything else that could affect output, specifically the quantities of other factors of production and technology, is fixed. 8.2.1 https://socialsci.libretexts.org/@go/page/21741 The shape of the aggregate production function shows that as employment increases, output increases, but at a decreasing rate. Increasing employment from 120 million to 130 million, for example, increases output by $500 billion to $12,000 billion at point B. The next 10 million workers increase production by $300 billion to $12,300 billion at point C. This example illustrates diminishing marginal returns. Diminishing marginal returnsSituation that occurs when additional units of a variable factor add less and less to total output, given constant quantities of other factors. occur when additional units of a variable factor add less and less to total output, given constant quantities of other factors. Figure 23.6 The Aggregate Production Function An aggregate production function (PF) relates total output to total employment, assuming all other factors of production and technology are fixed. It shows that increases in employment lead to increases in output but at a decreasing rate. It is easy to picture the problem of diminishing marginal returns in the context of a single firm. The firm is able to increase output by adding workers. But because the firm’s plant size and stock of equipment are fixed, the firm’s capital per worker falls as it takes on more workers.
Each additional worker adds less to output than the worker before. The firm, like the economy, experiences diminishing marginal returns. The Aggregate Production Function, the Market for Labor, and Long-Run Aggregate Supply To derive the long-run aggregate supply curve, we bring together the model of the labor market, introduced in the first macro chapter and the aggregate production function. As we learned, the labor market is in equilibrium at the natural level of employment. The demand and supply curves for labor intersect at the real wage at which the economy achieves its natural level of employment. We see in Panel (a) of Figure 23.7 that the equilibrium real wage is ω and the natural level of employment is L. Panel (b) shows that with employment of L, the economy can produce a real GDP of Y. That output equals the economy’s potential output. It is that level of potential output that determines the position of the long-run aggregate supply curve in Panel (c). P 1 1 1 Figure 23.7 Deriving the Long-Run Aggregate Supply Curve Panel (a) shows that the equilibrium real wage is ω, and the natural level of employment is L. Panel (b) shows that with employment of L, the economy can produce a real GDP of Y. That output equals the economy’s potential output. It is at that level of potential output that we draw the long-run aggregate supply curve in Panel (c). P 1 1 1 Changes in Long-Run Aggregate Supply The position of the long-run aggregate supply curve is determined by the aggregate production function and the demand and supply curves for labor. A change in any of these will shift the long-run aggregate supply curve. 8.2.2 https://socialsci.libretexts.org/@go/page/21741 Figure 23.8 shows one possible shifter of long-run aggregate supply: a change in the production function. Suppose, for example, that an improvement in technology shifts the aggregate production function in Panel (b) from PF to PF. Other developments that could produce an upward shift in the curve include an increase in the capital stock or in the availability of natural resources. 2 1 Figure 23.8 Shift in the Aggregate Production Function and the Long-Run Aggregate Supply Curve An improvement in technology shifts the aggregate production function upward in Panel (b). Because labor is more productive, the demand for labor shifts to the right in Panel (a), and the natural level of employment increases
to L. In Panel (c) the long-run aggregate supply curve shifts to the right to Y. 2 2 2 2 The shift in the production function to PF means that labor is now more productive than before. This will affect the demand for labor in Panel (a). Before the technological change, firms employed L workers at a real wage ω. If workers are more productive, firms will find it profitable to hire more of them at ω. The demand curve for labor thus shifts to D in Panel (a). The real wage rises to ω, and the natural level of employment rises to L. The increase in the real wage reflects labor’s enhanced productivityThe amount of output per worker., the amount of output per worker. To see how potential output changes, we see in Panel (b) how much output can be produced given the new natural level of employment and the new aggregate production function. The real GDP that the economy is capable of producing rises from Y to Y. The higher output is a reflection of a higher natural level of employment, along with the fact that labor has become more productive as a result of the technological advance. In Panel (c) the long-run aggregate supply curve shifts to the right to the vertical line at This analysis dispels a common misconception about the impact of improvements in technology or increases in the capital stock on employment. Some people believe that technological gains or increases in the stock of capital reduce the demand for labor, reduce employment, and reduce real wages. Certainly the experience of the United States and most other countries belies that notion. Between 1990 and 2007, for example, the U.S. capital stock and the level of technology increased dramatically. During the same period, employment and real wages rose, suggesting that the demand for labor increased by more than the supply of labor. As some firms add capital or incorporate new technologies, some workers at those firms may lose their jobs. But for the economy as a whole, new jobs become available and they generally offer higher wages. The demand for labor rises. Another event that can shift the long-run aggregate supply curve is an increase in the supply of labor, as shown in Figure 23.9. An increased supply of labor could result from immigration, an increase in the population, or increased participation in the labor force by the adult population. Increased participation by women in the labor force, for example, has tended to increase the supply curve for labor during the past several decades. Figure 23.9 Increase in the Supply of Labor and the Long
-Run Aggregate Supply Curve An increase in the supply of labor shifts the supply curve in Panel (a) to S, and the natural level of employment rises to L. The real wage falls to ω. With increased labor, the aggregate production function in Panel (b) shows that the economy is now capable of producing real GDP at Y. The long-run aggregate supply curve in Panel (c) shifts to LRAS. 2 2 2 2 2 In Panel (a), an increase in the labor supply shifts the supply curve to S. The increase in the supply of labor does not change the stock of capital or natural resources, nor does it change technology—it therefore does not shift the aggregate production function. Because there is no change in the production function, there is no shift in the demand for labor. The real wage falls from ω to ω in Panel (a), and the natural level of employment rises from L to L. To see the impact on potential output, Panel (b) shows that employment of L can produce real GDP of Y. The long-run aggregate supply curve in Panel (c) thus shifts to LRAS. Notice, however, that this shift in the long-run aggregate supply curve to the right is associated with a reduction in the real wage to Of course, the aggregate production function and the supply curve of labor can shift together, producing higher real wages at the same time population rises. That has been the experience of most industrialized nations. The increase in real wages in the United 8.2.3 https://socialsci.libretexts.org/@go/page/21741 States between 1990 and 2007, for example, came during a period in which an increasing population increased the supply of labor. The demand for labor increased by more than the supply, pushing the real wage up. The accompanying Case in Point looks at gains in real wages in the face of technological change, an increase in the stock of capital, and rapid population growth in the United States during the 19th century. Our model of long-run aggregate supply tells us that in the long run, real GDP, the natural level of employment, and the real wage are determined by the economy’s production function and by the demand and supply curves for labor. Unless an event shifts the aggregate production function, the demand curve for labor, or the supply curve for labor, it affects neither the natural level of employment nor potential output. Economic growth occurs only if an event shifts the economy’s production function
or if there is an increase in the demand for or the supply of labor. Key Takeaways The aggregate production function relates the level of employment to the level of real GDP produced per period. The real wage and the natural level of employment are determined by the intersection of the demand and supply curves for labor. Potential output is given by the point on the aggregate production function corresponding to the natural level of employment. This output level is the same as that shown by the long-run aggregate supply curve. Economic growth can be shown as a series of shifts to the right in LRAS. Such shifts require either upward shifts in the production function or increases in demand for or supply of labor. Try It! Suppose that the quantity of labor supplied is 50 million workers when the real wage is $20,000 per year and that potential output is $2,000 billion per year. Draw a three-panel graph similar to the one presented in Figure 23.9 to show the economy’s long-run equilibrium. Panel (a) of your graph should show the demand and supply curves for labor, Panel (b) should show the aggregate production function, and Panel (c) should show the long-run aggregate supply curve. Now suppose a technological change increases the economy’s output with the same quantity of labor as before to $2,200 billion, and the real wage rises to $21,500. In response, the quantity of labor supplied increases to 51 million workers. In the same three panels you have already drawn, sketch the new curves that result from this change. Explain what happens to the level of employment, the level of potential output, and the long-run aggregate supply curve. (Hint: you have information for only one point on each of the curves you draw—two for the supply of labor; simply draw curves of the appropriate shape. Do not worry about getting the scale correct.)  Case in Point: Technological Change, Employment, and Real Wages During the Industrial Revolution Figure 23.10 8.2.4 https://socialsci.libretexts.org/@go/page/21741 Wikimedia Commons – public domain. Technological change and the capital investment that typically comes with it are often criticized because they replace labor with machines, reducing employment. Such changes, critics argue, hurt workers. Using the model of aggregate demand and aggregate supply, however, we arrive at a quite different conclusion. The model predicts that improved technology will increase the demand for labor and boost real wages
. The period of industrialization, generally taken to be the time between the Civil War and World War I, was a good test of these competing ideas. Technological changes were dramatic as firms shifted toward mass production and automation. Capital investment soared. Immigration increased the supply of labor. What happened to workers? Employment more than doubled during this period, consistent with the prediction of our model. It is harder to predict, from a theoretical point of view, the consequences for real wages. The latter third of the 19th century was a period of massive immigration to the United States. Between 1865 and 1880, more than 5 million people came to the United States from abroad; most were of working age. The pace accelerated between 1880 and 1923, when more than 23 million people moved to the United States from other countries. Immigration increased the supply of labor, which should reduce the real wage. There were thus two competing forces at work: Technological change and capital investment tended to increase real wages, while immigration tended to reduce them by increasing the supply of labor. The evidence suggests that the forces of technological change and capital investment proved far more powerful than increases in labor supply. Real wages soared 60% between 1860 and 1890. They continued to increase after that. Real wages in manufacturing, for example, rose 37% from 1890 to 1914. Technological change and capital investment displace workers in some industries. But for the economy as a whole, they increase worker productivity, increase the demand for labor, and increase real wages. Sources: Wage data taken from Clarence D. Long, Wages and Earnings in the United States, 1860–1990 (Princeton, NJ: Princeton University Press, 1960), p. 109, and from Albert Rees, Wages in Manufacturing, 1890–1914 (Princeton, NJ: Princeton University Press, 1961), pp. 3–5. Immigration figures taken from Gary M. Walton and Hugh Rockoff, History of the American Economy, 6th ed. (New York: Harcourt Brace Jovanovich, 1990), p. 371. 8.2.5 https://socialsci.libretexts.org/@go/page/21741 Answer to Try It! Problem The production function in Panel (b) shifts up to PF. Because it reflects greater productivity of labor, firms will increase their demand for labor, and the demand curve for labor shifts to D in Panel (a). LRAS shifts to LRAS in Panel (c). Employment and potential output rise. Potential output will be
greater than $2,200 billion. 1 2 2 2 Figure 23.11 This page titled 8.2: Growth and the Long-Run Aggregate Supply Curve is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 23.2: Growth and the Long-Run Aggregate Supply Curve by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 8.2.6 https://socialsci.libretexts.org/@go/page/21741 8.3: Determinants of Economic Growth  Learning Objective 1. Discuss the sources of economic growth. 2. Discuss possible reasons why countries grow at different rates. In this section, we review the main determinants of economic growth. We also examine the reasons for the widening disparities in economic growth rates among countries in recent years. The Sources of Economic Growth As we have learned, there are two ways to model economic growth: (1) as an outward shift in an economy’s production possibilities curve, and (2) as a shift to the right in its long-run aggregate supply curve. In drawing either one at a point in time, we assume that the economy’s factors of production and its technology are unchanged. Changing these will shift both curves. Therefore, anything that increases the quantity or quality of factors of production or that improves the technology available to the economy contributes to economic growth. The sources of growth for the U.S. economy in the 20th century were presented in the chapter on sources of production. There we learned that the main sources of growth for the United States from 1948 to 2002 were divided between increases in the quantities of labor and of physical capital (about 60%) and in improvements in the qualities of the factors of production and technology (about 40%). Since 1995, however, improvements in factor quality and technology have been the main drivers of economic growth in the United States. In order to devote resources to increasing physical and human capital and to improving technology—activities that will enhance future production—society must forgo using them now to produce consumer goods. Even though the people in the economy would enjoy a higher standard of living today without this sacrifice, they are willing to reduce present consumption in order to have more goods and services available for the future. As a college student, you
personally made such a choice. You decided to devote time to study that you could have spent earning income. With the higher income, you could enjoy greater consumption today. You made this choice because you expect to earn higher income in the future and thus to enjoy greater consumption in the future. Because many other people in the society also choose to acquire more education, society allocates resources to produce education. The education produced today will enhance the society’s human capital and thus its economic growth. All other things equal, higher saving allows more resources to be devoted to increases in physical and human capital and technological improvement. In other words, saving, which is income not spent on consumption, promotes economic growth by making available resources that can be channeled into growth-enhancing uses. Explaining Recent Disparities in Growth Rates Toward the end of the 20th century, it appeared that some of the world’s more affluent countries were growing robustly while others were growing more slowly or even stagnating. This observation was confirmed in a major study by the Organization for Economic Co-operation and Development (OECD), whose members are listed in Table 23.1 “Growing Disparities in Rates of Economic Growth”. The table shows that for the OECD countries as a whole, economic growth per capita fell from an average of 2.2% per year in the 1980s to an average of 1.9% per year in the 1990s. The higher standard deviation in the latter period confirms an increased disparity of growth rates in the more recent period. Moreover, the data on individual countries show that per capita growth in some countries (specifically, the United States, Canada, Ireland, Netherlands, Norway, and Spain) picked up, especially in the latter half of the 1990s, while it decelerated in most of the countries of continental Europe and Japan. 1 Table 23.1 Growing Disparities in Rates of Economic Growth Trend Growth of GDP per Capita Country United States Japan 1980–1990 1990–2000 1996–2000 2.1 3.3 2.3 1.4 2.8 0.9 8.3.1 https://socialsci.libretexts.org/@go/page/21742 Trend Growth of GDP per Capita Country Germany France Italy United Kingdom Canada Austria Belgium Denmark Finland Greece Iceland Ireland Luxembourg Netherlands Portugal Spain Sweden Switzerland Turkey Australia New Zealand Mexico Korea Hungary Poland Czech Republic 2 OECD24 1.9 1.6 2.3 2.2 1.4 2
.1 2.0 1.9 2.2 0.5 1.7 3.0 4.0 1.6 3.1 2.3 1.7 1.4 2.1 1.6 1.4 0.0 7.2 — — — 2.2 1980–1990 1990–2000 1996–2000 1.2 1.5 1.5 2.1 1.7 1.9 1.9 1.9 2.1 1.8 1.5 6.4 4.5 2.4 2.8 2.7 1.5 0.4 2.1 2.4 1.2 1.6 5.1 2.3 4.2 1.7 1.9 1.7 1.9 1.7 2.3 2.6 2.3 2.3 2.3 3.9 2.7 2.6 7.9 4.6 2.7 2.7 3.2 2.6 1.1 1.9 2.8 1.8 2.7 4.2 3.5 4.8 1.4 2.2 Standard Deviation of OECD24 0.74 1.17 1.37 Variation in the growth in real GDP per capita has widened among the world’s leading industrialized economies. Source: Excerpted from Table 1.1 Organization for Economic Co-operation and Development, Sources of Economic Growth in OECD Countries, 2003: p. 32–33. The study goes on to try to explain the reasons for the divergent growth trends. The main findings were: In general, countries with accelerating per capita growth rates also experienced significant increases in employment, while those with stagnant or declining employment generally experienced reductions in per capita growth rates. Enhancements in human capital contributed to labor productivity and economic growth, but in slower growing countries such improvements were not enough to offset the impact of reduced or stagnant labor utilization. Information and communication technology has contributed to economic growth both through rapid technological progress within the information and communication technology industry itself as well as, more recently, through the use of information 8.3.2 https://socialsci.libretexts.org/@go/page/21742 and communication technology equipment in other industries. This has made an important contribution to growth in several of the faster growing countries. Other factors associated with more growth include: investments in physical and human capital, sound macroeconomic policies (especially low inflation), private sector research and development, trade exposure, and better developed financial
markets. Results concerning the impact of the size of the government and of public sector research and development on growth were more difficult to interpret. With qualifications, the study found that strict regulation of product markets (for example, regulations that reduce competition) and strict employment protection legislation (for example, laws that make hiring and firing of workers more difficult) had negative effects on growth. All countries show a large number of firms entering and exiting markets. But, a key difference between the United States and Europe is that new firms in the United States start out smaller and less productive than those of Europe but grow faster when they are successful. The report hypothesizes that lower start-up costs and less strict labor market regulations may encourage U.S. entrepreneurs to enter a market and then to expand, if warranted. European entrepreneurs may be less willing to experiment in a market in the first place. The general concern in the second half of the 1970s and the 1980s was that economic growth was slowing down and that it might not be possible to reverse this pattern. The 1990s and early 2000s, in which growth picked up in some countries but not in others, suggested that the problem was not universal and led to a search for the reasons for the disparities in growth rates that emerged. The OECD study described above gives some possible explanations. The findings of that study practically beg countries to examine closely their economic policies at a variety of levels and to consider changes that may add flexibility to their economies. In closing, it is worth reiterating that economic freedom and higher incomes tend to go together. Countries could not have attained high levels of income if they had not maintained the economic freedom that contributed to high incomes in the first place. Thus, it is also likely that rates of economic growth in the future will be related to the amount of economic freedom countries choose. We shall see in later chapters that monetary and fiscal policies that are used to stabilize the economy in the short run can also have an impact on long-run economic growth. Key Takeaways The main sources of growth for the United States from 1948 to 2002 were divided between increases in the quantities of labor and of physical capital (about 60%) and in improvements in the qualities of the factors of production and technology (about 40%). Since 1995, however, improvements in factor quality and technology have been the main drivers of economic growth in the United States. There has been a growing disparity in the rates of economic growth in industrialized countries in the last decade, which may reflect various differences in economic structures and policies. Try It!
All other things unchanged, compare the position of a country’s expected production possibility curve and the expected position of its long-run aggregate supply curve if: 1. Its labor force increases in size by 3% per year compared to 2% per year. 2. Its saving rate falls from 15% to 10%. 3. It passes a law making it more difficult to fire workers. 4. Its level of education rises more quickly than it has in the past.  Case in Point: Economic Growth in Poor Countries … or Lack Thereof Figure 23.12 8.3.3 https://socialsci.libretexts.org/@go/page/21742 Alan – A Home in Sullivan’s Gulch (A Portland Hooverville) – CC BY-NC-ND 2.0. Economist William Easterly in his aptly named book The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics admits that after 50 years of searching for the magic formula for turning poor countries into rich ones, the quest remains elusive. Poor countries just need more physical capital, you say? Easterly points out that between 1960 and 1985, the capital stock per work in both Gambia and Japan rose by over 500%. The result? In Gambia, output per worker over the 25-year period rose 2%; in Japan, output per worker rose 260%. So, it must be that poor countries need more human capital? Again, he finds startling comparisons. For example, human capital expanded faster in Zambia than in Korea, but Zambia’s annual growth rate is 7 percentage points below Korea’s. Too much population growth? Too little? More foreign aid? Too much? As Easterly proceeds, writing a prescription for growth seems ever more difficult: “None has delivered as promised,” he concludes (p. xi). While Easterly does not offer his own new panacea for how to move countries to a higher level of per capita GDP, where the model presented in this chapter does seem to provide some explanations of why a country’s growth rate may vary over time or differ from another country’s, he does argue that creating incentives for growth in poor countries is crucial. Acknowledging a role for plain luck, Easterly argues that good government policies—ones that keep low such negatives as inflation, corruption, and red tape—and quality institutions and laws—ones that, for example, honor contracts and reward merit
—will help. How to actually improve such incentives might constitute the next great quest: “We have learned once and for all that there are no magical elixirs to bring a happy ending to our quest for growth. Prosperity happens when all the players in the development game have the right incentives. It happens when government incentives induce technological adaptation, high-quality investment in machines, and high-quality schooling. It happens when donors face incentives that induce them to give aid to countries with good policies where aid will have high payoffs, not to countries with poor policies where aid is wasted. It happens when the poor get good opportunities and incentives, which requires government welfare programs that reward rather than penalize earning income. It happens when politics is not polarized between antagonistic interest groups.... The solutions are a lot more difficult to describe than the problems. The way forward must be to create incentives for growth for the trinity of governments, donors, and individuals.” (p. 289–90) Source: William Easterly, The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics (Cambridge: MIT Press, 2002). Answer to Try It! Problem Situations 1 and 4 should lead to a shift further outward in the country’s production possibility curve and further to the right in its long-run aggregate supply curve. Situations 2 and 3 should lead to smaller outward shifts in the country’s production possibility curve and smaller rightward shifts in its long-run aggregate supply curve. 8.3.4 https://socialsci.libretexts.org/@go/page/21742 1 The material in this section is based on Organization for Economic Co-operation and Development, The Sources of Economic Growth in OECD Countries, 2003. 2 Excludes Czech Republic, Hungary, Korean, Mexico, Poland, and Slovak Republic This page titled 8.3: Determinants of Economic Growth is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 23.3: Determinants of Economic Growth by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 8.3.5 https://socialsci.libretexts.org/@go/page/21742 8.4: Review and
Practice Summary We saw that economic growth can be measured by the rate of increase in potential output. Measuring the rate of increase in actual real GDP can confuse growth statistics by introducing elements of cyclical variation. Growth is an exponential process. A variable increasing at a fixed percentage rate doubles over fixed intervals. The doubling time is approximated by the rule of 72. The exponential nature of growth means that small differences in growth rates have large effects over long periods of time. Per capita rates of increase in real GDP are found by subtracting the growth rate of the population from the growth rate of GDP. Growth can be shown in the model of aggregate demand and aggregate supply as a series of rightward shifts in the long-run aggregate supply curve. The position of the LRAS is determined by the aggregate production function and by the demand and supply curves for labor. A rightward shift in LRAS results either from an upward shift in the production function, due to increases in factors of production other than labor or to improvements in technology, or from an increase in the demand for or the supply of labor. Saving plays an important role in economic growth, because it allows for more capital to be available for future production, so the rate of economic growth can rise. Saving thus promotes growth. In recent years, rates of growth among the world’s industrialized countries have grown more disparate. Recent research suggests this may be related to differing labor and product market conditions, differences in the diffusion of information and communications technologies, as well as differences in macroeconomic and trade policies. Evidence on the role that government plays in economic growth was less conclusive. Concept Problems 1. Suppose the people in a certain economy decide to stop saving and instead use all their income for consumption. They do nothing to add to their stock of human or physical capital. Discuss the prospects for growth of such an economy. 2. Singapore has a saving rate that is roughly three times greater than that of the United States. Its greater saving rate has been one reason why the Singapore economy has grown faster than the U.S. economy. Suppose that if the United States increased its saving rate to, say, twice the Singapore level, U.S. growth would surpass the Singapore rate. Would that be a good idea? 3. Suppose an increase in air pollution causes capital to wear out more rapidly, doubling the rate of depreciation. How would this affect economic growth? 4. Some people worry that increases in the capital stock will bring about an economy in which everything is done by machines, with no jobs left for
people. What does the model of economic growth presented in this chapter predict? 5. China’s annual rate of population growth was 1.2% from 1975 to 2003 and is expected to be 0.6% from 2003 through 2015. How do you think this will affect the rate of increase in real GDP? How will this affect the rate of increase in per capita real GDP? 6. Suppose technology stops changing. Explain the impact on economic growth. 7. Suppose a series of terrorist attacks destroys half the capital in the United States but does not affect the population. What will happen to potential output and to the real wage? 8. “Given the rate at which scientists are making new discoveries, we will soon reach the point that no further discoveries can be made. Economic growth will come to a stop.” Discuss. 9. Suppose real GDP increases during President Obama’s term in office at a 5% rate. Would that imply that his policies were successful in “growing the economy”? 10. Suppose that for some country it was found that its economic growth was based almost entirely on increases in quantities of factors of production. Why might such growth be difficult to sustain? Numerical Problems 1. The population of the world in 2003 was 6.314 billion. It grew between 1975 and 2003 at an annual rate of 1.6%. Assume that it continues to grow at this rate. 1. Compute the doubling time. 2. Estimate the world population in 2048 and 2093 (assuming all other things remain unchanged). 8.4.1 https://socialsci.libretexts.org/@go/page/21743 2. With a world population in 2003 of 6.314 billion and a projected population growth rate of 1.1% instead (which is the United Nations’ projection for the period 2003 to 2015). 1. Compute the doubling time. 2. State the year in which the world’s population would be 12.628 billion. 3. Suppose a country’s population grows at the rate of 2% per year and its output grows at the rate of 3% per year. 1. Calculate its rate of growth of per capita output. 2. If instead its population grows at 3% per year and its output grows at 2% per year, calculate its rate of growth of per capita output. 4. The rate of economic growth per capita in France from 1996 to 2000 was 1.9% per year, while in
Korea over the same period it was 4.2%. Per capita real GDP was $28,900 in France in 2003, and $12,700 in Korea. Assume the growth rates for each country remain the same. 1. Compute the doubling time for France’s per capita real GDP. 2. Compute the doubling time for Korea’s per capita real GDP. 3. What will France’s per capita real GDP be in 2045? 4. What will Korea’s per capita real GDP be in 2045? 5. Suppose real GDPs in country A and country B are identical at $10 trillion dollars in 2005. Suppose country A’s economic growth rate is 2% and country B’s is 4% and both growth rates remain constant over time. 1. On a graph, show country A’s potential output until 2025. 2. On the same graph, show country B’s potential output. 3. Calculate the percentage difference in their levels of potential output in 2025. Suppose country A’s population grows 1% per year and country B’s population grows 3% per year. 1. On a graph, show country A’s potential output per capita in 2025. 2. On the same graph, show country B’s potential output per capita in 2025. 3. Calculate the percentage difference in their levels of potential output per capita in 2025. 6. Two countries, A and B, have identical levels of real GDP per capita. In Country A, an increase in the capital stock increases the potential output by 10%. Country B also experiences a 10% increase in its potential output, but this increase is the result of an increase in its labor force. Using aggregate production functions and labor-market analyses for the two countries, illustrate and explain how these events are likely to affect living standards in the two economies. 7. Suppose the information below characterizes an economy: Employment (in millions) Real GDP (in billions 10 200 700 1,100 1,400 1,650 1,850 2,000 2,100 2,170 2,200 1. Construct the aggregate production function for this economy. 2. What kind of returns does this economy experience? How do you know? 3. Assuming that total available employment is 7 million, draw the economy’s long-run aggregate supply curve. 8.4.2 https://socialsci.libretexts.org/@go/page/
21743 Suppose that improvement in technology means that real GDP at each level of employment rises by $200 billion. 1. Construct the new aggregate production function for this economy. 2. Construct the new long-run aggregate supply curve for the economy. 8. In Table 23.1 “Growing Disparities in Rates of Economic Growth”, we can see that Japan’s growth rate of per capita real GDP fell from 3.3% per year in the 1980s to 1.4% per year in the 1990s. 1. Compare the percent increase in its per capita real GDP over the 20-year period to what it would have been if it had maintained the 3.3% per capita growth rate of the 1980s. 2. Japan’s per capita GDP in 1980 was about $24,000 (in U.S. 2000 dollars) in 1980. Calculate what it would have been if the growth rate of the 1980s had been maintained Calculate about how much it is, given the actual growth rates over the two decades. 3. In Table 23.1 “Growing Disparities in Rates of Economic Growth”, we can see that Ireland’s growth rate of per capita real GDP grew from 3.0% per year in the 1980s to 6.4% per year in the 1990s. 4. Compare the percent increase in its per capita real GDP over the 20-year period to what it would have been if it had maintained the 3.0% per capita growth rate of the 1980s. 5. Ireland’s per capita GDP in 1980 was about $10,000 (in U.S. 2000 dollars). Calculate what it would have been if the growth rate of the 1980s had been maintained. Calculate about how much it is, given the actual growth rates over the two decades. This page titled 8.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 23.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 8.4.3 https://socialsci.libretexts.org/@go/page/21743 CHAPTER OVERVIEW 9: The Nature and Creation of Money 9.1: What
Is Money? 9.2: The Banking System and Money Creation 9.3: The Federal Reserve System 9.4: Review and Practice Thumbnail: https://unsplash.com/photos/eBWzFKahEaU This page titled 9: The Nature and Creation of Money is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 9.1: What Is Money?  Learning Objective 1. Define money and discuss its three basic functions. 2. Distinguish between commodity money and fiat money, giving examples of each. 3. Define what is meant by the money supply and tell what is included in the Federal Reserve System’s two definitions of it (M1 and M2). If cigarettes and mackerel can be used as money, then just what is money? Money is anything that serves as a medium of exchange. A medium of exchange is anything that is widely accepted as a means of payment. In Romania under Communist Party rule in the 1980s, for example, Kent cigarettes served as a medium of exchange; the fact that they could be exchanged for other goods and services made them money. Money, ultimately, is defined by people and what they do. When people use something as a medium of exchange, it becomes money. If people were to begin accepting basketballs as payment for most goods and services, basketballs would be money. We will learn in this chapter that changes in the way people use money have created new types of money and changed the way money is measured in recent decades. The Functions of Money Money serves three basic functions. By definition, it is a medium of exchange. It also serves as a unit of account and as a store of value—as the “mack” did in Lompoc. A Medium of Exchange The exchange of goods and services in markets is among the most universal activities of human life. To facilitate these exchanges, people settle on something that will serve as a medium of exchange—they select something to be money. We can understand the significance of a medium of exchange by considering its absence. Barter occurs when goods are exchanged directly for other goods. Because no one item serves as a medium of exchange in a barter economy, potential buyers must find things that individual sellers will accept. A buyer might find a seller who will trade a pair of shoes for two chickens. Another seller might be willing to provide a haircut in exchange for a garden
hose. Suppose you were visiting a grocery store in a barter economy. You would need to load up a truckful of items the grocer might accept in exchange for groceries. That would be an uncertain affair; you could not know when you headed for the store which items the grocer might agree to trade. Indeed, the complexity—and cost —of a visit to a grocery store in a barter economy would be so great that there probably would not be any grocery stores! A moment’s contemplation of the difficulty of life in a barter economy will demonstrate why human societies invariably select something—sometimes more than one thing—to serve as a medium of exchange, just as prisoners in federal penitentiaries accepted mackerel. A Unit of Account Ask someone in the United States what he or she paid for something, and that person will respond by quoting a price stated in dollars: “I paid $75 for this radio,” or “I paid $15 for this pizza.” People do not say, “I paid five pizzas for this radio.” That statement might, of course, be literally true in the sense of the opportunity cost of the transaction, but we do not report prices that way for two reasons. One is that people do not arrive at places like Radio Shack with five pizzas and expect to purchase a radio. The other is that the information would not be very useful. Other people may not think of values in pizza terms, so they might not know what we meant. Instead, we report the value of things in terms of money. Money serves as a unit of account, which is a consistent means of measuring the value of things. We use money in this fashion because it is also a medium of exchange. When we report the value of a good or service in units of money, we are reporting what another person is likely to have to pay to obtain that good or service. A Store of Value The third function of money is to serve as a store of value, that is, an item that holds value over time. Consider a $20 bill that you accidentally left in a coat pocket a year ago. When you find it, you will be pleased. That is because you know the bill still has 9.1.1 https://socialsci.libretexts.org/@go/page/21745 value. Value has, in effect, been “stored” in that little piece of paper. Money, of course, is not the
only thing that stores value. Houses, office buildings, land, works of art, and many other commodities serve as a means of storing wealth and value. Money differs from these other stores of value by being readily exchangeable for other commodities. Its role as a medium of exchange makes it a convenient store of value. Because money acts as a store of value, it can be used as a standard for future payments. When you borrow money, for example, you typically sign a contract pledging to make a series of future payments to settle the debt. These payments will be made using money, because money acts as a store of value. Money is not a risk-free store of value, however. We saw in the chapter that introduced the concept of inflation that inflation reduces the value of money. In periods of rapid inflation, people may not want to rely on money as a store of value, and they may turn to commodities such as land or gold instead. Types of Money Although money can take an extraordinary variety of forms, there are really only two types of money: money that has intrinsic value and money that does not have intrinsic value. Commodity money is money that has value apart from its use as money. Mackerel in federal prisons is an example of commodity money. Mackerel could be used to buy services from other prisoners; they could also be eaten. Gold and silver are the most widely used forms of commodity money. Gold and silver can be used as jewelry and for some industrial and medicinal purposes, so they have value apart from their use as money. The first known use of gold and silver coins was in the Greek city-state of Lydia in the beginning of the seventh century B.C. The coins were fashioned from electrum, a natural mixture of gold and silver. One disadvantage of commodity money is that its quantity can fluctuate erratically. Gold, for example, was one form of money in the United States in the 19th century. Gold discoveries in California and later in Alaska sent the quantity of money soaring. Some of this nation’s worst bouts of inflation were set off by increases in the quantity of gold in circulation during the 19th century. A much greater problem exists with commodity money that can be produced. In the southern part of colonial America, for example, tobacco served as money. There was a continuing problem of farmers increasing the quantity of money by growing more tobacco. The problem was sufficiently serious that vigilante squads were organized. They roamed the countryside burning tobacco fields in an effort to keep the quantity
of tobacco, hence money, under control. (Remarkably, these squads sought to control the money supply by burning tobacco grown by other farmers.) Another problem is that commodity money may vary in quality. Given that variability, there is a tendency for lower-quality commodities to drive higher-quality commodities out of circulation. Horses, for example, served as money in colonial New England. It was common for loan obligations to be stated in terms of a quantity of horses to be paid back. Given such obligations, there was a tendency to use lower-quality horses to pay back debts; higher-quality horses were kept out of circulation for other uses. Laws were passed forbidding the use of lame horses in the payment of debts. This is an example of Gresham’s law: the tendency for a lower-quality commodity (bad money) to drive a higher-quality commodity (good money) out of circulation. Unless a means can be found to control the quality of commodity money, the tendency for that quality to decline can threaten its acceptability as a medium of exchange. But something need not have intrinsic value to serve as money. Fiat money is money that some authority, generally a government, has ordered to be accepted as a medium of exchange. The currency—paper money and coins—used in the United States today is fiat money; it has no value other than its use as money. You will notice that statement printed on each bill: “This note is legal tender for all debts, public and private.” Checkable deposits, which are balances in checking accounts, and traveler’s checks are other forms of money that have no intrinsic value. They can be converted to currency, but generally they are not; they simply serve as a medium of exchange. If you want to buy something, you can often pay with a check or a debit card. A check is a written order to a bank to transfer ownership of a checkable deposit. A debit card is the electronic equivalent of a check. Suppose, for example, that you have $100 in your checking account and you write a check to your campus bookstore for $30 or instruct the clerk to swipe your debit card and “charge” it $30. In either case, $30 will be transferred from your checking account to the bookstore’s checking account. Notice that it is the checkable deposit, not the check or debit card, that is money. The check or debit card just tells a bank to transfer money, in this case check
able deposits, from one account to another. 9.1.2 https://socialsci.libretexts.org/@go/page/21745 What makes something money is really found in its acceptability, not in whether or not it has intrinsic value or whether or not a government has declared it as such. For example, fiat money tends to be accepted so long as too much of it is not printed too quickly. When that happens, as it did in Russia in the 1990s, people tend to look for other items to serve as money. In the case of Russia, the U.S. dollar became a popular form of money, even though the Russian government still declared the ruble to be its fiat money. Heads Up! The term money, as used by economists and throughout this book, has the very specific definition given in the text. People can hold assets in a variety of forms, from works of art to stock certificates to currency or checking account balances. Even though individuals may be very wealthy, only when they are holding their assets in a form that serves as a medium of exchange do they, according to the precise meaning of the term, have “money.” To qualify as “money,” something must be widely accepted as a medium of exchange. Measuring Money The total quantity of money in the economy at any one time is called the money supply. Economists measure the money supply because it affects economic activity. What should be included in the money supply? We want to include as part of the money supply those things that serve as media of exchange. However, the items that provide this function have varied over time. Before 1980, the basic money supply was measured as the sum of currency in circulation, traveler’s checks, and checkable deposits. Currency serves the medium-of-exchange function very nicely but denies people any interest earnings. (Checking accounts did not earn interest before 1980.) Over the last few decades, especially as a result of high interest rates and high inflation in the late 1970s, people sought and found ways of holding their financial assets in ways that earn interest and that can easily be converted to money. For example, it is now possible to transfer money from your savings account to your checking account using an automated teller machine (ATM), and then to withdraw cash from your checking account. Thus, many types of savings accounts are easily converted into currency. Economists refer to the ease with which an asset can be converted into currency as the
asset’s liquidity. Currency itself is perfectly liquid; you can always change two $5 bills for a $10 bill. Checkable deposits are almost perfectly liquid; you can easily cash a check or visit an ATM. An office building, however, is highly illiquid. It can be converted to money only by selling it, a timeconsuming and costly process. As financial assets other than checkable deposits have become more liquid, economists have had to develop broader measures of money that would correspond to economic activity. In the United States, the final arbiter of what is and what is not measured as money is the Federal Reserve System. Because it is difficult to determine what (and what not) to measure as money, the Fed reports several different measures of money, including M1 and M2. M1 is the narrowest of the Fed’s money supply definitions. It includes currency in circulation, checkable deposits, and traveler’s checks. M2 is a broader measure of the money supply than M1. It includes M1 and other deposits such as small savings accounts (less than $100,000), as well as accounts such as money market mutual funds (MMMFs) that place limits on the number or the amounts of the checks that can be written in a certain period. M2 is sometimes called the broadly defined money supply, while M1 is the narrowly defined money supply. The assets in M1 may be regarded as perfectly liquid; the assets in M2 are highly liquid, but somewhat less liquid than the assets in M1. Even broader measures of the money supply include large time-deposits, money market mutual funds held by institutions, and other assets that are somewhat less liquid than those in M2. Figure 24.1 shows the composition of M1 and M2 in October 2010. 9.1.3 https://socialsci.libretexts.org/@go/page/21745 Figure 24.1 The Two Ms: October 2010 M1, the narrowest definition of the money supply, includes assets that are perfectly liquid. M2 provides a broader measure of the money supply and includes somewhat less liquid assets. Amounts represent money supply data in billions of dollars for October 2010, seasonally adjusted. Source: Federal Reserve Statistical Release H.6, Tables 3 and 4 (December 2, 2010). Amounts are in billions of dollars for October 2010, seasonally adjusted. Heads Up! Credit cards are not money. A credit card identifies you as
a person who has a special arrangement with the card issuer in which the issuer will lend you money and transfer the proceeds to another party whenever you want. Thus, if you present a MasterCard to a jeweler as payment for a $500 ring, the firm that issued you the card will lend you the $500 and send that money, less a service charge, to the jeweler. You, of course, will be required to repay the loan later. But a card that says you have such a relationship is not money, just as your debit card is not money. With all the operational definitions of money available, which one should we use? Economists generally answer that question by asking another: Which measure of money is most closely related to real GDP and the price level? As that changes, so must the definition of money. In 1980, the Fed decided that changes in the ways people were managing their money made M1 useless for policy choices. Indeed, the Fed now pays little attention to M2 either. It has largely given up tracking a particular measure of the money supply. The choice of what to measure as money remains the subject of continuing research and considerable debate. Key Takeaways Money is anything that serves as a medium of exchange. Other functions of money are to serve as a unit of account and as a store of value. Money may or may not have intrinsic value. Commodity money has intrinsic value because it has other uses besides being a medium of exchange. Fiat money serves only as a medium of exchange, because its use as such is authorized by the government; it has no intrinsic value. The Fed reports several different measures of money, including M1 and M2. Try It! Which of the following are money in the United States today and which are not? Explain your reasoning in terms of the functions of money. 1. Gold 2. A Van Gogh painting 3. A dime  Case in Point: Fiat-less Money Figure 24.2 9.1.4 https://socialsci.libretexts.org/@go/page/21745 Michael Mandiberg – 1 million iraqi dinar – CC BY-SA 2.0. “We don’t have a currency of our own,” proclaimed Nerchivan Barzani, the Kurdish regional government’s prime minister in a news interview in 2003. But, even without official recognition by the government, the so-called “Swiss” dinar certainly seemed to function
as a fiat money. Here is how the Kurdish area of northern Iraq, during the period between the Gulf War in 1991 and the fall of Saddam Hussein in 2003, came to have its own currency, despite the pronouncement of its prime minister to the contrary. After the Gulf War, the northern, mostly Kurdish area of Iraq was separated from the rest of Iraq though the enforcement of the nofly-zone. Because of United Nations sanctions that barred the Saddam Hussein regime in the south from continuing to import currency from Switzerland, the central bank of Iraq announced it would replace the “Swiss” dinars, so named because they had been printed in Switzerland, with locally printed currency, which became known as “Saddam” dinars. Iraqi citizens in southern Iraq were given three weeks to exchange their old dinars for the new ones. In the northern part of Iraq, citizens could not exchange their notes and so they simply continued to use the old ones. And so it was that the “Swiss” dinar for a period of about 10 years, even without government backing or any law establishing it as legal tender, served as northern Iraq’s fiat money. Economists use the word “fiat,” which in Latin means “let it be done,” to describe money that has no intrinsic value. Such forms of money usually get their value because a government or authority has declared them to be legal tender, but, as this story shows, it does not really require much “fiat” for a convenient, in-and-of-itself worthless, medium of exchange to evolve. What happened to both the “Swiss” and “Saddam” dinars? After the Coalition Provisional Authority (CPA) assumed control of all of Iraq, Paul Bremer, then head of the CPA, announced that a new Iraqi dinar would be exchanged for both of the existing currencies over a three-month period ending in January 2004 at a rate that implied that one “Swiss” dinar was valued at 150 “Saddam” dinars. Because Saddam Hussein’s regime had printed many more “Saddam” dinars over the 10-year period, while no “Swiss” dinars had been printed, and because the cheap printing of the “Saddam” dinars made them easy to counterfeit, over the decade the “Swiss
” dinars became relatively more valuable and the exchange rate that Bremer offered about equalized the purchasing power of the two currencies. For example, it took about 133 times as many “Saddam” dinars as “Swiss” dinars to buy a man’s suit in Iraq at the time. The new notes, sometimes called “Bremer” dinars, were printed in Britain and elsewhere and flown into Iraq on 22 flights using Boeing 747s and other large aircraft. In both the northern and southern parts of Iraq, citizens turned in their old dinars for the new ones, suggesting at least more confidence at that moment in the “Bremer” dinar than in either the “Saddam” or “Swiss” dinars. Sources: Mervyn A. King, “The Institutions of Monetary Policy” (lecture, American Economics Association Annual Meeting, San Diego, January 4, 2004), available at www.bankofengland.co.uk/speeches/speech208.pdf. Hal R. Varian, “Paper Currency Can Have Value without Government Backing, but Such Backing Adds Substantially to Its Value,” New York Times, January 15, 2004, p. C2. 9.1.5 https://socialsci.libretexts.org/@go/page/21745 Answer to Try It! Problem 1. Gold is not money because it is not used as a medium of exchange. In addition, it does not serve as a unit of account. It may, however, serve as a store of value. 2. A Van Gogh painting is not money. It serves as a store of value. It is highly illiquid but could eventually be converted to money. It is neither a medium of exchange nor a unit of account. 3. A dime is money and serves all three functions of money. It is, of course, perfectly liquid. This page titled 9.1: What Is Money? is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 24.1: What Is Money? by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economicsprinciples-v2.0/. 9.1.6 https://socialsci
.libretexts.org/@go/page/21745 9.2: The Banking System and Money Creation  Learning Objective 1. Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system. 2. Describe the process of money creation (destruction), using the concept of the deposit multiplier. 3. Describe how and why banks are regulated and insured. Where does money come from? How is its quantity increased or decreased? The answer to these questions suggests that money has an almost magical quality: money is created by banks when they issue loans. In effect, money is created by the stroke of a pen or the click of a computer key. We will begin by examining the operation of banks and the banking system. We will find that, like money itself, the nature of banking is experiencing rapid change. Banks and Other Financial Intermediaries An institution that amasses funds from one group and makes them available to another is called a financial intermediary. A pension fund is an example of a financial intermediary. Workers and firms place earnings in the fund for their retirement; the fund earns income by lending money to firms or by purchasing their stock. The fund thus makes retirement saving available for other spending. Insurance companies are also financial intermediaries, because they lend some of the premiums paid by their customers to firms for investment. Mutual funds make money available to firms and other institutions by purchasing their initial offerings of stocks or bonds. Banks play a particularly important role as financial intermediaries. Banks accept depositors’ money and lend it to borrowers. With the interest they earn on their loans, banks are able to pay interest to their depositors, cover their own operating costs, and earn a profit, all the while maintaining the ability of the original depositors to spend the funds when they desire to do so. One key characteristic of banks is that they offer their customers the opportunity to open checking accounts, thus creating checkable deposits. These functions define a bank, which is a financial intermediary that accepts deposits, makes loans, and offers checking accounts. Over time, some nonbank financial intermediaries have become more and more like banks. For example, some brokerage firms offer customers interest-earning accounts and make loans. They now allow their customers to write checks on their accounts. As nonbank financial intermediaries have grown, banks’ share of the nation’s credit market financial assets has diminished. In 1972, banks accounted for nearly 30% of U.S.
credit market financial assets. In 2007, that share had dropped to about 15%. The fact that banks account for a declining share of U.S. financial assets alarms some observers. We will see that banks are more tightly regulated than are other financial institutions; one reason for that regulation is to maintain control over the money supply. Other financial intermediaries do not face the same regulatory restrictions as banks. Indeed, their freedom from regulation is one reason they have grown so rapidly. As other financial intermediaries become more important, central authorities begin to lose control over the money supply. The declining share of financial assets controlled by “banks” began to change in 2008. Many of the nation’s largest investment banks—financial institutions that provided services to firms but were not regulated as commercial banks—began having serious financial difficulties as a result of their investments tied to home mortgage loans. As home prices in the United States began falling, many of those mortgage loans went into default. Investment banks that had made substantial purchases of securities whose value was ultimately based on those mortgage loans themselves began failing. Bear Stearns, one of the largest investment banks in the United States, required federal funds to remain solvent. Another large investment bank, Lehman Brothers, failed. In an effort to avoid a similar fate, several other investment banks applied for status as ordinary commercial banks subject to the stringent regulation those institutions face. One result of the terrible financial crisis that crippled the U.S. and other economies in 2008 may be greater control of the money supply by the Fed. Bank Finance and a Fractional Reserve System Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance. 9.2.1 https://socialsci.libretexts.org/@go/page/21746 Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans. The bank’s financial picture at a given time can be depicted using a simplified balance sheet, which is a financial statement showing assets, liabilities, and net worth. Assets are anything of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. All these are given dollar values in a firm’s balance sheet. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right. The
main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed. These assets are called reserves. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system. Table 24.1 “The Consolidated Balance Sheet for U.S. Commercial Banks, October 2010” shows a consolidated balance sheet for commercial banks in the United States for October 2010. Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans. Table 24.1 The Consolidated Balance Sheet for U.S. Commercial Banks, October 2010 Assets Reserves Other assets Loans Securities Total assets $1,040.2 1,743.7 6,788.7 2,452.6 $12,025.2 Liabilities and Net Worth Checkable deposits Other deposits Borrowings Other liabilities Total liabilities Net worth $1,792.0 6,103.6 1,927.5 855.8 10,678.9 1,346.4 This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, on October 2010. Source: Federal Reserve Statistical Release H.8, December 3, 2010. In the next section, we will learn that money is created when banks issue loans. Money Creation To understand the process of money creation today, let us create a hypothetical system of banks. We will focus on three banks in this system: Acme Bank, Bellville Bank, and Clarkston Bank. Assume that all banks are required to hold reserves equal to 10% of their checkable deposits. The quantity of reserves banks are required to hold is called required reserves. The reserve requirement is expressed as a required reserve ratio; it specifies the ratio of reserves to checkable deposits a bank must maintain. Banks may hold reserves in excess of the required level; such reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. Because banks earn relatively little interest on
their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves. When a bank’s excess reserves equal zero, it is loaned up. Finally, we shall ignore assets other than reserves and loans and deposits other than checkable deposits. To simplify the analysis further, we shall suppose that banks have no net worth; their assets are equal to their liabilities. Let us suppose that every bank in our imaginary system begins with $1,000 in reserves, $9,000 in loans outstanding, and $10,000 in checkable deposit balances held by customers. The balance sheet for one of these banks, Acme Bank, is shown in Table 24.2 “A Balance Sheet for Acme Bank”. The required reserve ratio is 0.1: Each bank must have reserves equal to 10% of its checkable deposits. Because reserves equal required reserves, excess reserves equal zero. Each bank is loaned up. Table 24.2 A Balance Sheet for Acme Bank Acme Bank 9.2.2 https://socialsci.libretexts.org/@go/page/21746 Assets Assets Reserves Loans $1,000 $9,000 Acme Bank Liabilities Liabilities Deposits $10,000 We assume that all banks in a hypothetical system of banks have $1,000 in reserves, $10,000 in checkable deposits, and $9,000 in loans. With a 10% reserve requirement, each bank is loaned up; it has zero excess reserves. Acme Bank, like every other bank in our hypothetical system, initially holds reserves equal to the level of required reserves. Now suppose one of Acme Bank’s customers deposits $1,000 in cash in a checking account. The money goes into the bank’s vault and thus adds to reserves. The customer now has an additional $1,000 in his or her account. Two versions of Acme’s balance sheet are given here. The first shows the changes brought by the customer’s deposit: reserves and checkable deposits rise by $1,000. The second shows how these changes affect Acme’s balances. Reserves now equal $2,000 and checkable deposits equal $11,000. With checkable deposits of $11,000 and a 10% reserve requirement, Acme is required to hold reserves of $1,100. With reserves equaling $2,000, Acme has
$900 in excess reserves. At this stage, there has been no change in the money supply. When the customer brought in the $1,000 and Acme put the money in the vault, currency in circulation fell by $1,000. At the same time, the $1,000 was added to the customer’s checking account balance, so the money supply did not change. Figure 24.3 Because Acme earns only a low interest rate on its excess reserves, we assume it will try to loan them out. Suppose Acme lends the $900 to one of its customers. It will make the loan by crediting the customer’s checking account with $900. Acme’s outstanding loans and checkable deposits rise by $900. The $900 in checkable deposits is new money; Acme created it when it issued the $900 loan. Now you know where money comes from—it is created when a bank issues a loan. Figure 24.4 Presumably, the customer who borrowed the $900 did so in order to spend it. That customer will write a check to someone else, who is likely to bank at some other bank. Suppose that Acme’s borrower writes a check to a firm with an account at Bellville Bank. In this set of transactions, Acme’s checkable deposits fall by $900. The firm that receives the check deposits it in its account at Bellville Bank, increasing that bank’s checkable deposits by $900. Bellville Bank now has a check written on an Acme account. Bellville will submit the check to the Fed, which will reduce Acme’s deposits with the Fed—its reserves—by $900 and increase Bellville’s reserves by $900. Figure 24.5 9.2.3 https://socialsci.libretexts.org/@go/page/21746 Notice that Acme Bank emerges from this round of transactions with $11,000 in checkable deposits and $1,100 in reserves. It has eliminated its excess reserves by issuing the loan for $900; Acme is now loaned up. Notice also that from Acme’s point of view, it has not created any money! It merely took in a $1,000 deposit and emerged from the process with $1,000 in additional checkable deposits. The $900 in new money Acme created when it issued a loan has not vanished—it is now in an
account in Bellville Bank. Like the magician who shows the audience that the hat from which the rabbit appeared was empty, Acme can report that it has not created any money. There is a wonderful irony in the magic of money creation: banks create money when they issue loans, but no one bank ever seems to keep the money it creates. That is because money is created within the banking system, not by a single bank. The process of money creation will not end there. Let us go back to Bellville Bank. Its deposits and reserves rose by $900 when the Acme check was deposited in a Bellville account. The $900 deposit required an increase in required reserves of $90. Because Bellville’s reserves rose by $900, it now has $810 in excess reserves. Just as Acme lent the amount of its excess reserves, we can expect Bellville to lend this $810. The next set of balance sheets shows this transaction. Bellville’s loans and checkable deposits rise by $810. Figure 24.6 The $810 that Bellville lent will be spent. Let us suppose it ends up with a customer who banks at Clarkston Bank. Bellville’s checkable deposits fall by $810; Clarkston’s rise by the same amount. Clarkston submits the check to the Fed, which transfers the money from Bellville’s reserve account to Clarkston’s. Notice that Clarkston’s deposits rise by $810; Clarkston must increase its reserves by $81. But its reserves have risen by $810, so it has excess reserves of $729. Figure 24.7 9.2.4 https://socialsci.libretexts.org/@go/page/21746 Notice that Bellville is now loaned up. And notice that it can report that it has not created any money either! It took in a $900 deposit, and its checkable deposits have risen by that same $900. The $810 it created when it issued a loan is now at Clarkston Bank. The process will not end there. Clarkston will lend the $729 it now has in excess reserves, and the money that has been created will end up at some other bank, which will then have excess reserves—and create still more money. And that process will just keep going as long as there are excess reserves to pass through the banking system in the form of loans. How much will ultimately be created by the system
as a whole? With a 10% reserve requirement, each dollar in reserves backs up $10 in checkable deposits. The $1,000 in cash that Acme’s customer brought in adds $1,000 in reserves to the banking system. It can therefore back up an additional $10,000! In just the three banks we have shown, checkable deposits have risen by $2,710 ($1,000 at Acme, $900 at Bellville, and $810 at Clarkston). Additional banks in the system will continue to create money, up to a maximum of $7,290 among them. Subtracting the original $1,000 that had been a part of currency in circulation, we see that the money supply could rise by as much as $9,000. Heads Up! Notice that when the banks received new deposits, they could make new loans only up to the amount of their excess reserves, not up to the amount of their deposits and total reserve increases. For example, with the new deposit of $1,000, Acme Bank was able to make additional loans of $900. If instead it made new loans equal to its increase in total reserves, then after the customers who received new loans wrote checks to others, its reserves would be less than the required amount. In the case of Acme, had it lent out an additional $1,000, after checks were written against the new loans, it would have been left with only $1,000 in reserves against $11,000 in deposits, for a reserve ratio of only 0.09, which is less than the required reserve ratio of 0.1 in the example. The Deposit Multiplier We can relate the potential increase in the money supply to the change in reserves that created it using the deposit multiplier (m ), which equals the ratio of the maximum possible change in checkable deposits (∆D) to the change in reserves (∆R). In our example, the deposit multiplier was 10: d Equation 24.1 To see how the deposit multiplier m is related to the required reserve ratio, we use the fact that if banks in the economy are loaned up, then reserves, R, equal the required reserve ratio (rrr) times checkable deposits, D: d Equation 24.2 9.2.5 https://socialsci.libretexts.org/@go/page/21746 A change in reserves produces a change in loans and a change in check
able deposits. Once banks are fully loaned up, the change in reserves, ∆R, will equal the required reserve ratio times the change in deposits, ∆D: Equation 24.3 Solving for ∆D, we have Equation 24.4 Dividing both sides by ∆R, we see that the deposit multiplier, m, is 1/rrr: d Equation 24.5 The deposit multiplier is thus given by the reciprocal of the required reserve ratio. With a required reserve ratio of 0.1, the deposit multiplier is 10. A required reserve ratio of 0.2 would produce a deposit multiplier of 5. The higher the required reserve ratio, the lower the deposit multiplier. Actual increases in checkable deposits will not be nearly as great as suggested by the deposit multiplier. That is because the artificial conditions of our example are not met in the real world. Some banks hold excess reserves, customers withdraw cash, and some loan proceeds are not spent. Each of these factors reduces the degree to which checkable deposits are affected by an increase in reserves. The basic mechanism, however, is the one described in our example, and it remains the case that checkable deposits increase by a multiple of an increase in reserves. The entire process of money creation can work in reverse. When you withdraw cash from your bank, you reduce the bank’s reserves. Just as a deposit at Acme Bank increases the money supply by a multiple of the original deposit, your withdrawal reduces the money supply by a multiple of the amount you withdraw. And just as money is created when banks issue loans, it is destroyed as the loans are repaid. A loan payment reduces checkable deposits; it thus reduces the money supply. Suppose, for example, that the Acme Bank customer who borrowed the $900 makes a $100 payment on the loan. Only part of the payment will reduce the loan balance; part will be interest. Suppose $30 of the payment is for interest, while the remaining $70 reduces the loan balance. The effect of the payment on Acme’s balance sheet is shown below. Checkable deposits fall by $100, loans fall by $70, and net worth rises by the amount of the interest payment, $30. Similar to the process of money creation, the money reduction process decreases checkable deposits by, at most, the amount of the reduction in deposits times the deposit multiplier. Figure 24.8 9.2.6 https://socialsci.libretexts.
org/@go/page/21746 The Regulation of Banks Banks are among the most heavily regulated of financial institutions. They are regulated in part to protect individual depositors against corrupt business practices. Banks are also susceptible to crises of confidence. Because their reserves equal only a fraction of their deposit liabilities, an effort by customers to get all their cash out of a bank could force it to fail. A few poorly managed banks could create such a crisis, leading people to try to withdraw their funds from well-managed banks. Another reason for the high degree of regulation is that variations in the quantity of money have important effects on the economy as a whole, and banks are the institutions through which money is created. Deposit Insurance From a customer’s point of view, the most important form of regulation comes in the form of deposit insurance. For commercial banks, this insurance is provided by the Federal Deposit Insurance Corporation (FDIC). Insurance funds are maintained through a premium assessed on banks for every $100 of bank deposits. If a commercial bank fails, the FDIC guarantees to reimburse depositors up to $250,000 (raised from $100,000 during the financial crisis of 2008) per insured bank, for each account ownership category. From a depositor’s point of view, therefore, it is not necessary to worry about a bank’s safety. One difficulty this insurance creates, however, is that it may induce the officers of a bank to take more risks. With a federal agency on hand to bail them out if they fail, the costs of failure are reduced. Bank officers can thus be expected to take more risks than they would otherwise, which, in turn, makes failure more likely. In addition, depositors, knowing that their deposits are insured, may not scrutinize the banks’ lending activities as carefully as they would if they felt that unwise loans could result in the loss of their deposits. Thus, banks present us with a fundamental dilemma. A fractional reserve system means that banks can operate only if their customers maintain their confidence in them. If bank customers lose confidence, they are likely to try to withdraw their funds. But with a fractional reserve system, a bank actually holds funds in reserve equal to only a small fraction of its deposit liabilities. If its customers think a bank will fail and try to withdraw their cash, the bank is likely to fail. Bank panics, in which frightened customers rush to withdraw their deposits, contributed to the failure of one-third of the nation’s banks between
1929 and 1933. Deposit insurance was introduced in large part to give people confidence in their banks and to prevent failure. But the deposit insurance that seeks to prevent bank failures may lead to less careful management—and thus encourage bank failure. Regulation to Prevent Bank Failure To reduce the number of bank failures, banks are severely limited in what they can do. They are barred from certain types of financial investments and from activities viewed as too risky. Banks are required to maintain a minimum level of net worth as a fraction of total assets. Regulators from the FDIC regularly perform audits and other checks of individual banks to ensure they are operating safely. The FDIC has the power to close a bank whose net worth has fallen below the required level. In practice, it typically acts to close a bank when it becomes insolvent, that is, when its net worth becomes negative. Negative net worth implies that the bank’s liabilities exceed its assets. When the FDIC closes a bank, it arranges for depositors to receive their funds. When the bank’s funds are insufficient to return customers’ deposits, the FDIC uses money from the insurance fund for this purpose. Alternatively, the FDIC may arrange for another bank to purchase the failed bank. The FDIC, however, continues to guarantee that depositors will not lose any money. Key Takeaways Banks are financial intermediaries that accept deposits, make loans, and provide checking accounts for their customers. Money is created within the banking system when banks issue loans; it is destroyed when the loans are repaid. An increase (decrease) in reserves in the banking system can increase (decrease) the money supply. The maximum amount of the increase (decrease) is equal to the deposit multiplier times the change in reserves; the deposit multiplier equals the reciprocal of the required reserve ratio. Bank deposits are insured and banks are heavily regulated. 9.2.7 https://socialsci.libretexts.org/@go/page/21746 Try It! 1. Suppose Acme Bank initially has $10,000 in deposits, reserves of $2,000, and loans of $8,000. At a required reserve ratio of 0.2, is Acme loaned up? Show the balance sheet of Acme Bank at present. 2. Now suppose that an Acme Bank customer, planning to take cash on an extended college graduation trip to India, withdraws $1,000 from her account. Show the changes to Acme Bank’
s balance sheet and Acme’s balance sheet after the withdrawal. By how much are its reserves now deficient? 3. Acme would probably replenish its reserves by reducing loans. This action would cause a multiplied contraction of checkable deposits as other banks lose deposits because their customers would be paying off loans to Acme. How large would the contraction be?  Case in Point: A Big Bank Goes Under Figure 24.9 Wikimedia Commons – CC BY-SA 3.0. It was the darling of Wall Street—it showed rapid growth and made big profits. Washington Mutual, a savings and loan based in the state of Washington, was a relatively small institution whose CEO, Kerry K. Killinger, had big plans. He wanted to transform his little Seattle S&L into the Wal-Mart of banks. Mr. Killinger began pursuing a relatively straightforward strategy. He acquired banks in large cities such as Chicago and Los Angeles. He acquired banks up and down the east and west coasts. He aggressively extended credit to low-income individuals and families—credit cards, car loans, and mortgages. In making mortgage loans to low-income families, WaMu, as the bank was known, quickly became very profitable. But it was exposing itself to greater and greater risk, according to the New York Times. Housing prices in the United States more than doubled between 1997 and 2007. During that time, loans to even low-income households were profitable. But, as housing prices began falling in 2007, banks such as WaMu began to experience losses as homeowners began to walk away from houses whose values suddenly fell below their outstanding mortgages. WaMu began losing money in 2007 as housing prices began falling. The company had earned $3.6 billion in 2006, and swung to a loss of $67 million in 2007, according to the Puget Sound Business Journal. Mr. Killinger was ousted by the board early in September of 2008. The bank failed later that month. It was the biggest bank failure in the history of the United States. 9.2.8 https://socialsci.libretexts.org/@go/page/21746 The Federal Deposit Insurance Corporation (FDIC) had just rescued another bank, IndyMac, which was only a tenth the size of WaMu, and would have done the same for WaMu if it had not been able to find a company to purchase it. But in this case, JPMorgan Chase agreed to take it over—its deposits, bank branches, and its troubled
asset portfolio. The government and the Fed even negotiated the deal behind WaMu’s back! The then chief executive officer of the company, Alan H. Fishman, was reportedly flying from New York to Seattle when the deal was finalized. The government was anxious to broker a deal that did not require use of the FDIC’s depleted funds following IndyMac’s collapse. But it would have done so if a buyer had not been found. As the FDIC reports on its Web site: “Since the FDIC’s creation in 1933, no depositor has ever lost even one penny of FDIC-insured funds.” Sources: Eric Dash and Andrew Ross Sorkin, “Government Seizes WaMu and Sells Some Assets,” The New York Times, September 25, 2008, p. A1; Kirsten Grind, “Insiders Detail Reasons for WaMu’s Failure,” Puget Sound Business Journal, January 23, 2009; and FDIC Web site at https://www.fdic.gov/edie/fdic_info.html. Answer to Try It! Problem 1. Acme Bank is loaned up, since $2,000/$10,000 = 0.2, which is the required reserve ratio. Acme’s balance sheet is: Figure 24.10 This page titled 9.2: The Banking System and Money Creation is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 24.2: The Banking System and Money Creation by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 9.2.9 https://socialsci.libretexts.org/@go/page/21746 9.3: The Federal Reserve System  Learning Objective 1. Explain the primary functions of central banks. 2. Describe how the Federal Reserve System is structured and governed. 3. Identify and explain the tools of monetary policy. 4. Describe how the Fed creates and destroys money when it buys and sells federal government bonds. The Federal Reserve System of the United States, or Fed, is the U.S. central bank. Japan’s central bank is the Bank of Japan; the European Union has established the European Central Bank
. Most countries have a central bank. A central bank performs five primary functions: (1) it acts as a banker to the central government, (2) it acts as a banker to banks, (3) it acts as a regulator of banks, (4) it conducts monetary policy, and (5) it supports the stability of the financial system. For the first 137 years of its history, the United States did not have a true central bank. While a central bank was often proposed, there was resistance to creating an institution with such enormous power. A series of bank panics slowly increased support for the creation of a central bank. The bank panic of 1907 proved to be the final straw. Bank failures were so widespread, and depositor losses so heavy, that concerns about centralization of power gave way to a desire for an institution that would provide a stabilizing force in the banking industry. Congress passed the Federal Reserve Act in 1913, creating the Fed and giving it all the powers of a central bank. Structure of the Fed In creating the Fed, Congress determined that a central bank should be as independent of the government as possible. It also sought to avoid too much centralization of power in a single institution. These potentially contradictory goals of independence and decentralized power are evident in the Fed’s structure and in the continuing struggles between Congress and the Fed over possible changes in that structure. In an effort to decentralize power, Congress designed the Fed as a system of 12 regional banks, as shown in Figure 24.12. Each of these banks operates as a kind of bankers’ cooperative; the regional banks are owned by the commercial banks in their districts that have chosen to be members of the Fed. The owners of each Federal Reserve bank select the board of directors of that bank; the board selects the bank’s president. Figure 24.12 The 12 Federal Reserve Districts and the Cities Where Each Bank Is Located Several provisions of the Federal Reserve Act seek to maintain the Fed’s independence. The board of directors for the entire Federal Reserve System is called the Board of Governors. The seven members of the board are appointed by the president of the 9.3.1 https://socialsci.libretexts.org/@go/page/21747 United States and confirmed by the Senate. To ensure a large measure of independence from any one president, the members of the Board of Governors have 14-year terms. One member of the board is selected by the president of the United States to serve as chairman
for a four-year term. As a further means of ensuring the independence of the Fed, Congress authorized it to buy and sell federal government bonds. This activity is a profitable one that allows the Fed to pay its own bills. The Fed is thus not dependent on a Congress that might otherwise be tempted to force a particular set of policies on it. The Fed is limited in the profits it is allowed to earn; its “excess” profits are returned to the Treasury. It is important to recognize that the Fed is technically not part of the federal government. Members of the Board of Governors do not legally have to answer to Congress, the president, or anyone else. The president and members of Congress can certainly try to influence the Fed, but they cannot order it to do anything. Congress, however, created the Fed. It could, by passing another law, abolish the Fed’s independence. The Fed can maintain its independence only by keeping the support of Congress—and that sometimes requires being responsive to the wishes of Congress. In recent years, Congress has sought to increase its oversight of the Fed. The chairman of the Federal Reserve Board is required to report to Congress twice each year on its monetary policy, the set of policies that the central bank can use to influence economic activity. Powers of the Fed The Fed’s principal powers stem from its authority to conduct monetary policy. It has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations. Reserve Requirements The Fed sets the required ratio of reserves that banks must hold relative to their deposit liabilities. In theory, the Fed could use this power as an instrument of monetary policy. It could lower reserve requirements when it wanted to increase the money supply and raise them when it wanted to reduce the money supply. In practice, however, the Fed does not use its power to set reserve requirements in this way. The reason is that frequent manipulation of reserve requirements would make life difficult for bankers, who would have to adjust their lending policies to changing requirements. The Fed’s power to set reserve requirements was expanded by the Monetary Control Act of 1980. Before that, the Fed set reserve requirements only for commercial banks that were members of the Federal Reserve System. Most banks are not members of the Fed; the Fed’s control of reserve requirements thus extended to only a minority of banks. The 1980 act required virtually all banks to satisfy the Fed’s reserve requirements. The Discount Window and Other Credit Facilities A major responsibility
of the Fed is to act as a lender of last resort to banks. When banks fall short on reserves, they can borrow reserves from the Fed through its discount window. The discount rate is the interest rate charged by the Fed when it lends reserves to banks. The Board of Governors sets the discount rate. Lowering the discount rate makes funds cheaper to banks. A lower discount rate could place downward pressure on interest rates in the economy. However, when financial markets are operating normally, banks rarely borrow from the Fed, reserving use of the discount window for emergencies. A typical bank borrows from the Fed only about once or twice per year. Instead of borrowing from the Fed when they need reserves, banks typically rely on the federal funds market to obtain reserves. The federal funds market is a market in which banks lend reserves to one another. The federal funds rate is the interest rate charged for such loans; it is determined by banks’ demand for and supply of these reserves. The ability to set the discount rate is no longer an important tool of Federal Reserve policy. To deal with the recent financial and economic conditions, the Fed greatly expanded its lending beyond its traditional discount window lending. As falling house prices led to foreclosures, private investment banks and other financial institutions came under increasing pressure. The Fed made credit available to a wide range of institutions in an effort to stem the crisis. In 2008, the Fed bailed out two major housing finance firms that had been established by the government to prop up the housing industry—Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation). Together, the two institutions backed the mortgages of half of the nation’s mortgage loans (Zuckerman, 2008). It also agreed to provide $85 billion to AIG, the huge insurance firm. AIG had a subsidiary that was heavily exposed to mortgage loan losses, and that crippled the firm. 9.3.2 https://socialsci.libretexts.org/@go/page/21747 The Fed determined that AIG was simply too big to be allowed to fail. Many banks had ties to the giant institution, and its failure would have been a blow to those banks. As the United States faced the worst financial crisis since the Great Depression, the Fed took center stage. Whatever its role in the financial crisis of 2007–2008, the Fed remains an important backstop for banks and other financial institutions needing liquidity. And for that, it uses the traditional discount window, supplemented
with a wide range of other credit facilities. The Case in Point in this section discusses these new credit facilities. Open-Market Operations The Fed’s ability to buy and sell federal government bonds has proved to be its most potent policy tool. A bond is a promise by the issuer of the bond (in this case the federal government) to pay the owner of the bond a payment or a series of payments on a specific date or dates. The buying and selling of federal government bonds by the Fed are called open-market operations. When the Fed buys or sells government bonds, it adds or subtracts reserves from the banking system. Such changes affect the money supply. Suppose the Fed buys a government bond in the open market. It writes a check on its own account to the seller of the bond. When the seller deposits the check at a bank, the bank submits the check to the Fed for payment. The Fed “pays” the check by crediting the bank’s account at the Fed, so the bank has more reserves. The Fed’s purchase of a bond can be illustrated using a balance sheet. Suppose the Fed buys a bond for $1,000 from one of Acme Bank’s customers. When that customer deposits the check at Acme, checkable deposits will rise by $1,000. The check is written on the Federal Reserve System; the Fed will credit Acme’s account. Acme’s reserves thus rise by $1,000. With a 10% reserve requirement, that will create $900 in excess reserves and set off the same process of money expansion as did the cash deposit we have already examined. The difference is that the Fed’s purchase of a bond created new reserves with the stroke of a pen, where the cash deposit created them by removing $1,000 from currency in circulation. The purchase of the $1,000 bond by the Fed could thus increase the money supply by as much as $10,000, the maximum expansion suggested by the deposit multiplier. Figure 24.13 Where does the Fed get $1,000 to purchase the bond? It simply creates the money when it writes the check to purchase the bond. On the Fed’s balance sheet, assets increase by $1,000 because the Fed now has the bond; bank deposits with the Fed, which represent a liability to the Fed, rise by $1,000 as well. When the Fed sells a bond, it gives the buyer a federal
government bond that it had previously purchased and accepts a check in exchange. The bank on which the check was written will find its deposit with the Fed reduced by the amount of the check. That bank’s reserves and checkable deposits will fall by equal amounts; the reserves, in effect, disappear. The result is a reduction in the money supply. The Fed thus increases the money supply by buying bonds; it reduces the money supply by selling them. Figure 24.14 shows how the Fed influences the flow of money in the economy. Funds flow from the public—individuals and firms —to banks as deposits. Banks use those funds to make loans to the public—to individuals and firms. The Fed can influence the volume of bank lending by buying bonds and thus injecting reserves into the system. With new reserves, banks will increase their lending, which creates still more deposits and still more lending as the deposit multiplier goes to work. Alternatively, the Fed can sell bonds. When it does, reserves flow out of the system, reducing bank lending and reducing deposits. 9.3.3 https://socialsci.libretexts.org/@go/page/21747 Figure 24.14 The Fed and the Flow of Money in the Economy Individuals and firms (the public) make deposits in banks; banks make loans to individuals and firms. The Fed can buy bonds to inject new reserves into the system, thus increasing bank lending, which creates new deposits, creating still more lending as the deposit multiplier goes to work. Alternatively, the Fed can sell bonds, withdrawing reserves from the system, thus reducing bank lending and reducing total deposits. The Fed’s purchase or sale of bonds is conducted by the Open Market Desk at the Federal Reserve Bank of New York, one of the 12 district banks. Traders at the Open Market Desk are guided by policy directives issued by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Board of Governors plus five regional bank presidents. The president of the New York Federal Reserve Bank serves as a member of the FOMC; the other 11 bank presidents take turns filling the remaining four seats. The FOMC meets eight times per year to chart the Fed’s monetary policies. In the past, FOMC meetings were closed, with no report of the committee’s action until the release of the minutes six weeks after the meeting. Faced with pressure to open its proceedings, the Fed began in 1994 issuing a report of the decisions
of the FOMC immediately after each meeting. In practice, the Fed sets targets for the federal funds rate. To achieve a lower federal funds rate, the Fed goes into the open market buying securities and thus increasing the money supply. When the Fed raises its target rate for the federal funds rate, it sells securities and thus reduces the money supply. Traditionally, the Fed has bought and sold short-term government securities; however, in dealing with the condition of the economy in 2009, wherein the Fed has already set the target for the federal funds rate at near zero, the Fed has announced that it will also be buying longer term government securities. In so doing, it hopes to influence longer term interest rates, such as those related to mortgages. Key Takeaways The Fed, the central bank of the United States, acts as a bank for other banks and for the federal government. It also regulates banks, sets monetary policy, and maintains the stability of the financial system. The Fed sets reserve requirements and the discount rate and conducts open-market operations. Of these tools of monetary policy, open-market operations are the most important. Starting in 2007, the Fed began creating additional credit facilities to help to stabilize the financial system. The Fed creates new reserves and new money when it purchases bonds. It destroys reserves and thus reduces the money supply when it sells bonds. Try It! Suppose the Fed sells $8 million worth of bonds. 1. How do bank reserves change? 2. Will the money supply increase or decrease? 3. What is the maximum possible change in the money supply if the required reserve ratio is 0.2? 9.3.4 https://socialsci.libretexts.org/@go/page/21747  Case in Point: Fed Supports the Financial System by Creating New Credit Facilities Figure 24.15 Shalbs – Department of Treasury – CC BY 2.0. Well before most of the public became aware of the precarious state of the U.S. financial system, the Fed began to see signs of growing financial strains and to act on reducing them. In particular, the Fed saw that short-term interest rates that are often quite close to the federal funds rate began to rise markedly above it. The widening spread was alarming, because it suggested that lender confidence was declining, even for what are generally considered low-risk loans. Commercial paper, in which large companies borrow funds for a period of about a month to manage their cash flow, is an example. Even companies with high credit ratings
were having to pay unusually high interest rate premiums in order to get funding, or in some cases could not get funding at all. To deal with the drying up of credit markets, beginning in late 2007 and accelerating ever since, the Fed has created an alphabet soup of new credit facilities. Some of these are offered in conjunction with the Department of the Treasury, which has more latitude in terms of accepting some credit risk. The facilities differ in terms of collateral used, the duration of the loan, which institutions are eligible to borrow, and the cost to the borrower. For example, the Primary Dealer Credit Facility (PDCF) allows primary dealers (i.e., those financial institutions that normally handle the Fed’s open market operations) to obtain overnight loans. The Term AssetBacked Securities Loan Facility (TALF) allows a wide range of companies to borrow, using the primary dealers as conduits, based on qualified asset-backed securities related to student, auto, credit card, and small business debt, for a three-year period. Most of these new facilities are designed to be temporary, with expirations some time in 2009, but they can be extended. What they have in common, though, is increasing liquidity that will hopefully stimulate private spending. For example, these credit facilities may encourage banks to pare down their excess reserves (which grew enormously as the financial crisis unfolded and the economy deteriorated) and to make more loans. In the words of Fed Chairman Ben Bernanke: “Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets. Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses and, all else equal, should increase the willingness of those institutions to lend and make markets.” The legal authority for most of these new credit facilities comes from a particular section of the Federal Reserve Act that allows the Board of Governors “in unusual and exigent circumstances” to extend credit to a wide range of market players. Sources: Ben S. Bernanke, “The Crisis and the Policy Response” (Stemp Lecture, London School of Economics, London, England, January 13, 2009); Richard DiCecio and Charles S. Gascon, “New Monetary Policy Tools?” Federal Reserve Bank of St. Louis at Reserve Monetary www.federalreserve
.gov/monetarypolicy/default.htm. Governors Federal Trends, Board 2008; May Web site of 9.3.5 https://socialsci.libretexts.org/@go/page/21747 Answer to Try It! Problem 1. Bank reserves fall by $8 million. 2. The money supply decreases. 3. The maximum possible decrease is $40 million, since ∆D = (1/0.2) × (−$8 million) = −$40 million. References Zuckerman, S., “Feds Take Control of Fannie Mae, Freddie Mac,” The San Francisco Chronicle, September 8, 2008, p. A-1. This page titled 9.3: The Federal Reserve System is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 24.3: The Federal Reserve System by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 9.3.6 https://socialsci.libretexts.org/@go/page/21747 9.4: Review and Practice Summary In this chapter we investigated the money supply and looked at how it is determined. Money is anything that serves as a medium of exchange. Whatever serves as money also functions as a unit of account and as a store of value. Money may or may not have intrinsic value. In the United States, the total of currency in circulation, traveler’s checks, and checkable deposits equals M1. A broader measure of the money supply is M2, which includes M1 plus assets that are highly liquid, but less liquid than those in M1. Banks create money when they issue loans. The ability of banks to issue loans is controlled by their reserves. Reserves consist of cash in bank vaults and bank deposits with the Fed. Banks operate in a fractional reserve system; that is, they maintain reserves equal to only a small fraction of their deposit liabilities. Banks are heavily regulated to protect individual depositors and to prevent crises of confidence. Deposit insurance protects individual depositors. A central bank serves as a bank for banks, a regulator of banks, a manager of the money supply, a bank for a nation’s government, and a supporter of financial markets generally. In the financial crisis that rocked the
United States and much of the world in 2008, the Fed played a central role in keeping bank and nonbank institutions afloat and in keeping credit available. The Federal Reserve System (Fed) is the central bank for the United States. The Fed is governed by a Board of Governors whose members are appointed by the president of the United States, subject to confirmation by the Senate. The Fed can lend to banks and other institutions through the discount window and other credit facilities, change reserve requirements, and engage in purchases and sales of federal government bonds in the open market. Decisions to buy or sell bonds are made by the Federal Open Market Committee (FOMC); the Fed’s open-market operations represent its primary tool for influencing the money supply. Purchases of bonds by the Fed initially increase the reserves of banks. With excess reserves on hand, banks will attempt to increase their loans, and in the process the money supply will change by an amount less than or equal to the deposit multiplier times the change in reserves. Similarly, the Fed can reduce the money supply by selling bonds. Concept Problems 1. Airlines have “frequent flier” clubs in which customers accumulate miles according to the number of miles they have flown with the airline. Frequent flier miles can then be used to purchase other flights, to rent cars, or to stay in some hotels. Are frequent flier miles money? 2. Debit cards allow an individual to transfer funds directly in a checkable account to a merchant without writing a check. How is this different from the way credit cards work? Are either credit cards or debit cards money? Explain. 3. Many colleges sell special cards that students can use to purchase everything from textbooks or meals in the cafeteria to use of washing machines in the dorm. Students deposit money in their cards; as they use their cards for purchases, electronic scanners remove money from the cards. To replenish a card’s money, a student makes a cash deposit that is credited to the card. Would these cards count as part of the money supply? 4. A smart card, also known as an electronic purse, is a plastic card that can be loaded with a monetary value. Its developers argue that, once widely accepted, it could replace the use of currency in vending machines, parking meters, and elsewhere. Suppose smart cards came into widespread use. Present your views on the following issues: 1. Would you count balances in the purses as part of the money supply? If so, would they be part of M1
? M2? 2. Should any institution be permitted to issue them, or should they be restricted to banks? 3. Should the issuers be subject to reserve requirements? 4. Suppose they were issued by banks. How do you think the use of such purses would affect the money supply? Explain your answer carefully. 5. Which of the following items is part of M1? M2? 1. $0.27 cents that has accumulated under a couch cushion. 2. Your $2,000 line of credit with your Visa account. 3. The $210 balance in your checking account. 4. $417 in your savings account. 5. 10 shares of stock your uncle gave you on your 18th birthday, which are now worth $520. 6. $200 in traveler’s checks you have purchased for your spring-break trip. 9.4.1 https://socialsci.libretexts.org/@go/page/21748 6. In the Middle Ages, goldsmiths took in customers’ deposits (gold coins) and issued receipts that functioned much like checks do today. People used the receipts as a medium of exchange. Goldsmiths also issued loans by writing additional receipts against which they were holding no gold to borrowers. Were goldsmiths engaging in fractional reserve banking? Why do you think that customers turned their gold over to goldsmiths? Who benefited from the goldsmiths’ action? Why did such a system generally work? When would it have been likely to fail? 7. A $1,000 deposit in Acme Bank has increased reserves by $1,000. A loan officer at Acme reasons as follows: “The reserve requirement is 10%. That means that the $1,000 in new reserves can back $10,000 in checkable deposits. Therefore I’ll loan an additional $10,000.” Is there any problem with the loan officer’s reasoning? Explain. 8. When the Fed buys and sells bonds through open-market operations, the money supply changes, but there is no effect on the money supply when individuals buy and sell bonds. Explain. Numerical Problems 1. Consider the following example of bartering: 1 10-ounce T-bone steak can be traded for 5 soft drinks. 1 soft drink can be traded for 10 apples. 100 apples can be traded for a T-shirt. 5 T-shirts can be exchanged for 1 textbook. It takes 4 textbooks to
get 1 VCR. 1. How many 10-ounce T-bone steaks could you exchange for 1 textbook? How many soft drinks? How many apples? 2. State the price of T-shirts in terms of apples, textbooks, and soft drinks. 3. Why do you think we use money as a unit of account? 2. Assume that the banking system is loaned up and that any open-market purchase by the Fed directly increases reserves in the banks. If the required reserve ratio is 0.2, by how much could the money supply expand if the Fed purchased $2 billion worth of bonds? 3. Suppose the Fed sells $5 million worth of bonds to Econobank. 1. What happens to the reserves of the bank? 2. What happens to the money supply in the economy as a whole if the reserve requirement is 10%, all payments are made by check, and there is no net drain into currency? 3. How would your answer in part b be affected if you knew that some people involved in the money creation process kept some of their funds as cash? 4. If half the banks in the nation borrow additional reserves totaling $10 million at the Fed discount window, and at the same time the other half of the banks reduce their excess reserves by a total of $10 million, what is likely to happen to the money supply? Explain. 5. Suppose a bank with a 10% reserve requirement has $10 million in reserves and $100 million in checkable deposits, and a major corporation makes a deposit of $1 million. 1. Explain how the deposit affects the bank’s reserves and checkable deposits. 2. By how much can the bank increase its lending? 6. Suppose a bank with a 25% reserve requirement has $50 million in reserves and $200 million in checkable deposits, and one of the bank’s depositors, a major corporation, writes a check to another corporation for $5 million. The check is deposited in another bank. 1. Explain how the withdrawal affects the bank’s reserves and checkable deposits. 2. By how much will the bank have to reduce its lending? 7. Suppose the bank in problem 6 faces a 20% reserve requirement. The customer writes the same check. How will this affect your answers? 8. Now consider an economy in which the central bank has just purchased $8 billion worth of government bonds from banks in the economy. What would be the effect of this purchase on the money supply in the country
, assuming reserve requirements of: 9.4.2 https://socialsci.libretexts.org/@go/page/21748 1. 10%. 2. 15%. 3. 20%. 4. 25%. 9. Now consider the same economy, and the central bank sells $8 billion worth of government bonds to local banks. State the likely effects on the money supply under reserve requirements of: 1. 10%. 2. 15%. 3. 20%. 4. 25%. 10. How would the purchase of $8 billion of bonds by the central bank from local banks be likely to affect interest rates? How about the effect on interest rates of the sale of $8 billion worth of bonds? Explain your answers carefully. This page titled 9.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 24.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 9.4.3 https://socialsci.libretexts.org/@go/page/21748 CHAPTER OVERVIEW 10: Financial Markets and the Economy 10.1: The Bond and Foreign Exchange Markets 10.2: Demand, Supply, and Equilibrium in the Money Market 10.3: Review and Practice Thumbnail: https://www.pexels.com/photo/man-people-woman-business-5849592/ This page titled 10: Financial Markets and the Economy is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 10.1: The Bond and Foreign Exchange Markets  Learning Objective 1. Explain and illustrate how the bond market works and discuss the relationship between the price of a bond and that bond’s interest rate. 2. Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity. 3. Explain and illustrate how the foreign exchange market works and how a change in demand for a country’s currency or a change in its supply affects macroeconomic activity. In this section, we will look at the bond market and at the market for foreign exchange. Events in these markets can affect the price level and output for the entire economy. The Bond Market In their
daily operations and in pursuit of new projects, institutions such as firms and governments often borrow. They may seek funds from a bank. Many institutions, however, obtain credit by selling bonds. The federal government is one institution that issues bonds. A local school district might sell bonds to finance the construction of a new school. Your college or university has probably sold bonds to finance new buildings on campus. Firms often sell bonds to finance expansion. The market for bonds is an enormously important one. When an institution sells a bond, it obtains the price paid for the bond as a kind of loan. The institution that issues the bond is obligated to make payments on the bond in the future. The interest rate is determined by the price of the bond. To understand these relationships, let us look more closely at bond prices and interest rates. Bond Prices and Interest Rates Suppose the manager of a manufacturing company needs to borrow some money to expand the factory. The manager could do so in the following way: he or she prints, say, 500 pieces of paper, each bearing the company’s promise to pay the bearer $1,000 in a year. These pieces of paper are bonds, and the company, as the issuer, promises to make a single payment. The manager then offers these bonds for sale, announcing that they will be sold to the buyers who offer the highest prices. Suppose the highest price offered is $950, and all the bonds are sold at that price. Each bond is, in effect, an obligation to repay buyers $1,000. The buyers of the bonds are being paid $50 for the service of lending $950 for a year. The $1,000 printed on each bond is the face value of the bond; it is the amount the issuer will have to pay on the maturity date of the bond—the date when the loan matures, or comes due. The $950 at which they were sold is their price. The difference between the face value and the price is the amount paid for the use of the money obtained from selling the bond. An interest rate is the payment made for the use of money, expressed as a percentage of the amount borrowed. Bonds you sold command an interest rate equal to the difference between the face value and the bond price, divided by the bond price, and then multiplied by 100 to form a percentage: Equation 25.1 At a price of $950, the interest rate is 5.3% The interest rate on any bond is determined by its price. As the price falls
, the interest rate rises. Suppose, for example, that the best price the manager can get for the bonds is $900. Now the interest rate is 11.1%. A price of $800 would mean an interest rate of 25%; $750 would mean an interest rate of 33.3%; a price of $500 translates into an interest rate of 100%. The lower the price of a bond relative to its face value, the higher the interest rate. Bonds in the real world are more complicated than the piece of paper in our example, but their structure is basically the same. They have a face value (usually an amount between $1,000 and $100,000) and a maturity date. The maturity date might be three months from the date of issue; it might be 30 years. 10.1.1 https://socialsci.libretexts.org/@go/page/21750 Whatever the period until it matures, and whatever the face value of the bond may be, its issuer will attempt to sell the bond at the highest possible price. Buyers of bonds will seek the lowest prices they can obtain. Newly issued bonds are generally sold in auctions. Potential buyers bid for the bonds, which are sold to the highest bidders. The lower the price of the bond relative to its face value, the higher the interest rate. Both private firms and government entities issue bonds as a way of raising funds. The original buyer need not hold the bond until maturity. Bonds can be resold at any time, but the price the bond will fetch at the time of resale will vary depending on conditions in the economy and the financial markets. Figure 25.1 illustrates the market for bonds. Their price is determined by demand and supply. Buyers of newly issued bonds are, in effect, lenders. Sellers of newly issued bonds are borrowers—recall that corporations, the federal government, and other institutions sell bonds when they want to borrow money. Once a newly issued bond has been sold, its owner can resell it; a bond may change hands several times before it matures. Figure 25.1 The Bond Market The equilibrium price for bonds is determined where the demand and supply curves intersect. The initial solution here is a price of $950, implying an interest rate of 5.3%. An increase in borrowing, all other things equal, increases the supply of bonds to S and forces the price of bonds down to $900. The interest rate rises to 11.1%. 2 Bonds are not
exactly the same sort of product as, say, broccoli or some other good or service. Can we expect bonds to have the same kind of downward-sloping demand curves and upward-sloping supply curves we encounter for ordinary goods and services? Yes. Consider demand. At lower prices, bonds pay higher interest. That makes them more attractive to buyers of bonds and thus increases the quantity demanded. On the other hand, lower prices mean higher costs to borrowers—suppliers of bonds—and should reduce the quantity supplied. Thus, the negative relationship between price and quantity demanded and the positive relationship between price and quantity supplied suggested by conventional demand and supply curves holds true in the market for bonds. If the quantity of bonds demanded is not equal to the quantity of bonds supplied, the price will adjust almost instantaneously to balance the two. Bond prices are perfectly flexible in that they change immediately to balance demand and supply. Suppose, for example, that the initial price of bonds is $950, as shown by the intersection of the demand and supply curves in Figure 25.1. We will assume that all bonds have equal risk and a face value of $1,000 and that they mature in one year. Now suppose that borrowers increase their borrowing by offering to sell more bonds at every interest rate. This increases the supply of bonds: the supply curve shifts to the right from S to S. That, in turn, lowers the equilibrium price of bonds—to $900 in Figure 25.1. The lower price for bonds means a higher interest rate. 2 1 The Bond Market and Macroeconomic Performance The connection between the bond market and the economy derives from the way interest rates affect aggregate demand. For example, investment is one component of aggregate demand, and interest rates affect investment. Firms are less likely to acquire 1 new capital (that is, plant and equipment) if interest rates are high; they’re more likely to add capital if interest rates are low. If bond prices fall, interest rates go up. Higher interest rates tend to discourage investment, so aggregate demand will fall. A fall in aggregate demand, other things unchanged, will mean fewer jobs and less total output than would have been the case with lower 10.1.2 https://socialsci.libretexts.org/@go/page/21750 rates of interest. In contrast, an increase in the price of bonds lowers interest rates and makes investment in new capital more attractive. That change may boost investment and thus boost aggregate demand. Figure 25.2 shows
how an event in the bond market can stimulate changes in the economy’s output and price level. In Panel (a), an increase in demand for bonds raises bond prices. Interest rates thus fall. Lower interest rates increase the quantity of investment demanded, shifting the aggregate demand curve to the right, from AD to AD in Panel (b). Real GDP rises from Y to Y ; the price level rises from P to P. In Panel (c), an increase in the supply of bonds pushes bond prices down. Interest rates rise. The quantity of investment is likely to fall, shifting aggregate demand to the left, from AD to AD in Panel (d). Output and the price level fall from Y to Y and from P to P, respectively. Assuming other determinants of aggregate demand remain unchanged, higher interest rates will tend to reduce aggregate demand and lower interest rates will tend to increase aggregate demand Figure 25.2 Bond Prices and Macroeconomic Activity An increase in the demand for bonds to D in Panel (a) raises the price of bonds to P, which lowers interest rates and boosts investment. That increases aggregate demand to AD in Panel (b); real GDP rises to Y and the price level rises to P. 2 b 2 2 2 2 b An increase in the supply of bonds to S lowers bond prices to P in Panel (c) and raises interest rates. The higher interest rate, 2 taken by itself, is likely to cause a reduction in investment and aggregate demand. AD falls to AD, real GDP falls to Y, and the price level falls to P in Panel (d). 2 2 2 1 2 In thinking about the impact of changes in interest rates on aggregate demand, we must remember that some events that change aggregate demand can affect interest rates. We will examine those events in subsequent chapters. Our focus in this chapter is on the way in which events that originate in financial markets affect aggregate demand. Foreign Exchange Markets Another financial market that influences macroeconomic variables is the foreign exchange market, a market in which currencies of different countries are traded for one another. Since changes in exports and imports affect aggregate demand and thus real GDP and the price level, the market in which currencies are traded has tremendous importance in the economy. Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars. United States purchasers of foreign goods must generally make the purchase in a foreign currency. An Egyptian family, for example, exchanges Egyptian pounds for dollars in order to pay for admission to Disney World. A German
financial investor purchases dollars to buy U.S. government bonds. A family from the United States visiting India, on the other hand, needs to obtain Indian rupees in order to make purchases there. A U.S. bank wanting to purchase assets in Mexico City first purchases pesos. These transactions are accomplished in the foreign exchange market. The foreign exchange market is not a single location in which currencies are traded. The term refers instead to the entire array of institutions through which people buy and sell currencies. It includes a hotel desk clerk who provides currency exchange as a 10.1.3 https://socialsci.libretexts.org/@go/page/21750 service to hotel guests, brokers who arrange currency exchanges worth billions of dollars, and governments and central banks that exchange currencies. Major currency dealers are linked by computers so that they can track currency exchanges all over the world. The Exchange Rate A country’s exchange rate is the price of its currency in terms of another currency or currencies. On December 12, 2008, for example, the dollar traded for 91.13 Japanese yen, 0.75 euros, 10.11 South African rands, and 13.51 Mexican pesos. There are as many exchange rates for the dollar as there are countries whose currencies exchange for the dollar—roughly 200 of them. Economists summarize the movement of exchange rates with a trade-weighted exchange rate, which is an index of exchange rates. To calculate a trade-weighted exchange rate index for the U.S. dollar, we select a group of countries, weight the price of the dollar in each country’s currency by the amount of trade between that country and the United States, and then report the price of the dollar based on that trade-weighted average. Because trade-weighted exchange rates are so widely used in reporting currency values, they are often referred to as exchange rates themselves. We will follow that convention in this text. Determining Exchange Rates The rates at which most currencies exchange for one another are determined by demand and supply. How does the model of demand and supply operate in the foreign exchange market? The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate. An increase in the exchange rate means it takes more foreign currency to buy a dollar. A higher exchange rate, in turn, makes U.S. goods and services more expensive for foreign buyers and reduces the quantity they will demand. That is likely to reduce the quantity
of dollars they demand. Foreigners thus will demand fewer dollars as the price of the dollar—the exchange rate—rises. Consequently, the demand curve for dollars is downward sloping, as in Figure 25.3. Figure 25.3 Determining an Exchange Rate The equilibrium exchange rate is the rate at which the quantity of dollars demanded equals the quantity supplied. Here, equilibrium occurs at exchange rate E, at which Q dollars are exchanged per period. The supply curve for dollars emerges from a similar process. When people and firms in the United States purchase goods, services, or assets in foreign countries, they must purchase the currency of those countries first. They supply dollars in exchange for foreign currency. The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates. A higher exchange rate means that a dollar trades for more foreign currency. In effect, the higher rate makes foreign goods and services cheaper to U.S. buyers, so U.S. consumers will purchase more foreign goods and services. People will thus supply more dollars at a higher exchange rate; we expect the supply curve for dollars to be upward sloping, as suggested in Figure 25.3. In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well. A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. 10.1.4 https://socialsci.libretexts.org/@go/page/21750 Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets. The most important traders are private buyers and sellers of currencies. Exchange Rates and Macroeconomic Performance People purchase a country’s currency for two quite different reasons: to purchase goods or services in that country, or to purchase the assets of that country—its money, its capital, its stocks, its bonds, or its real estate. Both of these motives must be considered to understand why demand and supply in the foreign exchange market may change. One thing that can cause the price of the dollar to rise, for example, is a reduction in bond prices in American markets. Figure 25.4 illustrates the effect of this change. Suppose the supply of bonds in the U.S. bond market increases from S to S in Panel (a). Bond prices will drop. Lower bond prices mean higher interest rates. Foreign financial investors, attracted by the opportunity to
earn higher returns in the United States, will increase their demand for dollars on the foreign exchange market in order to purchase U.S. bonds. Panel (b) shows that the demand curve for dollars shifts from D to D. Simultaneously, U.S. financial investors, attracted by the higher interest rates at home, become less likely to make financial investments abroad and thus supply fewer dollars to exchange markets. The fall in the price of U.S. bonds shifts the supply curve for dollars on the foreign exchange market from S to S, and the exchange rate rises from E to Figure 25.4 Shifts in Demand and Supply for Dollars on the Foreign Exchange Market In Panel (a), an increase in the supply of bonds lowers bond prices to P (and thus raises interest rates). Higher interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E. These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and in investment, reducing aggregate demand from AD to AD in Panel (c). The price level in the economy falls to P, and real GDP falls from Y to The higher exchange rate makes U.S. goods and services more expensive to foreigners, so it reduces exports. It makes foreign goods cheaper for U.S. buyers, so it increases imports. Net exports thus fall, reducing aggregate demand. Panel (c) shows that output falls from Y to Y ; the price level falls from P to P. This development in the foreign exchange market reinforces the impact of higher interest rates we observed in Figure 25.2, Panels (c) and (d). They not only reduce investment—they reduce net exports as well. 1 2 1 2 Key Takeaways A bond represents a borrower’s debt; bond prices are determined by demand and supply. The interest rate on a bond is negatively related to the price of the bond. As the price of a bond increases, the interest rate falls. An increase in the interest rate tends to decrease the quantity of investment demanded and, hence, to decrease aggregate demand. A decrease in the interest rate increases the quantity of investment demanded and aggregate demand. The demand for dollars on foreign exchange markets represents foreign demand for U.S. goods, services, and assets. The supply of dollars on foreign exchange markets represents U.S. demand for foreign goods, services, and assets. The demand for and the supply of dollars determine the exchange rate. A rise in U.S. interest
rates will increase the demand for dollars and decrease the supply of dollars on foreign exchange markets. As a result, the exchange rate will increase and aggregate demand will decrease. A fall in U.S. interest rates will have the opposite effect. Try It! Suppose the supply of bonds in the U.S. market decreases. Show and explain the effects on the bond and foreign exchange markets. Use the aggregate demand/aggregate supply framework to show and explain the effects on investment, net exports, real GDP, and the price level. 10.1.5 https://socialsci.libretexts.org/@go/page/21750  Case in Point: Betting on a Plunge Figure 25.5 DonkeyHotey – US Treasury Bond – 3D Illustration – CC BY 2.0. In 2004, a certain Thomas J. from Florida had a plan. He understood clearly the inverse relationship between bond prices and interest rates. What he did not understand was how expensive guessing incorrectly the direction of interest rates would be when he decided to buy into an “inverse bond” fund. An “inverse bond” fund is one that performs well when bond prices fall. The fund Thomas bought into happened to trade in 30year U.S. Treasury bonds, and Thomas guessed that interest rates on them would rise. The only problem with the plan was that the interest rate on 30-year bonds actually fell over the next year. So, the fund Thomas bought into lost value when the prices of these bonds rose. Expenses associated with this type of fund exacerbated Thomas’s loss. If only Thomas had known both the relationship between bond prices and interest rates and the direction of interest rates! Perhaps another thing he did not understand was that when he heard that the Federal Reserve was raising rates in 2004 that this referred to the federal funds rates, a very short-term interest rate. While other short-term interest rates moved with the federal funds rate in 2004, long-term rates did not even blink. Source: Chuck Jaffee, “Don’t Be Stupid: He Had Little Fun with ‘Inverse Bond Funds,’” Boston Herald, June 14, 2005, p. 34. Answer to Try It! Problem 1 2 If the supply of bonds decreases from S to S, bond prices will rise from P to P, as shown in Panel (a). Higher bond prices mean lower interest rates. Lower interest rates in
the United States will make financial investments in the United States less attractive to foreigners. As a result, their demand for dollars will decrease from D to D, as shown in Panel (b). Similarly, U.S. financial investors will look abroad for higher returns and thus supply more dollars to foreign exchange markets, shifting the supply curve from S to S. Thus, the exchange rate will decrease. The quantity of investment rises due to the lower interest rates. Net exports rise because the lower exchange rate makes U.S. goods and services more attractive to foreigners, thus increasing exports, and makes foreign goods less attractive to U.S. buyers, thus reducing imports. Increases in investment and net exports imply a rightward shift in the aggregate demand curve from AD to AD. Real GDP and the price level increase Figure 25.6 10.1.6 https://socialsci.libretexts.org/@go/page/21750 1 Consumption may also be affected by changes in interest rates. For example, if interest rates fall, consumers can more easily obtain credit and thus are more likely to purchase cars and other durable goods. To simplify, we ignore this effect. This page titled 10.1: The Bond and Foreign Exchange Markets is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 25.1: The Bond and Foreign Exchange Markets by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 10.1.7 https://socialsci.libretexts.org/@go/page/21750 10.2: Demand, Supply, and Equilibrium in the Money Market  Learning Objective 1. Explain the motives for holding money and relate them to the interest rate that could be earned from holding alternative assets, such as bonds. 2. Draw a money demand curve and explain how changes in other variables may lead to shifts in the money demand curve. 3. Illustrate and explain the notion of equilibrium in the money market. 4. Use graphs to explain how changes in money demand or money supply are related to changes in the bond market, in interest rates, in aggregate demand, and in real GDP and the price level. In this section we will explore the link between money markets, bond markets, and interest rates. We first look at the demand for money.
The demand curve for money is derived like any other demand curve, by examining the relationship between the “price” of money (which, we will see, is the interest rate) and the quantity demanded, holding all other determinants unchanged. We then link the demand for money to the concept of money supply developed in the last chapter, to determine the equilibrium rate of interest. In turn, we show how changes in interest rates affect the macroeconomy. The Demand for Money In deciding how much money to hold, people make a choice about how to hold their wealth. How much wealth shall be held as money and how much as other assets? For a given amount of wealth, the answer to this question will depend on the relative costs and benefits of holding money versus other assets. The demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity. To simplify our analysis, we will assume there are only two ways to hold wealth: as money in a checking account, or as funds in a bond market mutual fund that purchases long-term bonds on behalf of its subscribers. A bond fund is not money. Some money deposits earn interest, but the return on these accounts is generally lower than what could be obtained in a bond fund. The advantage of checking accounts is that they are highly liquid and can thus be spent easily. We will think of the demand for money as a curve that represents the outcomes of choices between the greater liquidity of money deposits and the higher interest rates that can be earned by holding a bond fund. The difference between the interest rates paid on money deposits and the interest return available from bonds is the cost of holding money. Motives for Holding Money One reason people hold their assets as money is so that they can purchase goods and services. The money held for the purchase of goods and services may be for everyday transactions such as buying groceries or paying the rent, or it may be kept on hand for contingencies such as having the funds available to pay to have the car fixed or to pay for a trip to the doctor. The transactions demand for money is money people hold to pay for goods and services they anticipate buying. When you carry money in your purse or wallet to buy a movie ticket or maintain a checking account balance so you can purchase groceries later in the month, you are holding the money as part of your transactions demand for money. The money people hold for contingencies represents their precautionary demand for money. Money held for precautionary purposes may include checking account balances kept for
possible home repairs or health-care needs. People do not know precisely when the need for such expenditures will occur, but they can prepare for them by holding money so that they’ll have it available when the need arises. People also hold money for speculative purposes. Bond prices fluctuate constantly. As a result, holders of bonds not only earn interest but experience gains or losses in the value of their assets. Bondholders enjoy gains when bond prices rise and suffer losses when bond prices fall. Because of this, expectations play an important role as a determinant of the demand for bonds. Holding bonds is one alternative to holding money, so these same expectations can affect the demand for money. John Maynard Keynes, who was an enormously successful speculator in bond markets himself, suggested that bondholders who anticipate a drop in bond prices will try to sell their bonds ahead of the price drop in order to avoid this loss in asset value. Selling a bond means converting it to money. Keynes referred to the speculative demand for money as the money held in response to concern that bond prices and the prices of other financial assets might change. 10.2.1 https://socialsci.libretexts.org/@go/page/21751 Of course, money is money. One cannot sort through someone’s checking account and locate which funds are held for transactions and which funds are there because the owner of the account is worried about a drop in bond prices or is taking a precaution. We distinguish money held for different motives in order to understand how the quantity of money demanded will be affected by a key determinant of the demand for money: the interest rate. Interest Rates and the Demand for Money The quantity of money people hold to pay for transactions and to satisfy precautionary and speculative demand is likely to vary with the interest rates they can earn from alternative assets such as bonds. When interest rates rise relative to the rates that can be earned on money deposits, people hold less money. When interest rates fall, people hold more money. The logic of these conclusions about the money people hold and interest rates depends on the people’s motives for holding money. The quantity of money households want to hold varies according to their income and the interest rate; different average quantities of money held can satisfy their transactions and precautionary demands for money. To see why, suppose a household earns and spends $3,000 per month. It spends an equal amount of money each day. For a month with 30 days, that is $100 per day. One
way the household could manage this spending would be to leave the money in a checking account, which we will assume pays zero interest. The household would thus have $3,000 in the checking account when the month begins, $2,900 at the end of the first day, $1,500 halfway through the month, and zero at the end of the last day of the month. Averaging the daily balances, we find that the quantity of money the household demands equals $1,500. This approach to money management, which we will call the “cash approach,” has the virtue of simplicity, but the household will earn no interest on its funds. Consider an alternative money management approach that permits the same pattern of spending. At the beginning of the month, the household deposits $1,000 in its checking account and the other $2,000 in a bond fund. Assume the bond fund pays 1% interest per month, or an annual interest rate of 12.7%. After 10 days, the money in the checking account is exhausted, and the household withdraws another $1,000 from the bond fund for the next 10 days. On the 20th day, the final $1,000 from the bond fund goes into the checking account. With this strategy, the household has an average daily balance of $500, which is the quantity of money it demands. Let us call this money management strategy the “bond fund approach.” Remember that both approaches allow the household to spend $3,000 per month, $100 per day. The cash approach requires a quantity of money demanded of $1,500, while the bond fund approach lowers this quantity to $500. The bond fund approach generates some interest income. The household has $1,000 in the fund for 10 days (1/3 of a month) and $1,000 for 20 days (2/3 of a month). With an interest rate of 1% per month, the household earns $10 in interest each month ([$1,000 × 0.01 × 1/3] + [$1,000 × 0.01 × 2/3]). The disadvantage of the bond fund, of course, is that it requires more attention— $1,000 must be transferred from the fund twice each month. There may also be fees associated with the transfers. Of course, the bond fund strategy we have examined here is just one of many. The household could begin each month with $1,500 in the
checking account and $1,500 in the bond fund, transferring $1,500 to the checking account midway through the month. This strategy requires one less transfer, but it also generates less interest—$7.50 (= $1,500 × 0.01 × 1/2). With this strategy, the household demands a quantity of money of $750. The household could also maintain a much smaller average quantity of money in its checking account and keep more in its bond fund. For simplicity, we can think of any strategy that involves transferring money in and out of a bond fund or another interest-earning asset as a bond fund strategy. Which approach should the household use? That is a choice each household must make—it is a question of weighing the interest a bond fund strategy creates against the hassle and possible fees associated with the transfers it requires. Our example does not yield a clear-cut choice for any one household, but we can make some generalizations about its implications. First, a household is more likely to adopt a bond fund strategy when the interest rate is higher. At low interest rates, a household does not sacrifice much income by pursuing the simpler cash strategy. As the interest rate rises, a bond fund strategy becomes more attractive. That means that the higher the interest rate, the lower the quantity of money demanded. Second, people are more likely to use a bond fund strategy when the cost of transferring funds is lower. The creation of savings plans, which began in the 1970s and 1980s, that allowed easy transfer of funds between interest-earning assets and checkable deposits tended to reduce the demand for money. Some money deposits, such as savings accounts and money market deposit accounts, pay interest. In evaluating the choice between holding assets as some form of money or in other forms such as bonds, households will look at the differential between what those funds pay and what they could earn in the bond market. A higher interest rate in the bond market is likely to increase this 10.2.2 https://socialsci.libretexts.org/@go/page/21751 differential; a lower interest rate will reduce it. An increase in the spread between rates on money deposits and the interest rate in the bond market reduces the quantity of money demanded; a reduction in the spread increases the quantity of money demanded. Firms, too, must determine how to manage their earnings and expenditures. However, instead of worrying about $3,000 per month, even a relatively small firm may be concerned about $3
,000,000 per month. Rather than facing the difference of $10 versus $7.50 in interest earnings used in our household example, this small firm would face a difference of $2,500 per month ($10,000 versus $7,500). For very large firms such as Toyota or AT&T, interest rate differentials among various forms of holding their financial assets translate into millions of dollars per day. How is the speculative demand for money related to interest rates? When financial investors believe that the prices of bonds and other assets will fall, their speculative demand for money goes up. The speculative demand for money thus depends on expectations about future changes in asset prices. Will this demand also be affected by present interest rates? If interest rates are low, bond prices are high. It seems likely that if bond prices are high, financial investors will become concerned that bond prices might fall. That suggests that high bond prices—low interest rates—would increase the quantity of money held for speculative purposes. Conversely, if bond prices are already relatively low, it is likely that fewer financial investors will expect them to fall still further. They will hold smaller speculative balances. Economists thus expect that the quantity of money demanded for speculative reasons will vary negatively with the interest rate. The Demand Curve for Money We have seen that the transactions, precautionary, and speculative demands for money vary negatively with the interest rate. Putting those three sources of demand together, we can draw a demand curve for money to show how the interest rate affects the total quantity of money people hold. The demand curve for money shows the quantity of money demanded at each interest rate, all other things unchanged. Such a curve is shown in Figure 25.7. An increase in the interest rate reduces the quantity of money demanded. A reduction in the interest rate increases the quantity of money demanded. Figure 25.7 The Demand Curve for Money The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate. The relationship between interest rates and the quantity of money demanded is an application of the law of demand. If we think of the alternative to holding money as holding bonds, then the interest rate—or the differential between the interest rate in the bond market and the interest paid on money deposits—represents the price of holding money. As is the case with all goods and services, an increase in price reduces the quantity demanded. Other Determinants of the Demand for Money We draw the demand curve
for money to show the quantity of money people will hold at each interest rate, all other determinants of money demand unchanged. A change in those “other determinants” will shift the demand for money. Among the most important 10.2.3 https://socialsci.libretexts.org/@go/page/21751 variables that can shift the demand for money are the level of income and real GDP, the price level, expectations, transfer costs, and preferences. Real GDP A household with an income of $10,000 per month is likely to demand a larger quantity of money than a household with an income of $1,000 per month. That relationship suggests that money is a normal good: as income increases, people demand more money at each interest rate, and as income falls, they demand less. An increase in real GDP increases incomes throughout the economy. The demand for money in the economy is therefore likely to be greater when real GDP is greater. The Price Level The higher the price level, the more money is required to purchase a given quantity of goods and services. All other things unchanged, the higher the price level, the greater the demand for money. Expectations The speculative demand for money is based on expectations about bond prices. All other things unchanged, if people expect bond prices to fall, they will increase their demand for money. If they expect bond prices to rise, they will reduce their demand for money. The expectation that bond prices are about to change actually causes bond prices to change. If people expect bond prices to fall, for example, they will sell their bonds, exchanging them for money. That will shift the supply curve for bonds to the right, thus lowering their price. The importance of expectations in moving markets can lead to a self-fulfilling prophecy. Expectations about future price levels also affect the demand for money. The expectation of a higher price level means that people expect the money they are holding to fall in value. Given that expectation, they are likely to hold less of it in anticipation of a jump in prices. Expectations about future price levels play a particularly important role during periods of hyperinflation. If prices rise very rapidly and people expect them to continue rising, people are likely to try to reduce the amount of money they hold, knowing that it will fall in value as it sits in their wallets or their bank accounts. Toward the end of the great German hyperinflation of the early 1920s, prices were doubling as often as three times a day
. Under those circumstances, people tried not to hold money even for a few minutes—within the space of eight hours money would lose half its value! Transfer Costs For a given level of expenditures, reducing the quantity of money demanded requires more frequent transfers between nonmoney and money deposits. As the cost of such transfers rises, some consumers will choose to make fewer of them. They will therefore increase the quantity of money they demand. In general, the demand for money will increase as it becomes more expensive to transfer between money and nonmoney accounts. The demand for money will fall if transfer costs decline. In recent years, transfer costs have fallen, leading to a decrease in money demand. Preferences Preferences also play a role in determining the demand for money. Some people place a high value on having a considerable amount of money on hand. For others, this may not be important. Household attitudes toward risk are another aspect of preferences that affect money demand. As we have seen, bonds pay higher interest rates than money deposits, but holding bonds entails a risk that bond prices might fall. There is also a chance that the issuer of a bond will default, that is, will not pay the amount specified on the bond to bondholders; indeed, bond issuers may end up paying nothing at all. A money deposit, such as a savings deposit, might earn a lower yield, but it is a safe yield. People’s attitudes about the trade-off between risk and yields affect the degree to which they hold their wealth as money. Heightened concerns about risk in the last half of 2008 led many households to increase their demand for money. Figure 25.8 shows an increase in the demand for money. Such an increase could result from a higher real GDP, a higher price level, a change in expectations, an increase in transfer costs, or a change in preferences. 10.2.4 https://socialsci.libretexts.org/@go/page/21751 Figure 25.8 An Increase in Money Demand An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D to D. The quantity of money demanded at interest rate r rises from M to M′. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left. 1 2 The Supply of Money The supply curve of money shows the relationship between the quantity of money supplied and
the market interest rate, all other determinants of supply unchanged. We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure 25.9 as a vertical line, determined by the Fed’s monetary policies. In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate. Changing the quantity of reserves and hence the money supply is an example of monetary policy. 10.2.5 https://socialsci.libretexts.org/@go/page/21751 Figure 25.9 The Supply Curve of Money We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the quantity of bank reserves, which is determined by the Fed. The supply curve of money is a vertical line at that quantity. Equilibrium in the Market for Money The money market is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. Figure 25.10 combines demand and supply curves for money to illustrate equilibrium in the market for money. With a stock of money (M), the equilibrium interest rate is r. Figure 25.10 Money Market Equilibrium The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied. Here, equilibrium occurs at interest rate r. Effects of Changes in the Money Market A shift in money demand or supply will lead to a change in the equilibrium interest rate. Let’s look at the effects of such changes on the economy. 10.2.6 https://socialsci.libretexts.org/@go/page/21751 Changes in Money Demand Suppose that the money market is initially in equilibrium at r with supply curve S and a demand curve D as shown in Panel (a) of Figure 25.11. Now suppose that there is a decrease in money demand, all other things unchanged. A decrease in money demand could result from a decrease in the cost of transferring between money and nonmoney deposits, from a change in expectations, or from a change in preferences. Panel (a) shows that the money demand curve shifts to the left
to D. We can see that the interest rate will fall to r. To see why the interest rate falls, we recall that if people want to hold less money, then they will want to hold more bonds. Thus, Panel (b) shows that the demand for bonds increases. The higher price of bonds means lower interest rates; lower interest rates restore equilibrium in the money market. 2 1 2 1 1 Figure 25.11 A Decrease in the Demand for Money A decrease in the demand for money due to a change in transactions costs, preferences, or expectations, as shown in Panel (a), will be accompanied by an increase in the demand for bonds as shown in Panel (b), and a fall in the interest rate. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD to AD, as shown in Panel (c). As a result, real GDP and the price level rise. 1 2 Lower interest rates in turn increase the quantity of investment. They also stimulate net exports, as lower interest rates lead to a lower exchange rate. The aggregate demand curve shifts to the right as shown in Panel (c) from AD to AD. Given the short-run aggregate supply curve SRAS, the economy moves to a higher real GDP and a higher price level. 2 1 An increase in money demand due to a change in expectations, preferences, or transactions costs that make people want to hold more money at each interest rate will have the opposite effect. The money demand curve will shift to the right and the demand for bonds will shift to the left. The resulting higher interest rate will lead to a lower quantity of investment. Also, higher interest rates will lead to a higher exchange rate and depress net exports. Thus, the aggregate demand curve will shift to the left. All other things unchanged, real GDP and the price level will fall. Changes in the Money Supply Now suppose the market for money is in equilibrium and the Fed changes the money supply. All other things unchanged, how will this change in the money supply affect the equilibrium interest rate and aggregate demand, real GDP, and the price level? Suppose the Fed conducts open-market operations in which it buys bonds. This is an example of expansionary monetary policy. The impact of Fed bond purchases is illustrated in Panel (a) of Figure 25.12. The Fed’s purchase of bonds shifts the demand curve for bonds to the right, raising bond prices to P. As we learned, when the Fed buys bonds, the supply of money increases
. Panel (b) of Figure 25.12 shows an economy with a money supply of M, which is in equilibrium at an interest rate of r. Now suppose the bond purchases by the Fed as shown in Panel (a) result in an increase in the money supply to M′; that policy change shifts the supply curve for money to the right to S. At the original interest rate r, people do not wish to hold the newly supplied money; they would prefer to hold nonmoney assets. To reestablish equilibrium in the money market, the interest rate must fall to increase the quantity of money demanded. In the economy shown, the interest rate must fall to r to increase the quantity of money demanded to M′. b 2 2 1 1 2 Figure 25.12 An Increase in the Money Supply The Fed increases the money supply by buying bonds, increasing the demand for bonds in Panel (a) from D to D and the price of bonds to P. This corresponds to an increase in the money supply to M′ in Panel (b). The interest rate must fall to r to achieve equilibrium. The lower interest rate leads to an increase in investment and net exports, which shifts the aggregate demand curve from AD to AD in Panel (c). Real GDP and the price level rise. 2 b 2 1 2 2 1 10.2.7 https://socialsci.libretexts.org/@go/page/21751 The reduction in interest rates required to restore equilibrium to the market for money after an increase in the money supply is achieved in the bond market. The increase in bond prices lowers interest rates, which will increase the quantity of money people demand. Lower interest rates will stimulate investment and net exports, via changes in the foreign exchange market, and cause the aggregate demand curve to shift to the right, as shown in Panel (c), from AD to AD. Given the short-run aggregate supply curve SRAS, the economy moves to a higher real GDP and a higher price level. 1 2 Open-market operations in which the Fed sells bonds—that is, a contractionary monetary policy—will have the opposite effect. When the Fed sells bonds, the supply curve of bonds shifts to the right and the price of bonds falls. The bond sales lead to a reduction in the money supply, causing the money supply curve to shift to the left and raising the equilibrium interest rate. Higher interest rates lead to a shift in the aggregate demand curve to the left. As we have seen in looking at both changes in demand for
and in supply of money, the process of achieving equilibrium in the money market works in tandem with the achievement of equilibrium in the bond market. The interest rate determined by money market equilibrium is consistent with the interest rate achieved in the bond market. Key Takeaways People hold money in order to buy goods and services (transactions demand), to have it available for contingencies (precautionary demand), and in order to avoid possible drops in the value of other assets such as bonds (speculative demand). The higher the interest rate, the lower the quantities of money demanded for transactions, for precautionary, and for speculative purposes. The lower the interest rate, the higher the quantities of money demanded for these purposes. The demand for money will change as a result of a change in real GDP, the price level, transfer costs, expectations, or preferences. We assume that the supply of money is determined by the Fed. The supply curve for money is thus a vertical line. Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied. All other things unchanged, a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level. Try It! In 2005 the Fed was concerned about the possibility that the United States was moving into an inflationary gap, and it adopted a contractionary monetary policy as a result. Draw a four-panel graph showing this policy and its expected results. In Panel (a), use the model of aggregate demand and aggregate supply to illustrate an economy with an inflationary gap. In Panel (b), show how the Fed’s policy will affect the market for bonds. In Panel (c), show how it will affect the demand for and supply of money. In Panel (d), show how it will affect the exchange rate. Finally, return to Panel (a) and incorporate these developments into your analysis of aggregate demand and aggregate supply, and show how the Fed’s policy will affect real GDP and the price level in the short run.  Case in Point: Money in Today’s World Figure 25.13 Travel Wallet Can Pac Swire – Hong Kong/ Travel Wallet – CC BY-NC 2.0. The models of the money and bond markets presented in this chapter suggest that the Fed can control the interest rate by deciding on a money supply that would lead to the desired equilibrium interest rate in the money market. Yet, Fed policy
announcements typically focus on what it wants the federal funds rate to be with scant attention to the money supply. Whereas throughout the 1990s, the Fed would announce a target federal funds rate and also indicate an expected change in the money supply, in 2000, when legislation requiring it to do so expired, it abandoned the practice of setting money supply targets. Why the shift? The factors that have made focusing on the money supply as a policy target difficult for the past 25 years are first banking deregulation in the 1980s followed by financial innovations associated with technological changes—in particular the maturation of electronic payment and transfer mechanisms—thereafter. Before the 1980s, M1 was a fairly reliable measure of the money people held, primarily for transactions. To buy things, one used cash, checks written on demand deposits, or traveler’s checks. The Fed could thus use reliable estimates of the money demand curve to predict what the money supply would need to be in order to bring about a certain interest rate in the money market. 10.2.8 https://socialsci.libretexts.org/@go/page/21751 Legislation in the early 1980s allowed for money market deposit accounts (MMDAs), which are essentially interest-bearing savings accounts on which checks can be written. MMDAs are part of M2. Shortly after, other forms of payments for transactions developed or became more common. For example, credit and debit card use has mushroomed (from $10.8 billion in 1990 to $30 billion in 2000), and people can pay their credit card bills, electronically or with paper checks, from accounts that are part of either M1 or M2. Another innovation of the last 20 years is the automatic transfer service (ATS) that allows consumers to move money between checking and savings accounts at an ATM machine, or online, or through prearranged agreements with their financial institutions. While we take these methods of payment for granted today, they did not exist before 1980 because of restrictive banking legislation and the lack of technological know-how. Indeed, before 1980, being able to pay bills from accounts that earned interest was unheard of. Further blurring the lines between M1 and M2 has been the development and growing popularity of what are called retail sweep programs. Since 1994, banks have been using retail-sweeping software to dynamically reclassify balances as either checking account balances (part of M1) or MMDAs (part of M2). They do this to avoid reserve requirements on checking accounts
. The software not only moves the funds but also ensures that the bank does not exceed the legal limit of six reclassifications in any month. In the last 10 years these retail sweeps rose from zero to nearly the size of M1 itself! Such changes in the ways people pay for transactions and banks do their business have led economists to think about new definitions of money that would better track what is actually used for the purposes behind the money demand curve. One notion is called MZM, which stands for “money zero maturity.” The idea behind MZM is that people can easily use any deposits that do not have specified maturity terms to pay for transactions, as these accounts are quite liquid, regardless of what classification of money they fall into. Some research shows that using MZM allows for a stable picture of the money market. Until more agreement has been reached, though, we should expect the Fed to continue to downplay the role of the money supply in its policy deliberations and to continue to announce its intentions in terms of the federal funds rate. Source: Pedre Teles and Ruilin Zhou, “A Stable Money Demand: Looking for the Right Monetary Aggregate,” Federal Reserve Bank of Chicago Economic Perspectives 29 (First Quarter, 2005): 50–59. Answer to Try It! Problem 1 1 P In Panel (a), with the aggregate demand curve AD, short-run aggregate supply curve SRAS, and long-run aggregate supply curve LRAS, the economy has an inflationary gap of Y − Y. The contractionary monetary policy means that the Fed sells bonds—a rightward shift of the bond supply curve in Panel (b), which decreases the money supply—as shown by a leftward shift in the money supply curve in Panel (c). In Panel (b), we see that the price of bonds falls, and in Panel (c) that the interest rate rises. A higher interest rate will reduce the quantity of investment demanded. The higher interest rate also leads to a higher exchange rate, as shown in Panel (d), as the demand for dollars increases and the supply decreases. The higher exchange rate will lead to a decrease in net exports. As a result of these changes in financial markets, the aggregate demand curve shifts to the left to AD in Panel (a). If all goes according to plan (and we will learn in the next chapter that it may not!), the new aggregate demand curve will intersect SRAS and LRAS at Y. P 2 Figure 25.14
10.2.9 https://socialsci.libretexts.org/@go/page/21751 1 In this chapter we are looking only at changes that originate in financial markets to see their impact on aggregate demand and aggregate supply. Changes in the price level and in real GDP also shift the money demand curve, but these changes are the result of changes in aggregate demand or aggregate supply and are considered in more advanced courses in macroeconomics. This page titled 10.2: Demand, Supply, and Equilibrium in the Money Market is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 25.2: Demand, Supply, and Equilibrium in the Money Market by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 10.2.10 https://socialsci.libretexts.org/@go/page/21751 10.3: Review and Practice Summary We began this chapter by looking at bond and foreign exchange markets and showing how each is related to the level of real GDP and the price level. Bonds represent the obligation of the seller to repay the buyer the face value by the maturity date; their interest rate is determined by the demand and supply for bonds. An increase in bond prices means a drop in interest rates. A reduction in bond prices means interest rates have risen. The price of the dollar is determined in foreign exchange markets by the demand and supply for dollars. We then saw how the money market works. The quantity of money demanded varies negatively with the interest rate. Factors that cause the demand curve for money to shift include changes in real GDP, the price level, expectations, the cost of transferring funds between money and nonmoney accounts, and preferences, especially preferences concerning risk. Equilibrium in the market for money is achieved at the interest rate at which the quantity of money demanded equals the quantity of money supplied. We assumed that the supply of money is determined by the Fed. An increase in money demand raises the equilibrium interest rate, and a decrease in money demand lowers the equilibrium interest rate. An increase in the money supply lowers the equilibrium interest rate; a reduction in the money supply raises the equilibrium interest rate. Concept Problems 1. What factors might increase the demand for bonds? The supply? 2. What would happen to the market for bonds if a
law were passed that set a minimum price on bonds that was above the equilibrium price? 3. When the price of bonds decreases, the interest rate rises. Explain. 4. One journalist writing about the complex interactions between various markets in the economy stated: “When the government spends more than it takes in taxes it must sell bonds to finance its excess expenditures. But selling bonds drives interest rates down and thus stimulates the economy by encouraging more investment and decreasing the foreign exchange rate, which helps our export industries.” Carefully analyze the statement. Do you agree? Why or why not? 5. What do you predict will happen to the foreign exchange rate if interest rates in the United States increase dramatically over the next year? Explain, using a graph of the foreign exchange market. How would such a change affect real GDP and the price level? 6. Suppose the government were to increase its purchases, issuing bonds to finance these purchases. Use your knowledge of the bond and foreign exchange markets to explain how this would affect investment and net exports. 7. How would each of the following affect the demand for money? 1. A tax on bonds held by individuals 2. A forecast by the Fed that interest rates will rise sharply in the next quarter 3. A wave of muggings 4. An announcement of an agreement between Congress and the president that, beginning in the next fiscal year, government spending will be reduced by an amount sufficient to eliminate all future borrowing 8. Some low-income countries do not have a bond market. In such countries, what substitutes for money do you think people would hold? 9. Explain what is meant by the statement that people are holding more money than they want to hold. 10. Explain how the Fed’s sale of government bonds shifts the supply curve for money. 11. Trace the impact of a sale of government bonds by the Fed on bond prices, interest rates, investment, net exports, aggregate demand, real GDP, and the price level. Numerical Problems 1. Compute the rate of interest associated with each of these bonds that matures in one year: a. b. Face Value $100 $100 Selling Price $80 $90 10.3.1 https://socialsci.libretexts.org/@go/page/21752 c. d. e. f. g. Face Value Selling Price $100 $200 $200 $200 $95 $180 $190 $195 Describe the relationship between the selling price of a bond and the interest rate. 2
. Suppose that the demand and supply schedules for bonds that have a face value of $100 and a maturity date one year hence are as follows: $100 95 90 85 80 75 70 Price Quantity Demanded Quantity Supplied 0 100 200 300 400 500 600 600 500 400 300 200 100 0 1. Draw the demand and supply curves for these bonds, find the equilibrium price, and determine the interest rate. 2. Now suppose the quantity demanded increases by 200 bonds at each price. Draw the new demand curve and find the new equilibrium price. What has happened to the interest rate? 3. Compute the dollar price of a German car that sells for 40,000 euros at each of the following exchange rates: 1. $1 = 1 euro 2. $1 = 0.8 euro 3. $1 = 0.75 euro 4. Consider the euro-zone of the European Union and Japan. The demand and supply curves for euros are given by the following table (prices for the euro are given in Japanese yen; quantities of euros are in millions): Price (in euros) Euros Demanded Euros Supplied ¥75 70 65 60 55 50 45 0 100 200 300 400 500 600 600 500 400 300 200 100 0 1. Draw the demand and supply curves for euros and state the equilibrium exchange rate (in yen) for the euro. How many euros are required to purchase one yen? 2. Suppose an increase in interest rates in the European Union increases the demand for euros by 100 million at each price. At the same time, it reduces the supply by 100 million at each price. Draw the new demand and supply curves and state the new equilibrium exchange rate for the euro. How many euros are now required to purchase one yen? 3. How will the event in (b) affect net exports in the European Union? 4. How will the event in (b) affect aggregate demand in the European Union? 10.3.2 https://socialsci.libretexts.org/@go/page/21752 5. How will the event in (b) affect net exports in Japan? 6. How will the event in (b) affect aggregate demand in Japan? 5. Suppose you earn $6,000 per month and spend $200 in each of the month’s 30 days. Compute your average quantity of money demanded if: 1. You deposit your entire earnings in your checking account at the beginning of the month. 2. You deposit $2,000 into your checking account on the 1
st, 11th, and 21st days of the month. 3. You deposit $1,000 into your checking account on the 1st, 6th, 11th, 16th, 21st, and 26th days of the month. 4. How would you expect the interest rate to affect your decision to opt for strategy (a), (b), or (c)? 6. Suppose the quantity demanded of money at an interest rate of 5% is $2 billion per day, at an interest rate of 3% is $3 billion per day, and at an interest rate of 1% is $4 billion per day. Suppose the money supply is $3 billion per day. 1. Draw a graph of the money market and find the equilibrium interest rate. 2. Suppose the quantity of money demanded decreases by $1 billion per day at each interest rate. Graph this situation and find the new equilibrium interest rate. Explain the process of achieving the new equilibrium in the money market. 3. Suppose instead that the money supply decreases by $1 billion per day. Explain the process of achieving the new equilibrium in the money market. 7. We know that the U.S. economy faced a recessionary gap in 2008 and that the Fed responded with an expansionary monetary policy. Present the results of the Fed’s action in a four-panel graph. In Panel (a), show the initial situation, using the model of aggregate demand and aggregate supply. In Panel (b), show how the Fed’s policy affects the bond market and bond prices. In Panel (c), show how the market for U.S. dollars and the exchange rate will be affected. In Panel (d), incorporate these developments into your analysis of aggregate demand and aggregate supply, and show how the Fed’s policy will affect real GDP and the price level in the short run. This page titled 10.3: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 25.3: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 10.3.3 https://socialsci.libretexts.org/@go/page/21752 CHAPTER OVERVIEW 11: Monetary Policy and the Fed 11.1: Monetary Policy in the
United States 11.2: Problems and Controversies of Monetary Policy 11.3: Monetary Policy and the Equation of Exchange 11.4: Review and Practice Thumbnail: https://www.pexels.com/photo/symbol-of-eagle-with-shield-on-dollar-banknote-4386226/ This page titled 11: Monetary Policy and the Fed is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 11.1: Monetary Policy in the United States  Learning Objective 1. Discuss the Fed’s primary and secondary goals and relate these goals to the legislation that created the Fed as well as to subsequent legislation that affects the Fed. 2. State and show graphically how expansionary and contractionary monetary policy can be used to close gaps. In many respects, the Fed is the most powerful maker of economic policy in the United States. Congress can pass laws, but the president must execute them; the president can propose laws, but only Congress can pass them. The Fed, however, both sets and carries out monetary policy. Deliberations about fiscal policy can drag on for months, even years, but the Federal Open Market Committee (FOMC) can, behind closed doors, set monetary policy in a day—and see that policy implemented within hours. The Board of Governors can change the discount rate or reserve requirements at any time. The impact of the Fed’s policies on the economy can be quite dramatic. The Fed can push interest rates up or down. It can promote a recession or an expansion. It can cause the inflation rate to rise or fall. The Fed wields enormous power. But to what ends should all this power be directed? With what tools are the Fed’s policies carried out? And what problems exist in trying to achieve the Fed’s goals? This section reviews the goals of monetary policy, the tools available to the Fed in pursuing those goals, and the way in which monetary policy affects macroeconomic variables. Goals of Monetary Policy When we think of the goals of monetary policy, we naturally think of standards of macroeconomic performance that seem desirable —a low unemployment rate, a stable price level, and economic growth. It thus seems reasonable to conclude that the goals of monetary policy should include the maintenance of full employment, the avoidance of inflation or deflation, and the promotion of economic growth. But these goals, each of which is desirable in itself
, may conflict with one another. A monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation. A monetary policy that seeks to reduce inflation may increase unemployment and weaken economic growth. You might expect that in such cases, monetary authorities would receive guidance from legislation spelling out goals for the Fed to pursue and specifying what to do when achieving one goal means not achieving another. But as we shall see, that kind of guidance does not exist. The Federal Reserve Act When Congress established the Federal Reserve System in 1913, it said little about the policy goals the Fed should seek. The closest it came to spelling out the goals of monetary policy was in the first paragraph of the Federal Reserve Act, the legislation that created the Fed: “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, [to make loans to banks], to establish a more effective supervision of banking in the United States, and for other purposes.” In short, nothing in the legislation creating the Fed anticipates that the institution will act to close recessionary or inflationary gaps, that it will seek to spur economic growth, or that it will strive to keep the price level steady. There is no guidance as to what the Fed should do when these goals conflict with one another. The Employment Act of 1946 The first U.S. effort to specify macroeconomic goals came after World War II. The Great Depression of the 1930s had instilled in people a deep desire to prevent similar calamities in the future. That desire, coupled with the 1936 publication of John Maynard Keynes’s prescription for avoiding such problems through government policy (The General Theory of Employment, Interest and Money), led to the passage of the Employment Act of 1946, which declared that the federal government should “use all practical means... to promote maximum employment, production and purchasing power.” The act also created the Council of Economic Advisers (CEA) to advise the president on economic matters. The Fed might be expected to be influenced by this specification of federal goals, but because it is an independent agency, it is not required to follow any particular path. Furthermore, the legislation does not suggest what should be done if the goals of achieving 11.1.1 https://socialsci.libretexts.org/@go/page/21754 full employment and maximum purchasing power conflict. The Full Employment and Balanced Growth Act of 1978 The clearest, and most specific, statement of federal economic
goals came in the Full Employment and Balanced Growth Act of 1978. This act, generally known as the Humphrey–Hawkins Act, specified that by 1983 the federal government should achieve an unemployment rate among adults of 3% or less, a civilian unemployment rate of 4% or less, and an inflation rate of 3% or less. Although these goals have the virtue of specificity, they offer little in terms of practical policy guidance. The last time the civilian unemployment rate in the United States fell below 4% was 1969, and the inflation rate that year was 6.2%. In 2000, the unemployment rate touched 4%, and the inflation rate that year was 3.4%, so the goals were close to being met. Except for 2007 when inflation hit 4.1%, inflation has hovered between 1.6% and 3.4% in all the other years between 1991 and 2008, so the inflation goal was met or nearly met, but unemployment fluctuated between 4.0% and 7.5% during those years. The Humphrey-Hawkins Act requires that the chairman of the Fed’s Board of Governors report twice each year to Congress about the Fed’s monetary policy. These sessions provide an opportunity for members of the House and Senate to express their views on monetary policy. Federal Reserve Policy and Goals Perhaps the clearest way to see the Fed’s goals is to observe the policy choices it makes. Since 1979, following a bout of doubledigit inflation, its actions have suggested that the Fed’s primary goal is to keep inflation under control. Provided that the inflation rate falls within acceptable limits, however, the Fed will also use stimulative measures to close recessionary gaps. In 1979, the Fed, then led by Paul Volcker, launched a deliberate program of reducing the inflation rate. It stuck to that effort through the early 1980s, even in the face of a major recession. That effort achieved its goal: the annual inflation rate fell from 13.3% in 1979 to 3.8% in 1982. The cost, however, was great. Unemployment soared past 9% during the recession. With the inflation rate below 4%, the Fed shifted to a stimulative policy early in 1983. In 1990, when the economy slipped into a recession, the Fed, with Alan Greenspan at the helm, engaged in aggressive open-market operations to stimulate the economy, despite the fact that the inflation rate had jumped to 6.1%. Much of that increase in the inflation rate, however, resulted from
an oil-price boost that came in the wake of Iraq’s invasion of Kuwait that year. A jump in prices that occurs at the same time as real GDP is slumping suggests a leftward shift in short-run aggregate supply, a shift that creates a recessionary gap. Fed officials concluded that the upturn in inflation in 1990 was a temporary phenomenon and that an expansionary policy was an appropriate response to a weak economy. Once the recovery was clearly under way, the Fed shifted to a neutral policy, seeking neither to boost nor to reduce aggregate demand. Early in 1994, the Fed shifted to a contractionary policy, selling bonds to reduce the money supply and raise interest rates. Then Fed Chairman Greenspan indicated that the move was intended to head off any possible increase in inflation from its 1993 rate of 2.7%. Although the economy was still in a recessionary gap when the Fed acted, Greenspan indicated that any acceleration of the inflation rate would be unacceptable. By March 1997 the inflation rate had fallen to 2.4%. The Fed became concerned that inflationary pressures were increasing and tightened monetary policy, raising the goal for the federal funds interest rate to 5.5%. Inflation remained well below 2.0% throughout the rest of 1997 and 1998. In the fall of 1998, with inflation low, the Fed was concerned that the economic recession in much of Asia and slow growth in Europe would reduce growth in the United States. In quarter-point steps it reduced the goal for the federal funds rate to 4.75%. With real GDP growing briskly in the first half of 1999, the Fed became concerned that inflation would increase, even though the inflation rate at the time was about 2%, and in June 1999, it raised its goal for the federal funds rate to 5% and continued raising the rate until it reached 6.5% in May 2000. With inflation under control, it then began lowering the federal funds rate to stimulate the economy. It continued lowering through the brief recession of 2001 and beyond. There were 11 rate cuts in 2001, with the rate at the end of that year at 1.75%; in late 2002 the rate was cut to 1.25%, and in mid-2003 it was cut to 1.0%. Then, with growth picking up and inflation again a concern, the Fed began again in the middle of 2004 to increase rates. By the end of 2006, the rate stood at 5.25% as a result of 17 quarter-point rate increases. Starting in September 2007, the Fed,
since 2006 led by Ben Bernanke, shifted gears and began lowering the federal funds rate, mostly in larger steps or 0.5 to 0.75 percentage points. Though initially somewhat concerned with inflation, it sensed that the economy was beginning to slow down. It moved aggressively to lower rates over the course of the next 15 months, and by the end of 2008, the rate was targeted at between 0% and 0.25%. In late 2008 and for at least the following two years, with inflation 11.1.2 https://socialsci.libretexts.org/@go/page/21754 running quite low and deflation threatening, the Fed seemed quite willing to use all of its options to try to keep financial markets running smoothly and to moderate the recession. What can we infer from these episodes in the 1980s, 1990s, and the first years of this century? It seems clear that the Fed is determined not to allow the high inflation rates of the 1970s to occur again. When the inflation rate is within acceptable limits, the Fed will undertake stimulative measures in response to a recessionary gap or even in response to the possibility of a growth slowdown. Those limits seem to have tightened over time. In the late 1990s and early 2000s, it appeared that an inflation rate above 3%—or any indication that inflation might rise above 3%—would lead the Fed to adopt a contractionary policy. While on the Federal Reserve Board in the early 2000s, Ben Bernanke had been an advocate of inflation targeting. Under that system, the central bank announces its inflation target and then adjusts the federal funds rate if the inflation rate moves above or below the central bank’s target. Mr. Bernanke indicated his preferred target to be an expected increase in the price level, as measured by the price index for consumer goods and services excluding food and energy, of between 1% and 2%. Thus, the inflation goal appears to have tightened even more—to a rate of 2% or less. If inflation were expected to remain below 2%, however, the Fed would undertake stimulative measures to close a recessionary gap. Whether the Fed will hold to that goal will not really be tested until further macroeconomic experiences unfold. Monetary Policy and Macroeconomic Variables We saw in an earlier chapter that the Fed has three tools at its command to try to change aggregate demand and thus to influence the level of economic activity. It can buy or sell federal government bonds through open-market operations, it can change the discount rate
, or it can change reserve requirements. It can also use these tools in combination. In the next section of this chapter, where we discuss the notion of a liquidity trap, we will also introduce more extraordinary measures that the Fed has at its disposal. Most economists agree that these tools of monetary policy affect the economy, but they sometimes disagree on the precise mechanisms through which this occurs, on the strength of those mechanisms, and on the ways in which monetary policy should be used. Before we address some of these issues, we shall review the ways in which monetary policy affects the economy in the context of the model of aggregate demand and aggregate supply. Our focus will be on open-market operations, the purchase or sale by the Fed of federal bonds. Expansionary Monetary Policy The Fed might pursue an expansionary monetary policy in response to the initial situation shown in Panel (a) of Figure 26.1. An economy with a potential output of Y is operating at Y ; there is a recessionary gap. One possible policy response is to allow the economy to correct this gap on its own, waiting for reductions in nominal wages and other prices to shift the short-run aggregate supply curve SRAS to the right until it intersects the aggregate demand curve AD at Y. An alternative is a stabilization policy that seeks to increase aggregate demand to AD to close the gap. An expansionary monetary policy is one way to achieve such a shift. P P 1 1 1 2 2 To carry out an expansionary monetary policy, the Fed will buy bonds, thereby increasing the money supply. That shifts the demand curve for bonds to D, as illustrated in Panel (b). Bond prices rise to P. The higher price for bonds reduces the interest rate. These changes in the bond market are consistent with the changes in the money market, shown in Panel (c), in which the greater money supply leads to a fall in the interest rate to r. The lower interest rate stimulates investment. In addition, the lower interest rate reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate to E in Panel (d). The lower exchange rate will stimulate net exports. The combined impact of greater investment and net exports will shift the aggregate demand curve to the right. The curve shifts by an amount equal to the multiplier times the sum of the initial changes in investment and net exports. In Panel (a), this is shown as a shift to AD, and the recessionary gap is closed. b 2 2 2 2 11.1.3 https://
socialsci.libretexts.org/@go/page/21754 Figure 26.1 Expansionary Monetary Policy to Close a Recessionary Gap In Panel (a), the economy has a recessionary gap Y − Y. 1 An expansionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD. In Panel (b), the Fed buys bonds, shifting the demand curve for bonds to D and increasing the price of bonds to P. By buying bonds, the Fed increases the money supply to M′ in Panel (c). The Fed’s action lowers interest rates to r. The lower interest rate also reduces the demand for and increases the supply of dollars, reducing the exchange rate to E in Panel (d). The resulting increases in investment and net exports shift the aggregate demand curve in Panel (a). b 2 P 2 2 2 2 Contractionary Monetary Policy The Fed will generally pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that the economy faces an inflationary gap; the aggregate demand and short-run aggregate supply curves intersect to the right of the longrun aggregate supply curve, as shown in Panel (a) of Figure 26.2. P Figure 26.2 A Contractionary Monetary Policy to Close an Inflationary Gap In Panel (a), the economy has an inflationary gap Y − Y. A contractionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD. In Panel (b), the Fed sells bonds, shifting the supply curve for bonds to S and lowering the price of bonds to P. The lower price of bonds means a higher interest rate, r, as shown in Panel (c). The higher interest rate also increases the demand for and decreases the supply of dollars, raising the exchange rate to E in Panel (d), which will increase net exports. The decreases in investment and net exports are responsible for decreasing aggregate demand in Panel (a). b 2 2 1 2 2 2 To carry out a contractionary policy, the Fed sells bonds. In the bond market, shown in Panel (b) of Figure 26.2, the supply curve shifts to the right, lowering the price of bonds and increasing the interest rate. In the money market, shown in Panel (c), the Fed’s 11.1.4 https://socialsci.libretexts.org/@go/page/21754 bond sales reduce the money supply and raise the interest rate. The
higher interest rate reduces investment. The higher interest rate also induces a greater demand for dollars as foreigners seek to take advantage of higher interest rates in the United States. The supply of dollars falls; people in the United States are less likely to purchase foreign interest-earning assets now that U.S. assets are paying a higher rate. These changes boost the exchange rate, as shown in Panel (d), which reduces exports and increases imports and thus causes net exports to fall. The contractionary monetary policy thus shifts aggregate demand to the left, by an amount equal to the multiplier times the combined initial changes in investment and net exports, as shown in Panel (a). Key Takeaways The Federal Reserve Board and the Federal Open Market Committee are among the most powerful institutions in the United States. The Fed’s primary goal appears to be the control of inflation. Providing that inflation is under control, the Fed will act to close recessionary gaps. Expansionary policy, such as a purchase of government securities by the Fed, tends to push bond prices up and interest rates down, increasing investment and aggregate demand. Contractionary policy, such as a sale of government securities by the Fed, pushes bond prices down, interest rates up, investment down, and aggregate demand shifts to the left. Try It! The figure shows an economy operating at a real GDP of Y and a price level of P, at the intersection of AD and SRAS. 1 1 1 1 Figure 26.3 1. What kind of gap is the economy experiencing? 2. What type of monetary policy (expansionary or contractionary) would be appropriate for closing the gap? 3. If the Fed decided to pursue this policy, what type of open-market operations would it conduct? 4. How would bond prices, interest rates, and the exchange rate change? 5. How would investment and net exports change? 6. How would the aggregate demand curve shift? 11.1.5 https://socialsci.libretexts.org/@go/page/21754  Case in Point: A Brief History of the Greenspan Fed Figure 26.4 Javier – Alan Greenspan – CC BY-NC-ND 2.0. With the passage of time and the fact that the fallout on the economy turned out to be relatively minor, it is hard in retrospect to realize how scary a situation Alan Greenspan and the Fed faced just two months after his appointment as Chairman of the Federal Reserve Board. On October 12, 1987, the stock market
had its worst day ever. The Dow Jones Industrial Average plunged 508 points, wiping out more than $500 billion in a few hours of feverish trading on Wall Street. That drop represented a loss in value of over 22%. In comparison, the largest daily drop in 2008 of 778 points on September 29, 2008, represented a loss in value of about 7%. When the Fed faced another huge plunge in stock prices in 1929—also in October—members of the Board of Governors met and decided that no action was necessary. Determined not to repeat the terrible mistake of 1929, one that helped to usher in the Great Depression, Alan Greenspan immediately reassured the country, saying that the Fed would provide adequate liquidity, by buying federal securities, to assure that economic activity would not fall. As it turned out, the damage to the economy was minor and the stock market quickly regained value. In the fall of 1990, the economy began to slip into recession. The Fed responded with expansionary monetary policy—cutting reserve requirements, lowering the discount rate, and buying Treasury bonds. Interest rates fell quite quickly in response to the Fed’s actions, but, as is often the case, changes to the components of aggregate demand were slower in coming. Consumption and investment began to rise in 1991, but their growth was weak, and unemployment continued to rise because growth in output was too slow to keep up with growth in the labor force. It was not until the fall of 1992 that the economy started to pick up steam. This episode demonstrates an important difficulty with stabilization policy: attempts to manipulate aggregate demand achieve shifts in the curve, but with a lag. Throughout the rest of the 1990s, with some tightening when the economy seemed to be moving into an inflationary gap and some loosening when the economy seemed to be possibly moving toward a recessionary gap—especially in 1998 and 1999 when parts of Asia experienced financial turmoil and recession and European growth had slowed down—the Fed helped steer what is now referred to as the Goldilocks (not too hot, not too cold, just right) economy. The U.S. economy again experienced a mild recession in 2001 under Greenspan. At that time, the Fed systematically conducted expansionary policy. Similar to its response to the 1987 stock market crash, the Fed has been credited with maintaining liquidity following the dot-com stock market crash in early 2001 and the attacks on the World Trade Center and the Pentagon in September 2001. When Greenspan retired in January 2006, many hailed him as the greatest central banker ever
. As the economy faltered in 2008 and as the financial crisis unfolded throughout the year, however, the question of how the policies of Greenspan’s Fed played into the current difficulties took center stage. Testifying before Congress in October 2008, he said that the country faces a “once-in-acentury credit tsunami,” and he admitted, “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in their firms.” The criticisms he has faced are twofold: that the very low interest rates used to fight the 2001 recession and maintained for too long fueled the real estate bubble and that he did not promote appropriate regulations to deal with the new financial instruments that were created in the early 2000s. While supporting some additional regulations when he testified before Congress, he also warned 11.1.6 https://socialsci.libretexts.org/@go/page/21754 that overreacting could be dangerous: “We have to recognize that this is almost surely a once-in-a-century phenomenon, and, in that regard, to realize the types of regulation that would prevent this from happening in the future are so onerous as to basically suppress the growth rate in the economy and... the standards of living of the American people.” Answers to Try It! Problems 1. Inflationary gap 2. Contractionary 3. Open-market sales of bonds 4. The price of bonds would fall. The interest rate and the exchange rate would rise. 5. Investment and net exports would fall. 6. The aggregate demand curve would shift to the left. This page titled 11.1: Monetary Policy in the United States is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 26.1: Monetary Policy in the United States by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 11.1.7 https://socialsci.libretexts.org/@go/page/21754 11.2: Problems and Controversies of Monetary Policy  Learning Objective 1. Explain the three kinds of lags that can influence the effectiveness of monetary policy.
2. Identify the macroeconomic targets at which the Fed can aim in managing the economy, and discuss the difficulties inherent in using each of them as a target. 3. Discuss how each of the following influences a central bank’s ability to achieve its desired macroeconomic outcomes: political pressures, the degree of impact on the economy (including the situation of a liquidity trap), and the rational expectations hypothesis. The Fed has some obvious advantages in its conduct of monetary policy. The two policy-making bodies, the Board of Governors and the Federal Open Market Committee (FOMC), are small and largely independent from other political institutions. These bodies can thus reach decisions quickly and implement them immediately. Their relative independence from the political process, together with the fact that they meet in secret, allows them to operate outside the glare of publicity that might otherwise be focused on bodies that wield such enormous power. Despite the apparent ease with which the Fed can conduct monetary policy, it still faces difficulties in its efforts to stabilize the economy. We examine some of the problems and uncertainties associated with monetary policy in this section. Lags Perhaps the greatest obstacle facing the Fed, or any other central bank, is the problem of lags. It is easy enough to show a recessionary gap on a graph and then to show how monetary policy can shift aggregate demand and close the gap. In the real world, however, it may take several months before anyone even realizes that a particular macroeconomic problem is occurring. When monetary authorities become aware of a problem, they can act quickly to inject reserves into the system or to withdraw reserves from it. Once that is done, however, it may be a year or more before the action affects aggregate demand. The delay between the time a macroeconomic problem arises and the time at which policy makers become aware of it is called a recognition lag. The 1990–1991 recession, for example, began in July 1990. It was not until late October that members of the FOMC noticed a slowing in economic activity, which prompted a stimulative monetary policy. In contrast, the most recent recession began in December 2007, and Fed easing began in September 2007. Recognition lags stem largely from problems in collecting economic data. First, data are available only after the conclusion of a particular period. Preliminary estimates of real GDP, for example, are released about a month after the end of a quarter. Thus, a change that occurs early in a quarter will not be reflected in the data until several months later. Second, estimates of economic indicators
are subject to revision. The first estimates of real GDP in the third quarter of 1990, for example, showed it increasing. Not until several months had passed did revised estimates show that a recession had begun. And finally, different indicators can lead to different interpretations. Data on employment and retail sales might be pointing in one direction while data on housing starts and industrial production might be pointing in another. It is one thing to look back after a few years have elapsed and determine whether the economy was expanding or contracting. It is quite another to decipher changes in real GDP when one is right in the middle of events. Even in a world brimming with computer-generated data on the economy, recognition lags can be substantial. Only after policy makers recognize there is a problem can they take action to deal with it. The delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted is called the implementation lag. For monetary policy changes, the implementation lag is quite short. The FOMC meets eight times per year, and its members may confer between meetings through conference calls. Once the FOMC determines that a policy change is in order, the required open-market operations to buy or sell federal bonds can be put into effect immediately. Policy makers at the Fed still have to contend with the impact lag, the delay between the time a policy is enacted and the time that policy has its impact on the economy. The impact lag for monetary policy occurs for several reasons. First, it takes some time for the deposit multiplier process to work itself out. The Fed can inject new reserves into the economy immediately, but the deposit expansion process of bank lending will need time to have its full effect on the money supply. Interest rates are affected immediately, but the money supply grows more slowly. Second, firms need some time to respond to the monetary policy with new investment spending—if they respond at all. 11.2.1 https://socialsci.libretexts.org/@go/page/21755 Third, a monetary change is likely to affect the exchange rate, but that translates into a change in net exports only after some delay. Thus, the shift in the aggregate demand curve due to initial changes in investment and in net exports occurs after some delay. Finally, the multiplier process of an expenditure change takes time to unfold. It is only as incomes start to rise that consumption spending picks up. The problem of lags suggests that monetary policy should respond not to statistical reports of economic conditions in
the recent past but to conditions expected to exist in the future. In justifying the imposition of a contractionary monetary policy early in 1994, when the economy still had a recessionary gap, Greenspan indicated that the Fed expected a one-year impact lag. The policy initiated in 1994 was a response not to the economic conditions thought to exist at the time but to conditions expected to exist in 1995. When the Fed used contractionary policy in the middle of 1999, it argued that it was doing so to forestall a possible increase in inflation. When the Fed began easing in September 2007, it argued that it was doing so to forestall adverse effects to the economy of falling housing prices. In these examples, the Fed appeared to be looking forward. It must do so with information and forecasts that are far from perfect. Estimates of the length of time required for the impact lag to work itself out range from six months to two years. Worse, the length of the lag can vary—when they take action, policy makers cannot know whether their choices will affect the economy within a few months or within a few years. Because of the uncertain length of the impact lag, efforts to stabilize the economy through monetary policy could be destabilizing. Suppose, for example, that the Fed responds to a recessionary gap with an expansionary policy but that by the time the policy begins to affect aggregate demand, the economy has already returned to potential GDP. The policy designed to correct a recessionary gap could create an inflationary gap. Similarly, a shift to a contractionary policy in response to an inflationary gap might not affect aggregate demand until after a self-correction process had already closed the gap. In that case, the policy could plunge the economy into a recession. Choosing Targets In attempting to manage the economy, on what macroeconomic variables should the Fed base its policies? It must have some target, or set of targets, that it wants to achieve. The failure of the economy to achieve one of the Fed’s targets would then trigger a shift in monetary policy. The choice of a target, or set of targets, is a crucial one for monetary policy. Possible targets include interest rates, money growth rates, and the price level or expected changes in the price level. Interest Rates Interest rates, particularly the federal funds rate, played a key role in recent Fed policy. The FOMC does not decide to increase or decrease the money supply. Rather, it engages in operations to nudge the federal funds rate up or down. Up until August
1997, it had instructed the trading desk at the New York Federal Reserve Bank to conduct open-market operations in a way that would either maintain, increase, or ease the current “degree of pressure” on the reserve positions of banks. That degree of pressure was reflected by the federal funds rate; if existing reserves were less than the amount banks wanted to hold, then the bidding for the available supply would send the federal funds rate up. If reserves were plentiful, then the federal funds rate would tend to decline. When the Fed increased the degree of pressure on reserves, it sold bonds, thus reducing the supply of reserves and increasing the federal funds rate. The Fed decreased the degree of pressure on reserves by buying bonds, thus injecting new reserves into the system and reducing the federal funds rate. The current operating procedures of the Fed focus explicitly on interest rates. At each of its eight meetings during the year, the FOMC sets a specific target or target range for the federal funds rate. When the Fed lowers the target for the federal funds rate, it buys bonds. When it raises the target for the federal funds rate, it sells bonds. Money Growth Rates Until 2000, the Fed was required to announce to Congress at the beginning of each year its target for money growth that year and each report dutifully did so. At the same time, the Fed report would mention that its money growth targets were benchmarks based on historical relationships rather than guides for policy. As soon as the legal requirement to report targets for money growth ended, the Fed stopped doing so. Since in recent years the Fed has placed more importance on the federal funds rate, it must adjust the money supply in order to move the federal funds rate to the level it desires. As a result, the money growth targets tended to fall by the wayside, even over the last decade in which they were being reported. Instead, as data on economic conditions unfolded, the Fed made, and continues to make, adjustments in order to affect the federal funds interest rate. 11.2.2 https://socialsci.libretexts.org/@go/page/21755 Price Level or Expected Changes in the Price Level Some economists argue that the Fed’s primary goal should be price stability. If so, an obvious possible target is the price level itself. The Fed could target a particular price level or a particular rate of change in the price level and adjust its policies accordingly. If, for example, the Fed sought an inflation rate of 2%, then it could
shift to a contractionary policy whenever the rate rose above 2%. One difficulty with such a policy, of course, is that the Fed would be responding to past economic conditions with policies that are not likely to affect the economy for a year or more. Another difficulty is that inflation could be rising when the economy is experiencing a recessionary gap. An example of this, mentioned earlier, occurred in 1990 when inflation increased due to the seemingly temporary increase in oil prices following Iraq’s invasion of Kuwait. The Fed was faced with a similar situation in the first half of 2008 when oil prices were again rising. If the Fed undertakes contractionary monetary policy at such times, then its efforts to reduce the inflation rate could worsen the recessionary gap. The solution proposed by Chairman Bernanke, who is an advocate of inflation rate targeting, is to focus not on the past rate of inflation or even the current rate of inflation, but on the expected rate of inflation, as revealed by various indicators, over the next year. This concept is discussed in the Case in Point essay that follows this section. Political Pressures The institutional relationship between the leaders of the Fed and the executive and legislative branches of the federal government is structured to provide for the Fed’s independence. Members of the Board of Governors are appointed by the president, with confirmation by the Senate, but the 14-year terms of office provide a considerable degree of insulation from political pressure. A president exercises greater influence in the choice of the chairman of the Board of Governors; that appointment carries a four-year term. Neither the president nor Congress has any direct say over the selection of the presidents of Federal Reserve district banks. They are chosen by their individual boards of directors with the approval of the Board of Governors. The degree of independence that central banks around the world have varies. A central bank is considered to be more independent if it is insulated from the government by such factors as longer term appointments of its governors and fewer requirements to finance government budget deficits. Studies in the 1980s and early 1990s showed that, in general, greater central bank independence was associated with lower average inflation and that there was no systematic relationship between central bank independence and other indicators of economic performance, such as real GDP growth or unemployment. By the rankings used in those studies, the Fed was considered quite independent, second only to Switzerland and the German Bundesbank at the time. Perhaps as a result of such findings, a number of countries have granted greater independence to their central banks in the last decade. The charter for the European
Central Bank, which began operations in 1998, was modeled on that of the German Bundesbank. Its charter states explicitly that its primary objective is to maintain price stability. Also, since 1998, central bank independence has increased in the United Kingdom, Canada, Japan, and New Zealand. 1 While the Fed is formally insulated from the political process, the men and women who serve on the Board of Governors and the FOMC are human beings. They are not immune to the pressures that can be placed on them by members of Congress and by the president. The chairman of the Board of Governors meets regularly with the president and the executive staff and also reports to and meets with congressional committees that deal with economic matters. The Fed was created by the Congress; its charter could be altered—or even revoked—by that same body. The Fed is in the somewhat paradoxical situation of having to cooperate with the legislative and executive branches in order to preserve its independence. The Degree of Impact on the Economy The problem of lags suggests that the Fed does not know with certainty when its policies will work their way through the financial system to have an impact on macroeconomic performance. The Fed also does not know with certainty towhat extent its policy decisions will affect the macroeconomy. For example, investment can be particularly volatile. An effort by the Fed to reduce aggregate demand in the face of an inflationary gap could be partially offset by rising investment demand. But, generally, contractionary policies do tend to slow down the economy as if the Fed were “pulling on a rope.” That may not be the case with expansionary policies. Since investment depends crucially on expectations about the future, business leaders must be optimistic about economic conditions in order to expand production facilities and buy new equipment. That optimism might not exist in a recession. Instead, the pessimism that might prevail during an economic slump could prevent lower interest rates from stimulating investment. An effort to stimulate the 11.2.3 https://socialsci.libretexts.org/@go/page/21755 economy through monetary policy could be like “pushing on a string.” The central bank could push with great force by buying bonds and engaging in quantitative easing, but little might happen to the economy at the other end of the string. What if the Fed cannot bring about a change in interest rates? A liquidity trap is said to exist when a change in monetary policy has no effect on interest rates. This would be the case if the money demand curve were horizontal
at some interest rate, as shown in Figure 26.5. If a change in the money supply from M to M′ cannot change interest rates, then, unless there is some other change in the economy, there is no reason for investment or any other component of aggregate demand to change. Hence, traditional monetary policy is rendered totally ineffective; its degree of impact on the economy is nil. At an interest rate of zero, since bonds cease to be an attractive alternative to money, which is at least useful for transactions purposes, there would be a liquidity trap. Figure 26.5 A Liquidity Trap When a change in the money supply has no effect on the interest rate, the economy is said to be in a liquidity trap. With the federal funds rate in the United States close to zero at the end of 2008, the possibility that the country is in or nearly in a liquidity trap cannot be dismissed. As discussed in the introduction to the chapter, at the same time the Fed lowered the federal funds rate to close to zero, it mentioned that it intended to pursue additional, nontraditional measures. What the Fed seeks to do is to make firms and consumers want to spend now by using a tool not aimed at reducing the interest rate, since it cannot reduce the interest rate below zero. It thus shifts its focus to the price level and to avoiding expected deflation. For example, if the public expects the price level to fall by 2% and the interest rate is zero, by holding money, the money is actually earning a positive real interest rate of 2%—the difference between the nominal interest rate and the expected deflation rate. Since the nominal rate of interest cannot fall below zero (Who would, for example, want to lend at an interest rate below zero when lending is risky whereas cash is not? In short, it does not make sense to lend $10 and get less than $10 back.), expected deflation makes holding cash very attractive and discourages spending since people will put off purchases because goods and services are expected to get cheaper. To combat this “wait-and-see” mentality, the Fed or other central bank, using a strategy referred to as quantitative easing, must convince the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation. In other words, it is aimed at creating expected inflation. For example, at the Fed’s October 2003 meeting, it announced that it would keep the federal funds rate at 1% for “a considerable period.”
When the Fed lowered the rate to between 0% and 0.25% in December 2008, it added that “the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” After working so hard to convince economic players that it will not tolerate inflation above 2%, the Fed must now convince the public that it will, but of course not too much! If it is successful, this extraordinary form of expansionary monetary policy will lead to increased purchases of goods and services, compared to what they would have been with expected deflation. Also, by providing banks with lots of liquidity, it is hoping to encourage them to lend. The Japanese economy provides an interesting modern example of a country that attempted quantitative easing. With a recessionary gap starting in the early 1990s and deflation in most years from 1995 on, Japan’s central bank, the Bank of Japan, began to lower the call money rate (equivalent to the federal funds rate in the United States), reaching near zero by the late 1990s. With growth still languishing, Japan appeared to be in a traditional liquidity trap. In late 1999, the Bank of Japan announced that it would maintain a zero interest rate policy for the foreseeable future, and in March 2001 it officially began a policy of quantitative 11.2.4 https://socialsci.libretexts.org/@go/page/21755 easing. In 2006, with the price level rising modestly, Japan ended quantitative easing and began increasing the call rate again. It should be noted that the government simultaneously engaged in expansionary fiscal policy. How well did these policies work? The economy began to grow modestly in 2003, though deflation between 1% and 2% remained. Some researchers feel that the Bank of Japan ended quantitative easing too early. Also, delays in implementing the policy, as well as delays in restructuring the banking sector, exacerbated Japan’s problems (OECD Economic Surveys, 2008; Spiegel, 2006). Fed Chairman Bernanke and other Fed officials have argued that the Fed is also engaged in credit easing (Bernanke, 2009; Yellen, 2009). Credit easing is a strategy that involves the extension of central bank lending to influence more broadly the proper functioning of credit markets and to improve liquidity. The specific new credit facilities that the Fed has created were discussed in the Case in Point in the chapter on the nature and creation of money. In general, the Fed is hoping that these new credit facilities will improve liquidity
in a variety of credit markets, ranging from those used by money market mutual funds to those involved in student and car loans. Rational Expectations One hypothesis suggests that monetary policy may affect the price level but not real GDP. The rational expectations hypothesis states that people use all available information to make forecasts about future economic activity and the price level, and they adjust their behavior to these forecasts. Figure 26.6 uses the model of aggregate demand and aggregate supply to show the implications of the rational expectations argument for monetary policy. Suppose the economy is operating at Y, as illustrated by point A. An increase in the money supply boosts aggregate demand to AD. In the analysis we have explored thus far, the shift in aggregate demand would move the economy to a higher level of real GDP and create an inflationary gap. That, in turn, would put upward pressure on wages and other prices, shifting the short-run aggregate supply curve to SRAS and moving the economy to point B, closing the inflationary gap in the long run. The rational expectations hypothesis, however, suggests a quite different interpretation. P 2 2 Figure 26.6 Monetary Policy and Rational Expectations Suppose the economy is operating at point A and that individuals have rational expectations. They calculate that an expansionary monetary policy undertaken at price level P will raise prices to P. They adjust their expectations—and wage demands—accordingly, quickly shifting the short-run aggregate supply curve to SRAS. The result is a movement along the long-run aggregate supply curve LRAS to point B, with no change in real GDP. 2 1 2 Suppose people observe the initial monetary policy change undertaken when the economy is at point A and calculate that the increase in the money supply will ultimately drive the price level up to point B. Anticipating this change in prices, people adjust their behavior. For example, if the increase in the price level from P to P is a 10% change, workers will anticipate that the prices they pay will rise 10%, and they will demand 10% higher wages. Their employers, anticipating that the prices they will receive will also rise, will agree to pay those higher wages. As nominal wages increase, the short-run aggregate supply curve immediately shifts to SRAS. The result is an upward movement along the long-run aggregate supply curve, LRAS. There is no change in real GDP. The monetary policy has no effect, other than its impact on the price level. This rational expectations argument relies on wages and prices being sufficiently flexible—not sticky, as described in an earlier
chapter—so that the change in expectations will allow the short-run aggregate supply curve to shift quickly to SRAS. 2 2 2 1 11.2.5 https://socialsci.libretexts.org/@go/page/21755 One important implication of the rational expectations argument is that a contractionary monetary policy could be painless. Suppose the economy is at point B in Figure 26.6, and the Fed reduces the money supply in order to shift the aggregate demand curve back to AD. In the model of aggregate demand and aggregate supply, the result would be a recession. But in a rational expectations world, people’s expectations change, the short-run aggregate supply immediately shifts to the right, and the economy moves painlessly down its long-run aggregate supply curve LRAS to point A. Those who support the rational expectations hypothesis, however, also tend to argue that monetary policy should not be used as a tool of stabilization policy. 1 For some, the events of the early 1980s weakened support for the rational expectations hypothesis; for others, those same events strengthened support for this hypothesis. As we saw in the introduction to an earlier chapter, in 1979 President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve and pledged his full support for whatever the Fed might do to contain inflation. Mr. Volcker made it clear that the Fed was going to slow money growth and boost interest rates. He acknowledged that this policy would have costs but said that the Fed would stick to it as long as necessary to control inflation. Here was a monetary policy that was clearly announced and carried out as advertised. But the policy brought on the most severe recession since the Great Depression—a result that seems inconsistent with the rational expectations argument that changing expectations would prevent such a policy from having a substantial effect on real GDP. Others, however, argue that people were aware of the Fed’s pronouncements but were skeptical about whether the anti-inflation effort would persist, since the Fed had not vigorously fought inflation in the late 1960s and the 1970s. Against this history, people adjusted their estimates of inflation downward slowly. In essence, the recession occurred because people were surprised that the Fed was serious about fighting inflation. Regardless of where one stands on this debate, one message does seem clear: once the Fed has proved it is serious about maintaining price stability, doing so in the future gets easier. To put this in concrete terms, Volcker’s fight made Greenspan’s work easier, and Greens
pan’s legacy of low inflation should make Bernanke’s easier. Key Takeaways Macroeconomic policy makers must contend with recognition, implementation, and impact lags. Potential targets for macroeconomic policy include interest rates, money growth rates, and the price level or expected rates of change in the price level. Even if a central bank is structured to be independent of political pressure, its officers are likely to be affected by such pressure. To counteract liquidity traps, central banks have used quantitative-easing and credit-easing strategies. No central bank can know in advance how its policies will affect the economy; the rational expectations hypothesis predicts that central bank actions will affect the money supply and the price level but not the real level of economic activity. Try It! The scenarios below describe the U.S. recession and recovery in the early 1990s. Identify the lag that may have contributed to the difficulty in using monetary policy as a tool of economic stabilization. 1. The U.S. economy entered into a recession in July 1990. The Fed countered with expansionary monetary policy in October 1990, ultimately lowering the federal funds rate from 8% to 3% in 1992. 2. Investment began to increase, although slowly, in early 1992, and surged in 1993.  Case in Point: Targeting Monetary Policy Figure 26.7 11.2.6 https://socialsci.libretexts.org/@go/page/21755 Medill DC – Bernanke – CC BY 2.0. Ben Bernanke, the chairman of the Federal Reserve Board, is among a growing group of economists who (at least under normal macroeconomic circumstances!) advocate targeting as an approach to monetary policy. The idea, first proposed in 1993 by Stanford University economist John Taylor, calls for the central bank to set an inflation target and, if the actual rate is above or below it, raise or lower the federal funds rate. The approach would be a change from the policy carried out under Alan Greenspan, who chaired the board from 1987 to 2006. Mr. Greenspan, who opposed targeting, favors a discretionary approach, one that some critics (and admirers) have called a “seat-of-thepants” approach to monetary policy. Targeting would not, according to Mr. Bernanke, be entirely formulaic, replacing the judgment of the Open Market Committee with a rigid rule. Mr. Bernanke has noted, for example, that if the inflation were to increase as a result of a supply side
shock (such as an increase in oil prices), then an automatic increase in the federal funds rate would not be appropriate. One danger of using the current inflation rate as a target is that it might be destabilizing. After all, the current rate is actually the rate for the past month or past several months. Adjusting the federal funds rate to past inflation could, given the inherent recognition and impact lags of monetary policy, easily lead to a worsening of the business cycle. Imagine that past inflation has increased as a result of a much earlier increase in the money supply. That inflation might already be correcting itself by the time a tightening effort takes hold in the economy. It thus could cause a contraction. Bernanke has said that his preferred target is the expected rate of increase for the next year in the price index for consumer goods and services, excluding food and energy prices. That would avoid the danger of relying on previous inflation rates. He has said that his “comfort zone” for expected inflation is between 1% and 2%. The central banks of Australia, Brazil, Canada, Great Britain, New Zealand, South Korea, and Sweden adopted targeting. Japan and the United States did not. A study by Goldman Sachs, the investment consulting and management firm, examined the performance of countries that did and did not engage in targeting. It found that countries that used targeting had more stable interest rates and sustained steady growth. Japan and the United States had much more volatile stock and bond markets. In short, the results of the study tended to support the practice of targeting inflation. Sources: Peter Coy, “What’s the Fuss over Inflation Targeting? Business Week 3958 (November 7, 2005): 34; Justin Fox, “Who Will Replace Greenspan? Who Cares?” Fortune 152, no. 9 (October 31, 2005): 114. Answers to Try It! Problems 1. The recognition lag: the Fed did not seem to “recognize” that the economy was in a recession until several months after the recession began. 2. The impact lag: investment did not pick up quickly after interest rates were reduced. Alternatively, it could be attributed to the expansionary monetary policy’s not having its desired effect, at least initially, on investment. 11.2.7 https://socialsci.libretexts.org/@go/page/21755 1 See, for example, Alberto Alesina and Lawrence H. Summers, “Central Bank Independence and Macro
economic Performance: Some Comparative Evidence,” Journal of Money, Credit, and Banking 25, no. 2 (May 1993): 151–62. References Bernanke, B. S., “The Crisis and the Policy Response” (Stamp Lecture, London School of Economics, London, England, January 13, 2009). OECD Economic Surveys: “Bringing an End to Deflation under the New Monetary Policy Framework,” Japan 2008 4 (April 2008): 49–61. Spiegel, M. M., “Did Quantitative Easing by the Bank of Japan Work?” FRBSF Economic Letter 2006, no. 28 (October 20, 2006): 1–3. Yellen, J. L., “U.S. Monetary Policy Objectives in the Short Run and the Long Run” (speech, Allied Social Sciences Association annual meeting, San Francisco, California, January 4, 2009). This page titled 11.2: Problems and Controversies of Monetary Policy is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 26.2: Problems and Controversies of Monetary Policy by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 11.2.8 https://socialsci.libretexts.org/@go/page/21755 11.3: Monetary Policy and the Equation of Exchange  Learning Objective 1. Explain the meaning of the equation of exchange, MV = PY, and tell why it must hold true. 2. Discuss the usefulness of the quantity theory of money in explaining the behavior of nominal GDP and inflation in the long run. 3. Discuss why the quantity theory of money is less useful in analyzing the short run. So far we have focused on how monetary policy affects real GDP and the price level in the short run. That is, we have examined how it can be used—however imprecisely—to close recessionary or inflationary gaps and to stabilize the price level. In this section, we will explore the relationship between money and the economy in the context of an equation that relates the money supply directly to nominal GDP. As we shall see, it also identifies circumstances in which changes in the price level are directly related to changes in the money supply. The
Equation of Exchange We can relate the money supply to the aggregate economy by using the equation of exchange: Equation 26.1 The equation of exchange shows that the money supply M times its velocity V equals nominal GDP. Velocity is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular time period. To see that nominal GDP is the price level multiplied by real GDP, recall from an earlier chapter that the implicit price deflator P equals nominal GDP divided by real GDP: Equation 26.2 Multiplying both sides by real GDP, we have Equation 26.3 Letting Y equal real GDP, we can rewrite the equation of exchange as Equation 26.4 We shall use the equation of exchange to see how it represents spending in a hypothetical economy that consists of 50 people, each of whom has a car. Each person has $10 in cash and no other money. The money supply of this economy is thus $500. Now suppose that the sole economic activity in this economy is car washing. Each person in the economy washes one other person’s car once a month, and the price of a car wash is $10. In one month, then, a total of 50 car washes are produced at a price of $10 each. During that month, the money supply is spent once. Applying the equation of exchange to this economy, we have a money supply M of $500 and a velocity V of 1. Because the only good or service produced is car washing, we can measure real GDP as the number of car washes. Thus Y equals 50 car washes. The price level P is the price of a car wash: $10. The equation of exchange for a period of 1 month is Now suppose that in the second month everyone washes someone else’s car again. Over the full two-month period, the money supply has been spent twice—the velocity over a period of two months is 2. The total output in the economy is $1,000—100 car washes have been produced over a two-month period at a price of $10 each. Inserting these values into the equation of exchange, we have 11.3.1 https://socialsci.libretexts.org/@go/page/21756 Suppose this process continues for one more month. For the three-month period, the money supply of $500 has been spent three times, for a velocity of 3. We have
The essential thing to note about the equation of exchange is that it always holds. That should come as no surprise. The left side, MV, gives the money supply times the number of times that money is spent on goods and services during a period. It thus measures total spending. The right side is nominal GDP. But that is a measure of total spending on goods and services as well. Nominal GDP is the value of all final goods and services produced during a particular period. Those goods and services are either sold or added to inventory. If they are sold, then they must be part of total spending. If they are added to inventory, then some firm must have either purchased them or paid for their production; they thus represent a portion of total spending. In effect, the equation of exchange says simply that total spending on goods and services, measured as MV, equals total spending on goods and services, measured as PY (or nominal GDP). The equation of exchange is thus an identity, a mathematical expression that is true by definition. To apply the equation of exchange to a real economy, we need measures of each of the variables in it. Three of these variables are readily available. The Department of Commerce reports the price level (that is, the implicit price deflator) and real GDP. The Federal Reserve Board reports M2, a measure of the money supply. For the second quarter of 2008, the values of these variables at an annual rate were M = $7,635.4 billion P = 1.22 Y = 11,727.4 billion To solve for the velocity of money, V, we divide both sides of Equation 26.4 by M: Equation 26.5 Using the data for the second quarter of 2008 to compute velocity, we find that V then was equal to 1.87. A velocity of 1.87 means that the money supply was spent 1.87 times in the purchase of goods and services in the second quarter of 2008. Money, Nominal GDP, and Price-Level Changes Assume for the moment that velocity is constant, expressed as. Our equation of exchange is now written as Equation 26.6 A constant value for velocity would have two important implications: 1. Nominal GDP could change only if there were a change in the money supply. Other kinds of changes, such as a change in government purchases or a change in investment, could have no effect on nominal GDP. 2. A change in the money supply would always change nominal GDP, and by an equal percentage. In

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