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bank to go undetected. At the same time, the owners of banks have an incentive to engage in overly risky investment behavior, such as making questionable loans at high interest rates. That’s because if all goes well, the owners profit; and if things go badly, the government covers the losses through federal deposit insurance. To reduce the incentive for excessive risk-taking, regulators require that the owners of banks hold substantially more assets than the value of bank deposits. That way, the bank will still have assets larger than its deposits even if some of its loans go bad, and losses will accrue against the bank owners’ assets, not the government. The excess of a bank’s assets over its bank deposits and other liabilities is called the bank’s capital. For example, First State Street Bank has capital of $100,000, equal to 9% of the total value of its assets. In practice, banks’ capital is required to equal at least 7% of the value of their assets. Reserve Requirements Another regulation used to reduce the risk of bank runs is reserve requirements, rules set by the Federal Reserve that establish the required reserve ratio for banks. For example, in the United States, the required reserve ratio for checkable bank deposits is 10%. The Discount Window One final protection against bank runs is the fact that the Federal Reserve, which we’ll discuss more thoroughly later, stands ready to lend money to banks, an arrangement known as the discount window. The ability to borrow money 246 means a bank can avoid being forced to sell its assets at fire -sale prices in order to satisfy the demands of a sudden rush of depositors demanding cash. Instead, it can turn to the Federal Reserve and borrow the funds it needs to pay off depositors. Determining the Money Supply Without banks, there would be no checkable deposits, and so the quantity of currency in circulation would equal the money supply. In that case, the money supply would be determined solely by whoever controls government minting and printing presses. But banks do exist, and through their creation of checkable bank deposits, they affect the money supply in two ways. First, banks remove some currency from circulation: dollar bills that are sitting in bank vaults, as opposed to sitting in people’s wallets, aren’t part of the money supply. Second, and much more importantly, banks create money by accepting deposits and making loans—that is, they make the money supply larger than just the value of currency in circulation.
Our next topic is how banks create money and what determines the amount of money they create. How Banks Create Money To see how banks create money, let’s examine what happens when someone decides to deposit currency in a bank. Consider the example of Silas, a miser, who keeps a shoebox full of cash under his bed. Suppose Silas realizes that it would be safer, as well as more convenient, to deposit that cash in the bank and to use his debit card when shopping. Assume that he deposits $1,000 into a checkable account at First Street Bank. What effect will Silas’s actions have on the money supply? Panel (a) of Figure 25.3 shows the initial effect of his deposit. First Street Bank credits Silas with $1,000 in his account, so the economy’s checkable bank deposits rise by $1,000. Meanwhile, Silas’s cash goes into the vault, raising First Street’s reserves by $1,000 as well This initial transaction has no effect on the money supply. Currency in circulation, part of the money supply, falls by $1,000; checkable bank deposits, also part of the money supply, rise by the same amount. f i g u r e 25.3 Effect on the Money Supply of Turning Cash into a Checkable Deposit at First Street Bank (a) Initial Effect Before Bank Makes a New Loan (b) Effect When Bank Makes a New Loan Assets Liabilities Assets No change Loans Reserves +$1,000 Checkable deposits +$1,000 +$900 Loans Reserves –$900 Liabilities No change When Silas deposits $1,000 (which had been stashed under his bed) into a checkable bank account, there is initially no effect on the money supply: currency in circulation falls by $1,000, but checkable bank deposits rise by $1,000. The corresponding entries on the bank’s T-account, depicted in panel (a), show deposits initially rising by $1,000 and the bank’s reserves initially rising by $1,000. In the second stage, depicted in panel (b), the bank holds 10% of Silas’s deposit ($100) as reserves and lends out the rest ($900) to Mary. As a result, its reserves fall by $900 and its loans increase by $900. Its liabilities, including Silas’s $1,000 deposit,
are unchanged. The money supply, the sum of checkable bank deposits and currency in circulation, has now increased by $900—the $900 now held by Mary 247 But this is not the end of the story because First Street Bank can now lend out part of Silas’s deposit. Assume that it holds 10% of Silas’s deposit—$100—in reserves and lends the rest out in cash to Silas’s neighbor, Mary. The effect of this second stage is shown in panel (b). First Street’s deposits remain unchanged, and so does the value of its assets. But the composition of its assets changes: by making the loan, it reduces its reserves by $900, so that they are only $100 larger than they were before Silas made his deposit. In the place of the $900 reduction in reserves, the bank has acquired an IOU, its $900 cash loan to Mary. So by putting $900 of Silas’s cash back into circulation by lending it to Mary, First Street Bank has, in fact, increased the money supply. That is, the sum of currency in circulation and checkable bank deposits has risen by $900 compared to what it had been when Silas’s cash was still under his bed. Although Silas is still the owner of $1,000, now in the form of a checkable deposit, Mary has the use of $900 in cash from her borrowings. And this may not be the end of the story. Suppose that Mary uses her cash to buy a television and a DVD player from Acme Merchandise. What does Anne Acme, the store’s owner, do with the cash? If she holds on to it, the money supply doesn’t increase any further. But suppose she deposits the $900 into a checkable bank deposit—say, at Second Street Bank. Second Street Bank, in turn, will keep only part of that deposit in reserves, lending out the rest, creating still more money. Assume that Second Street Bank, like First Street Bank, keeps 10% of any bank deposit in reserves and lends out the rest. Then it will keep $90 in reserves and lend out $810 of Anne’s deposit to another borrower, further increasing the money supply. Table 25.1 shows the process of money creation we have described so far. At first the money supply consists only of Silas’s $1,000. After he deposits
the cash into a t a b l e 25.1 How Banks Create Money First stage: Silas keeps his cash under his bed. Second stage: Silas deposits cash in First Street Bank, which lends out $900 to Mary, who then pays it to Anne Acme. Third stage: Anne Acme deposits $900 in Second Street Bank, which lends out $810 to another borrower. Currency in circulation Checkable bank deposits $1,000 $0 Money supply $1,000 900 810 1,000 1,900 1,900 2,710 checkable bank deposit and the bank makes a loan, the money supply rises to $1,900. After the second deposit and the second loan, the money supply rises to $2,710. And the process will, of course, continue from there. (Although we have considered the case in which Silas places his cash in a checkable bank deposit, the results would be the same if he put it into any type of near -money.) This process of money creation may sound familiar. Recall the multiplier process that we described in Module 16: an initial increase in real GDP leads to a rise in consumer spending, which leads to a further rise in real GDP, which leads to a further rise in consumer spending, and so on. What we have here is another kind of multiplier—the money multiplier. Next, we’ll learn what determines the size of this multiplier. Reserves, Bank Deposits, and the Money Multiplier In tracing out the effect of Silas’s deposit in Table 25.1, we assumed that the funds a bank lends out always end up being deposited either in the same bank or in another bank—so funds disbursed as loans come back to the banking system, even if not to the 248 Excess reserves are a bank’s reserves over and above its required reserves. The monetary base is the sum of currency in circulation and bank reserves lending bank itself. In reality, some of these loaned funds may be held by borrowers in their wallets and not deposited in a bank, meaning that some of the loaned amount “leaks” out of the banking system. Such leaks reduce the size of the money multiplier, just as leaks of real income into savings reduce the size of the real GDP multiplier. (Bear in mind, however, that the “leak” here comes from the fact that borrowers keep some of their funds in currency, rather than the fact that consumers save some
of their income.) But let’s set that complication aside for a moment and consider how the money supply is determined in a “checkable -deposits -only” monetary system, in which funds are always deposited in bank accounts and none are held in wallets as currency. That is, in our checkable -deposits -only monetary system, any and all funds borrowed from a bank are immediately deposited into a checkable bank account. We’ll assume that banks are required to satisfy a minimum reserve ratio of 10% and that every bank lends out all of its excess reserves, reserves over and above the amount needed to satisfy the minimum reserve ratio. Now suppose that for some reason a bank suddenly finds itself with $1,000 in excess reserves. What happens? The answer is that the bank will lend out that $1,000, which will end up as a checkable bank deposit somewhere in the banking system, launching a money multiplier process very similar to the process shown in Table 25.1. In the first stage, the bank lends out its excess reserves of $1,000, which becomes a checkable bank deposit somewhere. The bank that receives the $1,000 deposit keeps 10%, or $100, as reserves and lends out the remaining 90%, or $900, which again becomes a checkable bank deposit somewhere. The bank receiving this $900 deposit again keeps 10%, which is $90, as reserves and lends out the remaining $810. The bank receiving this $810 keeps $81 in reserves and lends out the remaining $729, and so on. As a result of this process, the total increase in checkable bank deposits is equal to a sum that looks like: $1,000 + $900 + $810 + $729 +... We’ll use the symbol rr for the reserve ratio. More generally, the total increase in checkable bank deposits that is generated when a bank lends out $1,000 in excess reserves is the: (25-1) Increase in checkable bank deposits from $1,000 in excess reserves = $1,000 + $1,000 × (1 − rr) + $1,000 × (1 − rr)2 + $1,000 × (1 − rr)3 +... As we have seen, an infinite series of this form can be simplified to: (25-2) Increase in checkable bank deposits from $1,000 in excess reserves = $
1,000/rr Given a reserve ratio of 10%, or 0.1, a $1,000 increase in excess reserves will increase the total value of checkable bank deposits by $1,000/0.1 = $10,000. In fact, in a checkable deposits -only monetary system, the total value of checkable bank deposits will be equal to the value of bank reserves divided by the reserve ratio. Or to put it a different way, if the reserve ratio is 10%, each $1 of reserves held by a bank supports $1/rr = $1/0.1 = $10 of checkable bank deposits. The Money Multiplier in Reality In reality, the determination of the money supply is more complicated than our simple model suggests because it depends not only on the ratio of reserves to bank deposits but also on the fraction of the money supply that individuals choose to hold in the form of currency. In fact, we already saw this in our example of Silas depositing the cash under his bed: when he chose to hold a checkable bank deposit instead of currency, he set in motion an increase in the money supply. To define the money multiplier in practice, we need to understand that the Federal Reserve controls the monetary base, the sum of currency in circulation and the 249 © reserves held by banks. The Federal Reserve does not determine how that sum is allocated between bank reserves and currency in circulation. Consider Silas and his deposit one more time: by taking the cash from under his bed and depositing it in a bank, he reduces the quantity of currency in circulation but increased bank reserves by an equal amount. So while the allocation of the monetary base changes—the amount in reserves grows and the amount in circulation shrinks—the total of these two, the monetary base, remains unchanged. The monetary base is different from the money supply in two ways. First, bank reserves, which are part of the monetary base, aren’t considered part of the money supply. A $1 bill in someone’s wallet is considered money because it’s available for an individual to spend, but a $1 bill held as bank reserves in a bank vault or deposited at the Federal Reserve isn’t considered part of the money supply because it’s not available for spending. Second, checkable bank deposits, which are part of the money supply because they are available for spending, aren’t part of the monetary base. Figure 25.4 shows the two concepts schematically
. The circle on the left represents the monetary base, consisting of bank reserves plus currency in circulation. The circle on the right represents the money supply, consisting mainly of currency in circulation plus checkable or near -checkable bank deposits. As the figure indicates, currency in circulation is part of both the monetary base and the money supply. But bank reserves aren’t part of the money supply, and checkable or near -checkable bank deposits aren’t part of the monetary base. In normal times, most of the monetary base actually consists of currency in circulation, which also makes up about half of the money supply. Now we can formally define the money multiplier: it’s the ratio of the money supply to the monetary base. Most importantly, this tells us the total number of dollars created in the banking system by each $1 addition to the monetary base. In a simple situation in which banks hold no excess reserves and all cash is deposited in banks, the money multiplier is 1/rr. So if the reserve requirement is 0.1 (the minimum required ratio for most checkable deposits in the United States), the money multiplier is 1/0.1 = 10, and if the Federal Reserve adds $100 to the monetary base, the money supply will increase by 10 × $100 = $1,000. During normal times, the actual money multiplier in the United States, using M1 as our measure of money, is about 1.9. That’s a lot smaller than 10. Normally, the reason the actual money multiplier is so small arises from the fact that people hold significant amounts of cash, and a dollar of currency in circulation, unlike a dollar in reserves, doesn’t support multiple dollars of the money supply. In fact, currency in circulation normally accounts for more than 90% of the monetary base. But as this book went to press in early 2010, the money multiplier was even smaller, about 0.8. What was going on? The money multiplier is the ratio of the money supply to the monetary base. It indicates the total number of dollars created in the banking system by each $1 addition to the monetary base. f i g u r e 25.4 The Monetary Base and the Money Supply The monetary base is equal to bank reserves plus currency in circulation. It is different from the money supply, consisting mainly of checkable or near -checkable bank deposits plus currency in circulation. Each dollar of bank reserves backs several dollars of bank deposits, making the money supply larger than
the monetary base. Monetary base Money supply Bank reserves Currency in circulation Checkable bank deposits 250 The answer is that early 2010 was not a normal time: Starting in late 2008, legislation intended to stabilize the troubled U.S. economy made it much more attractive for banks to hold excess reserves. And banks responded by increasing their reserves tremendously, from $10 billion in 2008 to $1.2 trillion by January of 2010. And those large excess reserves—funds not lent out to potential borrowers—increased the monetary base without increasing the money supply. It was as if that money had “leaked” out of the money multiplier process and into excess reserves held by banks, reducing the size of the money multiplier. M o d u l e 25 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Suppose you are a depositor at First Street Bank. You hear a rumor that the bank has suffered serious losses on its loans. Every depositor knows that the rumor isn’t true, but each thinks that most other depositors believe the rumor. Why, in the absence of deposit insurance, could this lead to a bank run? How does deposit insurance change the situation? 2. A con artist has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme? Tackle the Test: Multiple-Choice Questions 1. Bank reserves include which of the following? I. currency in bank vaults II. bank deposits held in accounts at the Federal Reserve III. customer deposits in bank checking accounts a. I only b. II only c. III only d. I and II only I, II, and III e. 2. The fraction of bank deposits actually held as reserves is the a. reserve ratio. b. required reserve ratio. c. excess reserve ratio. d. reserve requirement. e. monetary base. 3. Bank regulation includes which of the following? I. deposit insurance II. capital requirements III. reserve requirements 3. Assume that total reserves are equal to $200 and total checkable bank deposits are equal to $1,000. Also assume that the
public does not hold any currency and banks hold no excess reserves. Now suppose that the required reserve ratio falls from 20% to 10%. Trace out how this leads to an expansion in bank deposits. 4. Take the example of Silas depositing his $1,000 in cash into First Street Bank and assume that the required reserve ratio is 10%. But now assume that each recipient of a bank loan keeps half the loan in cash and deposits the rest. Trace out the resulting expansion in the money supply through at least three rounds of deposits. a. I only b. II only c. III only d. I and II e. I, II, and III 4. Which of the following changes would be the most likely to reduce the size of the money multiplier? a. a decrease in the required reserve ratio b. a decrease in excess reserves c. an increase in cash holding by consumers d. a decrease in bank runs e. an increase in deposit insurance 5. The monetary base equals a. currency in circulation. b. reserves held by banks. c. currency in circulation − reserves held by banks. d. currency in circulation + reserves held by banks. e. currency in circulation/reserves held by banks 251 Tackle the Test: Free-Response Questions 1. How will each of the following affect the money supply through 2. The required reserve ratio is 5%. a. If a bank has deposits of $100,000 and holds $10,000 as reserves, how much are its excess reserves? Explain. b. If a bank holds no excess reserves and it receives a new deposit of $1,000, how much of that $1,000 can the bank lend out and how much is the bank required to add to its reserves? Explain. c. By how much can an increase in excess reserves of $2,000 change the money supply in a checkable-deposits-only system? Explain. the money multiplier process? Explain. a. People hold more cash. b. Banks hold more excess reserves. c. The Fed increases the required reserve ratio. Answer (6 points) 1 point: It will decrease. 1 point: Money held as cash does not support multiple dollars in the money supply. 1 point: It will decrease. 1 point: Excess reserves are not loaned out and therefore do not expand the money supply. 1 point: It will decrease. 1 point: Banks will have to hold more as reserves and therefore loan out less. 252 Module 26 The Federal Reserve System: History
and Structure The Federal Reserve System Who’s in charge of ensuring that banks maintain enough reserves? Who decides how large the monetary base will be? The answer, in the United States, is an institution known as the Federal Reserve (or, informally, as “the Fed”). The Federal Reserve is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base. Other central banks include the Bank of England, the Bank of Japan, and the European Central Bank, or ECB. An Overview of the Twenty-first Century American Banking System Under normal circumstances, banking is a rather staid and unexciting business. Fortunately, bankers and their customers like it that way. However, there have been repeated episodes in which “sheer panic” would be the best description of banking conditions— the panic induced by a bank run and the specter of a collapse of a bank or multiple banks, leaving depositors penniless, bank shareholders wiped out, and borrowers unable to get credit. In this section, we’ll give an overview of the behavior and regulation of the American banking system over the last century. The creation of the Federal Reserve System in 1913 was largely a response to lessons learned in the Panic of 1907. In 2008, the United States found itself in the midst of a financial crisis that in many ways mirrored the Panic of 1907, which occurred almost exactly 100 years earlier. What you will learn in this Module: • The history of the Federal Reserve System • The structure of the Federal Reserve System • How the Federal Reserve has responded to major financial crises A central bank is an institution that oversees and regulates the banking system and controls the monetary base 253 Crisis in American Banking at the Turn of the Twentieth Century The creation of the Federal Reserve System in 1913 marked the beginning of the modern era of American banking. From 1864 until 1913, American banking was dominated by a federally regulated system of national banks. They alone were allowed to issue currency, and the currency notes they issued were printed by the federal government with uniform size and design. How much currency a national bank could issue depended on its capital. Although this system was an improvement on the earlier period in which banks issued their own notes with no uniformity and virtually no regulation, the national banking regime still suffered numerous bank failures and major financial crises—at least one and often two per decade. The main problem afflicting the system was that the money supply was not sufficiently responsive: it was difficult to shift currency around the country
to respond quickly to local economic changes. (In particular, there was often a tug -of -war between New York City banks and rural banks for adequate amounts of currency.) Rumors that a bank had insufficient currency to satisfy demands for withdrawals would quickly lead to a bank run. A bank run would then spark a contagion, setting off runs at other nearby banks, sowing widespread panic and devastation in the local economy. In response, bankers in some locations pooled their resources to create local clearinghouses that would jointly guarantee a member’s liabilities in the event of a panic, and some state governments began offering deposit insurance on their banks’ deposits. However, the cause of the Panic of 1907 was different from those of previous crises; in fact, its cause was eerily similar to the roots of the 2008 crisis. Ground zero of the 1907 panic was New York City, but the consequences devastated the entire country, leading to a deep four -year recession. The crisis originated in institutions in New York known as trusts, bank -like institutions that accepted deposits but that were originally intended to manage only inheritances and estates for wealthy clients. Because these trusts were supposed to engage only in low -risk activities, they were less regulated, had lower reserve requirements, and had lower cash reserves than national banks. However, as the American economy boomed during the first decade of the twentieth century, trusts began speculating in real estate and the stock market, areas of speculation forbidden to national banks. Being less regulated than national banks, trusts were able to pay their depositors higher returns. Yet trusts took a free ride on national banks’ reputation for soundness, with depositors considering them equally safe. As a result, trusts grew rapidly: by 1907, the total assets of trusts in New York City were as large as those of national banks. Meanwhile, the trusts declined to join the New York Clearinghouse, a consortium of New York City national banks that guaranteed one another’s soundness; that would have required the trusts to hold higher cash reserves, reducing their profits. The Panic of 1907 began with the failure of the Knickerbocker Trust, a large New York City trust that failed when it suffered massive losses in unsuccessful stock market speculation. Quickly, other New York trusts came under pressure, and frightened depositors began queuing in long lines to withdraw their funds. The New York Clearinghouse declined to step in and lend to the trusts, and even healthy trusts came under serious assault. Within two days, a dozen
major trusts had gone under. Credit markets froze, and the stock market fell dramatically as stock traders were unable to get credit to finance their trades, and business confidence evaporated. Fortunately, one of New York City’s wealthiest men, the banker J. P. Morgan, quickly stepped in to stop the panic. Understanding that the crisis was spreading and would In both the Panic of 1907 and the financial crisis of 2008, large losses from risky speculation destabilized the banking system. 254 soon engulf healthy institutions, trusts and banks alike, he worked with other bankers, wealthy men such as John D. Rockefeller, and the U.S. Secretary of the Treasury to shore up the reserves of banks and trusts so they could withstand the onslaught of withdrawals. Once people were assured that they could withdraw their money, the panic ceased. Although the panic itself lasted little more than a week, it and the stock market collapse decimated the economy. A four -year recession ensued, with production falling 11% and unemployment rising from 3% to 8%. Responding to Banking Crises: The Creation of the Federal Reserve Concerns over the frequency of banking crises and the unprecedented role of J. P. Morgan in saving the financial system prompted the federal government to initiate banking reform. In 1913 the national banking system was eliminated and the Federal Reserve System was created as a way to compel all deposit -taking institutions to hold adequate reserves and to open their accounts to inspection by regulators. The Panic of 1907 convinced many that the time for centralized control of bank reserves had come. The Federal Reserve was given the sole right to issue currency in order to make the money supply sufficiently responsive to satisfy economic conditions around the country. The Structure of the Fed The legal status of the Fed, which was created in 1913, is unusual: it is not exactly part of the U.S. government, but it is not really a private institution either. Strictly speaking, the Federal Reserve System consists of two parts: the Board of Governors and the 12 regional Federal Reserve Banks. The Board of Governors, which oversees the entire system from its offices in Washington, D.C., is constituted like a government agency: its seven members are appointed by the president and must be approved by the Senate. However, they are appointed for 14-year terms, to insulate them from political pressure in their conduct of monetary policy. Although the chair is appointed more frequently— every four years—it is traditional for the chair to be reappointed and serve much longer terms. For example, William McC
hesney Martin was chair of the Fed from 1951 until 1970. Alan Greenspan, appointed in 1987, served as the Fed’s chair until 2006. The 12 Federal Reserve Banks each serve a region of the country, known as a Federal Reserve district, providing various banking and supervisory services. One of their jobs, for example, is to audit the books of private -sector banks to ensure their financial health. Each regional bank is run by a board of directors chosen from the local banking and business community. The Federal Reserve Bank of New York plays a special role: it carries out open -market operations, usually the main tool of monetary policy. Figure 26.1 on the next page shows the 12 Federal Reserve districts and the city in which each regional Federal Reserve Bank is located. Decisions about monetary policy are made by the Federal Open Market Committee, which consists of the Board of Governors plus five of the regional bank presidents. The president of the Federal Reserve Bank of New York is always on the committee, and the other four seats rotate among the 11 other regional bank presidents. The chair of the Board of Governors normally also serves as the chair of the Federal Open Market Committee. The effect of this complex structure is to create an institution that is ultimately accountable to the voting public because the Board of Governors is chosen by the president and confirmed by the Senate, all of whom are themselves elected officials. But the long terms served by board members, as well as the indirectness of their appointment process, largely insulate them from short -term political pressures 255 f i g u r e 26.1 The Federal Reserve System 12 San Francisco 9 Minneapolis Kansas City 10 Dallas 11 7 Chicago Chicago Chicago Chicago St. Louis 8 1 Boston New York Philadelphia Board of Governors 2 3 Cleveland 4 Richmond 5 Atlanta 6 Alaska and Hawaii are part of the San Francisco District The Federal Reserve System consists of the Board of Governors in Washington, D.C., plus 12 regional Federal Reserve Banks. This map shows each of the 12 Federal Reserve districts. Source: Board of Governors of the Federal Reserve System. The Effectiveness of the Federal Reserve System Although the Federal Reserve System standardized and centralized the holding of bank reserves, it did not eliminate the potential for bank runs because banks’ reserves were still less than the total value of their deposits. The potential for more bank runs became a reality during the Great Depression. Plunging commodity prices hit American farmers particularly hard, precipitating a series of bank runs in 1930, 1931, and 1933, each of which started at midwestern banks and
then spread throughout the country. After the failure of a particularly large bank in 1930, federal officials realized that the economy -wide effects compelled them to take a less hands off approach and to intervene more vigorously. In 1932, the Reconstruction Finance Corporation (RFC) was established and given the authority to make loans to banks in order to stabilize the banking sector. Also, the Glass -Steagall Act of 1932, which increased the ability of banks to borrow from the Federal Reserve System, was passed. A loan to a leading Chicago bank from the Federal Reserve appears to have stopped a major banking crisis in 1932. However, the beast had not yet been tamed. Banks became fearful of borrowing from the RFC because doing so signaled weakness to the public. During the midst of the catastrophic bank run of 1933, the new U.S. president, Franklin Delano Roosevelt, was inaugurated. He immediately declared a “bank holiday,” closing all banks until regulators could get a handle on the problem. In March 1933, emergency measures were adopted that gave the RFC extraordinary powers to stabilize and restructure the banking industry by providing capital to banks either by loans or by outright purchases of bank shares. With the new regulations, regulators closed nonviable banks and recapitalized viable ones by allowing the RFC to buy preferred shares in banks (shares that gave the U.S. government more rights than regular shareholders) and by greatly expanding banks’ ability to borrow 256 commercial bank accepts deposits and is covered by deposit insurance. An investment bank trades in financial assets and is not covered by deposit insurance. A savings and loan (thrift) is another type of deposit -taking bank, usually specialized in issuing home loans from the Federal Reserve. By 1933, the RFC had invested over $16 billion (2008 dollars) in bank capital—one -third of the total capital of all banks in the United States at that time—and purchased shares in almost one -half of all banks. The RFC loaned more than $32 billion (2008 dollars) to banks during this period. Economic historians uniformly agree that the banking crises of the early 1930s greatly exacerbated the severity of the Great Depression, rendering monetary policy ineffective as the banking sector broke down and currency, withdrawn from banks and stashed under beds, reduced the money supply. Although the powerful actions of the RFC stabilized the banking industry, new legislation was needed to prevent future banking crises. The Glass -Steagall Act of 1933 separated banks into two categories, commercial banks, depository banks that accepted deposits and were
covered by deposit insurance, and investment banks, which engaged in creating and trading financial assets such as stocks and corporate bonds but were not covered by deposit insurance because their activities were considered more risky. Regulation Q prevented commercial banks from paying interest on checking accounts, in the belief that this would promote unhealthy competition between banks. In addition, investment banks were much more lightly regulated than commercial banks. The most important measure for the prevention of bank runs, however, was the adoption of federal deposit insurance (with an original limit of $2,500 per deposit). These measures were clearly successful, and the United States enjoyed a long period of financial and banking stability. As memories of the bad old days dimmed, Depression -era bank regulations were lifted. In 1980 Regulation Q was eliminated, and by 1999, the Glass -Steagall Act had been so weakened that offering services like trading financial assets were no longer off -limits to commercial banks. The Savings and Loan Crisis of the 1980s Along with banks, the banking industry also included savings and loans (also called S&Ls or thrifts), institutions designed to accept savings and turn them into long term mortgages for home -buyers. S&Ls were covered by federal deposit insurance and were tightly regulated for safety. However, trouble hit in the 1970s, as high inflation led savers to withdraw their funds from low -interest -paying S&L accounts and put them into higher-paying money market accounts. In addition, the high inflation rate severely eroded the value of the S&Ls’ assets, the long -term mortgages they held on their books. In order to improve S&Ls’ competitive position versus banks, Congress eased regulations to allow S&Ls to undertake much more risky investments in addition to long -term home mortgages. However, the new freedom did not bring with it increased oversight, leaving S&Ls with less oversight than banks. Not surprisingly, during the real estate boom of the 1970s and 1980s, S&Ls engaged in overly risky real estate lending. Also, corruption occurred as some S&L executives used their institutions as private piggy banks. Unfortunately, during the late 1970s and early 1980s, political interference from Congress kept insolvent S&Ls open when a bank in a comparable situation would have been quickly shut down by bank regulators. By the early 1980s, a large number of S&Ls had failed. Because accounts were covered by federal deposit insurance, the liabilities of a failed S&L were now
liabilities of the federal government, and depositors had to be paid from taxpayer funds. From 1986 through 1995, the federal government closed over 1,000 failed S&Ls, costing U.S. taxpayers over $124 billion dollars. In a classic case of shutting the barn door after the horse has escaped, in 1989 Congress put in place comprehensive oversight of S&L activities. It also empowered Fannie Mae and Freddie Mac to take over much of the home mortgage lending previously done by S&Ls. Fannie Mae and Freddie Mac are quasi -governmental agencies created during the Great Depression to make homeownership more affordable for low- and moderate -income households. It has been calculated that the S&L crisis helped cause a steep slowdown in the finance and real estate industries, leading to the recession of the early 1990s 257 A financial institution engages in leverage when it finances its investments with borrowed funds. The balance sheet effect is the reduction in a firm’s net worth from falling asset prices. A vicious cycle of de leveraging takes place when asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices. Back to the Future: The Financial Crisis of 2008 The financial crisis of 2008 shared features of previous crises. Like the Panic of 1907 and the S&L crisis, it involved institutions that were not as strictly regulated as deposittaking banks, as well as excessive speculation. Like the crises of the early 1930s, it involved a U.S. government that was reluctant to take aggressive action until the scale of the devastation became clear. In addition, by the late 1990s, advances in technology and financial innovation had created yet another systemic weakness that played a central role in 2008. The story of Long -Term Capital Management, or LTCM, highlights these problems. Long -term Capital (Mis)Management Created in 1994, LTCM was a hedge fund, a private investment partnership open only to wealthy individuals and institutions. Hedge funds are virtually unregulated, allowing them to make much riskier investments than mutual funds, which are open to the average investor. Using vast amounts of leverage— that is, borrowed money—in order to increase its returns, LTCM used sophisticated computer models to make money by taking advantage of small differences in asset prices in global financial markets to buy at a lower price and sell at a higher price. In one year, LTCM made a return as high as 40%. LTC
M was also heavily involved in derivatives, complex financial instruments that are constructed—derived—from the obligations of more basic financial assets. Derivatives are popular investment tools because they are cheaper to trade than basic financial assets and can be constructed to suit a buyer’s or seller’s particular needs. Yet their complexity can make it extremely hard to measure their value. LTCM believed that its computer models allowed it to accurately gauge the risk in the huge bets that it was undertaking in derivatives using borrowed money. However, LTCM’s computer models hadn’t factored in a series of financial crises in Asia and in Russia during 1997 and 1998. Through its large borrowing, LTCM had become such a big player in global financial markets that attempts to sell its assets depressed the prices of what it was trying to sell. As the markets fell around the world and LTCM’s panic -stricken investors demanded the return of their funds, LTCM’s losses mounted as it tried to sell assets to satisfy those demands. Quickly, its operations collapsed because it could no longer borrow money and other parties refused to trade with it. Financial markets around the world froze in panic. The Federal Reserve realized that allowing LTCM’s remaining assets to be sold at panic- stricken prices presented a grave risk to the entire financial system through the balance sheet effect: as sales of assets by LTCM depressed asset prices all over the world, other firms would see the value of their balance sheets fall as assets held on these balance sheets declined in value. Moreover, falling asset prices meant the value of assets held by borrowers on their balance sheet would fall below a critical threshold, leading to a default on the terms of their credit contracts and forcing creditors to call in their loans. This in turn would lead to more sales of assets as borrowers tried to raise cash to repay their loans, more credit defaults, and more loans called in, creating a vicious cycle of deleveraging. The Federal Reserve Bank of New York arranged a $3.625 billion bailout of LTCM in 1998, in which other private institutions took on shares of LTCM’s assets and obligations, liquidated them in an orderly manner, and eventually turned a small profit. Quick action by the Federal Reserve Bank of New York prevented LTCM from sparking a contagion, yet virtually all of LTCM’s investors were wiped out. Subprime Lending and the Housing Bubble After the LTCM crisis
, U.S. financial markets stabilized. They remained more or less stable even as stock prices fell sharply from 2000 to 2002 and the U.S. economy went into recession. During the recovery from the 2001 recession, however, the seeds for another financial crisis were planted. The story begins with low interest rates: by 2003, U.S. interest rates were at historically low levels, partly because of Federal Reserve policy and partly because of large inflows of capital from other countries, especially China. These low interest rates helped cause a boom in housing, which in turn led the U.S. economy out of recession. As housing boomed, however, financial institutions began taking on growing risks—risks that were not well understood. 258 Sub prime lending is lending to home buyers who don’t meet the usual criteria for being able to afford their payments. In securitization a pool of loans is assembled and shares of that pool are sold to investors Traditionally, people were only able to borrow money to buy homes if they could show that they had sufficient income to meet the mortgage payments. Making home loans to people who didn’t meet the usual criteria for borrowing, called subprime lending, was only a minor part of overall lending. But in the booming housing market of 2003–2006, subprime lending started to seem like a safe bet. Since housing prices kept rising, borrowers who couldn’t make their mortgage payments could always pay off their mortgages, if necessary, by selling their homes. As a result, subprime lending exploded. Who was making these subprime loans? For the most part, it wasn’t traditional banks lending out depositors’ money. Instead, most of the loans were made by “loan originators,” who quickly sold mortgages to other investors. These sales were made possible by a process known as securitization: financial institutions assembled pools of loans and sold shares in the income from these pools. These shares were considered relatively safe investments since it was considered unlikely that large numbers of home-buyers would default on their payments at the same time. But that’s exactly what happened. The housing boom turned out to be a bubble, and when home prices started falling in late 2006, many subprime borrowers were unable either to meet their mortgage payments or sell their houses for enough to pay off their mortgages. As a result, investors in securities backed by subprime mortgages started taking heavy losses. Many of the mortgage -backed assets were held by financial
institutions, including banks and other institutions playing bank -like roles. Like the trusts that played a key role in the Panic of 1907, these “nonbank banks” were less regulated than commercial banks, which allowed them to offer higher returns to investors but left them extremely vulnerable in a crisis. Mortgage -related losses, in turn, led to a collapse of trust in the financial system. Figure 26.2 shows one measure of this loss of trust: the TED spread, which is the difference between the interest rate on three -month loans that banks make to each other and the interest rate the federal government pays on three -month bonds. Since government bonds are considered extremely safe, the TED spread shows how much risk banks think they’re taking on when lending to each other. Normally, the spread is around a quarter of a percentage point, but it shot up in August 2007 and surged to an unprecedented 4.64 percentage points in October 2008. Crisis and Response The collapse of trust in the financial system, combined with the large losses suffered by financial firms, led to a severe cycle of deleveraging and a credit crunch for the economy as a whole. Firms found it difficult to borrow, even for short -term operations; individuals found home loans unavailable and credit card f i g u r e 26.2 The TED Spread The TED spread is the difference between the interest rate at which banks lend to each other and the interest rate on U.S. government debt. It’s widely used as a measure of financial stress. The TED spread soared as a result of the financial crisis that started in 2007. Source: British Bankers’ Association; Federal Reserve Bank of St. Louis. TED spread (percentage points) 5 4 3 2 1 2006 2007 2008 2009 Year 259 Like FDR, Barack Obama, shown here with his team of economic advisers, was faced with a major financial crisis upon taking office. limits reduced. Overall, the negative economic effect of the financial crisis bore a distinct and troubling resemblance to the effects of the banking crisis of the early 1930s, which helped cause the Great Depression. Policy makers noticed the resemblance and tried to prevent a repeat performance. Beginning in August 2007, the Federal Reserve engaged in a series of efforts to provide cash to the financial system, lending funds to a widening range of institutions and buying private-sector debt. The Fed and the Treasury Department also stepped in to rescue individual firms that were deemed too crucial to be allowed to fail, such as the investment bank Bear Stearns and
the insurance company AIG. In September 2008, however, policy makers decided that one major investment bank, Lehman Brothers, could be allowed to fail. They quickly regretted the decision. Within days of Lehman’s failure, widespread panic gripped the financial markets, as illustrated by the late surge in the TED spread shown in Figure 26.2. In response to the intensified crisis, the U.S. government intervened further to support the financial system, as the U.S. Treasury began “injecting” capital into banks. Injecting capital, in practice, meant that the U.S. government would supply cash to banks in return for shares—in effect, partially nationalizing the financial system. This new rescue plan was still in its early stages when this book went to press, and it was too early to judge its success. It is widely expected that the crisis of 2008 will lead to major changes in the financial system, probably the largest changes since the 1930s. Historically, it was considered enough to insure deposits and regulate commercial banks. The 2008 crisis raised new questions about the appropriate scope of safety nets and regulations. Like the crises preceding it, the financial crisis of 2008 exerted a powerful negative effect on the rest of the economy. M o d u l e 26 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. What are the similarities between the Panic of 1907, the S&L crisis, and the crisis of 2008? 2. Why did the creation of the Federal Reserve fail to prevent the bank runs of the Great Depression? What measures did stop the bank runs? Tackle the Test: Multiple-Choice Questions 3. Describe the balance sheet effect. Describe the vicious cycle of de leveraging. Why is it necessary for the government to step in to halt a vicious cycle of de leveraging? 1. Which of the following contributed to the creation of the 2. Which of the following is a part of both the Federal Reserve Federal Reserve System? I. the bank panic of 1907 II. the Great Depression III. the savings and loan crisis of the 1980s a. I only b. II only c. III only d. I and II only I, II, and III e. 260 System and the federal government? a. the Federal Reserve Board of Governors b. the 12 regional Federal Reserve Banks c. the Reconstruction Finance Corporation d. commercial banks e. the Treasury Department c. the Federal Open Market Committee d. the Board of Governors
of the Federal Reserve System e. the Reconstruction Finance Corporation 5. Which of the following contributed to the financial crisis of 2008? a. subprime lending b. securitization c. deleveraging d. low interest rates leading to a housing boom e. all of the above. a. What does the Board of Governors of the Federal Reserve System do? b. How many members serve on the group? c. Who appoints members? d. How long do members serve? e. Why do they serve a term of this length? f. How long does the chair serve? 3. Which of the following is NOT a role of the Federal Reserve System? a. controlling bank reserves b. printing currency (Federal Reserve notes) c. carrying out monetary policy d. supervising and regulating banks e. holding reserves for commercial banks 4. Who oversees the Federal Reserve System? a. the presidents of the Regional Federal Reserve Banks b. the president of the United States Tackle the Test: Free-Response Questions 1. a. What group determines monetary policy? b. How many members serve in this group? c. Who always serves in this group? d. Who sometimes serves in this group? Explain. Answer (5 points) 1 point: The Federal Open Market Committee (FOMC) 1 point: 12 1 point: Members of the Board of Governors and the New York Federal Reserve bank president 1 point: 4 of the other 11 Federal Reserve bank presidents 1 point: The 11 other Federal Reserve bank presidents rotate their service on the FOMC 261 What you will learn in this Module: • The functions of the Federal Reserve System • The major tools the Federal Reserve uses to serve its functions Module 27 The Federal Reserve: Monetary Policy The Federal Reserve System In the previous module, we learned that the Federal Reserve System serves as the central bank of the United States. It has two parts: the Board of Governors, which is part of the U.S. government, and the 12 regional Federal Reserve Banks, which are privately owned. But what are the functions of the Federal Reserve System, and how does it serve them? The Functions of the Federal Reserve System Today, the Federal Reserve’s functions fall into four basic categories: providing financial services to depository institutions, supervising and regulating banks and other financial institutions, maintaining the stability of the financial system, and conducting monetary policy. Let’s look at each in turn. Provide Financial Services The 12 regional Federal Reserve Banks provide financial services to depository institutions such as banks
and other large institutions, including the U.S. government. The Federal Reserve is sometimes referred to as the “banker’s bank” because it holds reserves, clears checks, provides cash, and transfers funds for commercial banks—all services that banks provide for their customers. The Federal Reserve also acts as the banker and fiscal agent for the federal government. The U.S. Treasury has its checking account with the Federal Reserve, so when the federal government writes a check, it is written on an account at the Fed. Supervise and Regulate Banking Institutions The Federal Reserve System is charged with ensuring the safety and soundness of the nation’s banking and financial system. The regional Federal Reserve Banks examine and regulate commercial banks in their district. The Board of Governors also engages in regulation and supervision of financial institutions. 262 Maintain the Stability of the Financial System As we have seen, one of the major reasons the Federal Reserve System was created was to provide the nation with a safe and stable monetary and financial system. The Fed is charged with maintaining the integrity of the financial system. As part of this function, Federal Reserve banks provide liquidity to financial institutions to ensure their safety and soundness. Conduct Monetary Policy One of the Federal Reserve’s most important functions is the conduct of monetary policy. As we will see, the Federal Reserve uses the tools of monetary policy to prevent or address extreme macroeconomic fluctuations in the U.S. economy. The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves. The federal funds rate is the interest rate determined in the federal funds market. The discount rate is the interest rate the Fed charges on loans to banks What the Fed Does How does the Fed go about performing its functions? The Federal Reserve has three main policy tools at its disposal: reserve requirements, the discount rate, and, perhaps most importantly, open -market operations. These tools play a part in how the Fed performs each of its functions as outlined below. The Reserve Requirement In our discussion of bank runs, we noted that the Fed sets a minimum required reserve ratio, currently equal to 10% for checkable bank deposits. Banks that fail to maintain at least the required reserve ratio on average over a two -week period face penalties. What does a bank do if it looks as if it has insufficient reserves to meet the Fed’s reserve requirement? Normally, it borrows additional reserves from other banks via the federal funds market, a financial market that allows banks
that fall short of the reserve requirement to borrow reserves (usually just overnight) from banks that are holding excess reserves. The interest rate in this market is determined by supply and demand but the supply and demand for bank reserves are both strongly affected by Federal Reserve actions. Later we will see how the federal funds rate, the interest rate at which funds are borrowed and lent in the federal funds market, plays a key role in modern monetary policy. In order to alter the money supply, the Fed can change reserve requirements. If the Fed reduces the required reserve ratio, banks will lend a larger percentage of their deposits, leading to more loans and an increase in the money supply via the money multiplier. Alternatively, if the Fed increases the required reserve ratio, banks are forced to reduce their lending, leading to a fall in the money supply via the money multiplier. Under current practice, however, the Fed doesn’t use changes in reserve requirements to actively manage the money supply. The last significant change in reserve requirements was in 1992. The Discount Rate Banks in need of reserves can also borrow from the Fed itself via the discount window. The discount rate is the interest rate the Fed charges on those loans. Normally, the discount rate is set 1 percentage point above the federal funds rate in order to discourage banks from turning to the Fed when they are in need of reserves. In order to alter the money supply, the Fed can change the discount rate. Beginning in the fall of 2007, the Fed reduced the spread between the federal funds rate and the discount rate as part of its response to an ongoing financial crisis, described later in this module. As a result, by the spring of 2008 the discount rate was only 0.25 percentage points above the federal funds rate. If the Fed reduces the spread between the discount rate and the federal funds rate, the cost to banks of being short of reserves falls; banks respond by increasing their trader works on the floor of the New York Stock Exchange as the Federal Reserve announces that it will be keeping its key interest rate near zero 263 An open -market operation is a purchase or sale of government debt by the Fed. lending, and the money supply increases via the money multiplier. If the Fed increases the spread between the discount rate and the federal funds rate, bank lending falls— and so will the money supply via the money multiplier. The Fed normally doesn’t use the discount rate to actively manage the money supply. Although, as we mentioned earlier, there was a temporary surge in lending through the discount window in 2007 in response to
a financial crisis. Today, normal monetary policy is conducted almost exclusively using the Fed’s third policy tool: open -market operations. Open-Market Operations Like the banks it oversees, the Federal Reserve has assets and liabilities. The Fed’s assets consist of its holdings of debt issued by the U.S. government, mainly short -term U.S. government bonds with a maturity of less than one year, known as U.S. Treasury bills. Remember, the Fed isn’t exactly part of the U.S. government, so U.S. Treasury bills held by the Fed are a liability of the government but an asset of the Fed. The Fed’s liabilities consist of currency in circulation and bank reserves. Figure 27.1 summarizes the normal assets and liabilities of the Fed in the form of a T-account. f i g u r e 27.1 The Federal Reserve’s Assets and Liabilities The Federal Reserve holds its assets mostly in short -term government bonds called U.S. Treasury bills. Its liabilities are the monetary base— currency in circulation plus bank reserves. Assets Liabilities Government debt (Treasury bills) Monetary base (Currency in circulation + bank reserves) In an open -market operation the Federal Reserve buys or sells U.S. Treasury bills, normally through a transaction with commercial banks—banks that mainly make business loans, as opposed to home loans. The Fed never buys U.S. Treasury bills directly from the federal government. There’s a good reason for this: when a central bank buys government debt directly from the government, it is lending directly to the government—in effect, the central bank is issuing “printing money” to finance the government’s budget deficit. As we’ll see later in the book, this has historically been a formula for disastrous levels of inflation. The two panels of Figure 27.2 show the changes in the financial position of both the Fed and commercial banks that result from open -market operations. When the Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s reserve account by an amount equal to the value of the Treasury bills. This is illustrated in panel (a): the Fed buys $100 million of U.S. Treasury bills from commercial banks, which increases the monetary base by $100 million because it increases bank reserves by $100 million. When the Fed sells U.S. Treasury bills to commercial banks,
it debits the banks’ accounts, reducing their reserves. This is shown in panel (b), where the Fed sells $100 million of U.S. Treasury bills. Here, bank reserves and the monetary base decrease. You might wonder where the Fed gets the funds to purchase U.S. Treasury bills from banks. The answer is that it simply creates them with a stroke of the pen—or, these days, a click of the mouse—that credits the banks’ accounts with extra reserves. (The Fed issues currency to pay for Treasury bills only when banks want the additional reserves in the form of currency.) Remember, the modern dollar is fiat money, which isn’t backed by anything. So the Fed can create additional monetary base at its own discretion. 264 27.2 Open-Market Operations by the Federal Reserve (a) An Open-Market Purchase of $100 Million (b) An Open-Market Sale of $100 Million Assets Liabilities Assets Liabilities Federal Reserve Treasury bills +$100 million Monetary base +$100 million Federal Reserve Treasury bills –$100 million Monetary base –$100 million Assets Liabilities Assets Liabilities Commercial banks Treasury bills –$100 million No change Commercial banks Treasury bills +$100 million No change Reserves +$100 million Reserves –$100 million In panel (a), the Federal Reserve increases the monetary base by purchasing U.S. Treasury bills from private commercial banks in an open-market operation. Here, a $100 million purchase of U.S. Treasury bills by the Federal Reserve is paid for by a $100 million increase in the monetary base. This will ultimately lead to an increase in the money supply via the money multiplier as banks lend out some of these new reserves. In panel (b), the Federal Reserve re- duces the monetary base by selling U.S. Treasury bills to private commercial banks in an open-market operation. Here, a $100 million sale of U.S. Treasury bills leads to a $100 million reduction in commercial bank reserves, resulting in a $100 million decrease in the monetary base. This will ultimately lead to a fall in the money supply via the money multiplier as banks reduce their loans in response to a fall in their reserves. The change in bank reserves caused by an open -market operation doesn’t directly affect the money supply. Instead, it starts the money multiplier in motion. After the $100 million increase in reserves shown in panel (a), commercial banks would lend out their additional reserves, immediately increasing
the money supply by $100 million. Some of those loans would be deposited back into the banking system, increasing reserves fyi Who Gets the Interest on the Fed’s Assets? As we’ve just learned, the Fed owns a lot of assets—Treasury bills—which it bought from commercial banks in exchange for the monetary base in the form of credits to banks’ reserve accounts. These assets pay interest. Yet the Fed’s liabilities consist mainly of the monetary base, liabilities on which the Fed doesn’t pay interest. So the Fed is, in effect, an institution that has the privilege of borrowing funds at a zero interest rate and lending them out at a positive interest rate. That sounds like a pretty profitable business. Who gets the profits? its operations but turns most of it over to the U.S. Treasury. For example, in 2009 the Federal Reserve System received $52.1 billion in income— largely in interest on its holdings of Treasury bills, of which $46.1 billion was returned to the Treasury. We can now finish the story of the impact of those forged $100 bills allegedly printed in North Korea. When a fake $100 bill enters circulation, it has the same economic effect as a real $100 bill printed by the U.S. government. That is, as long as nobody catches the forgery, the fake bill serves, for all practical purposes, as part of the monetary base. Meanwhile, the Fed decides on You do—or rather, U.S. taxpayers do. The Fed keeps some of the interest it receives to finance the size of the monetary base based on economic considerations—in particular, the Fed doesn’t let the monetary base get too large because that can cause inflation. So every fake $100 bill that enters circulation basically means that the Fed prints one less real $100 bill. When the Fed prints a $100 bill legally, however, it gets Treasury bills in return—and the interest on those bills helps pay for the U.S. government’s expenses. So a counterfeit $100 bill reduces the amount of Treasury bills the Fed can acquire and thereby reduces the interest payments going to the Fed and the U.S. Treasury. So taxpayers bear the real cost of counterfeiting 265 again and permitting a further round of loans, and so on, leading to a rise in the money supply. An open -market sale has the reverse effect: bank reserves fall, requiring banks to reduce their loans, leading to a fall in the
money supply. Economists often say, loosely, that the Fed controls the money supply—checkable deposits plus currency in circulation. In fact, it controls only the monetary base— bank reserves plus currency in circulation. But by increasing or reducing the monetary base, the Fed can exert a powerful influence on both the money supply and interest rates. This influence is the basis of monetary policy, discussed in detail in Modules 28 and 29. M o d u l e 2 7 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Assume that any money lent by a bank is deposited back in the banking system as a checkable deposit and that the reserve ratio is 10%. Trace out the effects of a $100 million open -market purchase of U.S. Treasury bills by the Fed on the value of checkable bank deposits. What is the size of the money multiplier? Tackle the Test: Multiple-Choice Questions 1. Which of the following is a function of the Federal Reserve 3. When the Fed makes a loan to a commercial bank, it charges a. no interest. b. the prime rate. c. the federal funds rate. d. the discount rate. e. the market interest rate. 4. If the Fed purchases U.S. Treasury bills from a commercial Bank reserves bank, what happens to bank reserves and the money supply? Money supply decrease increase decrease increase no change a. increase b. increase c. decrease d. decrease increase e. 5. When banks make loans to each other, they charge the a. prime rate. b. discount rate. c. d. CD rate. e. mortgage rate. federal funds rate. System? I. examine commercial banks II. print Federal Reserve notes III. conduct monetary policy a. I only b. II only c. III only d. I and III only I, II, and III e. 2. Which of the following financial services does the Federal Reserve provide for commercial banks? I. clearing checks II. holding reserves III. making loans a. I only b. II only c. III only d. I and II e. I, II, and III 266 Tackle the Test: Free-Response Questions 1. a. What are the three major tools of the Federal Reserve 2. What are the four basic functions of the Federal Reserve System? System and what part of the system is responsible for each? b. What would the Fed do with each tool to increase the money supply? Explain for each.
Answer (9 points) 1 point: The discount rate 1 point: The reserve requirement 1 point: Open-market operations 1 point: Decrease the discount rate 1 point: A lower discount rate makes it cheaper to borrow from the Fed so the money supply increases. 1 point: Decrease the reserve requirement 1 point: A lower reserve requirement allows banks to loan more, increasing the money supply. 1 point: Buy U.S. Treasury bills 1 point: When the Fed buys U.S. Treasury bills, banks’ excess reserves increase. When lent out, these excess reserves increase the money supply with the assistance of the money multiplier 267 What you will learn in this Module: • What the money demand curve is • Why the liquidity preference model determines the interest rate in the short run Module 28 The Money Market The Demand for Money Remember that M1, the most commonly used definition of the money supply, consists of currency in circulation (cash), plus checkable bank deposits, plus traveler’s checks. M2, a broader definition of the money supply, consists of M1 plus deposits that can easily be transferred into checkable deposits. We also learned why people hold money— to make it easier to purchase goods and services. Now we’ll go deeper, examining what determines how much money individuals and firms want to hold at any given time. The Opportunity Cost of Holding Money Most economic decisions involve trade -offs at the margin. That is, individuals decide how much of a good to consume by determining whether the benefit they’d gain from consuming a bit more of any given good is worth the cost. The same decision process is used when deciding how much money to hold. Individuals and firms find it useful to hold some of their assets in the form of money because of the convenience money provides: money can be used to make purchases directly, while other assets can’t. But there is a price to be paid (an opportunity cost) for that convenience: money held in your wallet earns no interest. As an example of how convenience makes it worth incurring some opportunity costs, consider the fact that even today—with the prevalence of credit cards, debit cards, and ATMs—people continue to keep cash in their wallets rather than leave the funds in an interest -bearing account. They do this because they don’t want to have to go to an ATM to withdraw money every time they want to make a small purchase. In other words, the convenience of keeping some cash in your wallet is more valuable than
the interest you would earn by keeping that money in the bank. Even holding money in a checking account involves a trade-off between convenience and earning interest. That’s because you can earn a higher interest rate by putting your money in assets other than a checking account. For example, many banks offer certificates of deposit, or CDs, which pay a higher interest rate than ordinary bank accounts. But CDs also carry a penalty if you withdraw the funds before a certain amount of time—say, six months—has elapsed. An individual who keeps funds in a checking account is forgoing the higher interest rate those funds would have earned if placed in a CD in return for the convenience of having cash readily available when needed. 268 Table 28.1 illustrates the opportunity cost of holding money in a specific month, June 2007. The first row shows the interest rate on one -month certificates of deposit—that is, the interest rate individuals could get if they were willing to tie their funds up for one month. In June 2007, one -month CDs yielded 5.30%. The second row shows the interest rate on interest -bearing bank accounts (specifically, those included in M1). Funds in these accounts were more accessible than those in CDs, but the price of that convenience was a much lower interest rate, only 2.478%. Finally, the last row shows the interest rate on currency—cash in your wallet—which was, of course, zero. t a b l e 28.1 Selected Interest Rates, June 2007 One - month CDs Interest - bearing demand deposits Currency Source: Federal Reserve Bank of St. Louis. 5.30% 2.478 Table 28.1 shows the opportunity cost of holding money at one point in time, but the opportunity cost of holding money changes when the overall level of interest rates changes. Specifically, when the overall level of interest rates falls, the opportunity cost of holding money falls, too. Table 28.2 illustrates this point by showing how selected interest rates changed between June 2007 and June 2008, a period when the Federal Reserve was slashing rates in an effort to fight off recession. Between June 2007 and June 2008, the federal funds rate, which is the rate the Fed controls most directly, fell by 3.25 percentage points. The interest rate on one -month CDs fell almost as much, 2.8 percentage points. That’s not an accident: all short -term interest rates—rates on financial assets that come due, or mature, within less than a year—tend to move
together, with rare exceptions. The reason short -term interest rates tend to move together is that CDs and other short -term assets (like one-month and three-month U.S. Treasury bills) are in effect competing for the same business. Any short -term asset that offers a lower -than -average interest rate will be sold by investors, who will move their wealth into a higher -yielding short -term asset. The selling of the asset, in turn, forces its interest rate up because investors must be rewarded with a higher rate in order to induce them to buy it. Conversely, investors will move their wealth into any short -term financial asset that offers an above -average interest rate. The purchase of the asset drives its interest rate down when sellers find they can lower the rate of return on the asset and still find willing buyers. So interest rates on short -term financial assets tend to be roughly the same because no asset will consistently offer a higher -than average or a lower -than -average interest rate. But as short -term interest rates fell between June 2007 and June 2008, the interest rates on money didn’t fall by the same amount. The interest rate on currency, of course, remained at zero. The interest rate paid on demand deposits did fall, but by much less than short -term interest rates. As a result, the opportunity cost of holding money fell. The last two rows of Table 28.2 show the differences between the interest t a b l e 28.2 Interest Rates and the Opportunity Cost of Holding Money Federal funds rate One - month certificates of deposit (CD) Interest-bearing demand deposits Currency CDs minus interest - bearing demand deposits CDs minus currency Source: Federal Reserve Bank of St. Louis. June 2007 June 2008 5.25% 5.30 2.773 0 2.527 5.30 2.00% 2.50 1.353 0 1.147 2.50 Short -term interest rates are the interest rates on financial assets that mature within less than a year 269 fyi Long-term Interest Rates Long -term interest rates—rates on bonds or loans that mature in several years—don’t necessarily move with short -term interest rates. How is that possible? Consider the case of Millie, who has already decided to place $1,000 in CDs for the next two years. However, she hasn’t decided whether to put the money in a one -year CD, at a 4% rate of interest, or a two
-year CD, at a 5% rate of interest. You might think that the two -year CD is a clearly better deal—but it may not be. Suppose that Millie expects the rate of interest on one - year CDs to rise sharply next year. If she puts her funds in a one -year CD this year, she will be able to reinvest the money at a much higher rate next year. And this could give her a two year rate of return that is higher than if she put her funds into the two -year CD. For example, if the rate of interest on one -year CDs rises from 4% this year to 8% next year, putting her funds in a one -year CD will give her an annual rate of return over the next two years of about 6%, better than the 5% rate on two -year CDs. The same considerations apply to investors deciding between short -term and long -term bonds. If they expect short -term interest rates to rise, investors may buy short -term bonds even if long -term bonds offer a higher interest rate. If they expect short -term interest rates to fall, investors may buy long -term bonds even if short -term bonds offer a higher interest rate. In practice, long -term interest rates reflect the average expectation in the market about what’s going to happen to short -term rates in the future. When long -term rates are higher than short -term rates, as they were in 2008, the market is signaling that it expects short -term rates to rise in the future. Long -term interest rates are interest rates on financial assets that mature a number of years in the future. The money demand curve shows the relationship between the quantity of money demanded and the interest rate. rates on demand deposits and currency and the interest rate on CDs. These differences declined sharply between June 2007 and June 2008. This reflects a general result: the higher the short -term interest rate, the higher the opportunity cost of holding money; the lower the short -term interest rate, the lower the opportunity cost of holding money. Table 28.2 contains only short -term interest rates. At any given moment, long term interest rates—interest rates on financial assets that mature, or come due, a number of years into the future—may be different from short -term interest rates. The difference between short -term and long -term interest rates is sometimes important as a practical matter. Moreover, it’s short -term rates rather than long -term rates
that affect money demand, because the decision to hold money involves trading off the convenience of holding cash versus the payoff from holding assets that mature in the short -term—a year or less. For our current purposes, however, it’s useful to ignore the distinction between short -term and long -term rates and assume that there is only one interest rate. The Money Demand Curve Because the overall level of interest rates affects the opportunity cost of holding money, the quantity of money individuals and firms want to hold is, other things equal, negatively related to the interest rate. In Figure 28.1, the horizontal axis shows the quantity of money demanded and the vertical axis shows the nominal interest rate, r, which you can think of as a representative short -term interest rate such as the rate on one -month CDs. Why do we place the nominal interest rate and not the real interest rate on the vertical axis? Because the opportunity cost of holding money includes both the real return that could be earned on a bank deposit and the erosion in purchasing power caused by inflation. The nominal interest rate includes both the forgone real return and the expected loss due to inflation. Hence, r in Figure 28.1 and all subsequent figures is the nominal interest rate. The relationship between the interest rate and the quantity of money demanded by the public is illustrated by the money demand curve, MD, in Figure 28.1. The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money, leading the public to reduce the quantity of money it demands. For example, if the interest rate is very low—say, 1%—the 270 28.1 The Money Demand Curve The money demand curve illustrates the relationship between the interest rate and the quantity of money demanded. It slopes downward: a higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. Interest rate Money demand curve, MD Quantity of money interest forgone by holding money is relatively small. As a result, individuals and firms will tend to hold relatively large amounts of money to avoid the cost and nuisance of converting other assets into money when making purchases. By contrast, if the interest rate is relatively high—say, 15%, a level it reached in the United States in the early 1980s—the opportunity cost of holding money is high. People will respond by keeping only small amounts in cash and deposits, converting assets into money only when needed. You might ask why we draw the money demand curve with the interest rate
—as opposed to rates of return on other assets, such as stocks or real estate—on the vertical axis. The answer is that for most people the relevant question in deciding how much money to hold is whether to put the funds in the form of other assets that can be turned fairly quickly and easily into money. Stocks don’t fit that definition because there are significant broker’s fees when you sell stock (which is why stock market investors are advised not to buy and sell too often); selling real estate involves even larger fees and can take a long time as well. So the relevant comparison is with assets that are “close to” money—fairly liquid assets like CDs. And as we’ve already seen, the interest rates on all these assets normally move closely together. Shifts of the Money Demand Curve Like the demand curve for an ordinary good, the money demand curve can be shifted by a number of factors. Figure 28.2 on the next page shows shifts of the money demand curve: an increase in the demand for money corresponds to a rightward shift of the MD curve, raising the quantity of money demanded at any given interest rate; a fall in the demand for money corresponds to a leftward shift of the MD curve, reducing the quantity of money demanded at any given interest rate. The most important factors causing the money demand curve to shift are changes in the aggregate price level, changes in real GDP, changes in banking technology, and changes in banking institutions. Changes in the Aggregate Price Level Americans keep a lot more cash in their wallets and funds in their checking accounts today than they did in the 1950s. One reason is that they have to if they want to be able to buy anything: almost everything costs more now than it did when you could get a burger, fries, and a drink at McDonald’s for 271 f i g u r e 28.2 Increases and Decreases in the Demand for Money A rise in money demand shifts the money demand curve to the right, from MD1 to MD2, and the quantity of money demanded rises at any given interest rate. A fall in money demand shifts the money demand curve to the left, from MD1 to MD3, and the quantity of money demanded falls at any given interest rate. Interest rate, r A fall in money demand shifts the money demand curve to the left. r1 A rise in money demand shifts the money demand curve to the right. MD3 MD1 MD2 M3 M1 M2
Quantity of money 45 cents and a gallon of gasoline for 29 cents. So higher prices increase the demand for money (a rightward shift of the MD curve), and lower prices reduce the demand for money (a leftward shift of the MD curve). We can actually be more specific than this: other things equal, the demand for money is proportional to the price level. That is, if the aggregate price level rises by 20%, the quantity of money demanded at any given interest rate, such as r1 in Figure 28.2, also rises by 20%—the movement from M1 to M2. Why? Because if the price of everything rises by 20%, it takes 20% more money to buy the same basket of goods and services. And if the aggregate price level falls by 20%, at any given interest rate the quantity of money demanded falls by 20%—shown by the movement from M1 to M3 at the interest rate r1. As we’ll see later, the fact that money demand is proportional to the price level has important implications for the long -run effects of monetary policy. Changes in Real GDP Households and firms hold money as a way to facilitate purchases of goods and services. The larger the quantity of goods and services they buy, the larger the quantity of money they will want to hold at any given interest rate. So an increase in real GDP—the total quantity of goods and services produced and sold in the economy—shifts the money demand curve rightward. A fall in real GDP shifts the money demand curve leftward. Changes in Technology There was a time, not so long ago, when withdrawing cash from a bank account required a visit during the bank’s hours of operation. And since most people tried to do their banking during lunch hour, they often found themselves standing in line. So people limited the number of times they needed to withdraw funds by keeping substantial amounts of cash on hand. Not surprisingly, this tendency diminished greatly with the advent of ATMs in the 1970s. As a result, the demand for money fell and the money demand curve shifted leftward. These events illustrate how changes in technology can affect the demand for money. In general, advances in information technology have tended to reduce the demand for money by making it easier for the public to make purchases without re-creation of a McDonald’s in the 1950s at the Ford Museum in Detroit, Michigan 272 holding significant sums of money. ATMs are only one example of how changes in technology have altered the demand for
money. The ability of stores to process credit card and debit card transactions via the Internet has widened their acceptance and similarly reduced the demand for cash. Changes in Institutions Changes in institutions can increase or decrease the demand for money. For example, until Regulation Q was eliminated in 1980, U.S. banks weren’t allowed to offer interest on checking accounts. So the interest you would forgo by holding funds in a checking account instead of an interest -bearing asset made the opportunity cost of holding funds in checking accounts very high. When banking regulations changed, allowing banks to pay interest on checking account funds, the demand for money rose and shifted the money demand curve to the right Money and Interest Rates The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 21⁄4 percent. Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters. So read the beginning of a press release from the Federal Reserve issued on March 18, 2008. (A basis point is equal to 0.01 percentage point. So the statement implies that the Fed lowered the target from 3% to 2.25%.) The federal funds rate is the rate at which banks lend reserves to each other to meet the required reserve ratio. As the statement implies, at each of its eight -times -a -year meetings, the Federal Open Market Committee sets a target value for the federal funds rate. It’s then up to Fed officials to achieve that target. This is done by the Open Market Desk at the Federal Reserve Bank of New York, which buys and sells short -term U.S. government debt, known as Treasury bills, to achieve that target. As we’ve already seen, other short -term interest rates, such as the rates on CDs, move with the federal funds rate. So when the Fed reduced its target for the federal funds rate from 3% to 2.25% in March 2008, many other short -term interest rates also fell by about three -quarters of a percentage point. How does the Fed go about achieving a target federal funds rate? And more to the point, how is the Fed able to affect interest rates at all? The Equilibrium Interest Rate Recall that, for simplicity, we’ve assumed that there is only one interest rate
paid on nonmonetary financial assets, both in the short run and in the long run. To understand how the interest rate is determined, consider Figure 28.3 on the next page, which illustrates the liquidity preference model of the interest rate; this model says that the interest rate is determined by the supply and demand for money in the market for money. Figure 28.3 combines the money demand curve, MD, with the money supply curve, MS, which shows how the quantity of money supplied by the Federal Reserve varies with the interest rate. The Federal Reserve can increase or decrease the money supply: it usually does this through open-market operations, buying or selling Treasury bills, but it can also lend via the discount window or change reserve requirements. Let’s assume for simplicity that the According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money. The money supply curve shows how the quantity of money supplied varies with the interest rate 273 f i g u r e 28.3 Equilibrium in the Money Market The money supply curve, MS, is vertical at the –– money supply chosen by the Federal Reserve, M. The money market is in equilibrium at the interest rate rE: the quantity of money demanded by the –– public is equal to M, the quantity of money supplied. At a point such as L, the interest rate, rL, is below rE and the corresponding quantity of money –– demanded, ML, exceeds the money supply, M. In an attempt to shift their wealth out of nonmoney interest -bearing financial assets and raise their money holdings, investors drive the interest rate up to rE. At a point such as H, the interest rate rH is above rE and the corresponding quantity of money –– demanded, MH, is less than the money supply, M. In an attempt to shift out of money holdings into nonmoney interest -bearing financial assets, investors drive the interest rate down to rE. Interest rate, r rH rE rL Equilibrium interest rate Money supply curve, MS H Equilibrium E MH M Money supply chosen by the Fed MD L ML Quantity of money Fed, using one or more of these methods, simply chooses the level of the money supply that it believes will achieve its interest rate target. Then the money supply curve is a vertical line, MS in Figure 28.3, with a horizontal intercept corresponding to the money. The money market equilibrium is at E, where MS and MD supply chosen
by the Fed, M cross. At this point the quantity of money demanded equals the money supply, M, leading to an equilibrium interest rate of rE. To understand why rE is the equilibrium interest rate, consider what happens if the money market is at a point like L, where the interest rate, rL, is below rE. At rL the public wants to hold the quantity of money ML, an amount larger than the actual money sup-. This means that at point L, the public wants to shift some of its wealth out of inply, M terest -bearing assets such as high-denomination CDs (which aren’t money) into money. This has two implications. One is that the quantity of money demanded is more than the quantity of money supplied. The other is that the quantity of interest -bearing nonmoney assets demanded is less than the quantity supplied. So those trying to sell nonmoney assets will find that they have to offer a higher interest rate to attract buyers. As a result, the interest rate will be driven up from rL until the public wants to hold the quantity of money that is actually available, M. That is, the interest rate will rise until it is equal to rE. Now consider what happens if the money market is at a point such as H in Figure 28.3, where the interest rate rH is above rE. In that case the quantity of money de- manded, MH, is less than the quantity of money supplied, M. Correspondingly, the quantity of interest -bearing nonmoney assets demanded is greater than the quantity supplied. Those trying to sell interest -bearing nonmoney assets will find that they can offer a lower interest rate and still find willing buyers. This leads to a fall in the interest rate from rH. It falls until the public wants to hold the quantity of money that is actu- ally available, M. Again, the interest rate will end up at rE. Two Models of the Interest Rate Here we have developed what is known as the liquidity preference model of the interest rate. In this model, the equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied. This model is different from, 274 but consistent with, another model known as the loanable funds model of the interest rates, which is developed in the next module. In the loanable funds model, we will see that the interest rate matches the quantity of loanable funds supplied by savers with the quantity
of loanable funds demanded for investment spending. M o d u l e 2 8 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Explain how each of the following would affect the quantity of money demanded, and indicate whether each change would cause a movement along the money demand curve or a shift of the money demand curve. a. Short -term interest rates rise from 5% to 30%. b. All prices fall by 10%. c. New wireless technology automatically charges supermarket purchases to credit cards, eliminating the need to stop at the cash register. d. In order to avoid paying taxes, a vast underground economy develops in which workers are paid their wages in cash rather than with checks. Tackle the Test: Multiple-Choice Questions 2. How will each of the following affect the opportunity cost or benefit of holding cash? Explain. a. Merchants charge a 1% fee on debit/credit card transactions for purchases of less than $50. b. To attract more deposits, banks raise the interest paid on six-month CDs. c. Real estate prices fall significantly. d. The cost of food rises significantly. 1. A change in which of the following will shift the money 4. Which of the following is true regarding short-term and demand curve? I. the aggregate price level II. real GDP III. the interest rate a. I only b. II only c. III only d. I and II only I, II, and III e. 2. Which of the following will decrease the demand for money? inflation a. an increase in the interest rate b. c. an increase in real GDP d. an increase in the availability of ATMs e. the adoption of Regulation Q 3. What will happen to the money supply and the equilibrium interest rate if the Federal Reserve sells Treasury securities? Money supply a. increase b. decrease c. increase d. decrease e. decrease increase increase decrease decrease no change Equilibrium interest rate long-term interest rates? a. Short-term interest rates are always above long-term interest rates. b. Short-term interest rates are always below long-term interest rates. c. Short-term interest rates are always equal to long-term interest rates. d. Short-term interest rates are more important for determining the demand for money. e. Long-term interest rates are more important for determining the demand for money. 5. The quantity of money demanded rises (that is, there is a movement along the money demand curve)
when a. the aggregate price level increases. b. the aggregate price level falls. c. real GDP increases. d. new technology makes banking easier. e. short-term interest rates fall 275 Tackle the Test: Free-Response Questions 1. Draw three correctly labeled graphs of the money market. 1 point: c. Money demand shifts left. Interest rate, r MS MD2 MD1 Quantity of money 2. Draw a correctly labeled graph showing equilibrium in the money market. Select an interest rate below the equilibrium interest rate and explain what occurs in the market at that interest rate and how the market will eventually return to equilibrium. Show the effect of each of the following three changes on a separate graph. a. The aggregate price level increases. b. Real GDP falls. c. There is a dramatic increase in online banking. Answer (6 points) 1 point: The vertical axis is labeled “Interest rate” or “r” and the horizontal axis is labeled “Quantity of money.” 1 point: Money supply is vertical and labeled. 1 point: Money demand is negatively sloped and labeled. 1 point: a. Money demand shifts right. Interest rate, r 1 point: b. Money demand shifts left. Interest rate, r MS MS MD1 MD2 Quantity of money MD2 MD1 Quantity of money 276 Module 29 The Market for Loanable Funds The Market for Loanable Funds Recall that, for the economy as a whole, savings always equals investment spending. In a closed economy, savings is equal to national savings. In an open economy, savings is equal to national savings plus capital inflow. At any given time, however, savers, the people with funds to lend, are usually not the same as borrowers, the people who want to borrow to finance their investment spending. How are savers and borrowers brought together? Savers and borrowers are matched up with one another in much the same way producers and consumers are matched up: through markets governed by supply and demand. In the circular -flow diagram, we noted that the financial markets channel the savings of households to businesses that want to borrow in order to purchase capital equipment. It’s now time to take a look at how those financial markets work. The Equilibrium Interest Rate There are a large number of different financial markets in the financial system, such as the bond market and the stock market. However, economists often work with a simplified model in which they assume that there is just one market that brings together those who want to lend money
(savers) and those who want to borrow (firms with investment spending projects). This hypothetical market is known as the loanable funds market. The price that is determined in the loanable funds market is the interest rate, denoted by r. It is the return a lender receives for allowing borrowers the use of a dollar for one year, calculated as a percentage of the amount borrowed. Recall that in the money market, the nominal interest rate is of central importance and always serves as the “price” measured on the vertical axis. The interest rate in the loanable funds market can be measured in either real or nominal terms—with or without the inclusion of expected inflation that makes nominal rates differ from real rates. Investors and savers care about the real interest rate, which tells them the price paid for the use of money aside from the amount paid to keep up with inflation. However, in the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal, so actual loan contracts specify a nominal interest rate rather than a real interest rate. For this reason, and because it facilitates comparisons between What you will learn in this Module: • How the loanable funds market matches savers and investors • The determinants of supply and demand in the loanable funds market • How the two models of interest rates can be reconciled The loanable funds market is a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders 277 The rate of return on a project is the profit earned on the project expressed as a percentage of its cost. the money market and the loanable funds market, the figures in this section are drawn with the vertical axis measuring the nominal interest rate for a given expected future inflation rate. As long as the expected inflation rate is unchanged, changes in the nominal interest rate also lead to changes in the real interest rate. We take up the influence of inflation later in this module. We should also note at this point that there are, in reality, many different kinds of nominal interest rates because there are many different kinds of loans—short -term loans, long -term loans, loans made to corporate borrowers, loans made to governments, and so on. In the interest of simplicity, we’ll ignore those differences and assume that there is only one type of loan. Figure 29.1 illustrates the hypothetical demand for loanable funds. On the horizontal axis we show the quantity of loanable funds demanded. On the vertical axis we
show the interest rate, which is the “price” of borrowing. To see why the demand curve for loanable funds, D, slopes downward, imagine that there are many businesses, each of which has one potential investment project. How does a given business decide whether or not to borrow money to finance its project? The decision depends on the interest rate the business faces and the rate of return on its project—the profit earned on the project expressed as a percentage of its cost. This can be expressed in a formula as: (29-1) Rate of return = Revenue from project–Cost of project Cost of project × 100 A business will want a loan when the rate of return on its project is greater than or equal to the interest rate. So, for example, at an interest rate of 12%, only businesses with projects that yield a rate of return greater than or equal to 12% will want a loan. The demand curve in Figure 29.1 shows that if the interest rate is 12%, businesses will want to borrow $150 billion (point A); if the interest rate is only 4%, businesses will want to borrow a larger amount, $450 billion (point B). That’s a consequence of our assumption that the demand curve slopes downward: the lower the interest rate, the larger the total quantity of loanable funds demanded. Why do we make that assumption? Because, in reality, the number of potential investment projects that yield at least 4% is always greater than the number that yield at least 12%. f i g u r e 29.1 The Demand for Loanable Funds The demand curve for loanable funds slopes downward: the lower the interest rate, the greater the quantity of loanable funds demanded. Here, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion. Interest rate, r 12% A 4 0 B Demand for loanable funds, D $150 450 Quantity of loanable funds (billions of dollars) 278 29.2 The Supply of Loanable Funds The supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. Here, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion. Interest rate, r 12% 4 0 Supply of loanable funds150 450 Quantity of loanable funds (billions of dollars) Figure 29.2 shows the hypothetical supply
of loanable funds. Again, the interest rate plays the same role that the price plays in ordinary supply and demand analysis. Savers incur an opportunity cost when they lend to a business; the funds could instead be spent on consumption—say, a nice vacation. Whether a given individual becomes a lender by making funds available to borrowers depends on the interest rate received in return. By saving your money today and earning interest on it, you are rewarded with higher consumption in the future when your loan is repaid with interest. So it is a good assumption that more people are willing to forgo current consumption and make a loan when the interest rate is higher. As a result, our hypothetical supply curve of loanable funds slopes upward. In Figure 29.2, lenders will supply $150 billion to the loanable funds market at an interest rate of 4% (point X ); if the interest rate rises to 12%, the quantity of loanable funds supplied will rise to $450 billion (point Y ). The equilibrium interest rate is the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. As you can see in Figure 29.3 on the next page, the equilibrium interest rate, rE, and the total quantity of lending, QE, are determined by the intersection of the supply and demand curves, at point E. Here, the equilibrium interest rate is 8%, at which $300 billion is lent and borrowed. Investment spending projects with a rate of return of 8% or more are funded; projects with a rate of return of less than 8% are not. Correspondingly, only lenders who are willing to accept an interest rate of 8% or less will have their offers to lend funds accepted. Figure 29.3 shows how the market for loanable funds matches up desired savings with desired investment spending: in equilibrium, the quantity of funds that savers want to lend is equal to the quantity of funds that firms want to borrow. The figure also shows that this match -up is efficient, in two senses. First, the right investments get made: the investment spending projects that are actually financed have higher rates of return than those that do not get financed. Second, the right people do the saving: the potential savers who actually lend funds are willing to lend for lower interest rates than those who do not. The insight that the loanable funds market leads to an efficient use of savings, although drawn from a highly simplified model, has important implications for real life. As we’ll see shortly,
it is the reason that a well -functioning financial system increases an economy’s long -run economic growth rate 279 f i g u r e 29.3 Equilibrium in the Loanable Funds Market At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here, the equilibrium interest rate is 8%, with $300 billion of funds lent and borrowed. Investment spending projects with a rate of return of 8% or higher receive funding; those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not. Interest rate, r 12% rE 8 4 0 Projects with rate of return 8% or greater are funded. S Offers not accepted from lenders who demand interest rate of more than 8%. Projects with rate of return less than 8% are not funded. D Offers accepted from lenders willing to lend at interest rate of 8% or less. Quantity of loanable funds (billions of dollars) E $300 QE Before we get to that, however, let’s look at how the market for loanable funds re- sponds to shifts of demand and supply. Shifts of the Demand for Loanable Funds The equilibrium interest rate changes when there are shifts of the demand curve for loanable funds, the supply curve for loanable funds, or both. Let’s start by looking at the causes and effects of changes in demand. The factors that can cause the demand curve for loanable funds to shift include the following: ■ Changes in perceived business opportunities: A change in beliefs about the rate of return on investment spending can increase or reduce the amount of desired spending at any given interest rate. For example, during the 1990s there was great excitement over the business possibilities created by the Internet, which had just begun to be widely used. As a result, businesses rushed to buy computer equipment, put fiber -optic cables in the ground, and so on. This shifted the demand for loanable funds to the right. By 2001, the failure of many dot -com businesses led to disillusionment with technology related investment; this shifted the demand for loanable funds back to the left. ■ Changes in the government’s borrowing: Governments that run budget deficits are major sources of the demand for loanable funds. As a result, changes in the budget deficit can shift the demand curve for loanable funds. For example, between
2000 and 2003, as the U.S. federal government went from a budget surplus to a budget deficit, net federal borrowing went from minus $189 billion—that is, in 2000 the federal government was actually providing loanable funds to the market because it was paying off some of its debt—to plus $416 billion because in 2003 the government had to borrow large sums to pay its bills. This change in the federal budget position had the effect, other things equal, of shifting the demand curve for loanable funds to the right. Figure 29.4 shows the effects of an increase in the demand for loanable funds. S is the supply of loanable funds, and D1 is the initial demand curve. The initial equilibrium interest rate is r1. An increase in the demand for loanable funds means that the quantity of funds demanded rises at any given interest rate, so the demand curve shifts rightward to D2. As a result, the equilibrium interest rate rises to r2 280 An increase in the demand for loanable funds... D2 D1 Quantity of loanable funds Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending. f i g u r e 29.4 An Increase in the Demand for Loanable Funds If the quantity of funds demanded by borrowers rises at any given interest rate, the demand for loanable funds shifts rightward from D1 to D2. As a result, the equilibrium interest rate rises from r1 to r2. Interest rate, r... leads to a rise in the equilibrium interest rate. r2 r1 The fact that an increase in the demand for loanable funds leads, other things equal, to a rise in the interest rate has one especially important implication: beyond concern about repayment, there are other reasons to be wary of government budget deficits. As we’ve already seen, an increase in the government’s deficit shifts the demand curve for loanable funds to the right, which leads to a higher interest rate. If the interest rate rises, businesses will cut back on their investment spending. So a rise in the government budget deficit tends to reduce overall investment spending. Economists call the negative effect of government budget deficits on investment spending crowding out. The threat of crowding out is a key source of concern about persistent budget deficits. Shifts of the Supply of Loanable Funds Like the demand for loanable funds, the supply of loanable funds can shift. Among the factors that can cause the supply of loan
able funds to shift are the following: ■ Changes in private savings behavior: A number of factors can cause the level of private savings to change at any given rate of interest. For example, between 2000 and 2006 rising home prices in the United States made many homeowners feel richer, making them willing to spend more and save less. This had the effect of shifting the supply of loanable funds to the left. The drop in home prices between 2006 and 2009 had the opposite effect, shifting the supply of loanable funds to the right. ■ Changes in capital inflows: Capital flows into a country can change as investors’ perceptions of that country change. For example, Argentina experienced large capital inflows during much of the 1990s because international investors believed that economic reforms early in the decade had made it a safe place to put their funds. By the late 1990s, however, there were signs of economic trouble, and investors lost confidence, causing the inflow of funds to dry up. As we’ve already seen, the United States has received large capital inflows in recent years, with much of the money coming from China and the Middle East. Those inflows helped fuel a big increase in residential investment spending— newly constructed homes—from 2003 to 2006. As a result of the worldwide slump, those inflows began to trail off in 2008 281 f i g u r e 29.5 An Increase in the Supply of Loanable Funds If the quantity of funds supplied by lenders rises at any given interest rate, the supply of loanable funds shifts rightward from S1 to S2. As a result, the equilibrium interest rate falls from r1 to r2. Interest rate, r... leads to a fall in the equilibrium interest rate. r1 r2 S1 S2 An increase in the supply of loanable funds... D Quantity of loanable funds Figure 29.5 shows the effects of an increase in the supply of loanable funds. D is the demand for loanable funds, and S1 is the initial supply curve. The initial equilibrium interest rate is r1. An increase in the supply of loanable funds means that the quantity of funds supplied rises at any given interest rate, so the supply curve shifts rightward to S2. As a result, the equilibrium interest rate falls to r2. Inflation and Interest Rates Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate. Historically, major changes in interest rates have been driven
by many factors, including changes in government policy and technological innovations that created new investment opportunities. However, arguably the most important factor affecting interest rates over time—the reason, for example, why interest rates today are much lower than they were in the late 1970s and early 1980s—is changing expectations about future inflation, which shift both the supply and the demand for loanable funds. To understand the effect of expected inflation on interest rates, recall our discussion in Module 14 of the way inflation creates winners and losers—for example, the way that high U.S. inflation in the 1970s and 1980s reduced the real value of homeowners’ mortgages, which was good for the homeowners but bad for the banks. We know that economists capture the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the distinction is as follows: Real interest rate = Nominal interest rate − Inflation rate The true cost of borrowing is the real interest rate, not the nominal interest rate. To see why, suppose a firm borrows $10,000 for one year at a 10% nominal interest rate. At the end of the year, it must repay $11,000—the amount borrowed plus the interest. But suppose that over the course of the year the average level of prices increases by 10%, so that the real interest rate is zero. Then the $11,000 repayment has the same purchasing power as the original $10,000 loan. In effect, the borrower has received a zero -interest loan. Similarly, the true payoff to lending is the real interest rate, not the nominal rate. Suppose that a bank makes a $10,000 loan for one year at a 10% nominal interest rate. At the end of the year, the bank receives an $11,000 repayment. But if the average level 282 According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged of prices rises by 10% per year, the purchasing power of the money the bank gets back is no more than that of the money it lent out. In effect, the bank has made a zero interest loan. The expectations of borrowers and lenders about future inflation rates are normally based on recent experience. In the late 1970s, after a decade of high inflation, borrowers and lenders expected future inflation to be high. By the late 1990s, after a decade of fairly low inflation, borrowers and lenders expected future inflation to be low. And these
changing expectations about future inflation had a strong effect on the nominal interest rate, largely explaining why interest rates were much lower in the early years of the twenty-first century than they were in the early 1980s. Let’s look at how changes in the expected future rate of inflation are reflected in the loanable funds model. In Figure 29.6, the curves S0 and D0 show the supply and demand for loanable funds given that the expected future rate of inflation is 0%. In that case, equilibrium is at E0 and the equilibrium nominal interest rate is 4%. Because expected future inflation is 0%, the equilibrium expected real interest rate over the life of the loan, the real interest rate expected by borrowers and lenders when the loan is contracted, is also 4%. Now suppose that the expected future inflation rate rises to 10%. The demand curve for funds shifts upward to D10: borrowers are now willing to borrow as much at a nominal interest rate of 14% as they were previously willing to borrow at 4%. That’s because with a 10% inflation rate, a 14% nominal interest rate corresponds to a 4% real interest rate. Similarly, the supply curve of funds shifts upward to S10: lenders require a nominal interest rate of 14% to persuade them to lend as much as they would previously have lent at 4%. The new equilibrium is at E10: the result of an expected future inflation rate of 10% is that the equilibrium nominal interest rate rises from 4% to 14%. This situation can be summarized as a general principle, known as the Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): the expected real interest rate is unaffected by the change in expected future inflation. According to the Fisher effect, an increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point. The central point is that both lenders and borrowers f i g u r e 29.6 The Fisher Effect D0 and S0 are the demand and supply curves for loanable funds when the expected future inflation rate is 0%. At an expected inflation rate of 0%, the equilibrium nominal interest rate is 4%. An increase in expected future inflation pushes both the demand and supply curves upward by 1 percentage point for every percentage point increase in expected future inflation. D10 and S10 are the demand and supply curves for loanable funds when the expected future inflation rate is 10%. The 10 percentage point increase in expected future inflation raises the equilibrium nominal
interest rate to 14%. The expected real interest rate remains at 4%, and the equilibrium quantity of loanable funds also remains unchanged. Nominal interest rate 14% 4 0 Demand for loanable funds at 10% expected inflation Supply of loanable funds at 10% expected inflation E10 Demand for loanable funds at 0% expected inflation Supply of loanable funds at 0% expected inflation D10 S10 S0 D0 Quantity of loanable funds E0 Q 283 base their decisions on the expected real interest rate. As long as the level of inflation is expected, it does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate. Reconciling the Two Interest Rate Models In Module 28 we developed what is known as the liquidity preference model of the interest rate. In that model, the equilibrium interest rate is the rate at which the quantity of money demanded equals the quantity of money supplied. In the loanable funds model, we see that the interest rate matches the quantity of loanable funds supplied by savers with the quantity of loanable funds demanded for investment spending. How do the two compare? The Interest Rate in the Short Run As we explained using the liquidity preference model, a fall in the interest rate leads to a rise in investment spending, I, which then leads to a rise in both real GDP and consumer spending, C. The rise in real GDP doesn’t lead only to a rise in consumer spending, however. It also leads to a rise in savings: at each stage of the multiplier process, part of the increase in disposable income is saved. How much do savings rise? According to the savings–investment spending identity, total savings in the economy is always equal to investment spending. This tells us that when a fall in the interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending. To put it another way, after a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded. Figure 29.7 shows how our two models of the interest rate are reconciled in the short run by the links among changes in the interest rate, changes in real GDP, and f i g u r e 29. 7 The Short -run Determination of the Interest Rate (a) The Liquidity Preference Model of the Interest Rate (b) The Loanable Funds Model of the Interest Rate Interest rate, r MS1 MS2
In the short run, an increase in the money supply reduces the interest rate... E1 r1 r2 E2 MD1 Interest rate, r r1 r2 S1 E1 S2... which leads to a short-run increase in real GDP and an increase in the supply of loanable funds. E2 D M1 M2 Quantity of money Q1 Q2 Quantity of loanable funds Panel (a) shows the liquidity preference model of the interest rate: the equilibrium interest rate matches the money supply to the quantity of money demanded. In the short run, the interest rate is determined in –– the money market, where an increase in the money supply, from M –– M shows the loanable funds model of the interest rate. The fall in the 1 to 2, pushes the equilibrium interest rate down, from r1 to r2. Panel (b) interest rate in the money market leads, through the multiplier effect, to an increase in real GDP and savings; to a rightward shift of the supply curve of loanable funds, from S1 to S2; and to a fall in the interest rate, from r1 to r2. As a result, the new equilibrium interest rate in the loanable funds market matches the new equilibrium interest rate in the money market at r2. 284 changes in savings. Panel (a) represents the liquidity preference model of the interest rate. MS1 and MD1 are the initial supply and demand curves for money. According to the liquidity preference model, the equilibrium interest rate in the economy is the rate at which the quantity of money supplied is equal to the quantity of money demanded in the money market. Panel (b) represents the loanable funds model of the interest rate. S1 is the initial supply curve and D is the demand curve for loanable funds. According to the loanable funds model, the equilibrium interest rate in the economy is the rate at which the quantity of loanable funds supplied is equal to the quantity of loanable funds demanded in the market for loanable funds. 1 to M In Figure 29.7 both the money market and the market for loanable funds are initially in equilibrium at E1 with the same interest rate, r1. You might think that this would happen only by accident, but in fact it will always be true. To see why, let’s look at what hap- pens when the Fed increases the money supply from M 2. This pushes the money supply curve rightward to MS
2, causing the equilibrium interest rate in the market for money to fall to r2, and the economy moves to a short-run equilibrium at E2. What happens in panel (b), in the market for loanable funds? In the short run, the fall in the interest rate due to the increase in the money supply leads to a rise in real GDP, which generates a rise in savings through the multiplier process. This rise in savings shifts the supply curve for loanable funds rightward, from S1 to S2, moving the equilibrium in the loanable funds market from E1 to E2 and also reducing the equilibrium interest rate in the loanable funds market. And we know that savings rise by exactly enough to match the rise in investment spending. This tells us that the equilibrium rate in the loanable funds market falls to r2, the same as the new equilibrium interest rate in the money market. In the short run, then, the supply and demand for money determine the interest rate, and the loanable funds market follows the lead of the money market. When a change in the supply of money leads to a change in the interest rate, the resulting change in real GDP causes the supply of loanable funds to change as well. As a result, the equilibrium interest rate in the loanable funds market is the same as the equilibrium interest rate in the money market. Notice our use of the phrase “in the short run.” Changes in aggregate demand affect aggregate output only in the short run. In the long run, aggregate output is equal to potential output. So our story about how a fall in the interest rate leads to a rise in aggregate output, which leads to a rise in savings, applies only to the short run. In the long run, as we’ll see next, the determination of the interest rate is quite different because the roles of the two markets are reversed. In the long run, the loanable funds market determines the equilibrium interest rate, and it is the market for money that follows the lead of the loanable funds market. The Interest Rate in the Long Run In the short run an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. In the long run, however, changes in the money supply don’t affect the interest rate. Figure 29.8 on the next page shows why. As in Figure 29.7, panel (a) shows the liquidity preference model of the
interest rate and panel (b) shows the supply and demand for loanable funds. We assume that in both panels the economy is initially at E1, in long -run macroeconomic equilibrium at potential output with the money supply 1. The demand curve for loanable funds is D, and the initial supply curve for equal to M loanable funds is S1. The initial equilibrium interest rate in both markets is r1. Now suppose the money supply rises from M 2. As we saw in Figure 29.7, this initially reduces the interest rate to r2. However, in the long run the aggregate price level will rise by the same proportion as the increase in the money supply (due to the neutrality of money, a topic presented in detail in the next section). A rise in the aggregate price level increases money demand in the same proportion. So in the long run the money demand curve shifts out to MD2, and the equilibrium interest rate rises back to its original level, r1. Panel (b) of Figure 29.8 shows what happens in the market for loanable funds. We saw earlier that an increase in the money supply leads to a short -run rise in real GDP and that 1 to 285 f i g u r e 29. 8 The Long -run Determination of the Interest Rate (a) The Liquidity Preference Model of the Interest Rate (b) The Loanable Funds Model of the Interest Rate Interest rate, r 1. In the long run, the rise in the price level shifts the money demand curve to the right,... Interest rate, r MS1 MS2 E1 r1 r2 E3 E2 2.... which raises the interest rate back to its original level... MD2 MD1 r1 r2 S1 E1 S2 3.... reducing real GDP and the supply of loanable funds until aggregate output equals potential output. E2 D M1 M2 Quantity of money Q1 Q2 Quantity of loanable funds –– 1 to M 2; panel (b) shows Panel (a) shows the liquidity preference model long-run adjustment to –– an increase in the money supply from M the corresponding long-run adjustment in the loanable funds market. As we discussed in Figure 29.7, the increase in the money supply reduces the interest rate from r1 to r2, increases real GDP, and increases savings in the short run. This is shown in panel (a) and panel (b) as the
movement from E1 to E2. In the long run, however, the increase in the money supply raises wages and other nominal prices; this shifts the money demand curve in panel (a) from MD1 to MD2, leading to an increase in the interest rate from r1 to r2 as the economy moves from E2 to E3. The rise in the interest rate causes a fall in real GDP and a fall in savings, shifting the loanable funds supply curve back to S1 from S2 and moving the loanable funds market from E2 back to E1. In the long run, the equilibrium interest rate is the rate that matches the supply and demand for loanable funds when real GDP equals potential output. this shifts the supply of loanable funds rightward from S1 to S2. In the long run, however, real GDP falls back to its original level as wages and other nominal prices rise. As a result, the supply of loanable funds, S, which initially shifted from S1 to S2, shifts back to S1. In the long run, then, changes in the money supply do not affect the interest rate. So what determines the interest rate in the long run—that is, what determines r1 in Figure 29.8? The answer is the supply and demand for loanable funds. More specifically, in the long run the equilibrium interest rate is the rate that matches the supply of loanable funds with the demand for loanable funds when real GDP equals potential output. M o d u l e 2 9 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Use a diagram of the loanable funds market to illustrate the effect of the following events on the equilibrium interest rate and quantity of loanable funds. a. An economy is opened to international movements of 2. Explain what is wrong with the following statement: “Savings and investment spending may not be equal in the economy as a whole in equilibrium because when the interest rate rises, households will want to save more money than businesses will want to invest.” capital, and a capital inflow occurs. b. Retired people generally save less than working people at any interest rate. The proportion of retired people in the population goes up. 3. Suppose that expected inflation rises from 3% to 6%. a. How will the real interest rate be affected by this change? b. How will the nominal interest rate be affected by this change? c. What will happen to
the equilibrium quantity of loanable 286 funds? Tackle the Test: Multiple-Choice Questions 1. A business will decide whether or not to borrow money to from its project. finance a project based on a comparison of the interest rate with the a. expected revenue b. profit c. rate of return d. cost generated e. demand generated 2. The real interest rate equals the a. nominal interest rate plus the inflation rate. b. nominal interest rate minus the inflation rate. c. nominal interest rate divided by the inflation rate. d. nominal interest rate times the inflation rate. e. federal funds rate. 3. Which of the following will increase the demand for loanable funds? a. a federal government budget surplus b. an increase in perceived business opportunities Tackle the Test: Free-Response Questions. a decrease in the interest rate d. positive capital inflows e. decreased private saving rates 4. Which of the following will increase the supply of loanable funds? a. an increase in perceived business opportunities b. decreased government borrowing c. an increased private saving rate d. an increase in the expected inflation rate e. a decrease in capital inflows 5. Both lenders and borrowers base their decisions on a. expected real interest rates. b. expected nominal interest rates. c. real interest rates. d. nominal interest rates. e. Nominal interest rates minus real interest rates. 1. Draw a correctly labeled graph showing equilibrium in the 2. Does each of the following affect either the supply or the demand for loanable funds, and if so, does the affected curve increase (shift to the right) or decrease (shift to the left)? a. There is an increase in capital inflows into the economy. b. Businesses are pessimistic about future business conditions. c. The government increases borrowing. d. The private savings rate decreases. loanable funds market. Answer (6 points) 1 point: Vertical axis labeled “Interest rate” or “r” 1 point: Horizontal axis labeled “Quantity of loanable funds” 1 point: Downward sloping demand curve for loanable funds (labeled) 1 point: Upward sloping supply curve for loanable funds (labeled) 1 point: Equilibrium quantity of loanable funds shown on horizontal axis below where curves intersect 1 point: Equilibrium interest rate shown on vertical axis across from where curves intersect Interest rate, r rE E S D QE Quantity of loanable funds 287 S e c t i o n 5 Review
Summary 1. Investment in physical capital is necessary for long -run economic growth. So in order for an economy to grow, it must channel savings into investment spending. 2. According to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole. The government is a source of savings when it runs a positive budget balance, also known as a budget surplus; it is a source of dissavings when it runs a negative budget balance, also known as a budget deficit. In a closed economy, savings is equal to national savings, the sum of private savings plus the budget balance. In an open economy, savings is equal to national savings plus capital inflow of foreign savings. When a capital outflow, or negative capital inflow, occurs, some portion of national savings is funding investment spending in other countries. 3. Households invest their current savings or wealth— their accumulated savings—by purchasing assets. Assets come in the form of either a financial asset, a paper claim that entitles the buyer to future income from the seller, or a physical asset, a claim on a tangible object that gives the owner the right to dispose of it as desired. A financial asset is also a liability from the point of view of its seller. There are four main types of financial assets: loans, bonds, stocks, and bank deposits. Each of them serves a different purpose in addressing the three fundamental tasks of a financial system: reducing transaction costs—the cost of making a deal; reducing financial risk—uncertainty about future outcomes that involves financial gains and losses; and providing liquid assets—assets that can be quickly converted into cash without much loss of value (in contrast to illiquid assets, which are not easily converted). 4. Although many small and moderate -size borrowers use bank loans to fund investment spending, larger companies typically issue bonds. Bonds with a higher risk of default must typically pay a higher interest rate. Business owners reduce their risk by selling stock. Although stocks usually generate a higher return than bonds, investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events. Most people are risk -averse, viewing the loss of a given amount of money as a significant hardship but viewing the gain of an equal amount of money as a much less significant benefit. Loan-backed securities, a recent innovation, are assets created by pooling individual loans and selling shares of that pool to investors. Because they are more
diversified and more liquid than individual loans, trading on financial markets like bonds, 288 they are preferred by investors. It can be difficult, however, to assess their quality. 5. Financial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify and life insurance companies allow families to reduce risk. 6. A bank allows individuals to hold liquid bank deposits that are then used to finance illiquid loans. Banks can perform this mismatch because on average only a small fraction of depositors withdraw their savings at any one time. Banks are a key ingredient in long -run economic growth. 7. Money is any asset that can easily be used to purchase goods and services. Currency in circulation and checkable bank deposits are both considered part of the money supply. Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated. 8. Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity backed money, such as paper currency backed by gold. Today the dollar is pure fiat money, whose value derives solely from its official role. 9. The Federal Reserve calculates two measures of the money supply. M1 is the narrowest monetary aggregate; it contains only currency in circulation, traveler’s checks, and checkable bank deposits. M2 includes a wider range of assets called near -moneys, mainly other forms of bank deposits, that can easily be converted into checkable bank deposits. 10. In order to evaluate a project in which costs or benefits are realized in the future, you must first transform them into their present values using the interest rate, r. The present value of $1 realized one year from now is $1/(1 + r), the amount of money you must lend out today to have $1 one year from now. Once this transformation is done, you should choose the project with the highest net present value. 11. Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care. To meet demands for cash, they maintain bank reserves composed of both currency held in vaults and deposits at the Federal Reserve. The reserve ratio is the ratio of bank reserves to bank deposits. A T-account summarizes a bank’
s financial position, with loans and reserves counted as assets, and deposits counted as liabilities. 12. Banks have sometimes been subject to bank runs, most notably in the early 1930s. To avert this danger, depositors are now protected by deposit insurance, bank owners face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds, and banks must satisfy reserve requirements, a legally mandated required reserve ratio. 13. When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so banks create money. If the entire money supply consisted of checkable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio. In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base. 14. In response to the Panic of 1907, the Fed was created to centralize holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions. 15. The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened the depth of the Depression. Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks. By 1933, banks had been separated into two categories: commercial (covered by deposit insurance) and investment (not covered). Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression. 16. The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses. Depositors in failed S&Ls were compensated with taxpayer funds because they were covered by deposit insurance. However, the crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s. 17. During the mid -1990s, the hedge fund LTCM used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed. LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging. As a result, credit markets around the world froze. The New York Fed coordinated a private bailout of LTCM and revived world credit markets. 18. Sub prime lending during the U.S. housing bubble of the
mid -2000s spread through the financial system via securitization. When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system. To prevent another Great Depression, the Fed and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank Section 5 Summary shares, and purchased private debt. Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 raised the question of whether a wider safety net and broader regulation were needed in the financial sector. 19. The monetary base is controlled by the Federal Reserve, the central bank of the United States. The Fed regulates banks and sets reserve requirements. To meet those requirements, banks borrow and lend reserves in the federal funds market at the federal funds rate. Through the discount window facility, banks can borrow from the Fed at the discount rate. 20. Open -market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying U.S. Treasury bills from banks or selling U.S. Treasury bills to banks. 21. The money demand curve arises from a trade -off between the opportunity cost of holding money and the liquidity that money provides. The opportunity cost of holding money depends on short -term interest rates, not long -term interest rates. Changes in the aggregate price level, real GDP, technology, and institutions shift the money demand curve. 22. According to the liquidity preference model of the interest rate, the interest rate is determined in the money market by the money demand curve and the money supply curve. The Federal Reserve can change the interest rate in the short run by shifting the money supply curve. In practice, the Fed uses open -market operations to achieve a target federal funds rate, which other shortterm interest rates generally follow. 23. The hypothetical loanable funds market shows how loans from savers are allocated among borrowers with investment spending projects. In equilibrium, only those projects with a rate of return greater than or equal to the equilibrium interest rate will be funded. By showing how gains from trade between lenders and borrowers are maximized, the loanable funds market shows why a well -functioning financial system leads to greater long -run economic growth. Government budget deficits can raise the interest rate and can lead to crowding out of investment spending. Changes in perceived business opportunities and in government borrowing shift the demand curve for loanable funds; changes in private savings and capital inflows shift the supply curve. 24
. Because neither borrowers nor lenders can know the future inflation rate, loans specify a nominal interest rate rather than a real interest rate. For a given expected future inflation rate, shifts of the demand and supply curves of loanable funds result in changes in the underlying real interest rate, leading to changes in the nominal interest rate. According to the Fisher effect, an increase in expected future inflation raises the nominal interest rate one-to-one so that the expected real interest rate remains unchanged. S u m m a r y 289 Key Terms Interest rate, p. 222 Currency in circulation, p. 231 Investment bank, p. 257 Savings–investment spending identity, p. 222 Checkable bank deposits, p. 231 Savings and loan (thrift), p. 257 Budget surplus, p. 223 Budget deficit, p. 223 Budget balance, p. 223 National savings, p. 223 Capital inflow, p. 223 Wealth, p. 224 Financial asset, p. 224 Physical asset, p. 224 Liability, p. 224 Transaction costs, p. 225 Financial risk, p. 225 Diversification, p. 225 Liquid, p. 226 Illiquid, p. 226 Loan, p. 226 Default, p. 226 Loan-backed securities, p. 227 Financial intermediary, p. 227 Mutual fund, p. 228 Pension fund, p. 228 Life insurance company, p. 228 Bank deposit, p. 229 Bank, p. 229 Money, p. 231 Problems Money supply, p. 231 Medium of exchange, p. 232 Store of value, p. 232 Unit of account, p. 233 Commodity money, p. 233 Leverage, p. 258 Balance sheet effect, p. 258 Vicious cycle of deleveraging, p. 258 Subprime lending, p. 259 Securitization, p. 259 Commodity -backed money, p. 234 Federal funds market, p. 263 Federal funds rate, p. 263 Discount rate, p. 263 Open -market operation, p. 264 Short-term interest rates, p. 269 Long-term interest rates, p. 270 Money demand curve, p. 270 Liquidity preference model of the interest rate, p. 273 Money supply curve, p. 273 Loanable funds market, p. 277 Rate of return, p. 278 Crowding out, p. 281 Fisher effect, p. 283 Fiat money, p. 234 Monetary aggregate, p. 234 Near -moneys, p. 235 Present value, p. 239 Net present value,
p. 240 Bank reserves, p. 243 T-account, p. 243 Reserve ratio, p. 244 Required reserve ratio, p. 244 Bank run, p. 246 Deposit insurance, p. 246 Reserve requirements, p. 246 Discount window, p. 246 Excess reserves, p. 249 Monetary base, p. 249 Money multiplier, p. 250 Central bank, p. 253 Commercial bank, p. 257 1. Given the following information about the closed economy of Brittania, what is the level of investment spending and private savings, and what is the budget balance? What is the relationship among investment spending, private savings, and the budget balance? Is national savings equal to investment spending? There are no government transfers. T = $50 million GDP = $1,000 million G = $100 million C = $850 million 4. What are the important types of financial intermediaries in the U.S. economy? What are the primary assets of these intermediaries, and how do they facilitate investment spending and saving? 5. For each of the following transactions, what is the initial effect (increase or decrease) on M1? or M2? a. You sell a few shares of stock and put the proceeds into your savings account. 2. Which of the following are examples of investment spending, investing in financial assets, or investing in physical assets? b. You sell a few shares of stock and put the proceeds into your checking account. a. Rupert Moneybucks buys 100 shares of existing Coca -Cola c. You transfer money from your savings account to your stock. checking account. b. Rhonda Moviestar spends $10 million to buy a mansion d. You discover $0.25 under the floor mat in your car and de- built in the 1970s. posit it in your checking account. c. Ronald Basketballstar spends $10 million to build a new e. You discover $0.25 under the floor mat in your car and de- mansion with a view of the Pacific Ocean. posit it in your savings account. d. Rawlings builds a new plant to make catcher’s mitts. e. Russia buys $100 million in U.S. government bonds. 3. Explain how a well-functioning financial system increases savings and investment spending, holding the budget balance and any capital flows fixed. 6. There are three types of money: commodity money, commodity backed money, and fiat money. Which type of money is used in each of the following situations? a.
Bottles of rum were used to pay for goods in colonial Australia. 290. Salt was used in many European countries as a medium of exchange. c. For a brief time, Germany used paper money (the “Rye Mark”) that could be redeemed for a certain amount of rye, a type of grain. d. The town of Ithaca, New York, prints its own currency, Ithaca HOURS, which can be used to purchase local goods and services. 7. Indicate whether each of the following is part of M1, M2, or neither: a. $95 on your campus meal card b. $0.55 in the change cup of your car c. $1,663 in your savings account d. $459 in your checking account e. 100 shares of stock worth $4,000 f. a $1,000 line of credit on your Sears credit card 8. You have won the state lottery. There are two ways in which you can receive your prize. You can either have $1 million in cash now, or you can have $1.2 million that is paid out as follows: $300,000 now, $300,000 in one year’s time, $300,000 in two years’ time, and $300,000 in three years’ time. The interest rate is 20%. How would you prefer to receive your prize? 9. The drug company Pfizer is considering whether to invest in the development of a new cancer drug. Development will require an initial investment of $10 million now; beginning one year from now, the drug will generate annual profits of $4 million for three years. a. If the interest rate is 12%, should Pfizer invest in the devel- opment of the new drug? Why or why not? b. If the interest rate is 8%, should Pfizer invest in the develop- ment of the new drug? Why or why not? 10. Tracy Williams deposits $500 that was in her sock drawer into a checking account at the local bank. a. How does the deposit initially change the T-account of the local bank? How does it change the money supply? b. If the bank maintains a reserve ratio of 10%, how will it re- spond to the new deposit? c. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan, by how much could the
total money supply in the economy expand in response to Tracy’s initial cash deposit of $500? d. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan and the bank maintains a reserve ratio of 5%, by how much could the money supply expand in response to an initial cash deposit of $500? 11. Ryan Cozzens withdraws $400 from his checking account at the local bank and keeps it in his wallet. a. How will the withdrawal change the T-account of the local bank and the money supply? b. If the bank maintains a reserve ratio of 10%, how will the bank respond to the withdrawal? Assume that the bank responds to insufficient reserves by reducing the amount of Section 5 Summary deposits it holds until its level of reserves satisfies its required reserve ratio. The bank reduces its deposits by calling in some of its loans, forcing borrowers to pay back these loans by taking cash from their checking deposits (at the same bank) to make repayment. c. If every time the bank decreases its loans, checkable bank deposits fall by the amount of the loan, by how much will the money supply in the economy contract in response to Ryan’s withdrawal of $400? d. If every time the bank decreases its loans, checkable bank deposits fall by the amount of the loan and the bank maintains a reserve ratio of 20%, by how much will the money supply contract in response to a withdrawal of $400? 12. In Westlandia, the public holds 50% of M1 in the form of currency, and the required reserve ratio is 20%. Estimate how much the money supply will increase in response to a new cash deposit of $500 by completing the accompanying table. (Hint: The first row shows that the bank must hold $100 in minimum reserves—20% of the $500 deposit—against this deposit, leaving $400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only $400 × 0.5 = $200 of the loan will be deposited in round 2 from the loan granted in round 1.) How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public doesn’t hold any of the loan in currency? What does this imply about the relationship between the public’s desire for holding currency and the money multiplier?
Round Deposits Required reserves Excess reserves Loans Held as currency 1 2 3 4 5 6 7 8 9 10 Total after 10 rounds $500.00 $100.00 $400.00 $400.00 $200.00 200.00????????????????????????????????????????????????? 13. What will happen to the money supply under the following cir- cumstances in a checkable-deposits-only system? a. The required reserve ratio is 25%, and a depositor withdraws $700 from his checkable bank deposit. b. The required reserve ratio is 5%, and a depositor withdraws $700 from his checkable bank deposit. c. The required reserve ratio is 20%, and a customer deposits $750 to her checkable bank deposit. d. The required reserve ratio is 10%, and a customer deposits $600 to her checkable bank deposit. S u m m a r y 291 b. How will the money supply change if the required reserve r1 E 14. Although the U.S. Federal Reserve doesn’t use changes in reserve requirements to manage the money supply, the central bank of Albernia does. The commercial banks of Albernia have $100 million in reserves and $1,000 million in checkable deposits; the initial required reserve ratio is 10%. The commercial banks follow a policy of holding no excess reserves. The public holds no currency, only checkable deposits in the banking system. a. How will the money supply change if the required reserve ratio falls to 5%? ratio rises to 25%? 15. Using Figure 26.1 find the Federal Reserve district in which you live. Go to http://www.federalreserve.gov/bios/pres. htm, and click on your district to identify the president of the Federal Reserve Bank in your district. Go to http://www.federalreserve.gov/fomc/ and determine if the president of the Fed is currently a voting member of the Federal Open Market Committee (FOMC). 16. The Congressional Research Service estimates that at least $45 million of counterfeit U.S. $100 notes produced by the North Korean government are in circulation. a. Why do U.S. taxpayers lose because of North Korea’s counterfeiting? b.
As of September 2008, the interest rate earned on one- year U.S. Treasury bills was 2.2%. At a 2.2% rate of interest, what is the amount of money U.S. taxpayers are losing per year because of these $45 million in counterfeit notes? 17. The accompanying figure shows new U.S. housing starts, in thousands of units per month, between January 1980 and September 2008. The graph shows a large drop in new housing starts in 1984–1991 and 2006–2008. New housing starts are related to the availability of mortgages. New housing starts (thousands) 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 1980 1985 1990 1995 2000 2005 Source: Federal Reserve Bank of St. Louis. 2008 Year a. What caused the drop in new housing starts in 1984–1991? b. What caused the drop in new housing starts in 2006–2008? c. How could better regulation of financial institutions have prevented these two occurrences? 292 18. Use the market for loanable funds shown in the accompanying diagram to explain what happens to private savings, private investment spending, and the rate of interest if the following events occur. Assume that there are no capital inflows or outflows. Interest rate S D Q1 Quantity of loanable funds a. The government reduces the size of its deficit to zero. b. At any given interest rate, consumers decide to save more. Assume the budget balance is zero. c. At any given interest rate, businesses become very optimistic about the future profitability of investment spending. Assume the budget balance is zero. 19. The government is running a budget balance of zero when it decides to increase education spending by $200 billion and finance the spending by selling bonds. The accompanying diagram shows the market for loanable funds before the government sells the bonds. Assume that there are no capital inflows or outflows. How will the equilibrium interest rate and the equilibrium quantity of loanable funds change? Is there any crowding out in the market? Interest rate 24% 22 20 18 16 14 12 10 8 6 4 2 0 S E $200 400 600 800 D 1,000 1,200 Quantity of loanable funds (billions of dollars) 20. In 2006, Congress estimated that the cost of the Iraq War was approximately $100 billion a year. Since the U.S. government was running a budget deficit at the time, assume that the war was financed by government borrowing
, which increases the demand for loanable funds without affecting supply. This question considers the likely effect of this government expenditure on the interest rate. a. Draw typical demand (D1) and supply (S1) curves for loanable funds without the cost of the war accounted for. Label the vertical axis “Interest rate” and the horizontal axis “Quantity of loanable funds.” Label the equilibrium point (E1) and the equilibrium interest rate (r1). b. Now consider a new diagram with the cost of the war in- cluded in the analysis. Shift the demand curve in the appropriate direction. Label the new equilibrium point (E2) and the new equilibrium interest rate (r2). c. How does the equilibrium interest rate change in response to government expenditure on the war? Explain. 21. How would you respond to a friend who claims that the government should eliminate all purchases that are financed by borrowing because such borrowing crowds out private investment spending? 22. Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and that Boris will repay the $10,000 with interest in one year. They agree to a nominal interest rate of 8%, reflecting a real interest rate of 3% on the loan and a commonly shared expected inflation rate of 5% over the next year. a. If the inflation rate is actually 4% over the next year, how does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off? b. If the actual inflation rate is 7% over the next year, how does that affect Boris and Lynn? Who is better off? 23. Using the accompanying diagram, explain what will happen to the market for loanable funds when there is a fall of Section 5 Summary 2 percentage points in the expected future inflation rate. How will the change in the expected future inflation rate affect the equilibrium quantity of loanable funds? Interest rate r1 8% E1 S1 D1 0 Q1 Quantity of loanable funds 24. Using a figure similar to Figure 29.7, explain how the money market and the loanable funds market react to a reduction in the money supply in the short run. 25. Contrast the short-run effects of an increase in the money supply on the interest rate to the long-run effects of an increase in the money supply on the interest rate. Which market determines the interest rate in the short run? Which market does so in the long run? What are the implications of your answers for
the effectiveness of monetary policy in influencing real GDP in the short run and the long run? S u m m a r y 293 This page intentionally left blank s e c t i o n Module 30 Long-run Implications of Fiscal Policy: Deficits and the Public Debt Module 31 Monetary Policy and the Interest Rate Module 32 Money, Output, and Prices in the Long Run Module 33 Types of Inflation, Disinflation, and Deflation Module 34 Inflation and Unemployment: The Phillips Curve Module 35 History and Alternative Views of Macroeconomics Module 36 The Modern Macroeconomic Consensus Economics by Example: “Will Technology Put Us All Out of Work?” 6 Inflation, Unemployment, and Stabilization Policies Jim Cramer’s Mad Money is one of the most popular shows on CNBC, a cable TV network that specializes in business and financial news. Cramer, who mostly offers investment advice, is known for his sense of showmanship. But few viewers were prepared for his outburst on August 3, 2007, when he began screaming about what he saw as inadequate action from the Federal Reserve: “Bernanke is being an academic! It is no time to be an academic.... He has no idea how bad it is out there. He has no idea! He has no idea!... and Bill Poole? Has no idea what it’s like out there!... They’re nuts! They know nothing!... The Fed is asleep! Bill Poole is a shame! He’s shameful!!” Who are Bernanke and Bill Poole? In the previous chapter we described the role of the Federal Reserve System, the U.S. central bank. At the time of Cramer’s tirade, Ben Bernanke, a former Princeton professor of economics, was the chair of the Fed’s Board of Governors, and William Poole, also a former economics professor, was the president of the Federal Reserve Bank of St. Louis. Both men, because of their positions, are members of the Federal Open Market Committee, which meets eight times a year to set monetary policy. In August 2007, Cramer was crying out for the Fed to change monetary policy in order to address what he perceived to be a growing financial crisis Why was Cramer screaming at the Federal Reserve rather than, say, the U.S. Treasury—or, for that matter, the president? The answer is that the Fed’s control of
monetary policy makes it the first line of response to macroeconomic difficulties—very much including the financial crisis that had Cramer so upset. Indeed, within a few weeks the Fed swung into action with a dramatic reversal of its previous policies. In Section 4, we developed the aggregate demand and supply model and introduced the use of fiscal policy to stabilize the economy. In Section 5, we introduced money, banking, and the Federal Reserve System, and began to look at how monetary policy is used to stabilize the economy. In this section, we use the models introduced in Sections 4 and 5 to further develop our understanding of stabilization policies (both fiscal and monetary), including their long-run effects on the economy. In addition, we introduce curve—a trade-off between short-run unexpected inflation and unemployment—and investigate the role of expectations in the economy. We end the section with a brief summary of the history of macroeconomic thought and how the modern consensus view of stabilization policy has developed. the Phillips 295 In August 2007, an agitated Jim Cramer demanded that the Fed do something to address the growing financial crisis. What you will learn in this Module: • Why governments calculate the cyclically adjusted budget balance • Why a large public debt may be a cause for concern • Why implicit liabilities of the government are also a cause for concern Module 30 Long-run Implications of Fiscal Policy: Deficits and the Public Debt In Module 20 we discussed how discretionary fiscal policy can be used to stabilize the economy in the short run. During a recession, an expansionary fiscal policy—raising government spending, lowering taxes, or both—can be used to shift the aggregate demand curve to the right. And when there are inflationary pressures in the economy, a contractionary fiscal policy—lowering government spending, raising taxes, or both— can be used to shift the aggregate demand curve to the left. But how do these policies affect the economy over a longer period of time? In this module we will look at some of the long-term effects of fiscal policy, including budget balance, debt, and liabilities. The Budget Balance Headlines about the government’s budget tend to focus on just one point: whether the government is running a budget surplus or a budget deficit and, in either case, how big. People usually think of surpluses as good: when the federal government ran a record surplus in 2000, many people regarded it as a cause for celebration. Conversely, people usually think of deficits as bad: when the Congressional Budget Office projected a record
federal deficit for 2009, many people regarded it as a cause for concern. How do surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? To answer those questions, let’s look at the causes and consequences of surpluses and deficits. The Budget Balance as a Measure of Fiscal Policy What do we mean by surpluses and deficits? The budget balance, which we have previously defined, is the difference between the government’s tax revenue and its spending, both on goods and services and on government transfers, in a given year. That is, the budget balance—savings by government—is defined by Equation 30-1: (30-1) SGovernment = T − G − TR 296 where T is the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers. A budget surplus is a positive budget balance, and a budget deficit is a negative budget balance. Other things equal, expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Conversely, contractionary fiscal policies—reduced government purchases of goods and services, lower government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller. You might think this means that changes in the budget balance can be used to measure fiscal policy. In fact, economists often do just that: they use changes in the budget balance as a “quick - and - dirty” way to assess whether current fiscal policy is expansionary or contractionary. But they always keep in mind two reasons this quick and - dirty approach is sometimes misleading: ■ Two different changes in fiscal policy that have equal-size effects on the budget balance may have quite unequal effects on the economy. As we have already seen, changes in government purchases of goods and services have a larger effect on real GDP than equal - size changes in taxes and government transfers. ■ Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy. To understand the second point, we need to examine the effects of the business cycle on the budget. The Business Cycle and the Cyclically Adjusted Budget Balance Historically, there has been a strong relationship between the federal government’s budget balance and
the business cycle. The budget tends to move into deficit when the economy experiences a recession, but deficits tend to get smaller or even turn into surpluses when the economy is expanding. Figure 30.1 shows the federal budget deficit as a percentage of GDP from 1970 to 2009. Shaded areas indicate recessions; unshaded areas indicate expansions. As you can see, the federal budget deficit increased around the time of each recession and usually declined during expansions. In fact, in the late 30.1 The U.S. Federal Budget Deficit and the Business Cycle The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions. Source: Bureau of Economic Analysis; National Bureau of Economic Research. Budget deﬁcit (percent of GDP) 10% 8 6 4 2 0 –2 1970 1975 1980 1985 1990 1995 2000 2005 2009 Year 297 stages of the long expansion from 1991 to 2000, the deficit actually became negative— the budget deficit became a budget surplus. The relationship between the business cycle and the budget balance is even clearer if we compare the budget deficit as a percentage of GDP with the unemployment rate, as we do in Figure 30.2. The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls. Is this relationship between the business cycle and the budget balance evidence that policy makers engage in discretionary fiscal policy? Not necessarily. It is largely automatic stabilizers that drive the relationship shown in Figure 30.2. As we learned in the discussion of automatic stabilizers in Module 21, government tax revenue tends to rise and some government transfers, like unemployment benefit payments, tend to fall when the economy expands. Conversely, government tax revenue tends to fall and some government transfers tend to rise when the economy contracts. So the budget tends to move toward surplus during expansions and toward deficit during recessions even without any deliberate action on the part of policy makers. In assessing budget policy, it’s often useful to separate movements in the budget balance due to the business cycle from movements due to discretionary fiscal policy changes. The former are affected by automatic stabilizers and the latter by deliberate changes in government purchases, government transfers, or taxes. It’s important to realize that business - cycle effects on the budget balance are temporary: both recessionary gaps (in which real GDP is below potential output) and inflationary gaps (in which real GDP is above potential output) tend to be eliminated in the long run. Removing their effects on the
budget balance sheds light on whether the government’s taxing and spending policies are sustainable in the long run. In other words, do the government’s tax policies yield enough revenue to fund its spending in the long run? As we’ll learn shortly, this is a fundamentally more important question than whether the government runs a budget surplus or deficit in the current year. To separate the effect of the business cycle from the effects of other factors, many governments produce an estimate of what the budget balance would be if there were neither a recessionary nor an inflationary gap. The cyclically adjusted budget balance Budget deﬁcit (percent of GDP) 10% 8 6 4 2 0 –2 –4 Budget deﬁcit Unemployment rate Unemployment rate (percent) 12% 10 8 6 4 2 1970 1975 1980 1985 1990 1995 2000 2005 2009 Year The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. f i g u r e 30.2 The U.S. Federal Budget Deficit and the Unemployment Rate There is a close relationship between the budget balance and the business cycle: a recession moves the budget balance toward deficit, but an expansion moves it toward surplus. Here, the unemployment rate serves as an indicator of the business cycle, and we should expect to see a higher unemployment rate associated with a higher budget deficit. This is confirmed by the figure: the budget deficit as a percentage of GDP moves closely in tandem with the unemployment rate. Source: Bureau of Economic Analysis; Bureau of Labor Statistics. 298 30.3 The Actual Budget Deficit Versus the Cyclically Adjusted Budget Deficit The cyclically adjusted budget deficit is an estimate of what the budget deficit would be if the economy were at potential output. It fluctuates less than the actual budget deficit, because years of large budget deficits also tend to be years when the economy has a large recessionary gap. Source: Congressional Budget Office. Actual budget deﬁcit, cyclically adjusted budget deﬁcit (percent of GDP) 10% 8 6 4 2 0 –2 –4 1970 Actual budget deﬁcit Cyclically adjusted budget deﬁcit 1975 1980 1985 1990 1995 2000 2005 2009 Year is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and
the extra transfers it would make if an inflationary gap were eliminated. Figure 30.3 shows the actual budget deficit and the Congressional Budget Office estimate of the cyclically adjusted budget deficit, both as a percentage of GDP, since 1970. As you can see, the cyclically adjusted budget deficit doesn’t fluctuate as much as the actual budget deficit. In particular, large actual deficits, such as those of 1975 and 1983, are usually caused in part by a depressed economy. Should the Budget Be Balanced? Persistent budget deficits can cause problems for both the government and the economy. Yet politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes. As a result, there are occasional attempts by policy makers to force fiscal discipline by introducing legislation—even a constitutional amendment—forbidding the government from running budget deficits. This is usually stated as a requirement that the budget be “balanced”—that revenues at least equal spending each fiscal year. Would it be a good idea to require a balanced budget annually? Most economists don’t think so. They believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. They don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. As we learned earlier, the tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments push the budget toward deficit. If constrained by a balanced budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession 299 A fiscal year runs from October 1 to September 30 and is labeled according to the calendar year in which it ends. Public debt is government debt held by individuals and institutions outside the government. Nonetheless, policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary. Long -Run Implications of Fiscal Policy During the 1990s, the Japanese government engaged in massive deficit spending in an effort to increase aggregate demand. That policy was partly successful: although Japan’s economy was sluggish during the 1990s, it avoided a severe slump comparable to what happened to many countries in the 1930s. Yet the fact that Japan was
running large deficits year after year made many observers uneasy, as Japan’s debt—the accumulation of past deficits, net of surpluses—climbed to alarming levels. Now that we understand how government surpluses and deficits happen, let’s take a closer look at their long-run effects on the economy. Deficits, Surpluses, and Debt When a family spends more than it earns over the course of a year, it has to raise the extra funds either by selling assets or by borrowing. And if a family borrows year after year, it will eventually end up with a lot of debt. The same is true for governments. With a few exceptions, governments don’t raise large sums by selling assets such as national parkland. Instead, when a government spends more than the tax revenue it receives—when it runs a budget deficit—it almost always borrows the extra funds. And governments that run persistent budget deficits end up with substantial debts. To interpret the numbers that follow, you need to know a slightly peculiar feature of federal government accounting. For historical reasons, the U.S. government does not keep the books by calendar years. Instead, budget totals are kept by fiscal years, which run from October 1 to September 30 and are labeled by the calendar year in which they end. For example, fiscal 2009 began on October 1, 2008, and ended on September 30, 2009. At the end of fiscal 2009, the U.S. federal government had total debt equal to $12 trillion. However, part of that debt represented special accounting rules specifying that the federal government as a whole owes funds to certain government programs, especially Social Security. We’ll explain those rules shortly. For now, however, let’s focus on public debt: government debt held by individuals and institutions outside the government. At the end of fiscal 2009, the federal government’s public debt was “only” $7.6 trillion, or 53% of GDP. If we include the debts of state and local governments, total government public debt was approximately 69% of GDP. U.S. federal government public debt at the end of fiscal 2009 was larger than it was at the end of fiscal 2008 because the federal government ran a budget deficit during fiscal 2009. A government that runs persistent budget deficits will experience a rising level of debt. Why is this a problem? Problems Posed by Rising Government Debt There are two reasons to be concerned when a government runs persistent budget deficits.
We described one reason previously: when the government borrows funds in the financial markets, it is competing with firms that plan to borrow funds for investment spending. As a result, the government’s borrowing may “crowd out” private investment spending, increasing interest rates and reducing the economy’s long - run rate of growth. The second reason: today’s deficits, by increasing the government’s debt, place financial pressure on future budgets. The impact of current deficits on future budgets is straightforward. Like individuals, governments must pay their bills, including interest payments on their accumulated debt. When a government is deeply in debt, those interest payments can be substantial. In fiscal 2009, the U.S. federal government paid 300.7% of GDP—$383 billion—in interest on its debt. And although this is a relatively large fraction of GDP, other countries pay even greater fractions of their GDP to service their debt. For example, in 2009, Greece paid interest of about 5.4% of GDP. Other things equal, a government paying large sums in interest must raise more revenue from taxes or spend less than it would otherwise be able to afford—or it must borrow even more to cover the gap. And a government that borrows to pay interest on its outstanding debt pushes itself even deeper into debt. This process can eventually push a government to the point at which lenders question its ability to repay. Like consumers who have maxed out their credit cards, the government will find that lenders are unwilling to lend any more funds. The result can be that the government defaults on its debt—it stops paying what it owes. Default is often followed by deep financial and economic turmoil. The idea of a government defaulting sounds far - fetched, but it is not impossible. In the 1990s, Argentina, a relatively high - income developing country, was widely praised for its economic policies—and it was able to borrow large sums from foreign lenders. By 2001, however, Argentina’s interest payments were spiraling out of control, and the country stopped paying the sums that were due. Default creates havoc in a country’s financial markets and badly shakes public confidence in both the government and the economy. Argentina’s debt default was accompanied by a crisis in the country’s banking system and a very severe recession. And even if a highly indebted government avoids default, a heavy debt burden typically forces it to slash spending or raise taxes, politically unpopular measures that can also damage the economy One
question some people ask is: can’t a government that has trouble borrowing just print money to pay its bills? Yes, it can, but this leads to another problem: inflation. In fact, budget problems are the main cause of very severe inflation, as we’ll see later. The point for now is that governments do not want to find themselves in a position where the choice is between defaulting on their debts and inflating those debts away. Concerns about the long -run effects of deficits need not rule out the use of fiscal policy to stimulate the economy when it is depressed. However, these concerns do mean that governments should try to offset budget deficits in bad years with budget surpluses in good years. In other words, governments should run a budget that is approximately balanced over time. Have they actually done so? Deficits and Debt in Practice Figure 30.4 on the next page shows how the U.S. federal government’s budget deficit and its debt have evolved since 1940. Panel (a) shows the federal deficit as a percentage of GDP. As you can see, the federal government ran huge deficits during World War II. It briefly ran surpluses after the war, but it has normally run deficits ever since, especially after 1980. This seems inconsistent with the advice that governments should offset deficits in bad times with surpluses in good times. However, panel (b) of Figure 30.4 shows that these deficits have not led to runaway debt. To assess the ability of governments to pay their debt, we often use the debt– GDP ratio, the government’s debt as a percentage of GDP. We use this measure, rather than simply looking at the size of the debt because GDP, which measures the size of the economy as a whole, is a good indicator of the potential taxes the government can collect. If the government’s debt grows more slowly than GDP, the burden of paying that debt is actually falling compared with the government’s potential tax revenue. What we see from panel (b) is that although the federal debt has grown in almost every year, the debt–GDP ratio fell for 30 years after the end of World War II. This shows that the debt–GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. Growth and inflation sometimes allow a government that runs persistent budget deficits to nevertheless have a declining debt–GDP ratio Lautario Palacios, 7, holds a sign that
calls for politicians to stop robbing, during a January 9, 2002 demonstration in Buenos Aires, Argentina. The debt–GDP ratio is the government’s debt as a percentage of GDP 301 f i g u r e 30. 4 U.S. Federal Deficits and Debt (a) The U.S. Federal Budget Deﬁcit Since 1940 (b) The U.S. Public Debt–GDP Ratio Since 1940 Budget deﬁcit (percent of GDP) 40% 30 20 10 0 –10 1940 Public debt (percent of GDP) 120% 100 80 60 40 20 1950 1960 1970 1980 1990 2000 2009 Year 1940 1950 1960 1970 1980 1990 2000 2009 Year Panel (a) shows the U.S. federal budget deficit as a percentage of GDP since 1940. The U.S. government ran huge deficits during World War II and has usually run smaller deficits ever since. Panel (b) shows the U.S. debt–GDP ratio. Comparing panels (a) and (b), you can see that in many years the debt–GDP ratio has declined in spite of government deficits. This seeming paradox reflects the fact that the debt–GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt. Source: Office of Management and Budget. Still, a government that runs persistent large deficits will have a rising debt–GDP ratio when debt grows faster than GDP. Panel (a) of Figure 30.5 shows Japan’s budget deficit as a percentage of GDP, and panel (b) shows Japan’s debt–GDP ratio, both since 1990. As we have already mentioned, Japan began running large deficits in the early 1990s, a by -product of its effort to prop up aggregate demand with f i g u r e 30. 5 Japanese Deficits and Debt (a) The Japanese Budget Deﬁcit Since 1990 (b) The Japanese Debt–GDP Ratio Since 1990 Budget deﬁcit (percent of GDP) 12% 10 8 6 4 2 0 –2 –4 Public debt (percent of GDP) 100% 80 60 40 20 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2009 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2009 Year Year Panel (a) shows the budget deficit of Japan as a percent of GDP since 1990 and panel (b) shows its debt–GDP ratio. The large deficits that the Japanese government began running in the early
1990s have led to a rapid rise in its debt–GDP ratio as debt has grown more quickly than GDP. This has led some analysts to express concern about the long -run fiscal health of the Japanese economy. Source: International Monetary Fund. 302 fyi What Happened to the Debt from World War II? As you can see from Figure 30.4, the government paid for World War II by borrowing on a huge scale. By the war’s end, the public debt was more than 100% of GDP, and many people worried about how it could ever be paid off. dipped slightly in the next few years, as the United States ran postwar budget surpluses, but the government budget went back into deficit in 1950 with the start of the Korean War. By 1962, the public debt was back up to $248 billion. The truth is that it never was paid off. In 1946, But by that time nobody was worried about the public debt was $242 billion; that number the fiscal health of the U.S. government be- cause the debt–GDP ratio had fallen by more than half. The reason? Vigorous economic growth, plus mild inflation, had led to a rapid rise in GDP. The experience was a clear lesson in the peculiar fact that modern governments can run deficits forever, as long as they aren’t too large. Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. government spending. This has led to a rapid rise in the debt–GDP ratio. For this reason, some economic analysts are concerned about the long -run fiscal health of the Japanese economy. Implicit Liabilities Looking at Figure 30.4, you might be tempted to conclude that the U.S. federal budget is in fairly decent shape: the return to budget deficits after 2001, and large— but temporary—increases in government spending in response to the recession that began in 2007, caused the debt–GDP ratio to rise a bit, but that ratio is still low compared with both historical experience and some other wealthy countries. In fact, however, experts on long -run budget issues view the situation of the United States (and other countries with high public debt, such as Japan and Greece) with alarm. The reason is the problem of implicit liabilities. Implicit liabilities are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. The largest
implicit liabilities of the U.S. government arise from two transfer programs that principally benefit older Americans: Social Security and Medicare. The third - largest implicit liability, Medicaid, benefits low - income families. In each of these cases, the government has promised to provide transfer payments to future as well as current beneficiaries. So these programs represent a future debt that must be honored, even though the debt does not currently show up in the usual statistics. Together, these three programs currently account for almost 40% of federal spending. The implicit liabilities created by these transfer programs worry fiscal experts. Figure 30.6 on the next page shows why. It shows actual spending on Social Security and on Medicare and Medicaid as percentages of GDP from 1962 to 2008, with Congressional Budget Office projections of spending through 2083. According to these projections, spending on Social Security will rise substantially over the next few decades and spending on the two health care programs will soar. Why? In the case of Social Security, the answer is demography. Social Security is a “pay -as you - go” system: current workers pay payroll taxes that fund the benefits of current retirees. So demography—specifically, the ratio of the number of retirees drawing benefits to the number of workers paying into Social Security—has a major impact on Social Security’s finances. There was a huge surge in the U.S. birth rate between 1946 and 1964, the years of the baby boom. Baby boomers are currently of working age— which means they are paying taxes, not collecting benefits. As the baby boomers retire, they will stop earning income that is taxed and start collecting benefits. As a result, the ratio of retirees receiving benefits to workers paying into the Social Security system will rise. In 2008, there were 31 retirees receiving benefits for every 100 workers paying into 303 f i g u r e 30.6 Future Demands on the Federal Budget This figure shows Congressional Budget Office projections of spending on social insurance programs as a share of GDP. Partly as a result of an aging population, but mainly because of rising health care costs, these programs are expected to become much more expensive over time, posing problems for the federal budget. Source: Congressional Budget Office. Medicare and Medicaid Social Security Actual data CBO projection Spending (percent of GDP) 30% 20 10 1962 1980 2000 2008 2020 2040 2060 2083 Year the system. By 2030, according to the Social Security Administration, that number will rise to 46; by 2050, it will rise to 48; and by
2080 that number will be 51. This will raise benefit payments relative to the size of the economy. The aging of the baby boomers, by itself, poses only a moderately sized long - run fiscal problem. The projected rise in Medicare and Medicaid spending is a much more serious concern. The main story behind projections of higher Medicare and Medicaid spending is the long -run tendency of health care spending to rise faster than overall spending, both for government - funded and for private-funded health care. To some extent, the implicit liabilities of the U.S. government are already reflected in debt statistics. We mentioned earlier that the government had a total debt of $12 trillion at the end of fiscal 2009, but that only $7.6 trillion of that total was owed to the public. The main explanation for that discrepancy is that both Social Security and part of Medicare (the hospital insurance program) are supported by dedicated taxes: their expenses are paid out of special taxes on wages. At times, these dedicated taxes yield more revenue than is needed to pay current benefits. In particular, since the mid -1980s the Social Security system has been taking in more revenue than it currently needs in order to prepare for the retirement of the baby boomers. This surplus in the Social Security system has been used to accumulate a Social Security trust fund, which was $2.5 trillion at the end of fiscal 2009. The money in the trust fund is held in the form of U.S. government bonds, which are included in the $12 trillion in total debt. You could say that there’s something funny about counting bonds in the Social Security trust fund as part of government debt. After all, these bonds are owed by one part of the government (the government outside the Social Security system) to another part of the government (the Social Security system itself). But the debt corresponds to a real, if implicit, liability: promises by the government to pay future retirement benefits. So many economists argue that the gross debt of $12 trillion, the sum of public debt and government debt held by Social Security and other trust funds, is a more accurate indication of the government’s fiscal health than the smaller amount owed to the public alone. 304 fyi Argentina’s Creditors Take a Haircut As we mentioned earlier, the idea that a government’s debt can reach a level at which the government can’t pay its creditors can seem far - fetched. In the United States, government debt is usually regarded as the safest
asset there is. But countries do default on their debts—they fail to repay the money they borrowed. In 1998, Russia defaulted on its bonds, triggering a worldwide panic in financial markets. In 2001, in the biggest default of modern times, the government of Argentina stopped making payments on $81 billion in debt. How did the Argentine default happen? During much of the 1990s, the country was experiencing an economic boom and the government was easily able to borrow money from abroad. Although deficit spending led to rising government debt, few considered this a problem. In 1998, however, the country slid into an economic slump that reduced tax revenues, leading to much larger deficits. Foreign lenders, increasingly nervous about the country’s ability to repay, became unwilling to lend more except at very high interest rates. By 2001, the country was caught in a vicious circle: to cover its deficits and pay off old loans as they came due, it was forced to borrow at much higher interest rates, and the escalating interest rates on new borrowing made the deficits even bigger. Argentine officials tried to reassure lenders by raising taxes and cutting government spending. But they were never able to balance the budget due to the continuing recession and the negative multiplier impact of their contractionary fiscal policies. These strongly contractionary fiscal policies drove the country deeper into recession. Late in 2001, facing popular protests, the Argentine government collapsed, and the country defaulted on its debt. Creditors can take individuals who fail to pay debts to court. The court, in turn, can seize the debtors’ assets and force them to pay part of future earnings to their creditors. But when a country defaults, it’s different. Its creditors can’t send in the police to seize the country’s assets. They must negotiate a deal with the country for partial repayment. The only leverage creditors have in these negotiations is the defaulting government’s fear that if it fails to reach a settlement, its reputation will suffer and it will be unable to borrow in the future. (A report by Reuters, the news agency, on Argentina’s debt negotiations was headlined “Argentina to unhappy bondholders: so sue.”) It took three years for Argentina to reach an agreement with its creditors because the new Argentine government was determined to strike a hard bargain. And it did. Here’s how Reuters described the settlement reached in March 2005: “The deal, which exchanged new paper valued at around 32 cents for every dollar in default
, was the biggest ‘haircut,’ or loss on principal, for investors of any sovereign bond restructuring in modern times.” Let’s put this into English: Argentina forced its creditors to trade their “sovereign bonds”—debts of a sovereign nation, that is, Argentina—for new bonds worth only 32% as much. Such a reduction in the value of debt is known as a “haircut.” It’s important to avoid two misconceptions about this “haircut.” First, you might be tempted to think that because Argentina ended up paying only a fraction of the sums it owed, it paid a small price for default. In fact, Argentina’s default accompanied one of the worst economic slumps of modern times, a period of mass unemployment, soaring poverty, and widespread unrest. Second, it’s tempting to dismiss the Argentine story as being of little relevance to countries like the United States. After all, aren’t we more responsible than that? But Argentina wouldn’t have been able to borrow so much in the first place if its government hadn’t been well regarded by international lenders. In fact, as late as 1998 Argentina was widely admired for its economic management. What Argentina’s slide into default shows is that concerns about the long - run effects of budget deficits are not at all academic. Due to its large and growing debt–GDP ratio, one recession pushed Argentina over the edge into economic collapse. M o d u l e 30 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Why is the cyclically adjusted budget balance a better measure of the long-run sustainability of government policies than the actual budget balance? 2. Explain why states required by their constitutions to balance their budgets are likely to experience more severe economic fluctuations than states not held to that requirement 305 3. Explain how each of the following events would affect the public debt or implicit liabilities of the U.S. government, other things equal. Would the public debt or implicit liabilities be greater or smaller? a. The growth rate of real GDP increases. b. Retirees live longer. c. Tax revenue decreases. d. The government borrows to pay interest on its current public debt. 4. Suppose the economy is in a slump and the current public debt is quite large. Explain the trade - off of short - run versus long - run objectives that policy makers face
when deciding whether or not to engage in deficit spending. Tackle the Test: Multiple-Choice Questions 1. If government spending exceeds tax revenues, which of the following is necessarily true? There is a I. positive budget balance. II. budget deficit. III. recession. a. I only b. II only III only c. d. I and II only I, II, and III e. 2. Which of the following fiscal policies is expansionary? Taxes a. increase by $100 million b. decrease by $100 million c. increase by $100 million d. decrease by $100 million e. both (a) and (d) Government spending increases by $100 million decreases by $100 million decreases by $100 million increases by $100 million 3. The cyclically adjusted budget deficit is an estimate of what the budget balance would be if real GDP were a. greater than potential output. b. equal to nominal GDP. Tackle the Test: Free-Response Questions 1. Consider the information provided below for the hypothetical country of Zeta. Tax revenues = 2,000 Government purchases of goods and services = 1,500 Government transfers = 1,000 Real GDP = 20,000 Potential output = 18,000 a. Is the budget balance in Zeta positive or negative? What is c. equal to potential output. d. falling. e. calculated during a recession. 4. During a recession in the United States, what happens automatically to tax revenues and government spending? Tax revenues a. increase b. decrease c. increase d. decrease e. decrease Government spending increases decreases decreases increases does not change 5. Which of the following is a reason to be concerned about persistent budget deficits? a. crowding out b. government default c. the opportunity cost of future interest payments d. higher interest rates leading to decreased long-run growth e. all of the above Answer (8 points) 1 point: Negative 1 point: −500 1 point: Expansion 1 point: Real GDP > potential output the amount of the budget balance? 1 point: No b. Zeta is currently in what phase of the business cycle? c. Explain. Is Zeta implementing the appropriate fiscal policy given the current state of the economy? Explain. d. How does Zeta’s cyclically adjusted budget deficit compare with its actual budget deficit? Explain. 1 point: Zeta is running a budget deficit during an expansion. 1 point: It is larger. 1 point: Because if real GDP equaled potential output, tax revenues would be
lower and government transfers would be higher. 2. In Module 29 you learned about the market for loanable funds, which is intimately related to our current topic of budget deficits. Use a correctly labeled graph of the market for loanable funds to illustrate the effect of a persistent budget deficit. Identify and explain the effect persistent budget deficits can have on private investment. 306 Module 31 Monetary Policy and the Interest Rate In Modules 28 and 29 we developed models of the money market and the loanable funds market. We also saw how these two markets are consistent and related. In the short run, the interest rate is determined in the money market and the loanable funds market adjusts in response to changes in the money market. However, in the long run, the interest rate is determined by matching the supply and demand of loanable funds that arise when real GDP equals potential output. Now we are ready to use these models to explain how the Federal Reserve can use monetary policy to stabilize the economy in the short run. Monetary Policy and the Interest Rate Let’s examine how the Federal Reserve can use changes in the money supply to change the interest rate. Figure 31.1 on the next page shows what happens when the Fed in- creases the money supply from M 2. The economy is originally in equilibrium at E1, with the equilibrium interest rate r1 and the money supply M 1. An increase in the money supply by the Fed to M 2 shifts the money supply curve to the right, from MS1 to MS2, and leads to a fall in the equilibrium interest rate to r2. Why? Because r2 is the only interest rate at which the public is willing to hold the quantity of money actually sup- plied, M 2. So an increase in the money supply drives the interest rate down. Similarly, a reduction in the money supply drives the interest rate up. By adjusting the money supply up or down, the Fed can set the interest rate. 1 to M In practice, at each meeting the Federal Open Market Committee decides on the interest rate to prevail for the next six weeks, until its next meeting. The Fed sets a target federal funds rate, a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through open-market operations—the purchase or sale of Treasury bills—until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window and changes in reserve requirements
, aren’t used on a regular basis (although the Fed used discount window lending in its efforts to address the 2008 financial crisis). What you will learn in this Module: • How the Federal Reserve implements monetary policy, moving the interest rate to affect aggregate output • Why monetary policy is the main tool for stabilizing the economy The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate and uses open-market operations to achieve that target 307 f i g u r e 31.1 The Effect of an Increase in the Money Supply on the Interest Rate The Federal Reserve can lower the interest rate by increasing the money supply. Here, the equilibrium interest rate falls from r1 to r2 in response to an increase in the money supply from M 2. In 1 to M order to induce people to hold the larger quantity of money, the interest rate must fall from r1 to r2. Interest rate, r An increase in the money supply... MS1 MS2... leads to a fall in the interest rate. r1 r2 E1 E2 M1 M2 MD Quantity of money Figure 31.2 shows how interest rate targeting works. In both panels, rT is the target federal funds rate. In panel (a), the initial money supply curve is MS1 with money sup- ply M 1, and the equilibrium interest rate, r1, is above the target rate. To lower the interest rate to rT, the Fed makes an open - market purchase of Treasury bills, which leads to an increase in the money supply via the money multiplier. This is illustrated in f i g u r e 31.2 Setting the Federal Funds Rate Interest rate, r... drives the interest rate down. r1 rT (a) Pushing the Interest Rate Down to the Target Rate (b) Pushing the Interest Rate Up to the Target Rate An open-market purchase... MS1 MS2 Interest rate, r An open-market sale... MS2 MS1 E1 E2 M1 M2 MD Quantity of money... drives the interest rate up. rT r1 E2 E1 M2 M1 MD Quantity of money The Federal Reserve sets a target for the federal funds rate and uses open -market operations to achieve that target. In both panels the target rate is rT. In panel (a) the initial equilibrium interest rate, r1
, is above the target rate. The Fed increases the money supply by making an open - market purchase of Treasury bills, pushing the money supply curve rightward, from MS1 to MS2, and driving the interest rate down to rT. In panel (b) the initial equilibrium interest rate, r1, is below the target rate. The Fed reduces the money supply by making an open - market sale of Treasury bills, pushing the money supply curve leftward, from MS1 to MS2, and driving the interest rate up to rT. 308 fyi The Fed Reverses Course During the summer of 2007, many called for a change in Federal Reserve policy. At first the Fed remained unmoved. On August 7, 2007, the Federal Open Market Committee decided to stand pat, making no change in its interest rate policy. The official statement did, however, concede that “financial markets have been volatile in recent weeks” and that “credit conditions have become tighter for some households and businesses.” Just three days later, the Fed issued a special statement basically assuring market players that it was paying attention, and on August 17 it issued another statement declaring that it was “monitoring the situation,” which is Fed - speak for “we’re getting nervous.” And on September 18, the Fed did what CNBC analyst Jim Cramer wanted: it cut the target federal funds rate “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” In effect, it conceded that Cramer’s worries were at least partly right. It was the beginning of a major change in monetary policy. The figure shows two interest rates from the beginning of 2004 to early 2010: the target federal funds rate decided by the Federal Open Market Committee, which dropped in a series of steps starting in September 2007, and the aver- Federal funds rate age effective rate that prevailed in the market each day. The figure shows that the interest rate cut six weeks after Cramer’s diatribe was only the first of several cuts. As you can see, this was a reversal of previous policy: previously the Fed had generally been raising rates, not reducing them, out of concern that inflation might become a problem. But starting in September 2007, fighting the financial crisis took priority. By the way, notice how beginning on December 16, 2008, it looks as if there are two target federal funds rates. What happened? The
Federal Open Market Committee set a target range for the federal funds rate, between 0% and 0.25%, starting on that date. That target range was still in effect at the time of writing. The figure also shows that that the Fed doesn’t always hit its target. There were a number of days, especially in 2008, when the actual federal funds rate was significantly above or below the target rate. But these episodes didn’t last long, and overall the Fed got what it wanted, at least as far as short-term interest rates were concerned. 6% 5 4 3 2 1 Effective federal funds rate Target federal funds rate 2004 2005 2006 2007 2008 2009 2010 Year panel (a) by the rightward shift of the money supply curve from MS1 to MS2 and an in- crease in the money supply to M 2. This drives the equilibrium interest rate down to the target rate, rT. Panel (b) shows the opposite case. Again, the initial money supply curve is MS1 with money supply M 1. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open - market sale of Treasury bills, leading to a fall in the money supply to M 2 via the money multiplier. The money supply curve shifts leftward from MS1 to MS2, driving the equilibrium interest rate up to the target federal funds rate, rT. Monetary Policy and Aggregate Demand We have seen how fiscal policy can be used to stabilize the economy. Now we will see how monetary policy—changes in the money supply or the interest rate, or both—can play the same role 309 Expansionary monetary policy is monetary policy that increases aggregate demand. Contractionary monetary policy is monetary policy that reduces aggregate demand. Expansionary and Contractionary Monetary Policy Previously we said that monetary policy shifts the aggregate demand curve. We can now explain how that works: through the effect of monetary policy on the interest rate. Suppose that the Federal Reserve expands the money supply. As we’ve seen, this leads to a lower interest rate. A lower interest rate, in turn, will lead to more investment spending, which will lead to higher real GDP, which will lead to higher consumer spending, and so on through the multiplier process. So the total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right. Monetary policy that shifts the AD curve
to the right, as illustrated in panel (a) of Figure 31.3, is known as expansionary monetary policy. f i g u r e 31.3 Monetary Policy and Aggregate Demand (a) Expansionary Monetary Policy (b) Contractionary Monetary Policy Aggregate price level Aggregate price level AD1 AD2 Real GDP AD3 AD1 Real GDP An expansionary monetary policy, shown in panel (a), shifts the aggregate demand curve to the right from AD1 to AD2. A con- tractionary monetary policy, shown in panel (b), shifts the aggregate demand curve to the left, from AD1 to AD3. Suppose, alternatively, that the Federal Reserve contracts the money supply. This leads to a higher interest rate. The higher interest rate leads to lower investment spending, which leads to lower real GDP, which leads to lower consumer spending, and so on. So the total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left. Monetary policy that shifts the AD curve to the left, as illustrated in panel (b) of Figure 31.3, is called contractionary monetary policy. Monetary Policy in Practice We have learned that policy makers try to fight recessions. They also try to ensure price stability: low (though usually not zero) inflation. Actual monetary policy reflects a combination of these goals. In general, the Federal Reserve and other central banks tend to engage in expansionary monetary policy when actual real GDP is below potential output. Panel (a) of Figure 31.4 shows the U.S. output gap, which we defined as the percentage difference between actual real GDP and potential output, versus the federal funds rate since 1985. (Recall that the output gap is positive when actual real GDP exceeds potential output.) 310 31.4 Tracking Monetary Policy Using the Output Gap, Inflation, and the Taylor Rule (a) Output Gap vs. Federal Funds Rate (b) Inﬂation Rate vs. Federal Funds Rate Output gap 4% 2 0 –2 –4 –6 –8 1985 Federal funds rate Output gap 1990 1995 2000 2005 2009 Year (c) The Taylor Rule Federal funds rate Federal funds rate 12% 10 8 6 4 2 0 –2 1985 Federal funds rate (Taylor rule) 1990 1995 2000 2005 2009 Year Federal funds rate 12% 10 8 6 4 2 0 Inﬂation rate Inﬂation rate 6% 5 4 3 2 1 0 –1 –2 1985 Federal funds rate 1990
1995 2000 2005 2009 Year Federal funds rate 12% 10 8 6 4 2 0 Panel (a) shows that the federal funds rate usually rises when the output gap is positive—that is, when actual real GDP is above potential output—and falls when the output gap is negative. Panel (b) illustrates that the federal funds rate tends to be high when inflation is high and low when inflation is low. Panel (c) shows the Taylor rule in action. The green line shows the actual federal funds rate from 1985 to 2009. The purple line shows the interest rate the Fed should have set according to the Taylor rule. The fit isn’t perfect—in fact, in 2009 the Taylor rule suggests a negative interest rate, an impossibility—but the Taylor rule does a better job of tracking U.S. monetary policy than either the output gap or the inflation rate alone. Source: Federal Reserve Bank of St. Louis; Bureau of Economic Analysis; Bureau of Labor Statistics. As you can see, the Fed has tended to raise interest rates when the output gap is rising— that is, when the economy is developing an inflationary gap—and cut rates when the output gap is falling. The big exception was the late 1990s, when the Fed left rates steady for several years even as the economy developed a positive output gap (which went along with a low unemployment rate). One reason the Fed was willing to keep interest rates low in the late 1990s was that inflation was low. Panel (b) of Figure 31.4 compares the inflation rate, measured as the rate of change in consumer prices excluding food and energy, with the federal funds rate. You can see how low inflation during the mid-1990s and early 2000s helped encourage loose monetary policy both in the late 1990s and in 2002–2003. In 1993, Stanford economist John Taylor suggested that monetary policy should follow a simple rule that takes into account concerns about both the business cycle and inflation. The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. He also suggested that actual monetary policy often looks as if the Federal Reserve was, in fact, more or less following the proposed rule. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 × output gap) The Taylor rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap 311 Panel (
c) of Figure 31.4 compares the federal funds rate specified by the Taylor rule with the actual federal funds rate from 1985 to 2009. With the exception of 2009, the Taylor rule does a pretty good job at predicting the Fed’s actual behavior—better than looking at either the output gap alone or the inflation rate alone. Furthermore, the direction of changes in interest rates predicted by an application of the Taylor rule to monetary policy and the direction of changes in actual interest rates have always been the same—further evidence that the Fed is using some form of the Taylor rule to set monetary policy. But, what happened in 2009? A combination of low inflation and a large and negative output gap briefly put the Taylor’s rule of prediction of the federal funds into negative territory. But a negative federal funds rate is, of course, impossible. So the Fed did the best it could—it cut rates aggressively and the federal funds rate fell to almost zero. Monetary policy, rather than fiscal policy, is the main tool of stabilization policy. Like fiscal policy, it is subject to lags: it takes time for the Fed to recognize economic problems and time for monetary policy to affect the economy. However, since the Fed moves much more quickly than Congress, monetary policy is typically the preferred tool. Inflation Targeting The Federal Reserve tries to keep inflation low but positive. The Fed does not, however, explicitly commit itself to achieving any particular rate of inflation, although it is widely believed to prefer inflation at around 2% per year. By contrast, a number of other central banks do have explicit inflation targets. So rather than using the Taylor rule to set monetary policy, they instead announce the inflation rate that they want to achieve—the inflation target—and set policy in an attempt to hit that target. This method of setting monetary policy is called inflation targeting. The central bank of New Zealand, which was the first country to adopt inflation targeting, specified a range for that target of 1% to 3%. Other central banks commit themselves to achieving a specific number. For example, the Bank of England is supposed to keep inflation at 2%. In practice, there doesn’t seem to be much difference between these versions: central banks with a target range for inflation seem to aim for the middle of that range, and central banks with a fixed target tend to give themselves considerable wiggle room. One major difference between inflation targeting and the Taylor rule is that inflation targeting is forward -looking rather than backward -looking. That is, the Taylor rule
adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation. Advocates of inflation targeting argue that it has two key advantages, transparency and accountability. First, economic uncertainty is reduced because the public knows the objective of an inflation -targeting central bank. Second, the central bank’s success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable. Critics of inflation targeting argue that it’s too restrictive because there are times when other concerns—like the stability of the financial system—should take priority over achieving any particular inflation rate. Indeed, in late 2007 and early 2008 the Fed cut interest rates much more than either the Taylor rule or inflation targeting would have dictated because it feared that turmoil in the financial markets would lead to a major recession (which it did, in fact). Many American macroeconomists have had positive things to say about inflation targeting—including Ben Bernanke, the current chair of the Federal Reserve. At the time of this writing, however, there were no moves to have the Fed adopt an explicit inflation target, and during normal times it still appears to set monetary policy by applying a loosely defined version of the Taylor rule Stanford economist John Taylor suggested a simple rule for monetary policy. Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target. 312 fyi What the Fed Wants, the Fed Gets What’s the evidence that the Fed can actually cause an economic contraction or expansion? You might think that finding such evidence is just a matter of looking at what happens to the economy when interest rates go up or down. But it turns out that there’s a big problem with that approach: the Fed usually changes interest rates in an attempt to tame the business cycle, raising rates if the economy is expanding and reducing rates if the economy is slumping. So in the actual data, it often looks as if low interest rates go along with a weak economy and high rates go along with a strong economy. In a famous 1994 paper titled “Monetary Policy Matters,” the macroeconomists Christina Romer and David Romer solved this problem by focusing on episodes in which monetary policy wasn’t a reaction to the business cycle. Specifically, they used minutes from the Federal Open Market Committee and other sources to identify episodes “in which the Federal Reserve in effect decided to attempt to create a recession to reduce inflation.” Contraction
ary monetary policy is sometimes used to eliminate infla- Unemployment rate 12% tion that has become embedded in the economy, rather than just as a tool of macroeconomic stabilization. In this case, the Fed needs to create a recessionary gap—not just eliminate an inflationary gap—to wring embedded inflation out of the economy. The figure shows the unemployment rate be- tween 1952 and 1984 (orange) and identifies five dates on which, according to Romer and Romer, the Fed decided that it wanted a recession (vertical red lines). In four out of the five cases, the decision to contract the economy was followed, after a modest lag, by a rise in the unemployment rate. On average, Romer and Romer found, the unemployment rate rises by 2 percentage points after the Fed decides that unemployment needs to go up. So yes, the Fed gets what it wants. 10 8 6 4 2 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 Year M o d u l e 31 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Assume that there is an increase in the demand for money at every interest rate. Using a diagram, show what effect this will have on the equilibrium interest rate for a given money supply. 2. Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in question 1 to keep the federal funds rate unchanged? Illustrate with a diagram. 3. Suppose the economy is currently suffering from a recessionary gap and the Federal Reserve uses an expansionary monetary policy to close that gap. Describe the short -run effect of this policy on the following. a. the money supply curve b. the equilibrium interest rate c. d. consumer spending e. aggregate output investment spending 313 Tackle the Test: Multiple-Choice Questions 1. At each meeting of the Federal Open Market Committee, the Federal Reserve sets a target for which of the following? I. the federal funds rate II. the prime interest rate III. the market interest rate a. I only b. II only c. III only d. I and III only I, II, and III e. 2. Which of the following actions can the Fed take to decrease the equilibrium interest rate? increase the money supply a. b. increase money demand c. decrease the money supply d. decrease money demand e. both (a) and (d) 4. Which of
the following is a goal of monetary policy? a. zero inflation b. deflation c. price stability d. increased potential output e. decreased actual real GDP 5. When implementing monetary policy, the Federal Reserve attempts to achieve a. an explicit target inflation rate. b. zero inflation. c. a low rate of deflation. d. a low, but positive inflation rate. e. 4–5% inflation. 3. Contractionary monetary policy attempts to interest rates. aggregate demand by a. decrease increase b. c. decrease d. increase increase e. increasing decreasing decreasing increasing maintaining Tackle the Test: Free-Response Questions 1. a. Give the equation for the Taylor rule. b. How well does the Taylor rule fit the Fed’s actual behavior? 2. a. What can the Fed do with each of its tools to implement expansionary monetary policy during a recession? b. Use a correctly labeled graph of the money market to explain how the Fed’s use of expansionary monetary policy affects interest rates in the short run. c. Explain how the interest rate changes you graphed in part b affect aggregate supply and demand in the short run. d. Use a correctly labeled aggregate demand and supply graph to illustrate how expansionary monetary policy affects aggregate output in the short run. Explain. c. What does the Taylor rule predict will happen when the inflation rate increases? Explain. d. What does the Taylor rule predict will happen if the economy sinks further into a recession? Explain. Answer (7 points) 1 point: Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 × output gap) 1 point: Not exactly, but fairly well 1 point: It does better than any one measure alone, and it has always correctly predicted the direction of change of interest rates. 1 point: The federal funds rate will increase. 1 point: According to the equation, the federal funds rate increases by 1.5 percentage points for every one percentage point increase in inflation. OR, the Taylor rule predicts contractionary monetary policy during periods of inflation. 1 point: The federal funds rate will decrease. 1 point: According to the equation, the federal funds rate decreases by 0.5 percentage points for every one percentage point decrease in the output gap, as from −1% to −2%, indicating a deeper recession. OR, the Taylor rule predicts expansionary monetary policy during periods of recession. 314 What you will learn in this Module: • The effects of an inappropriate monetary policy • The concept
of monetary neutrality and its relationship to the long-term economic effects of monetary policy Module 32 Money, Output, and Prices in the Long Run In the previous module we discussed how expansionary and contractionary monetary policy can be used to stabilize the economy. The Federal Reserve can use its monetary policy tools to change the money supply and cause the equilibrium interest rate in the money market to increase or decrease. But what if a central bank pursues a monetary policy that is not appropriate? That is, what if a central bank pursues expansionary policy during an expansion or contractionary policy during a recession? In this module we consider how a counter-productive action by a central bank can actually destabilize the economy in the short run. We also introduce the long-run effects of monetary policy. As we learned in the last section, the money market (where monetary policy has its effect on the money supply) determines the interest rate only in the short run. In the long run, the interest rate is determined in the market for loanable funds. Here we look at long-run adjustments and consider the long-run effects of monetary policy. Money, Output, and Prices Because of its expansionary and contractionary effects, monetary policy is generally the policy tool of choice to help stabilize the economy. However, not all actions by central banks are productive. In particular, as we’ll see later, central banks sometimes print money not to fight a recessionary gap but to help the government pay its bills, an action that typically destabilizes the economy. What happens when a change in the money supply pushes the economy away from, rather than toward, long - run equilibrium? The economy is self - correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money supply, we can make a stronger statement: in the long run, changes in the quantity of money affect the aggregate price level, but they do not change real aggregate output or the interest rate. To see why, let’s look at what happens if the central bank permanently increases the money supply 315 Short-Run and Long -Run Effects of an Increase in the Money Supply To analyze the long - run effects of monetary policy, it’s helpful to think of the central bank as choosing a target for the money supply rather than for the interest rate. In assessing the effects of an increase in the money supply, we return to the analysis of the long -run effects of an increase
in aggregate demand. Figure 32.1 shows the short -run and long -run effects of an increase in the money supply when the economy begins at potential output, Y1. The initial short -run aggregate supply curve is SRAS1, the long -run aggregate supply curve is LRAS, and the initial aggregate demand curve is AD1. The economy’s initial equilibrium is at E1, a point of both short - run and long - run macroeconomic equilibrium because it is on both the short -run and the long - run aggregate supply curves. Real GDP is at potential output, Y1. Now suppose there is an increase in the money supply. Other things equal, an increase in the money supply reduces the interest rate, which increases investment spending, which leads to a further rise in consumer spending, and so on. So an increase in the money supply increases the quantity of goods and services demanded, shifting the AD curve rightward to AD2. In the short run, the economy moves to a new short - run macroeconomic equilibrium at E2. The price level rises from P1 to P2, and real GDP rises from Y1 to Y2. That is, both the aggregate price level and aggregate output increase in the short run. But the aggregate output level Y2 is above potential output. As a result, nominal wages will rise over time, causing the short - run aggregate supply curve to shift leftward. This process stops only when the SRAS curve ends up at SRAS2 and the economy ends up at point E3, a point of both short - run and long - run macroeconomic equilibrium. The long -run effect of an increase in the money supply, then, is that the aggregate price level has increased from P1 to P3, but aggregate output is back at potential f i g u r e 32.1 The Short -Run and Long -Run Effects of an Increase in the Money Supply An increase in the money supply generates a positive short -run effect, but no long -run effect, on real GDP. Here, the economy begins at E1, a point of short - run and long - run macroeconomic equilibrium. An increase in the money supply shifts the AD curve rightward, and the economy moves to a new short -run equilibrium at E2 and a new real GDP of Y2. But E2 is not a long - run equilibrium: Y2 exceeds potential output, Y1, leading over time to an increase in nominal wages. In the long run
, the increase in nominal wages shifts the short - run aggregate supply curve leftward, to a new position at SRAS2. The economy reaches a new short run and long - run macroeconomic equilibrium at E3 on the LRAS curve, and output falls back to potential output, Y1. The only long - run effect of an increase in the money supply is an increase in the aggregate price level from P1 to P3. Aggregate price level An increase in the money supply reduces the interest rate and increases aggregate demand... P3 P2 P1 LRAS E3 E1 SRAS2 SRAS1... but the eventual rise in nominal wages leads to a fall in short-run aggregate supply and aggregate output falls back to potential output. AD2 E2 AD1 Y1 Y2 Real GDP Potential output 316 output, Y1. In the long run, a monetary expansion raises the aggregate price level but has no effect on real GDP. If the money supply decreases, the story we have just told plays out in reverse. Other things equal, a decrease in the money supply raises the interest rate, which decreases investment spending, which leads to a further decrease in consumer spending, and so on. So a decrease in the money supply decreases the quantity of goods and services demanded at any given aggregate price level, shifting the aggregate demand curve to the left. In the short run, the economy moves to a new short-run macroeconomic equilibrium at a level of real GDP below potential output and a lower aggregate price level. That is, both the aggregate price level and aggregate output decrease in the short run. But what happens over time? When the aggregate output level is below potential output, nominal wages fall. When this happens, the short -run aggregate supply curve shifts rightward. This process stops only when the SRAS curve ends up at a point of both short - run and long- run macroeconomic equilibrium. The long - run effect of a decrease in the money supply, then, is that the aggregate price level decreases, but aggregate output is back at potential output. In the long run, a monetary contraction decreases the aggregate price level but has no effect on real GDP. Monetary Neutrality How much does a change in the money supply change the aggregate price level in the long run? The answer is that a change in the money supply leads to a proportional change in the aggregate price level in the long run. For example, if the money supply falls 25%, the aggregate price level falls 25% in the long
run; if the money supply rises 50%, the aggregate price level rises 50% in the long run. How do we know this? Consider the following thought experiment: suppose all prices in the economy—prices of final goods and services and also factor prices, such as nominal wage rates—double. And suppose the money supply doubles at the same time. What difference does this make to the economy in real terms? None. All real variables in the economy—such as real GDP and the real value of the money supply (the amount of goods and services it can buy)—are unchanged. So there is no reason for anyone to behave any differently. We can state this argument in reverse: if the economy starts out in long - run macroeconomic equilibrium and the money supply changes, restoring long - run macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real value of the money supply to its original level. So if the money supply falls 25%, the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on. This analysis demonstrates the concept known as monetary neutrality, in which changes in the money supply have no real effects on the economy. In the long run, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage. Economists argue that money is neutral in the long run. This is, however, a good time to recall the dictum of John Maynard Keynes: “In the long run we are all dead.” In the long run, changes in the money supply don’t have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. Monetary policy does have powerful real effects on the economy in the short run, often making the difference between recession and expansion. And that matters a lot for society’s welfare. Changes in the Money Supply and the Interest Rate in the Long Run In the short run, an increase in the money supply leads to a fall in the interest rate, and a decrease in the money supply leads to a rise in the interest rate. Module 29 explained that in the long run it’s a different story: changes in the money supply don’t affect the interest rate at all. Here we’ll review that story and discuss the reasons behind it in greater detail. According to the concept of monetary neutrality, changes in the
money supply have no real effects on the economy 317 f i g u r e 32.2 1 to M The Long -Run Determination of the Interest Rate In the short run, an increase in the money supply from M 2 pushes the interest rate down from r1 to r2 and the economy moves to E2, a short-run equilibrium. In the long run, however, the aggregate price level rises in proportion to the increase in the money supply, leading to an increase in money demand at any given interest rate in proportion to the increase in the aggregate price level, as shown by the shift from MD1 to MD2. The result is that the quantity of money demanded at any given interest rate rises by the same amount as the quantity of money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1. Interest rate, r MS1 MS2 An increase in the money supply lowers the interest rate in the short run... E1 r1 r2 E3 E2... but in the long run higher prices lead to greater money demand, raising the interest rate to its original level. MD1 MD2 M1 M2 Quantity of money Figure 32.2 shows the money supply curve and the money demand curve before and after the Fed increases the money supply. We assume that the economy is initially at E1, in long - run macroeconomic equilibrium at potential output, and with money supply M 1. The initial equilibrium interest rate, determined by the intersection of the money demand curve MD1 and the money supply curve MS1, is r1. fy i International Evidence of Monetary Neutrality These days monetary policy is quite similar among wealthy countries. Each major nation (or, in the case of the euro, the eurozone) has a central bank that is insulated from political pressure. All of these central banks try to keep the aggregate price level roughly stable, which usually means inflation of at most 2% to 3% per year. But if we look at a longer period and a wider group of countries, we see large differences in the growth of the money supply. Between 1970 and the present, the money supply rose only a few percentage points per year in countries such as Switzerland and the United States, but rose much more rapidly in some poorer countries, such as South Africa. These differences allow us to see whether it is really true that increases in the money supply lead, in the long run, to equal percentage increases in the aggregate price level. The figure
shows the annual percentage increases in the money supply and average annual increases in the aggregate price level—that is, the average rate of inflation—for a sample of Average annual increase in price level 25% 20 10 15 0 5 countries during the period 1970–2007, with each point representing a country. If the relationship between increases in the money supply and changes in the aggregate price level were exact, the points would lie precisely on a 45-degree line. In fact, the relationship isn’t exact because other factors besides money affect the aggregate price level. But the scatter of points clearly lies close to a 45-degree line, showing a more or less proportional relationship between money and the aggregate price level. That is, the data support the concept of monetary neutrality in the long run. 45-degree line Iceland Japan Switzerland United States Canada Europe South Africa Korea Australia India 5 10 15 20 25 30% Average annual increase in money supply 318 Now suppose the money supply increases from M 2. In the short run, the economy moves from E1 to E2 and the interest rate falls from r1 to r2. Over time, however, the aggregate price level rises, and this raises money demand, shifting the money demand curve rightward from MD1 to MD2. The economy moves to a new long-run equilibrium at E3, and the interest rate rises to its original level of r1. 1 to M How do we know that the long - run equilibrium interest rate is the original interest rate, r1? Because the eventual increase in money demand is proportional to the increase in money supply, thus counteracting the initial downward effect on interest rates. Let’s follow the chain of events to see why. With monetary neutrality, an increase in the money supply is matched by a proportional increase in the price level in the long run. If the money supply rises by, say, 50%, the price level will also rise by 50%. Changes in the price level, in turn, cause proportional changes in the demand for money. So a 50% increase in the money supply raises the aggregate price level by 50%, which increases the quantity of money demanded at any given interest rate by 50%. Thus, at the initial interest rate of r1, the quantity of money demanded rises exactly as much as the money supply, and r1 is again the equilibrium interest rate. In the long run, then, changes in the money supply do not affect the interest rate. M o d u l e 32 AP R e v i e w Solutions appear
at the back of the book. Check Your Understanding 1. Suppose the economy begins in long-run macroeconomic 2. Again supposing the economy begins in long-run equilibrium. What is the long-run effect on the aggregate price level of a 5% increase in the money supply? Explain. macroeconomic equilibrium, what is the long-run effect on the interest rate of a 5% increase in the money supply? Explain. Tackle the Test: Multiple-Choice Questions 1. In the long run, changes in the quantity of money affect which of the following? I. real aggregate output II. interest rates III. the aggregate price level a. I only b. II only c. III only d. I and II only I, II, and III e. 2. An increase in the money supply will lead to which of the following in the short run? a. higher interest rates b. decreased investment spending c. decreased consumer spending d. increased aggregate demand e. lower real GDP 3. A 10% decrease in the money supply will change the aggregate price level in the long run by a. zero. b. less than 10%. c. 10%. d. 20%. e. more than 20%. 4. Monetary neutrality means that, in the long run, changes in the money supply a. can not happen. b. have no effect on the economy. c. have no real effect on the economy. d. increase real GDP. e. change real interest rates. 5. A graph of percentage increases in the money supply and average annual increases in the price level for various countries provides evidence that a. changes in the two variables are exactly equal. b. the money supply and aggregate price level are unrelated. c. money neutrality holds only in wealthy countries. d. monetary policy is ineffective. e. money is neutral in the long run 319 2. a. Draw a correctly labeled graph of aggregate demand and supply showing an economy in long-run macroeconomic equilibrium. b. On your graph, show what happens in the short run if the central bank increases the money supply to pay off a government deficit. Explain. c. On your graph, show what will happen in the long run. Explain. Tackle the Test: Free-Response Questions 1. Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short -run and long -run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the
following: a. aggregate output b. the aggregate price level c. the real value of the money supply (its purchasing power for goods and services) d. the interest rate Answer (8 points) 1 point: Aggregate output rises in the short run. 1 point: Aggregate output falls back to potential output in the long run. 1 point: The aggregate price level rises in the short run (by less than 25%). 1 point: The aggregate price level rises by 25% in the long run. 1 point: The real value of the money supply increases in the short run. 1 point: The real value of the money supply does not change (relative to its original value) in the long run. 1 point: The interest rate falls in the short run. 1 point: The interest rate rises back to its original level in the long run. 320 What you will learn in this Module: • The classical model of the price level • Why efforts to collect an inflation tax by printing money can lead to high rates of inflation and even hyperinflation • The types of inflation: cost-push and demand-pull Module 33 Types of Inflation, Disinflation, and Deflation We have seen that monetary policy affects economic welfare in the short-run. Let’s take a closer look at two phenomena that involve monetary policy: inflation and deflation. Money and Inflation In the summer of 2008, the African nation of Zimbabwe achieved the unenviable distinction of having the world’s highest inflation rate: 11 million percent a year. Although the United States has not experienced the inflation levels that some countries have seen, in the late 1970s and early 1980s, consumer prices were rising at an annual rate as high as 13%. The policies that the Federal Reserve instituted to reduce this high level led to the deepest recession since the Great Depression. As we’ll see later, moderate levels of inflation such as those experienced in the United States—even the double-digit inflation of the late 1970s—can have complex causes. Very high inflation, the type suffered by Zimbabwe, is associated with rapid increases in the money supply while the causes of moderate inflation, the type experienced in the United States, are quite different. To understand what causes inflation, we need to revisit the effect of changes in the money supply on the overall price level. Then we’ll turn to the reasons why governments sometimes increase the money supply very rapidly. The Classical Model of Money and Prices We learned that in the short run an increase in the money
supply increases real GDP by lowering the interest rate and stimulating investment spending and consumer spending. However, in the long run, as nominal wages and other sticky prices rise, real GDP falls back to its original level. So in the long run, an increase in the money supply does not change real GDP. Instead, other things equal, it leads to an equal percentage rise in the overall price level; that is, the prices of all goods and services in the economy, including nominal wages and the prices of intermediate goods, rise by the same percentage as m o d u l e 3 3 Ty 321 the money supply. And when the overall price level rises, the aggregate price level—the prices of all final goods and services—rises as well. As a result, a change in the nominal money supply, M, leads in the long run to a change in the aggregate price level, P, that leaves the real quantity of money, M/P, at its original level. As a result, there is no long-run effect on aggregate demand or real GDP. For example, when Turkey dropped six zeros from its currency, the Turkish lira, in January 2005, Turkish real GDP did not change. The only thing that changed was the number of zeros in prices: instead of something costing 2,000,000 lira, it cost 2 lira. This is, to repeat, what happens in the long run. When analyzing large changes in the aggregate price level, however, macroeconomists often find it useful to ignore the distinction between the short run and the long run. Instead, they work with a simplified model in which the effect of a change in the money supply on the aggregate price level takes place instantaneously rather than over a long period of time. You might be concerned about this assumption given the emphasis we’ve placed on the difference between the short run and the long run. However, for reasons we’ll explain shortly, this is a reasonable assumption to make in the case of high inflation. The simplified model in which the real quantity of money, M/P, is always at its long run equilibrium level is known as the classical model of the price level because it was commonly used by “classical” economists prior to the influence of John Maynard Keynes. To understand the classical model and why it is useful in the context of high inflation, let’s revisit the AD–AS model and what it says about the effects of an increase in the money supply. (Unless otherwise
noted, we will always be referring to changes in the nominal supply of money.) Figure 33.1 reviews the effects of an increase in the money supply according to the AD–AS model. The economy starts at E1, a point of short - run and long -run macroeconomic equilibrium. It lies at the intersection of the aggregate demand curve, AD1, and the short - run aggregate supply curve, SRAS1. It also lies on the long - run aggregate supply curve, LRAS. At E1, the equilibrium aggregate price level is P1. Now suppose there is an increase in the money supply. This is an expansionary monetary policy, which shifts the aggregate demand curve to the right, to AD2, and moves the economy to a new short -run macroeconomic equilibrium at E2. Over time, however, The Turkish currency is the lira. When Turkey made 1,000,000 “old” lira equivalent to 1 “new” lira, real GDP was unaffected because of the neutrality of money. According to the classical model of the price level, the real quantity of money is always at its long -run equilibrium level. f i g u r e 33.1 The Classical Model of the Price Level Starting at E1, an increase in the money supply shifts the aggregate demand curve rightward, as shown by the movement from AD1 to AD2. There is a new short -run macroeconomic equilibrium at E2 and a higher price level at P2. In the long run, nominal wages adjust upward and push the SRAS curve leftward to SRAS2. The total percent increase in the price level from P1 to P3 is equal to the percent increase in the money supply. In the classical model of the price level, we ignore the transition period and think of the price level as rising to P3 immediately. This is a good approximation under conditions of high inflation. Aggregate price level P3 P2 P1 LRAS SRAS2 SRAS1 E3 E1 E2 AD2 AD1 YP Y2 Potential output Real GDP 322 nominal wages adjust upward in response to the rise in the aggregate price level, and the SRAS curve shifts to the left, to SRAS2. The new long - run macroeconomic equilibrium is at E3, and real GDP returns to its initial level. The long - run increase in the aggregate price level from P1 to P3 is proportional to the increase in the money supply. As a result

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