Ch. 11
Money is any asset that is widely acceptable as a means of payment and is highly liquid. An asset is considered liquid if it can be converted to cash quickly and at little cost. Credit limits on credit cards are not money because the right to borrow is not an asset. Stocks, bonds, and gold bars are not money because they are not widely acceptable.
M1 is the standard definition of the money stock. It is the sum of cash in the hands of the public, demand deposits, other checkable deposits, and travelers’ checks. For simplification, this chapter defines the money supply as cash in the hands of the public plus demand deposits.
Banks are important examples of financial intermediaries—business firms that assemble loanable funds and channel those funds to borrowers. A bank’s assets include property and buildings, government and corporate bonds, loans, vault cash, and accounts with the Federal Reserve. The Federal Reserve requires that banks hold a minimum fraction of their deposits as vault cash or accounts with the Fed. These are a bank’s required reserves. Total reserves less required reserves equals excess reserves. Demand deposits are a bank’s liability, because customers have the right to withdraw these funds from their checking accounts. A bank’s net worth is equal to total assets minus total liabilities.
Congress established the Federal Reserve System in 1913, as a corporation whose stockholders are the private banks that it regulates. There are 12 Federal Reserve Banks, each serving a different part of the United States. The Board of Governors supervises the Federal Reserve System. This board consists of seven members who are appointed by the President, and confirmed by the Senate for a 14-year term. The most powerful person at the Fed is the Chairman of the Board of Governors, who is appointed by the President for a four-year term. The Federal Open Market Committee consists of all seven governors of the Fed, along with the 12 district bank presidents. It meets about eight times per year and sets the general course for the nation’s money supply.
Some of the Fed’s most important responsibilities are supervising and regulating banks, acting as a bank for banks, issuing paper currency, clearing checks, and controlling the money supply.
The Fed uses open market operations to control the money supply. It buys government bonds when it wants to increase the money supply, and sells government bonds when it wants to decrease the money supply.
When the Fed buys government bonds, it injects reserves into the banking system. This increases the amount of excess reserves in the banking system, which allows banks to make new loans. When banks create loans, the total supply of money increases. When the Fed sells government bonds, it removes reserves from the banking system, and causes the money supply to contract.
The demand deposit multiplier is the number by which we multiply an injection of reserves to get the total change in demand deposits. The size of the demand deposit multiplier is negatively related to the required reserve ratio. The multiplier is weakened by the public’s desire to hold cash and banks’ desires to hold excess reserves.
The Fed can also control the money supply by changing the required reserve ratio or by changing the discount rate (the rate the Fed charges banks when it lends them reserves). Lowering the required reserve ratio or the discount rate increases the money supply, and vice versa.
A bank failure occurs when a bank is unable to meet the requests of its depositors to withdraw their funds. A run on a bank occurs when a bank’s depositors all try to withdraw their funds at one time. A banking panic occurs when many banks fail simultaneously. The Federal Deposit Insurance Corporation was created by Congress in 1933, to prevent banking panics by reimbursing those who lose their deposits when a bank fails. FDIC protection for bank accounts is not costless—banks must pay insurance premiums to the FDIC, and they pass this cost on to their depositors and borrowers. Additionally, FDIC insurance weakens bank managers’ incentives to act responsibly, and increases the need for banking regulation
Ch. 12
Money is one of the ways we can hold our wealth. Given a fixed total amount of wealth, if we want to hold more wealth as money, we must hold less wealth in other forms. To keep things simple, we can imagine that individuals choose how to divide wealth between two assets: money and bonds. Money can be used as a means of payment but earns no interest, while bonds earn interest but cannot be used as a means of payment. The price level, real income, and the interest rate determine how much money an individual will decide to hold. The demand for money by businesses follows the same principles as the demand for money by individuals.
The economy-wide quantity of money demanded is the amount of total wealth in the economy that all wealth holders, together, choose to hold as money, rather than as bonds. The money demand curve shows the total quantity of money demanded in the economy at each interest rate. A change in the interest rate moves us along the money demand curve, while a change in real income or the price level will cause the money demand curve to shift.
The economy’s money supply curve shows the total money supply at each interest rate. This line is vertical because once the Fed sets the money supply, it remains constant until the Fed changes it. Open market purchases of bonds inject reserves into the banking system and shift the money supply curve rightward. Open market sales have the opposite effect.
In the short run the equilibrium interest rate is determined in the money market. Equilibrium in the money market occurs when the quantity of money people are actually holding is equal to the quantity of money they want to hold. When the interest rate is above its equilibrium level, people try to get rid of their excess supply of money by buying bonds. This raises bond prices and lowers interest rates until people are satisfied with their money holdings. A similar process drives up the interest rate when it is below its equilibrium level.
When the Fed controls or manipulates the money supply in order to achieve any macroeconomic goal it is engaging in monetary policy. When the Fed increases the money supply, the equilibrium interest rate falls and spending on plant and equipment, new housing, and consumer durables increases. This produces a multiplier effect that increases equilibrium GDP. Decreasing the money supply has the opposite effect.
Fiscal policy (like any other spending changes) leads to an initial change in equilibrium GDP, which is partially offset by a second change in equilibrium GDP that occurs in response to money market changes. An increase in government spending, for example, raises the interest rate and crowds out some private investment. It may also crowd out consumption spending. There is an important difference between crowding out in the classical model and the effects in the short-run. In the classical, long-run model, there is complete crowding out, while here the crowding out effect is not complete. This analysis assumes that the Fed does not change the money supply in response to shifts in the aggregate expenditure line.
Our view of the interest rate depends on the time period we are considering. The market for loanable funds determines the interest rate in the long-run (classical) model, while the money market determines the interest rate in the short run.
Another source of interest rate changes is a shift in the money demand curve due to a change in expectations about future interest rates. For instance, a general expectation that interest rates will rise in the future will cause the money demand curve to shift rightward in the present, driving up the interest rate in the present.
A Using the Theory section shows how the Fed used monetary policy to save the economy from a more severe and longer lasting recession in 2001.
Ch. 13
This chapter shows that we can improve our understanding of economic fluctuations by building a model that allows for changes in the price level. The relationship between the price level and output is a two-way relationship. Changes in the price level cause changes in real GDP, but changes in real GDP also cause changes in the price level. The aggregate demand (AD) curve illustrates the first causal relationship, while the aggregate supply (AS) curve illustrates the second.
The AD curve tells us the equilibrium real GDP at any price level. This is the level of output at which total spending equals total output. Movements along the AD curve occur when the price level changes. The AD curve shifts when anything other than a change in the price level causes equilibrium GDP to change. These other influences include changes in government purchases, autonomous consumption spending, investment spending, net exports, taxes, and the money supply.
The AS curve tells us the price level consistent with firms’ unit costs and their percentage markup at any level of output over the short run. Movements along the AS curve occur when a change in total output causes a change in the price level. A change in output affects unit costs and the price level in three key ways: it will cause a change in nonlabor input prices, it will cause a change in input requirements per unit of output, and it will cause a change in the nominal wage. Since nominal wages respond slowly to changes in output, the AS curve is derived while assuming that the nominal wage rate is given.
The AS curve shifts when anything other than a change in real GDP causes the price level to change. Short run changes in unit costs that are not caused by changes in output (such as changes in world oil prices or the weather) and changes in nominal wage rates cause the AS curve to shift. Unit costs change in the short run because of changes in world oil prices, the weather, technology, and, if it were not constant, the nominal wage. (A later section of the chapter examines a change in the nominal wage.)
Short-run equilibrium is at the intersection of the AD and AS curves.
A demand shock is an event that causes the AD curve to shift. A positive demand shock shifts the AD curve to the right and increases both real GDP and the price level in the short run. A negative demand shock shifts the AD curve to the left and decreases both real GDP and the price level in the short run.
When a demand shock pulls the economy away from full-employment, changes in the wage rate will shift the AS curve, eventually causing the economy to self-correct and return to full-employment output. A vertical long-run AS curve illustrates this result. This long-run AS curve shows that the economy pehaves as the classical model predicts after the self-correcting mechanism has done its job. Demand shocks cannot change equilibrium GDP in the long run. An increase in government purchases, for instance, causes a complete crowding out effect that leaves total output and total spending unchanged. Since it can take several years to return the economy to full-employment after a demand shock, governments are reluctant to rely on the self-correcting mechanism alone to keep the economy on track, and rely on fiscal and monetary policies to return to full-employment more quickly.
A supply shock is an event that causes the AS curve to shift. A negative supply shock shifts the AS curve upward, causing stagflation in the short run, while a positive supply shock shifts the AS curve downward, increasing output and decreasing the price level. In the long run, however, supply shocks self-correct in the same way as demand shocks, so that the economy returns to full employment.
In the real world, several things complicate the adjustment process as described in the chapter. To draw the AS curve, the chapter assumes that output prices are completely flexible in the short run, and that nominal wages are completely rigid in the short run. But in some markets, output prices are not completely flexible, and nominal wages are not completely rigid, in the short run. In addition, recovering from a demand or supply shock requires adjustments other than changes in prices and wages. While these observations complicate the adjustment process in the real world, they do not change the basic outlines of that process as described in the chapter.
The AD and AS curves are tools that help us understand important economic events. This chapter closes by using these tools to explain the forces behind the recessions of 1990–91 and 2001, and jobless expansions.
Ch. 15
This chapter examines the government’s role in the macroeconomy, exploring recent trends in the government’s budget, and the causes and effects of those trends. It also explores the differences between fiscal policy’s long-run effects on the economy and its short-run effects.
There are three categories of federal government outlays: government purchases of goods and services, transfer payments, and interest on the national debt. Nonmilitary purchases account for a stable, low 2 percent of GDP, while military purchases have declined dramatically over the past several decades. Transfers, which include retirement benefits, health programs, and income security, are the fastest growing part of government outlays, currently equal to about 12.5 percent of GDP. Interest on the national debt grew rapidly in the early 1980s, fell slowly in the early 1990s, and then fell dramatically as the national debt dropped from 1998 to 2001. Interest relative to GDP continued to decline in the early 200s, even though the national debt was rising, because the Federal Reserve repeatedly lowered interest rates and kept them low. From 1992 to 2000, federal government spending as a percentage of GDP fell steadily. The main causes of the decline have been the continued sharp decreases in military spending, and more modest decreases in transfer payments relative to GDP during a long expansion. In the early 2000s—due to a rise in military and domestic security spending—federal outlays as a percentage of GDP began rising, and seem likely to continue rising through the decade.
The federal government obtains most of its revenue from the personal income tax and the social security tax. In the early 2000s, federal tax revenues began a projected downward trend due to long-term reductions in tax rates. The government has been raising Social security tax rates not just to keep the system solvent, but to build up reserves for retiring baby boomers.
When total tax revenue exceeds total government spending in any year, the government runs a budget surplus in that year. When the reverse occurs, and total government spending is greater than total tax revenue, the government runs a budget deficit. The national debt is the total amount that the federal government owes at a given point in time. The national debt is the total value of government bonds held by the public. Deficits add to the national debt, while surpluses subtract from the national debt. Since the cumulative total of the government’s deficits has been greater than its surpluses, the national debt has grown in recent decades.
Economic fluctuations affect both transfer payments and tax revenues. In a recession, because transfers rise and tax revenue falls, the federal budget deficit increases (or the surplus falls). An expansion has the opposite effects on the federal deficit.
Because the business cycle has systematic effects on spending and revenue, economists find it useful to divide the deficit into two components: the cyclical deficit and the structural deficit. Cyclical deficits, which can be attributed to the current state of the economy, are not a cause for concern because they do not contribute to a long-run rise in the national debt. We have a cyclical deficit when output is below potential GDP, and a cyclical surplus when output is above potential. When the economy is operating just at full employment, the cyclical deficit is zero. Changes in the cyclical deficit or surplus act as an automatic stabilizer—they help make economic fluctuations milder than they would otherwise be. The structural deficit is the part of the deficit that is not caused by economic fluctuations.
If a government changes its spending or taxes specifically to counteract an expansion or recession, it is engaging in counter-cyclical fiscal policy. In the 1960s and 1970s, many economists and government officials believed that counter-cyclical fiscal policy could be an effective tool to counteract the business cycle. Today, however, many believe that fiscal policy should be reserved for addressing long-run resource allocation issues, and that monetary policy should be used for stabilization purposes. Fiscal policy is not as flexible as monetary policy—in practice, there are important timing problems, and it is not easy to reverse. In addition, the Fed is likely to view fiscal policy actions as demand shocks and neutralize them.