Investment spending by firms tends to fall during recessions

Macroeconomics Presentation

· The presentation is individual

· Time max = 7 minutes / student

· Slides max = 7 PowerPoint

· Students will choose to develop ONE of the following three topics:

· Unemployment in Ukraine: calculate labor force, unemployment rate, types of unemployment, minimum wage laws; develop a time series from the last 4 years, reasons for unemployment rates.

· Economic growth in Ukraine rate of growth & time series from the last 4 years, nominal GDP, real GDP, deflator, reasons for growth (decrease)

· Inflation in Ukraine: calculate the Consumer Price Index (CPI) and rate of inflation and time series for the last 4 years. Give reasons for prices' evolution in the country

Use your national statistics office data and develop the graphs in excel. Use theory learned in class. (No copy paste from webs, blogs, etc)

Formalities:

· Wordcount: ---

· Font: Arial 12 pts.

· Text alignment: Justified.

· The in-text References and the Bibliography have to be in Harvard’s citation style.

Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final goods and services produced within a given period of time.

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together.

Fact 3: As Output Falls, Unemployment Rises

Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

4

The Model of Aggregate Supply and Aggregate Demand

In classical macroeconomic theory, the amount of output depends on the economy’s ability to supply goods and services, which in turn depends on the supplies of capital and labor and on the available production technology.

The economy works quite differently when prices are sticky. In this case, as we will see, output also depends on the economy’s demand for goods and services.

Demand, in turn, depends on a variety of factors: consumers’ confidence about their economic prospects, firms’ perceptions about the profitability of new investments, and monetary and fiscal policy. Because monetary and fiscal policy can influence demand, and demand in turn can influence the economy’s output over the time horizon when prices are sticky, price stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run.

The Assumptions of Classical Economics

Money does not matter in a classical world. If the quantity of money in the

Economy were to double, everything would cost twice as much, and everyone’s income

would be twice as high. But so what? The change would be nominal. The things that

People really care about—whether they can afford, and so on—would be exactly the same. have a job, how many goods and services

Most economists believe that, beyond a period of several years, changes in

the money supply affect prices and other nominal variables but do not affect real GDP,

unemployment, and other real variables—just as classical theory says.

The model of short-run economic fluctuations focuses on the behavior of two

variables.

1.The first variable is the economy’s output of goods and services, as

measured by real GDP.

2.The second is the average level of prices, as measured by the CPI or the GDP

deflator. Notice that output is a real variable, whereas the price level is a nominal

variable. By focusing on the relationship between these two variables, we are departing

from the classical assumption that real and nominal variables can be studied separately.

The aggregate-supply curve shows the quantity of goods and services that firms

produce and sell at each price level. According to this model, the price level and

the quantity of output adjust to bring aggregate demand and aggregate supply

into balance.

The Aggregate-Demand Curve

Why does a change in the price level move the quantity of goods and services

demanded in the opposite direction?

Y = C + I + G + NX.

The Price Level and Consumption: The Wealth Effect

A decrease in the price level raises the real value of money and makes

consumers wealthier, which in turn encourages them to spend more. The increase in

consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and

makes consumers poorer, which in turn reduces consumer spending and the quantity

demanded.

The Price Level and Investment: The Interest-Rate Effect

When the price level falls, households try to reduce their

holdings of money by lending some of it out. For instance, a household might

use its excess money to buy interest-bearing bonds. as households try to convert some

of their money into interest-bearing assets, they drive down interest rates.

The Price Level and Net Exports: The Exchange-Rate Effect

When a fall in the country price level causes interest rates to fall, the real

value of the dollar declines in foreign exchange markets. This depreciation stimulates

U.S. net exports and thereby increases the quantity of goods and services demanded.

Example: As a mutual fund tries to convert its dollars into euros to buy the German

bonds, it increases the supply of dollars in the market for foreign currency exchange.

The increased supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro.

Why the Aggregate-Demand Curve Might Shift

Shifts Arising from Changes in Consumption

Shifts Arising from Changes in Investment

Shifts Arising from Changes in Government Purchases

Shifts Arising from Changes in Net Exports

The Aggregate-Supply Curve

Unlike the aggregate-demand curve, which always slopes downward, the

aggregate-supply curve shows a relationship that depends crucially on the time

horizon examined. In the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate-supply curve slopes upward.

In the long run, an economy’s production of goods and services (its real GDP)

Depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

Why the Aggregate-Supply Curve Is Vertical in the Long Run

Since the amount of money does not affect technology or the supplies of labor, capital,

and natural resources, the output of goods and services in the two economies would be the same.

Why the Long-Run Aggregate-Supply Curve Might Shift

The potential output or full-employment output, or the natural level of output

because it shows what the economy produces when unemployment is at its

natural, or normal, rate. The natural level of output is the rate of production

toward which the economy gravitates in thelong run.

Shifts Arising from Changes in Labor

Shifts Arising from Changes in Capital

Shifts Arising from Changes in Natural Resources

Shifts Arising from Changes in Technological Knowledge

Using Aggregate Demand and Aggregate Supply to Depict

Long-Run Growth and Inflation

The two most important forces in practice are technology and monetary policy.

The short-run fluctuations in output and the price level that we will be studying should

be viewed as deviations from the long-run trends ofoutput growth and inflation.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

The quantity of output supplied deviates from its long-run, or natural, level when

the actual price level in the economy deviates from the price level that people expected

To prevail. When the price level rises above the level that people expected, output rises

above its natural level, and when the price level falls below the expected level,

output falls below its natural level.

The Sticky-Wage Theory

Nominal wages are slow to adjust to changing economic conditions.

In other words, wages are “sticky” in the short run. To some extent, the slow

adjustment of nominal wages is attributable to long-term contracts between

workers and firms that fix nominal wages

The Sticky-Price Theory

This slow adjustment of prices occurs in part because there are costs to adjusting

prices, called menu costs. These menu costs include the cost of printing and

distributing catalogs and the time required to change price tags. As a result of these

costs, prices as well as wages may be sticky in the short run.

The Misperceptions Theory

Suppose the overall price level falls below the level that suppliers expected. When

suppliers see the prices of their products fall, they may mistakenly believe that their

relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices in the economy

Two Causes of Economic Fluctuations

The Effects of a Shift in Aggregate Demand

The Effects of a Shift in Aggregate Supply

Fiscal Policy

The government can influence the behavior of the economy not only with monetary policy but also with fiscal policy. Fiscal policy refers to the government’s choices regarding the overall level of government purchases and taxes.

Changes in Government Purchases

When policymakers change the money supply or the level of taxes, they shift the aggregate-demand curve indirectly by influencing the spending decisions of firms or households. By contrast, when the government alters its own purchases of goods and services, it shifts the aggregate-demand curve directly.

The Multiplier Effect

1. When the government buys $20 billion of goods from Boeing, that purchase has

repercussions. The immediate impact of the higher demand from the government is to raise employment and profits at Boeing.

2. Then, as the workers see higher earnings and the firm owners see higher profits, they respond to this increase in income by raising their own spending on consumer goods. As a result, the government purchase from Boeing raises the demand for the products of many other firms in the economy.

3. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect on aggregate demand.

4. This multiplier effect continues even after this first round. When consumer

spending rises, the firms that produce these consumer goods hire more people and

experience higher profits. Higher earnings and profits stimulate consumer spending once again and so on.

The marginal propensity to consume (MPC)

Definition: The fraction of extra income that a household consumes rather than saves. For example, suppose that the marginal propensity to consume is 3 / 4

This means that for every extra dollar that a household earns, the household spends $0.75 (3/4 of the dollar) and saves $0.25.

With an MPC of 3/4, when the workers and owners of Boeing earn $20 billion from the government contract, they increase their consumer spending by :

¾ * $20 billion = $15 billion.

The process begins when the government spends $20 billion, which implies that national income (earnings and profits) also rises by this amount. This increase in income in turn raises consumer spending by MPC * $20 billion, which raises the income for the workers and owners of the firms that produce the consumption goods.

This second increase in income again raises consumer spending, this time by MPC * (MPC * $20 billion). These feedback effects go on and on.

To find the total impact on the demand for goods and services, we add up all

these effects:

Change in government purchases = $20 billion

First change in consumption = MPC . $20 billion

Second change in consumption = MPC2 . $20 billion

Third change in consumption = MPC3 . $20 billion

• •

• •

• •

Total change in demand

= (1 + MPC + MPC2+ MPC3 + . . .) . $20 billion.

Multiplier = 1 + MPC + MPC2 + MPC3 + . . . .

This multiplier tells us the demand for goods and services that each dollar of government purchases generates.

To simplify this equation for the multiplier, recall from math class that this expression is an infinite geometric series. For x between −1 and +1,

1 + x + x2 + x3 + . . . = 1 / (1 − x).

In our case, x = MPC. Thus,

Multiplier = 1/(1 − MPC).

For example, if MPC is 3 /4 the multiplier is 1/(1 − 3/4), which is 4. In this case, the

$20 billion of government spending generates $80 billion of demand for goods

and services.

This formula for the multiplier shows that the size of the multiplier depends on

the marginal propensity to consume. While an MPC of 3/4 leads to a multiplier of

4, an MPC of ½ leads to a multiplier of only 2.

The Crowding-Out Effect

The multiplier effect seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in aggregate demand is necessarily larger than $20 billion.

Yet another effect works in the opposite direction. While an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rate to rise, which reduces investment spending and puts downward pressure on aggregate demand. aggregate demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

Example:

To see why crowding out occurs, let’s consider what happens in the money

market when the government buys planes from Boeing. As we have discussed, this increase in demand raises the incomes of the workers and owners of this firm (and, because of the multiplier effect, of other firms as well). As incomes rise, households plan to buy more goods and services and, as a result, choose to hold more of their wealth in liquid form. That is, the increase in income caused by the fiscal expansion raises the demand for money.

Because the Fed has not changed the money supply, the vertical supply curve remains the same. When the higher level of income shifts the money demand

curve to the right from MD1 to MD2, the interest rate must rise from r1 to r2 to keep supply and demand in balance.

The increase in the interest rate, in turn, reduces the quantity of goods and services demanded. In particular, because borrowing is more expensive, the demand for residential and business investment goods declines. In other words, as the increase in government purchases increases the demand for goods and services, it may also crowd out investment.

This crowding-out effect partially offsets the impact of government purchases on aggregate demand, as illustrated in panel (b) of Figure 5. The increase in government purchases initially shifts the aggregate-demand curve from AD1 to AD2, but once crowding out takes place, the aggregate-demand curve drops back to AD3.

Changes in Taxes

The other important instrument of fiscal policy, besides the level of government

purchases, is the level of taxation. When the government cuts personal income taxes, for instance, it increases households’ take-home pay. Households will save some of this additional income, but they will also spend some of it on consumer goods. Because it increases consumer spending, the tax cut shifts the aggregate- demand curve to the right.

Similarly, a tax increase depresses consumer spending and shifts the aggregate-demand curve to the left. The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect. At the same time, higher income leads to higher money demand, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. This is the crowding-out effect.

Using Policy to Stabilize the Economy

Should policymakers use these instruments to control aggregate demand and stabilize the economy? If so, when? If not, why not?

The level of taxation is one determinant of the position of the aggregate-demand

curve. When the government raises taxes, aggregate demand will fall, depressing

production and employment in the short run.

If the Central bank wants to prevent this adverse effect of the fiscal policy, it can expand aggregate demand by increasing the money supply. A monetary expansion would reduce interest rates, stimulate investment spending, and expand aggregate demand.

If monetary policy is set appropriately, the combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected.

Keynes emphasized the key role of aggregate demand in explaining short-run economic fluctuations. Keynes claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level.

Keynes (and his many followers) argued that aggregate demand fluctuates because of largely irrational waves of pessimism and optimism. He used the term “animal spirits” to refer to these arbitrary changes in attitude. When pessimism reigns, households reduce consumption spending and firms reduce investment spending. The result is reduced aggregate demand, lower production, and higher unemployment.

Conversely, when optimism reigns, households and firms increase spending.

The result is higher aggregate demand, higher production, and inflationary pressure.

In principle, the government can adjust its monetary and fiscal policy in response to these waves of optimism and pessimism and, thereby, stabilize the economy. For example, when people are excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand.

Automatic Stabilizers

The lags in implementation reduce the efficacy of policy as a tool for short-run stabilization. The economy would be more stable, therefore, if policymakers could find a way to avoid some of these lags.

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are closely tied to economic activity.

The personal income tax depends on households’ incomes, the payroll tax depends on workers’ earnings, and the corporate income tax depends on firms’ profits. Because incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

Some government spending also acts as an automatic stabilizer.

In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support.

This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.

45

Monetary Policy

What is Fiat Money?

Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money.

The Functions of Money

Money has three functions in the economy: It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy, such as stocks, bonds, real estate, art, and even baseball cards. Let’s examine each of these functions of money.

A. A medium of exchange is an item that buyers give to sellers when they purchase goods and services. When you go to a store to buy a shirt, the store gives you the shirt and you give the store your money. This transfer of money from buyer to seller allows the transaction to take place. When you walk into a store, you are confident that the store will accept your money for the items it is selling because

money is the commonly accepted medium of exchange.

B. A unit of account is the yardstick people use to post prices and record debts. When you go shopping, you might observe that a shirt costs $50 and a hamburger costs $5. Even though it would be accurate to say that the price of a shirt is 10 hamburgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in this way. Similarly, if you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services. When we want to measure and record economic value, we use money as the unit of account.

C. A store of value is an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. Money is not the only store of value in the economy: A person can also transfer purchasing power from the present to the future by holding nonmonetary assets such as stocks and bonds. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets.

The most obvious asset to include is currency—the paper bills and coins in

the hands of the public. Currency is clearly the most widely accepted medium of

exchange in our economy. There is no doubt that it is part of the money stock.

To measure the money stock, therefore, you might want to include demand deposits—balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store.

The two most commonly used, designated M1 and M2. M2 includes more assets in its measure of money than does M1.

The important point is that the money stock economy includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services.

Central bank (CB)—

An institution designed to oversee the banking system and regulate the quantity of money in the economy. Other major central banks around the world include the Bank of England, the Bank of Japan, and the European Central Bank.

The first job of a CB is to regulate banks and ensure the health of the banking system. This task is largely the responsibility of the regional Banks.

It also acts as a bank’s bank. That is, the CB makes loans to banks when banks themselves want to borrow. When financially troubled banks find themselves short of cash, the CB acts as a lender of last resort—a lender to those who cannot borrow anywhere else—to maintain stability in the overall banking system.

The second and more important job is to control the quantity of money that is made available in the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy.

Central Bank primary tool is the open-market operation—the purchase and sale of government bonds. A government bond is a certificate of indebtedness of the government.

If the government decides to decrease the money supply, the CB sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars the CB receives for the bonds are out of the hands of the public. Thus, an open-market sale of bonds by the CB decreases the money supply.

Central banks are important institutions because changes in the money supply can profoundly affect the economy.

The amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your checking account).

Because demand deposits are held in banks, the behavior of banks can influence the quantity of demand deposits in the economy and, therefore, the money supply.

Reserve ratio

Let’s suppose that the total quantity of currency is $100. The supply of money is, therefore, $100. Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution—that is, it accepts deposits but does not make loans. The purpose of the bank is to give depositors a safe place to keep their money. Deposits that banks have received but have not loaned out are called reserves.

On the left side of the T-account are the bank’s assets of $100 (the reserves it holds

in its vaults). On the right side are the bank’s liabilities of $100 (the amount it

owes to its depositors). Because the assets and liabilities exactly balance, this

accounting statement is called a balance sheet.

Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.

Fractional-reserve banking.

The fraction of total deposits that a bank holds as reserves is called the reserve ratio. This ratio is influenced by both government regulation and bank policy. As we discuss more fully later in the chapter, the CB sets a minimum amount of reserves that banks must hold, called a reserve requirement

Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This

means that it keeps 10 percent of its deposits in reserve and loans out the rest.

Now let’s look again at the bank’s T-account:

First National still has $100 in liabilities because making the loans did not alter the

bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90.

Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits. Yet when First National lends out some of these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency.

The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money.

Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money.

At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before.

The Money Multiplier:

Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank:

After the deposit, this bank has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans.

In this way, Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the T-account for Third National Bank:

It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money. If you laboriously add the infinite sequence of numbers in the preceding example, you find that the $100 of reserves

generates $1,000 of money.

The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1,000 of money, the money multiplier is 10.

What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R = 1/10, so the money multiplier is 10.

If a bank holds $1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank must hold $100 in reserves. The money multiplier just turns this idea around:

If the banking system as a whole holds a total of $100 in reserves, it can have only $1,000 in deposits. In other words, if R is the ratio of reserves to deposits at each bank (that is, the reserve ratio), then the ratio of deposits to reserves in the banking system (that is, the money multiplier) must be 1/R.

If the reserve ratio were only 1/20 (5 percent =0,05), then the banking system would have 20 times as much in deposits as in reserves, implying a money multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if the reserve ratio were 1/4 (25 percent), deposits would be 4 times reserves, the money multiplier would be 4, and each dollar of reserves would generate $4 of money.

The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. In the special case of 100-percent-reserve banking, the reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create money.

In the bank balance sheets you have seen so far, a bank accepts deposits and either uses those deposits to make loans or holds them as reserves. More realistically, a bank gets financial resources not only from accepting deposits but also, like other companies, from issuing equity and debt. The resources that a bank obtains from issuing equity to its owners are called bank capital. A bank uses these financial resources in various ways to generate profit for its owners. It not only makes loans and holds reserves but also buys financial securities, such a stocks and bonds.

Here is a more realistic example of a bank’s balance sheet:

By the rules of accounting, the reserves, loans, and securities on the left side of the balance sheet must always equal, in total, the deposits, debt, and capital on the right side of the balance sheet.

The value of the owners’ equity is, by definition, the value of the bank’s assets (reserves, loans, and securities) minus the value of its liabilities (deposits and debt). Therefore, the left and right sides of the balance sheet always sum to the same total.

Many businesses in the economy rely on leverage, the use of borrowed money to supplement existing funds for investment purposes. Indeed, whenever anyone uses debt to finance an investment project, she is applying leverage.

The leverage ratio is the ratio of the bank’s total assets to bank capital. In this example, the leverage ratio is $1,000/$50, or 20. A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets. Of the $20 of assets, $19 are financed with borrowed money—either by taking in deposits or issuing debt.

Open-Market Operations are where the CB conducts open-market operations when it buys or sells government bonds. To increase the money supply, the CB instructs its bond traders to buy bonds from the public in the nation’s bond markets. The dollars the Fed pays for the bonds increase the number of dollars in the economy.

CB to Banks: CB can also increase the quantity of reserves in the economy by lending reserves to banks. Banks borrow from the CB when they feel they do not have enough reserves on hand, either to satisfy bank regulators, meet depositor withdrawals, make new loans, or for some other business reason.

Traditionally, banks borrow from the CB’s discount window and pay an interest rate on that loan called the discount rate.

Reserve Requirements One way the CB can influence the reserve ratio is by altering reserve requirements, the regulations that set the minimum amount of reserves that banks must hold against their deposits.

Unconventional monetary policy: quantitative easing

We can think of the premium on an asset as determined by supply and demand for the asset. If the demand for an asset decreases, whether because buyers become more risk averse, or because some investors just decide not to hold the asset, the premium will increase. If, instead, the demand increases, the premium will decrease. This is true whether the increased demand comes from private investors or from the central bank.

This is the logic which led central banks to buy assets other than short term bonds, with the intention of decreasing the premium on those assets, and thus decreasing the corresponding borrowing rates with the aim of stimulating economic activity. They did this by financing their purchases through money creation, leading to a large increase in the money supply. Although the increase in the money supply had no effect on the policy rate, the purchase of these other assets decreased their premium, leading to lower borrowing rates and higher spending. These purchase programs are known as quantitative easing, or credit easing, policies.

Debt:

Do not confuse the words deficit and debt. Debt is a stock—what the government owes as a result of past deficits. The deficit is a flow—how much the government borrows during a given year.

Suppose that, starting from a balanced budget, the government decreases taxes, creating a budget deficit. What will happen to the debt over time? Will the government need to increase taxes later? If so, by how much?

We can write the budget deficit in year t as:

deficit t = r Bt - 1 + Gt - Tt

Bt - 1 is government debt at the end of year t - 1, or, equivalently, at the beginning of year t; r is the real interest rate, which we shall assume to be constant here. Thus, rBt - 1 equals the real interest payments on the government debt in year t.

Gt is government spending on goods and services during year t.

Tt is taxes minus transfers during year t.

In words: The budget deficit equals spending, including interest payments on the

debt, minus taxes net of transfers.

The government budget constraint then simply states that the change in government debt during year t is equal to the deficit during year t:

Bt - Bt - 1 = deficit t

If the government runs a deficit, government debt increases as the government

borrows to fund the part of spending in excess of revenues. If the government runs a surplus, government debt decreases as the government uses the budget surplus to repay part of its outstanding debt.

Using the definition of the deficit we can rewrite the government budget constraint as:

Bt - Bt - 1 = rBt - 1 + Gt – Tt

The government budget constraint links the change in government debt to the initial level of debt (which affects interest payments) and to current government spending and taxes. It is often convenient to decompose the deficit into the sum of two terms:

1. Interest payments on the debt, rBt - 1.

2. The difference between spending and taxes, Gt - Tt . This term is called the primary deficit (equivalently, Tt - Gt is called the primary surplus).

Money Growth and Inflation

The Classical Theory of Inflation

We begin our study of inflation by developing the quantity theory of money. This theory is often called “classical” because it was developed by some of the earliest economic thinkers

The Level of Prices and the Value of Money

The economy’s overall price level can be viewed in two ways. So far, we have viewed the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

Suppose P is the price level as measured by the consumer price index or the GDP deflator. Then P measures the number of dollars needed to buy a basket of goods and services.

Now turn this idea around: The quantity of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services.

When the price of a cone (P) is $2, then the value of a dollar (1/P) is half a cone. When the price (P) rises to $3, the value of a dollar (1/P) falls to a third of a cone. The actual economy produces thousands of goods and services, so we use a price index rather than the price of a single good. But the logic remains the same: When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium

The supply and demand for money determines the value of money.

First consider money supply. In the preceding chapter, we discussed how the Federal Reserve, together with the banking system, determines the supply of money. When the Fed sells bonds in open-market operations, it receives dollars in exchange and contracts the money supply. When the Fed buys government bonds, it pays out dollars and expands the money supply. In addition, if any of these dollars are deposited in banks, which hold some as reserves and loan out the rest, the money multiplier swings into action, and these open-market operations can have an even greater effect on the money supply.

We ignore the complications introduced by the banking system and simply take the quantity of money supplied as a policy variable that the CB controls.

Now consider money demand. Most fundamentally, the demand for money reflects how much wealth people want to hold in liquid form. Many factors influence the quantity of money demanded. The amount of currency that people hold in their wallets, for instance, depends on how much they rely on credit cards and on whether an automatic teller machine is easy to find.

The quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest bearing bond rather than leaving it in his wallet or low-interest checking account.

What ensures that the quantity of money the CB supplies balances the quantity of money people demand?

The answer depends on the time horizon being considered. The long- run answer, however, is much simpler. In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.

If the price level is above the equilibrium level, people will want to hold more money than the CB has created, so the price level must fall to balance supply and demand.

If the price level is below the equilibrium level, people will want to hold less money than the CB has created, and the price level must rise to balance supply and demand. At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

What Is Seigniorage?

Seigniorage is the difference between the face value of money, such as a $10 bill or quarter coin, and the cost to produce it. In other words, the economic cost of producing a currency within a given economy or country is lower than the actual exchange value, which generally accrues to governments who mint the money. If the seigniorage is positive, the government will make an economic profit; while a negative seigniorage will result in an economic loss.

Seigniorage is the difference in face value of money, such as a $0.25 quarter coin, and the cost to produce it.

Seigniorage may be counted as positive revenue for a government when the money it creates is worth more than it costs to produce.

In some situations, the production of currency can result in a loss instead of a gain for the government creating the currency (e.g. producing copper pennies).

The Effects of a Monetary Injection

Imagine that the economy is in equilibrium and then, suddenly, the CB doubles the supply of money by printing some dollar bills and dropping them around the country from helicopters. (Or the CB could inject money into the economy by buying some government bonds from the public in open-market operations.)

What happens after such a monetary injection? How does the new equilibrium compare to the old one?

The monetary injection shifts the supply curve to the right from MS1 to MS2, and the equilibrium moves from point A to point B. As a result, the value of money (shown on the left axis) decreases from 1/2 to 1/4 , and the equilibrium price level (shown on the right axis) increases from 2 to 4.

When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.

This explanation of how the price level is determined and why it might change over time is called the quantity theory of money.

According to the quantity theory, the quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. As economist Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.”

The Classical Dichotomy and Monetary Neutrality

Economic variables should be divided into two groups. The first group consists of nominal variables—variables measured in monetary units. The second group consists of real variables— variables measured in physical units. For example, the income of corn farmers is a nominal variable because it is measured in dollars, whereas the quantity of corn they produce is a real variable because it is measured in bushels. Nominal GDP is a nominal variable because it measures the dollar value of the economy’s output of goods and services; real GDP is a real variable because it measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services. The separation of real and nominal variables is now called the classical dichotomy.

Nominal variables are influenced by developments in the economy’s monetary system, whereas money is largely irrelevant for explaining real variables.

Real variables, such as production, employment, real wages, and real interest rates, are unchanged. The irrelevance of monetary changes for real variables is called monetary neutrality.

When we say that the price of corn is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables. But what about a relative price—the price of one thing compared to another? In our example, we could say that the price of a bushel of corn is 2 bushels of wheat. This relative price is not measured in terms of money. When comparing the prices of any two goods, the dollar signs cancel, and the resulting number is measured in physical units. Thus, while dollar prices are nominal variables, relative prices are real variables.

Velocity and the Quantity Equation

How many times per year is the typical dollar bill used to pay for a newly produced good or service? The answer to this question is given by a variable called the velocity of money: the rate at which money changes hands.

To calculate the velocity of money, we divide the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money, then velocity is:

V = (P * Y)/M.

Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10,

and that the quantity of money in the economy is $50. Then the velocity of money is:

V = ($10 * 100)/$50

= 20.

In this economy, people spend a total of $1,000 per year on pizza. For this $1,000

of spending to take place with only $50 of money, each dollar bill must change

hands on average 20 times per year.

This equation can be rewritten as:

M * V = P * Y.

This equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). It is called the quantity equation because it relates the quantity of money (M) to the nominal value of output (P * Y).