Economics 101: Principles of Economics

1. Economics 101: Principles of Economics • Questions?

2. Monetary System • Why is this thing valuable? • Barter requires a “double coincidence of wants” • What is money? • To an economist, money is the set of assets people regularly use to buy goods and services from others. • $20 bill is money, stock is not. A check is money, a bond is not. • Functions of Money (1) Medium of exchange is what buyers give sellers (2) Unit of account is the measurement system people use for prices, income, debts, etc. (3) Store of value is an item people can use to transfer purchasing power from today (present) to tomorrow (future)

3. Monetary System • Commodity money has intrinsic value (gold, cigarettes, etc.) • Fiat money has no intrinsic value (gov’t says it’s money!) • How much money is there? • Currency • Demand deposits (money in a checking account) • Other checkable deposits • Sum of these is called M1 • M2 is broader measure • M1 + savings deposits + money market funds • Who regulates money? • The Federal Reserve (“Federal Reserve Notes”) is the central bank of USA • Est. 1914 after several bank failures • Two main functions • Regulate banking system and control the money supply • FOMCmeets every 6 weeks in DC to determine country’s monetary policy • Interest rate cut on Nov 6, 2002

4. Tools of the Fed • The Fed controls the money supply in 3 ways (1) Open Market Operations are sales/purchases of US government bonds (2) Reserve Requirements are regulations on min amount of reserves banks must hold against demand deposits (3)Discount Rate is the interest rate on loans from Fed to banks • How closely can Fed control the money supply with these tools?

5. Monetary System • The Fed controls the money supply via open market operations • Open Market Operations are sales/purchases of US government bonds • To increase money supply, should they buy or sell gov’t bonds? • Buy the bonds back from the public, giving the public money • How do banks affect the money supply? • Simple bank that holds all its deposits as reserves (deposits that are not loaned out) • Under 100% reserve banking, banks do not affect the money supply • Fractional Reserve Banking • Reserve Ratio is the percent of deposits held as reserves • The Fed sets the minimum reserve requirement (can hold excess reserves) AssetsLiabilities Reserves $10 Deposits $100 Loans 90 • Banks create money via loans -- money supply here is $190 • Note that wealth is still same since borrowers have $90 in debt too

6. Money Multiplier • Bank One AssetsLiabilities Reserves $10 Deposits $100 Loans 90 • Bank Two AssetsLiabilities Reserves $9 Deposits $90 Loans 81 • Bank Three AssetsLiabilities Reserves $8.10 Deposits $81 Loans 72.90 • Money Multiplier is how much money the banking system creates with $1 of reserves • Money Multiplier = 1/r where r is reserve ratio

7. Money Growth and Inflation Value of Money (1/P) • Inflation, deflation, hyperinflation • "The new bogey" (Economist Nov 2001) • What determines how fast prices rise? • Principle #9: Prices rise when the government prints too much money. • Quantity Theory of Money • Higher prices are typically not due to changing preferences • Likely due to inflation, less valuable dollars • If P is the cost of our basket of goods, then 1/P is how much stuff $1 will buy (value of money) • Supply of Money • Fed controls in 3 ways • Demand for Money • Interest returns on bonds/stocks, frequency of credit card use, ATM availability, price level Money Supply Prices are too low Money Demand Quantity of Money • In the long-run, the price level adjusts so that quantity of money demanded = qty. of money supplied

8. Money Growth and Inflation Value of Money (1/P) Price Level (P) • Purchase of government bonds by the Fed leads to higher prices (dollars are less valuable) S1 S2 • Excess supply of Money • What do people do with it? • Spend it or save it (deposit/bonds, etc) • Result is greater demand for g & s • Production Q = Af(K, L, N, H) is same • So prices of g & s go up • So qty of money demanded goes up Money Demand Quantity of Money • Quantity Theory of Money says that the quantity of money determines the price level, and that the growth rate of qty. of money determines the inflation rate

9. Money Neutrality • What is money neutrality and why is it more relevant in the long-run than the short-run? • First, notice the distinction between nominal and real variables • Nominal variables are measured in dollars (monetary units) • Real variables are measured in physical units (# cars, # t-shirts, etc.) • Real wage, real GDP, real interest rate • Why distinguish? • Money Neutrality is the idea that changes in money supply don’t affect real variables • Fed doubles money supply  prices, wages, etc. double but real variables stay same • Money neutrality is less realistic in short-run (we’ll get to that), but a good assumption for the long-run

10. Quantity Equation • Quantity Equation relates the quantity of money, M, to the nominal value of output, PY. • MV = PY • Velocity of Money (V) = the rate at which dollars change hands • Quantity Theory of Money says that the quantity of money determines the price level, and the growth rate of qty. of money determines the inflation rate 1. V has been stable over time 2. When Fed changes M, value of output (PY) changes proportionately 3. Money neutrality implies that Y does not change 4. Thus, changes in M must get reflected in changes in P 5. And when Fed changes M, P must change along with it.

11. Why Hyperinflations? • If printing too much money causes hyperinflations, why do governments do it? • inflation tax • Is inflation bad ? • Yes … • No … • So what exactly are the costs of inflation? • Shoeleather costs • Menu costs • Automatic variation in relative prices • Exaggerated capital gains & interest income discouraging savings • Less clarity by investors about successful and unsuccessful firms • Arbitrary redistribution of wealth by unexpected inflation

12. Short-run vs. Long-run Macro Theory • What causes short-run fluctuations in economic activity? • Can the government help prevent layoffs & falling real incomes? • Facts about economic fluctuations 1. Economic fluctuations are irregular and unpredictable We talk of a business cycle, but it’s not a fixed “cycle” 2. Most macro variables move together 3. As output falls, unemployment rises • Can we explain short-run economic fluctuations?

13. Aggregate Demand&Aggregate Supply Price Level Aggregate Supply • AD-AS is our model of short-run fluctuations • Aggregate Demand curve shows the qty of g & s demanded at each price level • Aggregate Supply curve shows the qty of g & s firms produce at each price level • Not just a “bigger version” of microeconomic supply and demand model • Microeconomic substitution from one market to another doesn’t occur at macroeconomic level • Papple causes people to buy more oranges • Papple causes apple sellers to hire inputs away from orange-makers, for example • So why is AD downward-sloping and AS upward-sloping? Aggregate Demand Quantity of Output

14. Aggregate Demandcurve Price Level • Aggregate Demand curve shows the qty of g & s demanded at each price level • Why does a fall in price level raise the overall qty of g & s demanded ? • Y = C + I + G + NX • Take G as fixed, but how does P affect C, I, NX? • 1. Wealth effect • P  purch power  spending = C  AD • 2.Interest-rate effect • P   money needed  saving  lower interest rates  investment (via bank loans, new firms)  AD • 3.Exchange-rate effect • P   money needed  saving  lower interest rates  S$, D¥ (seeking higher interest rate abroad)   real exchange rate  US exports,  US imports  NX  AD Aggregate Demand |MS Quantity of Output • Shifts in AD curve • 1. Consumption • 2. Investment • 3. Gov’t Purchases • 4. Net Exports