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12. Money and Banking. Chapter Objectives. The Functions of Money and the Components of the U.S. Money Supply What “Backs” the Money Supply, Making Us Willing to Accept It? The Makeup of the Federal Reserve and the U.S. Banking System

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slide1

12

Money and

Banking

chapter objectives
Chapter Objectives
  • The Functions of Money and the Components of the U.S. Money Supply
  • What “Backs” the Money Supply, Making Us Willing to Accept It?
  • The Makeup of the Federal Reserve and the U.S. Banking System
  • The Functions and Responsibilities of the Federal Reserve
the origin of money
The Origin of Money
  • Money develops from barter due to
    • lack of coincidence of wants
    • lack of divisibility
    • Example: direct exchange vs. indirect exchange

Wheat serves as a “medium of exchange.”

the origin of money cont d
The Origin of Money cont’d
  • Media of exchange in history:
    • cattle in ancient Greece
    • leather in ancient Rome
    • animal pelts, whiskey and tobacco leaves in the American colonies
    • wampum (strings of beads) among American Indians
    • dried fish in Canadian maritime colonies
    • maize (corn) in Mexico
    • salt and iron farming tools in parts of Africa
    • wives in ancient Egypt; and cigarettes in German POW camps
the origin of money cont d1
The Origin of Money cont’d

Money evolves as more and more people and groups begin to use and accept the same commodity as a medium of exchange; through this self-reinforcing process the more that people use a given good as a medium of exchange the more generally acceptable the good becomes and the more likely it is for other people to turn to this good as a medium of in order to solve the problems of barter.

the function of money
The Function of Money
  • Money:
    • is defined as the general medium of exchange accepted by all people in the economy, to buy and sell.
    • always originates as a useful commodity. All money comes into being as commodity money, historically, gold and silver.
    • is not the product of a “social contract” or government fiat. Money cannot originate as paper fiat money.
  • Subsidiary functions of money:
    • store of value
    • unit of account (tool of economic calculation)
qualities of a good money
Qualities of a Good Money
  • Generally acceptable—widely demanded nonmonetary employments
  • Naturally scarce
  • Portable—a high value/weight ratio making it easy to carry
  • Homogeneous—all units are identical to one another
  • Divisible—it can be divided into small units without loss of value
  • Durable— does not perish or deteriorate quickly with use
  • Recognizable—easy to confirm or test its authenticity
the monetary unit
The Monetary Unit
  • For a commodity money such as gold the monetary unit is a unit of weight of gold.
  • For example:
    • U.S. $: 1834-1933 legally defined as $1:00 ≈ 1/20 oz. gold (23.22 grains of gold)
    • British £: 1821-1931 legally defined as £1.00 ≈ ¼ oz. gold; French franc as ₣1.00 ≈ 1/100 oz. gold.
  • So “exchange rate” for 100 years:
    • $4:86/£ ( ¼ oz. gold ÷ 1/20 oz. gold)
kinds of money
Kinds of Money
  • Commodity Money: money consisting of a tangible good supplied by the market.
  • Fiat Money: paper money decreed by governments as legal tender, which legally must be accepted as payments for taxes and all private debts.
features of fiat money
Features of Fiat Money
  • Fiat money is the logical and historical conclusion of the process of debasement of the currency.
  • Fiat monetary unit is a pure name which no longer is defined by a specific quantity of a valuable commodity and can be affixed by government to a nearly worthless item.
    • fiat money can therefore be created practically without cost or limit.
    • can and has resulted in hyperinflation, a period of inflation during which the value of money rapidly falls toward zero as prices rise toward infinity.
the value of money
The Value of Money
  • Prices of Goods Purchasing Power of Money

$1.00/1 Coke 1 Coke/$

$10.00/1 pizza or 1/10th pizza/$

$100.00/1 IPod or 1/100th iPod/$

$1,000/1 laptop or 1/1,000th laptop/$

  • A rise in prices causes a fall in the purchasing power of money

$2.00/ 1 Coke ½ Coke/$

$20.00/ 1 pizza or 1/20th pizza/$

$200.00/1 IPod or 1/200th iPod/$

$2,000/1 laptop or 1/2,000th laptop/$

  • Inflation therefore leads to a “shrinking” dollar.
measuring the money supply
Measuring the Money Supply
  • Commodity Money:
    • the money supply is the total monetary gold in existence in the economy, namely, the total weight of gold coins and bullion available to be used as a medium of exchange.
    • the money supply (M) can be calculated by summing up the cash balances or individual stocks of money (m) held by all people in the economy.
    • Thus: M = Σ m.
fed measures of the u s money supply
Fed Measures of the U.S. Money Supply
  • M1: currency, demand deposits, traveler’s checks, and other checkable deposits.
    • M1 = $2.4 trillion (January 2013)
  • Institutions offering checkable deposits
    • Commercial banks
    • Savings and loan associations
    • Mutual savings banks
    • Credit unions
fed measures of the u s money supply1
Fed Measures of the U.S. Money Supply
  • M2: everything in M1 plus savings deposits, small time deposits, retail money market mutual funds, and a few minor categories.
    • M2 = $9.9 trillion (June 2012)
fed measures of the u s money supply2
Fed Measures of the U.S. Money Supply
  • MZM: M2 + institutional MMMFs – small time deposits
  • Money Definition MZM
    • Money Zero Maturity
    • Immediately Available
    • January 2013 M2 was $10,439 Billion and MZM was $11,451 Billion
money defined
Money Defined

M1

M2

January 2013

+

Currency

46%

M1

+

Checkable Deposits

22%

54%

+

Small Time Deposits

7.6%

Money Market Mutual

Funds Held By Individuals

(MMMF)

15.6%

+

Savings Deposits

Including Money Market

Deposit Accounts (MMDA)

62%

+

Totals

$2,459

Billion

$10,439

Billion

common confusions about money
Common Confusions about Money
  • Money is not wealth. Wealth is the total (estimated) market value of an individual's assets.
  • Money is not income. Income is a sum of money payments per unit of time.
  • Money does not “circulate.” At every moment all existing money is always money is always owned by someone—is lying “idle” in someone’s cash balance.
money supply
Money Supply
  • Are Credit Cards Money?
  • What “Backs” the Money Supply?
    • NOTHING!
  • Stable Value of Money
  • Money as Debt
    • Acceptability
    • Legal Tender
    • Relative Scarcity
money supply1
Money Supply
  • Money and Prices
    • Purchasing Power of the Dollar

$V = 1/P

    • Inflation and Acceptability
  • Stabilizing Money’s Purchasing Power
    • Intelligent Management of the Money Supply – Monetary Policy
    • Appropriate Fiscal Policy
true money supply
True Money Supply
  • TMS = M2
    • Minus MMMFs
    • Minus small time deposits
    • Plus U.S. government deposits
    • Plus demand deposits due to foreign commercial banks and official institutions
    • Plus time and savings deposits due to foreign banks and official institutions
why tms aggregate
Why TMS Aggregate
  • For an item to be included in the money supply or monetary aggregate it must fulfill the following criteria:
    • It must be routinely and universally accepted in exchange for goods and services
    • It must serve as the final means of payment in all transactions, completing discharging the debt owed without creating a new debt
  • OR
    • It must be an instantly convertible claim to the general medium of exchange, meaning that it must be interchangeable with the general medium of exchange on demand at par (face value)
the money supply
The Money Supply
  • The money supply (or money stock): the quantity of money available in the economy
  • What assets should be considered part of the money supply? Two candidates:
    • Currency: the paper bills and coins in the hands of the (non-bank) public
    • Demand deposits: balances in bank accounts that depositors can access on demand by writing a check
money supply ms
Money Supply (MS)
  • In today’s world, MS determined by Federal Reserve, although the banking system and consumers have an influence MS
  • For now, we assume the Fed precisely controls MS and sets it at some fixed amount.
money demand md
Money Demand (MD)
  • Refers to how much wealth people want to hold in liquid form.
  • Depends on P: An increase in P reduces the value of money, so more money is required to buy G & S.
  • Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal.
  • (These “other things” include real income, interest rates, availability of ATMs.)
the money supply demand diagram
The Money Supply-Demand Diagram

Value of Money, 1/P

Price Level, P

1

As the value of money rises, the price level falls.

1

1.33

3/4

2

1/2

1/4

4

Quantity of Money

the money supply demand diagram1
The Money Supply-Demand Diagram

Value of Money, 1/P

MS1

Price Level, P

1

1

1.33

3/4

The Fed sets MS at some fixed value, regardless of P.

2

1/2

1/4

4

Quantity of Money

$1000

the money supply demand diagram2
The Money Supply-Demand Diagram

Value of Money, 1/P

A fall in value of money (or increase in P) increases the quantity of money demanded:

Price Level, P

1

1

1.33

3/4

2

1/2

1/4

4

MD1

Quantity of Money

the money supply demand diagram3
The Money Supply-Demand Diagram

MS1

P adjusts to equate quantity of money demanded with money supply.

Price Level, P

Value of Money, 1/P

1

1

1.33

3/4

eq’mvalue of money

eq’m price level

2

1/2

1/4

4

MD1

Quantity of Money

$1000

the effects of a monetary injection
The Effects of a Monetary Injection

MS1

MS2

Price Level, P

Value of Money, 1/P

Then the value of money falls and P rises.

1

1

Suppose the Fed increases the money supply.

1.33

3/4

A

2

1/2

eq’mvalue of money

eq’m price level

B

1/4

4

MD1

Quantity of Money

$2000

$1000

a brief look at the adjustment process
A Brief Look at the Adjustment Process

Result from graph: Increasing MS causes P to rise.

  • How does this work? Short version:
  • At the initial P, an increase in MS causes excess supply of money.
  • People get rid of their excess money by spending it on G & S or by loaning it to others, who spend it. Result: increased demand for goods.
  • But supply of goods does not increase, so prices must rise.
  • (Other things happen in the short run, which we will study in later chapters.)
monetary adjustment process
Monetary Adjustment Process
  • Excess Supply of Money
  • MS > MD → ↑DG → ↑P → ↓PPM → ↑Qdm → MS = MD
  • Excess Demand for Money
  • MS < MD → ↓DG → ↓P → ↑ PPM → ↓Qdm → MS = MD
the proper supply of money
The Proper Supply of Money
  • For centuries economists debated the question “What is the optimal supply of money?”
  • Why should economists discuss this question, when they would never ask what the “optimal” supply of pizzas, iPads or automobiles should be?
  • Most economists agree that the proper supplies of goods and services should be determined by the price system and profit-and-loss test of the market.
difference between money and other goods capital
Difference between Money and Other Goods Capital
  • Capital goods resources are used up or worn out in the process of producing consumer goods.
  • Consumer goods are typically destroyed by consumption.
  • Money is the general medium of exchange and in performing this function it is not used up or destroyed but is transferred from one cash balance to the other.
the federal reserve system
The Federal Reserve System
  • The Federal Reserve Act of 1913 created the Federal Reserve System
    • To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes
    • First United States Bank [1791-1811]
    • Second United States Bank [1816-1836]
      • The charters of both were allowed to lapse
    • The 1907 bank crises caused the public to demand the government do something to keep this from happening again
the federal reserve system1
The Federal Reserve System
  • The Federal Reserve has five main jobs
    • Conduct monetary policy which is, by far, the most important job
      • Monetary policy is the control of the rate of growth of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth
    • Serve as lender of last resort to commercial banks, savings banks, savings and loan associations, and credit unions
the federal reserve district banks
The Federal Reserve District Banks
  • Each Federal Reserve District Bank is owned by the several hundred member banks in that district
    • A commercial bank becomes a member by buying stock in the Federal Reserve District Bank
    • So, the Fed is a quasi public-private enterprise, not controlled by the president or Congress
      • Effective control is really exercised by the Federal Reserve Board of Governors in Washington, D.C.
the federal reserve system2
The Federal Reserve System
  • 12 District Banks
  • Propose discount rates
  • Hold reserve balances for member institutions
  • Lends reserves
  • Furnish currency
  • Collects & clears checks
  • Handle U.S. government debt & cash balances
  • Board of Governors
    • 7 appointed members
    • Appointed by President
    • Confirmed by Senate
  • Sets reserve requirements
  • Supervises & regulates member banks
  • Establishes and administers regulations
  • Oversees Federal Reserve Banks
federal reserve system
Federal Reserve System
  • The Federal Reserve and the Banking System
    • Historical Background
    • Board of Governors
    • Federal Open Market Committee (FOMC)
      • Open Market Operations
federal reserve system1
Federal Reserve System

Framework of the Federal Reserve

System and the Relationship to the Public

Board of Governors

Federal Open Market Committee

12 Federal Reserve Banks

Commercial Banks

Thrift Institutions

(Savings and Loan Associations,

Mutual Savings Banks,

Credit Unions)

The Public

(Households and

Businesses)

federal reserve system2
Federal Reserve System

The 12 Federal Reserve Banks

Source: Federal Reserve Bulletin

federal reserve system3
Federal Reserve System

The 12 Federal Reserve Banks

  • Private and Public Control
  • Central Bank
  • Quasi-Public Banks
  • Banker’s Banks
  • Commercial Banks and Thrifts
federal reserve system4
Federal Reserve System

Fed Functions and the Money Supply

  • Issuing Currency
  • Setting Reserve Requirements and Holding Reserves
  • Lending Money to Banks and Thrifts
    • Discount Rate
  • Check Collection
  • Fiscal Agent for U.S.
  • Supervising Banks
  • Controlling the Money Supply
federal reserve system5
Federal Reserve System

Fed Functions and the Money Supply

  • Federal Reserve Independence
  • Recent Developments
    • Relative Decline of Banks and Thrifts
    • Consolidation Among Banks and Thrifts
    • Convergence of Services Provided by Financial Institutions
    • Globalization of Financial Markets
    • Electronic Payments
financial institutions

GLOBAL PERSPECTIVE

Financial Institutions
  • Barclays (U.K.)
  • UBS (Switzerland)
  • Citigroup (U.S.)
  • ING Group (Netherland)
  • Mizuho Financial (Japan)
  • Allianz Worldwide (Germany)
  • Bank of America (U.S.)
  • HSBC Group (U.K.)
  • BNP Paribus (France)
  • JPMorgan Chase (U.S.)
  • Deutsche Bank Group (Germany)
  • Royal Bank of Scotland (U.K.)

World’s Largest Financial Institutions

2005 Assets (Millions of U.S. Dollars)

$1,587,061

1,519,399

1,494,037

1,369,546

1,325,227

1,300,648

1,291,795

1,274,219

1,227,951

1,198,942

1,134,826

1,119,901

Source: Forbes Global 2000

financial institutions1

GLOBAL PERSPECTIVE

Financial Institutions
  • Deutsche Bank Group (Germany) $2,804,332
  • BNP Paribus (France) $2,546,693
  • Industrial & Commercial Bank of

China Limited (China) $2,458,597

  • Barclays (U.K.) $2,426,889
  • Japan Post Bank (Japan) $2,362,977
  • Crédit Agricole SA (France) $2,233,521
  • Royal Bank of Scotland (U.K.) $2,224,124
  • China Construction Bank

Corporation (China) $1,951,046

  • Bank of Tokyo (Japan) $1,948,128
  • Bank of China Limited (China) $1,879,280

World’s Largest Financial Institutions

2013 Assets (Millions of U.S. Dollars)

Source: Forbes Global 2000

which state boasts two federal reserve banks
Which state boasts two Federal Reserve Banks?
  • Solution:  Missouri, with FRBs in St. Louis and Kansas City. 
  • (Champ Clark of Missouri was Speaker of the House of Representatives in 1913, when the Federal Reserve System was established.)
financial institutions2
Financial Institutions

Major U.S. Financial Institutions

  • Commercial Banks (7,300)
  • Thrifts (11,000)
  • Insurance Companies
  • Mutual Fund Companies
  • Pension Funds
  • Securities Firms
slide48

13

Money

Creation

chapter objectives1
Chapter Objectives
  • Why the U.S. Banking System is Called a “Fractional Reserve” System
  • Distinction Between a Bank’s Actual Reserves and Its Required Reserves
  • How a Bank Can Create Money Through Granting Loans
  • The Multiple Expansion of Loans and Money by the Entire Banking System
  • The Monetary Multiplier and How to Calculate it
bank reserves
Bank Reserves
  • In a fractional reserve banking system, banks keep a fraction of deposits as reservesand use the rest to make loans.
  • The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.
  • Banks may hold more than this minimum amount if they choose.
  • The reserve ratio, R
    • fraction of deposits that banks hold as reserves
    • total reserves as a percentage of total deposits
fractional reserve system
Fractional Reserve System
  • The Goldsmiths
  • Characteristics
    • Banks Create Money Through Lending
    • Fractional Reserve Banks are Subject to “Panics” or “Runs”
fractional reserve system1
Fractional Reserve System
  • Balance Sheet (T-Account)

Assets = Liabilities + Net Worth

  • Transactions Needed to Enable Banks to Create Money Through Lending

As Follows…

creating a bank

Assets

Liabilities and Net Worth

Creating a Bank

Transaction 1:

  • Creating a Bank
  • Vault Cash

Creating a Bank

Balance Sheet 1: Wahoo Bank

Cash

$250,000

Stock Shares

$250,000

creating a bank1

Assets

Liabilities and Net Worth

Creating a Bank

Transaction 2:

  • Acquiring Property and Equipment

Acquiring Property and Equipment

Balance Sheet 2: Wahoo Bank

Cash

$10,000

Stock Shares

$250,000

Property

$240,000

creating a bank2

Assets

Liabilities and Net Worth

Creating a Bank

Transaction 3:

  • Accepting Deposits
    • Receive $100,000 as a Checkable Deposit

Accepting Deposits

Balance Sheet 3: Wahoo Bank

Cash

$110,000

Checkable

Deposits

$100,000

Property

$240,000

Stock Shares

$250,000

creating a bank3

Commercial Bank’s

Required Reserves

Reserve

Ratio

=

Commercial Bank’s

Checkable-Deposit Liabilities

Creating a Bank

Transaction 4:

  • Depositing Reserves in a Federal Reserve Bank
    • Required Reserves
    • Reserve Ratio
bank t account
Bank T-Account
  • T-Account: a simplified accounting statement that shows a bank’s assets & liabilities.
  • Example:
  • Banks’ liabilities include deposits, assets include loans & reserves.
  • In this example, notice that R = $10/$100 = 10%.
creating a bank4

Current

Requirement

Statutory

Limits

Type of Deposit

Checkable Deposits:

$0-$9.8 Million

$6-$43.9 Million

Over $43.9 Million

0%

3

10

3%

3

8-14

Noncheckable Nonpersonal

Savings and Time Deposits

0

0-9

Assets

Liabilities and Net Worth

Creating a Bank

Transaction 4:

Depositing Reserves at the Fed

Balance Sheet 4: Wahoo Bank

Cash

$0

Checkable

Deposits

Reserves

$110,000

$100,000

Property

$240,000

Stock Shares

$250,000

creating a bank5

Excess

Reserves

Actual

Reserves

Required

Reserves

-

=

Creating a Bank

Transaction 4:

  • Control
    • Banking Regulators
  • Asset and Liability
    • Transactions are Both

Excess Reserves

creating a bank6

Assets

Liabilities and Net Worth

Creating a Bank

Transaction 5:

  • Clearing a Check
    • $50,000 Check Presented for Payment

Clearing a Check

Balance Sheet 5: Wahoo Bank

Reserves

$60,000

Checkable

Deposits

$50,000

Property

$240,000

Stock Shares

$250,000

money creating transactions

Assets

Liabilities and Net Worth

Money Creating Transactions

Transaction 6a:

  • Granting a Loan
    • $50,000 Loan Deposited to Checking Account

When a Loan is Negotiated

Balance Sheet 6a: Wahoo Bank

Reserves

$60,000

Checkable

Deposits

$100,000

Loans

$50,000

Property

$240,000

Stock Shares

$250,000

money creating transactions1

Assets

Liabilities and Net Worth

Money Creating Transactions

Transaction 6b:

  • Using the Loan
    • $50,000 Loan Cashed From Checking Account

After a Check is Drawn on the Loan

Balance Sheet 6b: Wahoo Bank

Reserves

$10,000

Checkable

Deposits

$50,000

Loans

$50,000

Property

$240,000

Stock Shares

$250,000

A Single Bank Can Only Lend An Amount

Equal to their Preloan Excess Reserves

money creating transactions2

Assets

Liabilities and Net Worth

Money Creating Transactions

Transaction 7:

  • Buying Government Securities From Dealer
    • Deposits Payment Into Checking Account

Buying Government Securities

Balance Sheet 7: Wahoo Bank

Reserves

$60,000

Checkable

Deposits

$100,000

Securities

$50,000

Property

$240,000

Stock Shares

$250,000

money creating transactions3
Money Creating Transactions

Profits, Liquidity, and the

Federal Funds Market

  • Profit
    • Loans
    • Securities
  • Liquidity
    • Impact Upon Reserves
  • Overnight Bank Loans
  • Federal Funds Market
    • Federal Funds Rate
the banking system
The Banking System
  • Multiple-Deposit Expansion
  • The Banking System’s Lending Potential
  • Assumptions:
    • 20% Required Reserves
    • All Banks “Loaned Up”
    • Banks Lend All of Excess Reserves
the banking system1

(2)

Required

Reserves

(Reserve

Ratio = .2)

(1)

Acquired

Reserves

and Deposits

(3)

Excess

Reserves

(1)-(2)

(4)

Amount Bank Can

Lend; New Money

Created = (3)

Bank

The Banking System

Bank A

Bank B

Bank C

Bank D

Bank E

Bank F

Bank G

Bank H

Bank I

Bank J

Bank K

Bank L

Bank M

Bank N

Other Banks

$100.00

80.00

64.00

51.20

40.96

32.77

26.21

20.97

16.78

13.42

10.74

8.59

6.87

5.50

21.99

$20.00

16.00

12.80

10.24

8.19

6.55

5.24

4.20

3.36

2.68

2.15

1.72

1.37

1.10

4.40

$80.00

64.00

51.20

40.96

32.77

26.21

20.97

16.78

13.42

10.74

8.59

6.87

5.50

4.40

17.59

$80.00

64.00

51.20

40.96

32.77

26.21

20.97

16.78

13.42

10.74

8.59

6.87

5.50

4.40

17.59

$400.00

the monetary multiplier

1

Monetary

Multiplier

=

Required Reserve Ratio

1

m

=

R

The Monetary Multiplier

Monetary Multiplier or Checkable-Deposit Multiplier

or in Symbols…

Graphic

Example

New Reserves

$100

$80

Excess

Reserves

$20

Required

Reserves

$100

Initial

Deposit

$400

Bank System Lending

Money Created

the monetary multiplier1
The Monetary Multiplier
  • Reversibility
    • Making Loans Creates Money
    • Loan Repayment Destroys Money
    • Multiple Step Money Expansion
    • Multiple Step Destruction of Money
a more realistic balance sheet
A More Realistic Balance Sheet
  • Leverage ratio: the ratio of assets to bank capital
    • In this example, the leverage ratio = $1000/$50 = 20
  • Interpretation:
    • for every $20 in assets
    • $ 1 is from the bank’s owners
    • $19 is financed with borrowed money.
slide70

14

Interest Rates and Monetary Policy

chapter objectives2
Chapter Objectives
  • How the Equilibrium Interest Rate is Determined in the Market for Money
  • The Goals and Tools of Monetary Policy
  • The Federal Funds Rate and How the Fed Controls It
  • The Mechanisms by Which Monetary Policy Affects GDP and the Price Level
  • Effectiveness of Monetary Policy and its Shortcomings
the structure of the fed
The Structure of the Fed
  • Federal Reserve System
    • Board of Governors (7 members), DC
    • 12 regional Fed banks
    • Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks
    • FOMC decides monetary policy

Ben S. Bernanke Chair of FOMC,

Feb 2006 – present

review the business cycle
Review the Business Cycle:
  • Artificial Credit Expansion
  • “Artificial Boom”
  • Crunch
    • Credit Crunch
    • Real Resource Crunch
  • Recession
  • Recovery
the unsustainable malinvestment boom
The Unsustainable MalinvestmentBoom
  • Suppose that the interest rate is 5% and the firm is considering a project that will yield 4%.
  • Will it engage in the project?
  • Suppose the Central Bank lowers the interest rate from 5% to 3%.
  • What will the firm do now?
malinvestment boom continues
Malinvestment Boom continues
  • During the course of the artificial boom, malinvestments are built up.
  • Consumers reduce savings with lower interest rates.
  • So we have an increase in consumption and an increase in investment.
  • Ivan and the Brickyard.
slide76

The Initial Boom Phase of the Business Cycle

Consumer Goods

C1

C1

Unsustainable Boom

C0

C0

Dueling Structure of Production

Time

I1

I0

Investment Goods

Interest Rates

S = Savers

i0

S + New Money

i1

D = Borrowers

S0= I0

Investible Funds

I1

S1

the fed has a choice
The Fed has a Choice:
  • As the firms compete for resources, input prices are driven up making them look for more funding.
  • Short-term interest rates rise from the firms’ actions.
  • The central bank has a decision to make:
    • halt the expansion
    • expand the money supply at a faster rate
the fed has a choice1
The Fed has a Choice:
  • The central bank may choose to halt the expansion and increase interest rates out of a fear of rising price levels. The effect of this policy is a credit crunch.
  • If, instead, the central bank continues along an expansionist policy, input prices rise and reflect the real resource crunch.
the crunch
The Crunch
  • When the crisis hits, there are two problems facing the entrepreneur:
    • increasing interest rates
    • rising input costs
  • With an increase in interest rates, there is an impact on both working capital and fixed capital.
  • The longer lived the capital equipment, the greater the impact on its value.
  • Interest rates will rise, but short-term rates will increase more than long-term rates.
the liquidation phase
The Liquidation Phase:
  • Only through the process of converting the malinvestments into productive capital can the foundation for growth be achieved.
  • Only the Austrian School argues that Liquidation is a necessary condition for recovery.
the liquidation phase continued
The Liquidation Phase: Continued
  • The firms that invested during the artificial boom suffer the economic losses.
  • They sell their capital equipment at a discounted rate to other firms.
  • These other firms can turn an economic profit even at the previous prices because these firms have purchased the capital equipment at a discount.
  • This liquidation process is how the malinvestments are converted into new fixed capital equipment.
  • This process is necessary for normal economic growth to occur.
the recession illustrated
The Recession Illustrated:

Consumer Goods

C1

C1

C0

C0

C2

C2

Time

I1

I0

I2

Investment Goods

Interest Rates

S’

S

i0

S + New Money

i2 =

i1

D

D’

S0= I0

S1

Investible Funds

I1

S2= I2

so what s happening now
So what’s happening now?
  • Each Business Cycle is unique.
  • 2001 dot.com bust led to another bubble.
  • Money flows into Real-Estate.
  • Community Reinvestment Act encouraged banks to take on more risk.
  • Fannie Mae and Freddie Mac rules changed and encouraged them to buy mortgage-backed securities. (GSE’s only needed 3% held in reserve.)
  • Sub-Prime Market Emerges—In 2006, 20% of all mortgages were sub-prime. 81% of those were securitized.
so what s happening now1
So what’s happening now?
  • Sub-Prime Market Emerges—In 2006, 20% of all mortgages were sub-prime. 81% of those were securitized.
  • Toxic Assets and Troubled Asset Relief Program (TARP): Of the $700b, $350b bought equity (preferred stock), not assets.
  • The Fed led a massive increase in the money supply by buying anything and everything it wanted.
so what s happening now2
So what’s happening now?
  • FASB 157: New Mark-to-Market accounting rules are go into effect June 15th, 2009.
  • Stimulus Package, Bail-Outs and a huge Federal Budget adds to the fire.
recovery
Recovery:
  • Recovery is through the same process of normal growth.
  • In other words, the “Magic Formula”

Savings Investment Capital Accumulation

Higher Productivity More Stuff

Higher Living Standards

implications
Implications:
  • Keynesian Policy cannot pull an economy out of a recession.
  • Expansionist Monetary Policy cannot pull an economy out of a recession.
  • Downturns are created by increasing input prices, not just increasing interest rates.
  • Fixed capital equipment has to be sold-off.
  • Increasing savings is needed for the transformation to occur.
1 keynesian policy cannot pull an economy out of a recession
1. Keynesian Policy cannot pull an economy out of a recession
  • Keynesian policies are designed to keep aggregate demand high.
  • Any increase in aggregate demand will put pressure on input prices to also rise.
  • The problem illustrated above is that after the crunch phase, the return on capital has fallen considerably.
  • In order to maintain profitability by increasing output prices, the output prices have to either keep pace with or outstrip the increases in the input prices.
  • The output levels cannot be maintained due to the real resource crunch that is pressuring input price increases.
expansionist monetary policy cannot pull an economy out of a recession
Expansionist Monetary Policy cannot pull an economy out of a recession
  • Expansionist monetary prescriptions for curing a recession are to stimulate investments by keeping interest rates relatively low and stabilizing the growth of the money supply.
  • Such prescriptions also cannot pull an economy out of a recession, since it ignores the malinvested capital that is locked into unproductive arrangements.
  • The case study of the failure of employing both Keynesian and Monetarist prescriptions is Japan since 1990.
implications1
Implications:
  • Fixed capital equipment has to be sold-off at reduced prices in order to transform the malinvestments does not seem to explain the duration of the recession phase.
  • Capital’s specificity is a stumbling point that tends to reduce the smooth transition of the fixed capital into productive structures.
  • Capital is not an amorphous mass, a homogeneous blob of “K.”
  • Capital goods have differing degrees of specificity, complementarity and substitutability. It is not simply a question of lowering the price and then plugging the machine into another production process.
slide91
Typically, projects need to be integrated into other existing firms. Austrians have long argued that merely investing capital does not lead to economic growth, but correctly arranged capital structures guided by the market process are the mechanism for growth.
  • Rearranging prices is simply not enough to pull an economy out of a recession. Some of the more specific capital may have to be thrown away—scrapped—if no other firm could make a profit from it.
slide92
A liberalization of merger and acquisition laws could improve the situation.
  • Furthermore, the elimination of other obstacles found in bankruptcy laws could help expedite the transfer of malinvestments into productive ventures.
increasing savings is needed for the transformation to occur
Increasing savings is needed for the transformation to occur
  • In order for the second firm to purchase the capital equipment from the first firm, the purchaser will need funds.
  • Newly created credit will only start the boom/bust cycle again. Only real savings can allow the transformation process to occur.
increasing savings is needed for the transformation to occur1
Increasing savings is needed for the transformation to occur
  • A government interested in helping an economy out of a recession has to then do the following:
    • first, not interfere with the price adjustment process;
    • second, not reinflate the money supply;
    • finally, try to increase the amount of savings in the country. It could do this through liberalizing its laws to allow for increased savings to flow in from abroad and it could also cut taxes on domestic savers.
increasing savings is needed for the transformation to occur2
Increasing savings is needed for the transformation to occur
  • By increasing the amount of savings, the amount of malinvestments that could be transformed into profitable investment increases.
  • Increasing the amount of savings available for investment quickly can shorten the duration of a recession.
conclusions
Conclusions:
  • The most significant point is that the Austrians were correct to spend so much energy explaining the cause of the business cycle.
  • It is only an understanding of the cause that allows us to determine the best policies to follow to generate an economic recovery.
  • If the government follows policies that are contrary to the Austrian prescription, the situation will not only fail to improve, it will worsen.
conclusions1
Conclusions:
  • The lesson is that as long as output prices stay up (through Keynesian policies) or if the Monetarists keep interest rates from rising (or maybe push them lower), or if input prices are rising (a real resource crunch), we will have a recession.
  • The only way out is through the painful but necessary liquidation process.
conclusions2
Conclusions:
  • The best means to transform malinvestments into viable economic activities is through increasing savings.
  • This means that one of the government’s most effective policies is to cut taxes on the savers. Those who are savers are usually labeled as “the rich.” Unfortunately, the prescriptions of “get government out of the market” or a “tax cut for the rich” tend not to be politically popular. Nevertheless, it is the duty of the economist to present the truth.
conclusions3
Conclusions:
  • The economist cannot state that the government should do nothing. Such a strategy was tested in the 1930s.
  • The modern economist needs to present the case that the government caused the recession and only by removing the government from the equation can the economy truly recover.
interest rates
Interest Rates
  • Defined as the Price Paid for the Use of Money
  • Demand for Money
    • Transactions Demand, D1
    • Asset Demand, D2
    • Total Money Demand, Dm

…Graphically

interest rates1

50

50

100

100

150

150

200

200

50

100

150

200

250

300

Interest Rates

Demand for Money and the Money Market

(a)

Transactions

Demand for

Money, Dt

(b)

Asset

Demand for

Money, Da

(c)

Total

Demand for

Money, Dm

And Supply

10

7.5

5

2.5

0

Sm

=

+

Rate of Interest, I percent

5

Dt

Da

Dm

Amount of Money

Demanded

(Billions of Dollars)

Amount of Money

Demanded

(Billions of Dollars)

Amount of Money

Demanded and Supplied

(Billions of Dollars)

the demand for money
The Demand for Money

The Opportunity Cost of Holding Money

  • Short-term interest rates are the interest rates on financial assets that mature within six months or less.
  • Long-term interest rates are interest rates on financial assets that mature a number of years in the future.
interest rates2
Interest Rates
    • Equilibrium Interest Rate
      • Changes with shifts in money supply and money demand
  • Interest Rates and Bond Prices
    • Bond Prices Fall When Interest Rates Rise
    • Bond Prices Rise When Interest Rates Fall
    • Inverse Relationship Between Interest Rates and Bond Prices
consolidated balance sheet federal reserve banks
Consolidated Balance SheetFederal Reserve Banks
  • Assets
    • Securities
    • Loans to Commercial Banks
  • Liabilities
    • Reserves of Commercial Banks
    • Treasury Deposits
    • Federal Reserve Notes Outstanding
consolidated balance sheet federal reserve banks1

Assets

Liabilities and Net Worth

$2,753,843

19,250

230,446

$837,768

$ 44,867

4,463

754,567

63,615

$837,768

Consolidated Balance SheetFederal Reserve Banks

Consolidated Balance Sheet of

the 12 Federal Reserve Banks

Feb 7, 2013 (in Millions)

Securities

Loans to Commercial

Banks

All Other Assets

Total

Reserves of Commercial

Banks

Treasury Deposits

Federal Reserve Notes

(Outstanding)

All Other Liabilities and

Net Worth

Total

Source: Federal Reserve Statistical Release, H.4.1, May 7, 2003

consolidated balance sheet federal reserve banks2

GLOBAL PERSPECTIVE

Consolidated Balance SheetFederal Reserve Banks

Central Banks, Selected Nations

Australia:

Canada:

Euro Zone:

Japan:

Mexico:

Russia

Sweden:

United Kingdom:

United States:

Reserve Bank of Australia (RBA)

Bank of Canada

Central Bank of Europe (CBE)

Bank of Japan (BOJ)

Banco de Mexico (Mex Bank)

Central Bank of Russia

Sveriges Riksbank

Bank of England

Federal Reserve System (the “Fed”)

(12 Regional Federal Reserve Banks)

ptpt of interest
PTPT of Interest

Preferences→D&S: Consumer Good→Price of Good →MRP of Factors→Rental Prices of Factors

↑ ↓

Time Pref.→D&S: Present Money →r→Capital Value

sources of net income
Sources of Net Income
  • Gross Profit (Net Income)
    • Interest for entrepreneurial capital invested
    • Profit for entrepreneurial foresight
    • Wages for entrepreneurial labor
    • Quasi-wages for entrepreneurial leadership
market rate of interest
Market Rate of Interest
  • Market Rate of Interest
    • Pure Rate of Interest (Duration)
    • Entrepreneurial Uncertainty
    • Price Premium
    • Unanticipated Changes in PPM
exploitation theory of interest
Exploitation Theory of Interest
  • Interest is the surplus value of labor extracted by the capitalists
    • Based on the fallacious labor theory of value
    • Labor is paid its full value and interest is for advancing labor present money (MRP - DMRP)
    • Labor could receive MRP by waiting to be paid or lending its upfront pay
productivity theories of interest
Productivity Theories of Interest
  • Capital generates a flow of productive services earned from owning it: 100 units of rice matures into 110
    • Physical productivity affects MRP, not r
    • With trade, monetary return on investment in rice is the interest return
    • CV=MRP/r $100=$10/0.10 $200=$10/0.05
    • Interest return exists regardless of physical productivity: sheep, hardtack, figs
eclectic theories of interest
Eclectic Theories of Interest
  • Time Preferences → S → r ← D ← Productivity of Capital
    • Violates ends-means causal chain
    • Fallacy of the vicious circle
b hm bawerk s theory of interest
Böhm-Bawerk’s Theory of Interest
  • Value Productivity of Capital

↓Time Preferences→D&S: Present Goods→r

Subjective Factors

waiting theory of interest
“Waiting” Theory of Interest
  • “Waiting” is a factor of production and r is its price
    • “Waiting” is a superfluous mediating concept between time preference and the rate of interest
    • Cannot apply marginal productivity theory of factor pricing to “waiting”
murphy s criticism of the ptpt
Murphy’s Criticism of the PTPT
  • Dilemma from the two definitions of time preference: present satisfaction or present goods
  • Time preference as satisfaction is neither necessary nor sufficient for a positive premium of the present
h lsmann s criticism of the ptpt
Hülsmann’s Criticism of the PTPT
  • Two contradictory claims: larger stock of a future good is preferred to a smaller stock of a present good and a good in the present is a different good than the good in the future
  • Time preference is between two options of choice for the same good but r is between present goods and future goods
tools of monetary policy
Tools of Monetary Policy
  • Open Market Operations
    • Buying Securities
      • From Commercial Banks
      • From the Public
    • Selling Securities
      • To Commercial Banks
      • To the Public
  • When the Fed Sells Securities, Commercial Bank Reserves are Reduced
tools of monetary policy1
Tools of Monetary Policy

Fed Buys $1,000 Bond from a Commercial Bank

New Reserves

$1000

$1000

Excess

Reserves

$5000

Bank System Lending

Total Increase in the Money Supply, ($5,000)

tools of monetary policy2
Tools of Monetary Policy

Fed Buys $1,000 Bond from the Public

Check is Deposited

New Reserves

$1000

$800

Excess

Reserves

$200

Required

Reserves

$1000

Initial

Checkable

Deposit

$4000

Bank System Lending

Total Increase in the Money Supply, ($5000)

tools of monetary policy3
Tools of Monetary Policy
  • The Reserve Ratio
    • Raising the Reserve Ratio
    • Lowering the Reserve Ratio
  • The Discount Rate
    • Borrowing from the Fed by Banks Increases Reserves and Enhances Lending Ability
tools of monetary policy4
Tools of Monetary Policy
  • Term auction facility
    • Introduced December 2007
    • Banks bid for the right to borrow reserves
  • Relative Importance of Each
tools of monetary policy5
Tools of Monetary Policy
  • Open market operations most important
  • Reserve ratio last changed 1992
  • Discount rate was a passive tool
  • Term auction facility is new
    • Guaranteed amount lent by the Fed
    • Anonymous
targeting the federal funds rate
Targeting the Federal Funds Rate
  • Rate charged by banks on overnight loans
  • Targeted by the Federal Reserve
  • FOMC conducts open market operations to achieve the target
  • Demand curve for Federal funds
  • Supply curve for Federal funds
targeting the federal funds rate1
Targeting the Federal Funds Rate

Using Open Market Operations

To Set The Federal Funds Rate

4.5

Sf3

4.0

Sf1

Federal Funds Rate, Percent

3.5

Sf2

Df

Qf3

Qf1

Qf2

Quantity of Reserves

monetary policy
Monetary Policy
  • Expansionary monetary policy
    • Economy faces a recession
    • Lower target for federal funds rate
    • Fed buys securities
    • Expanded money supply
    • Downward pressure on other interest rates
  • Contractionary monetary policy
taylor rule
Taylor Rule
  • Rule of thumb for tracking actual monetary policy
  • Fed has 2% target inflation rate
  • If real GDP = potential GDP and inflation is 2% then target federal funds rate is 4%
  • Target varies as inflation and real GDP vary
monetary policy1

Rate of Interest, i (Percent)

Price Level

Amount of Money

Demanded and Supplied

(Billions of Dollars)

Amount of Investment, I

(Billions of Dollars)

Real Domestic Product, GDP

(Billions of Dollars)

Monetary Policy

Monetary Policy and Equilibrium GDP

(a)

The Market

For Money

(b)

Investment

Demand

(c)

Equilibrium Real

GDP and the

Price Level

Sm1

Sm2

Sm3

AS

10

8

6

0

P3

AD3

I=$25

P2

AD2

I=$20

Dm

ID

AD1

I=$15

$125

$150

$175

$15

$20

$25

Q1

Qf

Q3

monetary policy2
Monetary Policy
  • Affect on real GDP and price level
  • Cause-effect chain
    • Market for money
    • Investment and the interest rate
    • Investment and aggregate demand
    • Real GDP and prices
  • Expansionary monetary policy
  • Restrictive monetary policy
monetary policy3
Monetary Policy

Expansionary Monetary Policy

Problem: Unemployment and Recession

CAUSE-EFFECT CHAIN

Fed Buys Bonds, Lowers Reserve

Ratio, or Lowers the Discount Rate

Excess Reserves Increase

Federal Funds Rate Falls

Money Supply Rises

Interest Rate Falls

Investment Spending Increases

Aggregate Demand Increases

Real GDP Rises

monetary policy4
Monetary Policy

Restrictive Monetary Policy

Problem: Inflation

CAUSE-EFFECT CHAIN

Fed Sells Bonds, Increases Reserve

Ratio, or Increases the Discount Rate

Excess Reserves Decrease

Federal Funds Rate Rises

Money Supply Falls

Interest Rate Rises

Investment Spending Decreases

Aggregate Demand Decreases

Inflation Declines

monetary policy5
Monetary Policy
  • Advantages over fiscal policy
    • Speed and flexibility
    • Isolation from political pressure
  • Recent U.S. monetary policy
  • Problems and complications
    • Recognition lag
    • Administrative lag
    • Operational lag
    • Cyclical asymmetry
ricardo s law
Ricardo’s Law
  • An increase in the money supply confers no benefit on society, because the purchasing power of money is always adjusted by the market to permit all exchanges to occur that are mutually beneficial.
  • Therefore: any supply of money is sufficient to yield the full social benefits of a medium of exchange.
the angel gabriel or helicopter model
The Angel Gabriel (or Helicopter) Model
  • Benevolent but economically ignorant angel doubles everyone’s cash balances overnight.
    • The effect on the purchasing power of money.
    • The effect on the real supply M/P (example: M =$1,000; P=$10/pizza → M/P = 100 pizzas).
    • The effect on the distribution of income.
monetary policy6
Monetary Policy
  • Cyclical Asymmetry
  • “Artful Management” or “Inflation Targeting”
  • “The Big Picture”
ad as theory of price level real output and stabilization policy
AD-AS Theory of Price Level - Real Output and Stabilization Policy

Consumption

(Cd)

Input

Resources

With Prices

Investment

(Ig)

Aggregate

Supply

Levels of

Output,

Employment,

Income, and

Prices

Aggregate

Demand

Productivity

Sources

Net Export

Spending

(Xn)

Legal-

Institutional

Environment

Government

Spending

(G)

the mortgage debt crisis
The Mortgage Debt Crisis
  • Home mortgage default 2007
  • Banks write off bad loans
  • Reserves reduced
  • Fed as lender of last resort
  • Term auction facility
  • Fed lowered federal funds rate
  • Mortgage backed securities as a new innovation
    • Bad incentives
the federal funds rate
The Federal Funds Rate
  • On any given day, banks with insufficient reserves can borrow from banks with excess reserves.
  • The interest rate on these loans is the federal funds rate.
  • The FOMC uses OMOs to target the fed funds rate.
  • Changes in the fed funds rate cause changes in other rates and have a big impact on the economy.
monetary policy and the fed funds rate
Monetary Policy and the Fed Funds Rate

To raise fed funds rate, Fed sells gov’t bonds (OMO).

This removes reserves from the banking system, reduces supply of federal funds,

causes rfto rise.

Federal funds rate

F

F2

F1

Quantity of federal funds

the fed s tools of monetary control
The Fed’s Tools of Monetary Control
  • Earlier, we learned
    • Money supply = money multiplier × bank reserves
    • The Fed can change the money supply by changing bank reserves
    • or changing the money multiplier.
how the fed influences reserves
How the Fed Influences Reserves
  • Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.
    • If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account.
      • With more reserves, the bank can make more loans, increasing the money supply.
    • To decrease bank reserves and the money supply, the Fed sells government bonds.
how the fed influences reserves1
How the Fed Influences Reserves
  • The Fed makes loans to banks, increasing their reserves.
    • Traditional method: adjusting the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow
    • New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans.
  • The more banks borrow, the more reserves they have for funding new loans and increasing the money supply.
how the fed influences the reserve ratio
How the Fed Influences the Reserve Ratio
  • Recall: reserve ratio = reserves/deposits, which inversely affects the money multiplier.
  • The Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits.
    • Reducing reserve requirements would lower the reserve ratio and increase the money multiplier.
  • Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. Raising this interest rate would increase the reserve ratio and lower the money multiplier.
problems controlling the money supply
Problems Controlling the Money Supply
  • If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.
  • If banks hold more reserves than required, they make fewer loans, and money supply falls.
  • Yet, the Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.
how well has the fed performed
How Well Has the Fed Performed?

Look at the base year.

the fed dollar v s the gold dollar 1
The Fed Dollar vs. the Gold Dollar 1
  • $22.57 in the year 2012 has the same "purchasing power" as $1 in the year 1914 (the year the Fed began operating)
  • $17.23 in the year 2012 has the same "purchasing power" as $1 in the year 1933 (U.S. abandoned the domestic gold standard)
  • $5.67 in the year 2012 has the same "purchasing power" as $1 in the year 1971 (U.S. closed the “gold window” on foreign governments and central banks)
  • $2.23 in the year 2012 has the same "purchasing power" as $1 in the year 1984 (“Great Moderation”)
the fed dollar vs the gold dollar 2
The Fed Dollar vs. the Gold Dollar 2
  • $0.80 in the year 1914 had the same "purchasing power" as $1 in the year 1800.
  • $0.67 in the year 1896 (the year of new gold discoveries in South Africa) had the same "purchasing power" as $1 in the year 1800.
  • $0.82 in the year 1896 had the same "purchasing power" as $1 in the year 1880 (period of greatest rate of growth in U.S. history).
  • $1.19 in the year 1914 had the same "purchasing power" as $1 in the year 1896 (the year of new gold discoveries and period of “Great Inflation”).
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International

Trade

Chapter 18!