Transcript Introduction to Economics

Introduction to Economics
Macroeconomics
The US Economy
Llad Phillips
1
Economics in the News

President Bush approves the biggest
increase in the defense budget since
President Reagan
 an
issue: will this be inflationary?
 An issue: what is the opportunity cost?
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Percentage of Government
Spending on Various Programs
Local Expenditures (1996)
Administration and
other 32%
Public welfare 5%
Highways 5%
Health and hospitals
9%
Police protection 5%
Education 42%
State Expenditures (1998)
Administration and
other 20%
Police and
corrections 4% Highways 8% Health and hospitals
8%
Public welfare 25%
Education 35%
Federal Expenditures (1999)
Net interest 13%
Social security
23%
Other 14%
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National defense
16%
International
affairs 1%
Income security
14%
Medicare 11%
Health 8%
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GDP Deflator: History
early thirties: deflation
 World War II: inflation
 Korean War: inflation
 fifties and sixties: price stability
 Vietnam War: inflation

 Lyndon

seventies: inflation
 OPEC:

Johnson: “guns and butter”
energy prices
nineties: price stability
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GDP Deflator: Percentage Change
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Source: http://www.yardeni.com
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Guns or Butter
Home
Front
“Butter”
Last Year
This year
Govt.: Tax it away
or borrow to buy
it away
Production Possibility
Frontier
War Front “Guns”
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Concepts

The real or physical economy
 mystery:
competitive markets transform
individual greed into social welfare
 measure of the physical economy: index of
industrial production

the money economy
 is
money a veil?
 Mystery: money creation
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Index of Industrial Production
Source: http://www.yardeni.com
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The Creation and Destruction of
Value

Stock Market
 Then:100
shares@$20 per share = $2000
 Now: 100 shares@$10 per share = $1000
Where did the value go?
 In the long run: the value of a share of stock
is equal to the present value of future
earnings (profits) per share
 In the short run: irrational exuberance or
excessive pessimism

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The Creation of Money

Governments
 Pay
for wars or economic development by
printing money
 use money to buy goods for the government
 the government can put a lot of money in
circulation by printing it
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Money Supply and Inflation

GDP (real) x GDP Deflator = Money
Supply x velocity of circulation
Q
xP=MxV
Q x P = M x V
 If money supply increases more rapidly than
output then prices go up

Who keeps an eye on the government?
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In Last Year’s Local News
Santa Barbara News Press
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How Does Bank Failure Affect
the Economy?
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Is a wave of bank failures on the
way?

Source of instability in the capitalist system
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The Creation and Destruction of
Money

Banks
 Make
loans and create deposits
 Call loans and decrease deposits
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Outline: Lecture Eight
The Banking System
 The Federal Reserve

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Why are Banking Systems Unstable?

Illiquid
 Insufficient

cash on hand
Insolvent
 Liabilities
 Bad
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exceed assets
loans
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Full Reserve Banking
 Dates
to the Middle Ages
goldsmiths
accept
customer deposits of gold
issue certificates of deposit to customer
• customer can use certificates as a medium
of exchange
• paper money substitutes for gold money
• no money creation
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Assets-Liabilities Statement
Amount
Amount Liability
Asset
bank loan
cash
margin loan
stocks
bonds
policy loans
insurance
(surrender)
card balances
other
mortgage
house equity
car loan
personal
property
Total
Total
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Full Reserve Banking
Goldsmith
Assets
Liabilities
customer deposits
of gold, e.g. 1,000 Florins
certificates of deposit,
e.g. 1,000 Florins
Note: The goldsmith is perfectly liquid. If a customer
comes in with a certificate of deposit, the goldsmith has
the reserves of gold to exchange for the certificate.
Note: The goldsmith is perfectly solvent. The value
of the gold reserves held as assets equals the value of
the certificates issued, i.e assets equal liabilities.
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Banking as a Business
Goldsmiths note that only about 25% of
customers want to exchange certificates for
gold on a given day
 This creates an incentive for the goldsmiths
to use some of the remaining gold reserves
to make loans and earn interest

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Fractional Reserve Banking
Assets
Goldsmith
customer deposits
of gold, e.g. 1,000 Florins
Liabilities
certificates of deposit,
e.g. 1,000 Florins
loans of 500 Florins
certificates of deposit, 500 Florins
(money creation)
Note: The goldsmith is no longer perfectly liquid. If all the
customers come in with certificates of deposit and demand
1,500 Florins, the goldsmith only has reserves of 1,000 Florins
in gold to exchange for the certificates. The customers panic!
Note: The goldsmith may not remain solvent. If the goldsmith
makes unwise loans, and the customer in debt defaults, then the
value of assets, 1,000 Florins, is less than the value of liabilities,
1,500 Florins.
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History of US Capitalism
 Punctuated
by a series of banking
crises
for
example: panic of 1907
 motivates
the formation of the Federal
Reserve, 1913
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Banking Crises (continued)
widespread
bank failures in 1932
depositors
lose money
Roosevelt declares a bank holiday
upon assuming office
Federal Deposit Insurance Corporation
, FDIC, created in 1934
• insures accounts up to $100,000
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Banking Crises (continued)
Savings
and Loans failures in the
1980’s
in
1989 & 1990, 100’s of insolvent
thrifts taken over
• bail out of depositors costs US taxpayers
about $500 B
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Number of Banks Suspended Because of Financial
Difficulties .
10000
1933
1000
1893
1988
1908
1878
1937
100
1976
10
1992
1984
1976
1968
1960
1952
1944
1936
1928
1920
1912
1904
1896
1888
1880
1872
1
1864
Number
.
Year
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Fractional Reserve Banking is
subject to two threats

Liquidity Crisis
 rumors
 depositors
lose
confidence
 run on the banks to
withdraw deposits
 not enough reserves to
meet demands of
depositors
 panic
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
Bank Failures
 banks
make unsound
loans

for example, make real
estate loans and then the
real estate market
crashes
 debtors
default on
loans
 banks become
insolvent
 depositors lose money
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Economic Concept: Moral Hazard

The creation of the Federal Deposit
Insurance Corporation, FDIC, and the
Federal Savings and Loan Insurance
Corporation, FSLIC, did not prevent the
failure of S&L’s in the 80’s
 with
an account insured up to $100,000, a
depositor then takes less care to check out the
policies and practices of an S&L before
depositing cash
 this
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effect of insurance making one feel “safe” and
hence taking less care to avoid loss is called moral
hazard
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Deposits of Suspended Banks in Billions of $
.
53.8 B, '91
100
3.6 B, '33
10
1.6 B, '74
1996
1991
1986
1981
1976
1971
1966
1961
1956
160 M, '39
1951
1946
1941
1936
1931
1926
0.1
1921
Deposits
1
0.01
0.001
0.0001
Year
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Source: http://www.fdic.gov/
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Source: http://www.fdic.gov/
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Source: http://www.fdic.gov/
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The Federal Reserve
Objectives
 Tools
 Organization and Structure

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The Federal Reserve

Objectives
 prevent
liquidity crises
 prevent solvency crises
 control inflation and money stock growth
 stabilize short term interest rates
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Federal Reserve as Central Bank

Tools
 lender
of last resort to private
banks
 sets required ratio of reserves
to deposits
 establishes sound banking
practices
 manipulates bank reserves
 affects federal funds rate and
sets the discount rate
Fed: Lender of Last Resort to Banks at Discount Rate, 99-01
Source: Federal Reserve Bank of Minneapolis
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Fed: Lender of Last Resort to Banks at Discount Rate, 00-02
Source: Federal Reserve Bank of Minneapolis
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10
Federal Reserve Bank Discount Rate, 1983-2000
8
%
6
4
Year and Month
2
84
86
88
90
92
94
96
98
00
Fed Sets Ratio of Minimum
Bank Reserves to Bank Deposits
 Helps
Prevent Liquidity Crises
 For Example: Dec 1992
deposits
of 0-$42.2M (small banks)
 required
deposits
of $42.2+M- (large banks)
 required
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minimum reserve ratio: 3%
minimum reserve ratio: 10%
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Reserve Ratios (Continued)

For Example 1994
 deposits
of 0-$4M: 0% reserve ratio
 deposits of $4+M-$51.9M: 3% reserve ratio
 deposits of $51.9M- :10%

Infrequent Changes in Reserve Ratios
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Fed: Establish Sound Banking Practices
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Source: http://www.frbch.org/
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Federal Reserve: Organization and Structure
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Vice Chair: Board of Governors
Members replacing Kelley and Meyers : Susan Scmidt Bies,
Mark W. Olson, Ben S. Bernanke, Donald L. Kohn
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Federal Open Market Committee Meetings
2002: November 6, December 10
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Federal Open Market Committee
 Federal
Open Market Committee: 12
Members
Seven
Board Governors
President of New York Fed
Four other presidents
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Federal Reserve Open Market Operations

Tight Money Policy
 Fed
sells securities in secondary market
 decreases bank reserves
 decreases excess reserves
 decreases banking system capacity to make loans

Easy Money Policy
 Fed
buys securities in secondary market
 increases bank reserves
 increases excess reserves
 increases banking system capacity to make loans
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FOMC Tries to Loosen Credit
Buys Treasuries in Secondary Market
FED
Commercial Banks
Fed Assets Fed
Bank
Liabilities Assets
Bank
Liabilities
 Govt.
Sec.=
+$1B
No
Change
 Bank
 Govt.
Reserve
Sec. = Deposits = $1B
+$1B
 Reserve
Deposits
with Fed =
+$1B
No
Change
Net Result: changes asset mix of banks & increases total bank reserves
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FOMC Tries to Tighten Credit
Sells Treasuries in Secondary Market
FED
Commercial Banks
Fed Assets Fed
Bank
Liabilities Assets
Bank
Liabilities
 Govt.
 Bank
 Govt.
Sec.= -$1B Reserve
Sec. =
Deposits = +$1B
-$1B
 Reserve
Deposits
with Fed =
-$1B
No
Change
No
Change
Net
Result: changes asset mix of banks & decreases total bank reserves
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Limitations to FOMC Efforts

FOMC can increase reserves by buying
securities: this enables banks to make loans
 Fed
can not force banks to make loans
 Fed can not force consumers or businesses to
ask banks for loans
Metaphor: “you can lead a horse to water,
but you can not make him drink”
 Contractionary monetary policy is more
direct than expansionary monetary policy

 if
Fed sells securities, this reduces reserves, and
hence for a given level of bank deposits and
required reserves, decreases excess reserves50
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Understanding Open Market Operations
Familiarity with the Fed’s balance sheet
 Definitions of Banking Reserve Aggregates
 Fed is a corporation

 national
banks are chartered by the US
Comptroller of Currency
 national
banks must be members and buy stock; this
provides Fed with working capital
 state
banks can be members if they choose
 Fed’s profits, above a given level, are given to
US Treasury
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Federal Reserve System Balance Sheet,
August 13, 1997
Assets
$B
US Govt.
410.2
Securities
Loans to Banks
0.4
Currency
Outstanding
Gold
Other
Total
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Liabilities
Currency in
Circulation
Treasury
Deposits
25.4 Other
$B
456.7
11.1 Subtotal
48.2 Bank Reserve
Deposits
495.3 Total
484.7
10.6
5.0
23.0
495.3
Source: TheWall Street Journal, Friday 8-22-97, p.C 18
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Bank Reserve Aggregates, 10-21-98
Total Reserves( cash in Bank Vaults
& Deposits with Fed)
Nonborrowed Reserves
$43.9 B
Required Reserves
$42.6 B
Excess Reserves*
$1.3 B
Free Reserves**
$1.1 B
$43.7 B
* Excess Reserves = Total Reserves - Required Reserves
** Free Reserves = Excess Reserves - Borrowed Reserves
Source: The Wall Street Journal, Friday 8-22-97, p.C 18
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How Effective Has the Fed Been?

Fed Goals
 maximum
employment
 stable prices
 moderate long-term interest rates

Fed Objectives or Targets
 quantity
of reserves
 price of reserves
 federal
funds rate, FFR, is the interest rate banks
charge one another for borrowing reserves for a day
or so; mostly large urban banks borrowing from
small suburban and rural banks
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Misery Index = Unemployment Rate + Inflation Rate
Misery Index: 1929-1996 .
25
20
Index
15
10
5
Hoover
Roosevelt
Truman
Ike
Year
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
29
0
LBJ Nixon/
Reagan Bush
JFK
Clinton
Ford Carter
The Federal Reserve System: Purposes & Functions
http://www.bog.frb.fed.us/
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PDF format: Adobe Acrobat
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The Federal Reserve System: Purposes & Functions
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http://www.bog.frb.fed.us/
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PDF format: Adobe Acrobat
Summary-Vocabulary-Concepts



full reserve banking  Federal Reserve (FR)
 District
fractional reserve
 Board of Governors
banking
 Open Market Committee
banking system crisis
 open market operations
 illiquid
bank
 insolvent bank





FDIC, FSLIC
lender of last resort
discount rate
ratio of required
reserves to deposits
Federal Funds Rate
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 policy
goals
 policy targets

Reserve Aggregates
 total
reserves
 nonborrowed reserves
 required reserves
 excess reserves
 free reserves

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secondary Treasuries market
GDP: Nominal and Real
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Source: http://www.yardeni.com
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GDP Deflator, 1992=100 .
120
100
60
40
20
Year
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60
97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
0
29
Index
80
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