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Chapter 11
Money is any asset that is widely acceptable as a means of payment and is highly liquid.
An asset is considered liquid if it can be converted to cash quickly and at little cost.
Credit limits on credit cards are not money because the right to borrow is not an asset.
Stocks, bonds, and gold bars are not money because they are not widely acceptable.
M1 is the standard definition of the money stock. It is the sum of cash in the hands of
the public, demand deposits, other checkable deposits, and travelers’ checks. For
simplification, this chapter defines the money supply as cash in the hands of the public
plus demand deposits.
Banks are important examples of financial intermediaries—business firms that
assemble loanable funds and channel those funds to borrowers. A bank’s assets include
property and buildings, government and corporate bonds, loans, vault cash, and accounts
with the Federal Reserve. The Federal Reserve requires that banks hold a minimum
fraction of their deposits as vault cash or accounts with the Fed. These are a bank’s
required reserves. Total reserves less required reserves equals excess reserves. Demand
deposits are a bank’s liability, because customers have the right to withdraw these funds
from their checking accounts. A bank’s net worth is equal to total assets minus total
liabilities.
Congress established the Federal Reserve System in 1913, as a corporation whose
stockholders are the private banks that it regulates. There are 12 Federal Reserve Banks, each
serving a different part of the United States. The Board of Governors supervises the Federal
Reserve System. This board consists of seven members who are appointed by the President,
and confirmed by the Senate for a 14-year term. The most powerful person at the Fed is the
Chairman of the Board of Governors, who is appointed by the President for a four-year term.
The Federal Open Market Committee consists of all seven governors of the Fed, along with
the 12 district bank presidents. It meets about eight times per year and sets the general course
for the nation’s money supply.
Some of the Fed’s most important responsibilities are supervising and regulating
banks, acting as a bank for banks, issuing paper currency, clearing checks, and
controlling the money supply.
The Fed uses open market operations to control the money supply. It buys
government bonds when it wants to increase the money supply, and sells government
bonds when it wants to decrease the money supply.
When the Fed buys government bonds, it injects reserves into the banking system. This
increases the amount of excess reserves in the banking system, which allows banks to make
new loans. When banks create loans, the total supply of money increases. When the Fed sells
government bonds, it removes reserves from the banking system, and causes the money
supply to contract.
The demand deposit multiplier is the number by which we multiply an injection of
reserves to get the total change in demand deposits. The size of the demand deposit
multiplier is negatively related to the required reserve ratio. The multiplier is weakened
by the public’s desire to hold cash and banks’ desires to hold excess reserves.
The Fed can also control the money supply by changing the required reserve ratio or by
changing the discount rate (the rate the Fed charges banks when it lends them reserves).
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Lowering the required reserve ratio or the discount rate increases the money supply, and
vice versa.
A bank failure occurs when a bank is unable to meet the requests of its depositors to
withdraw their funds. A run on a bank occurs when a bank’s depositors all try to
withdraw their funds at one time. A banking panic occurs when many banks fail
simultaneously. The Federal Deposit Insurance Corporation was created by Congress in
1933, to prevent banking panics by reimbursing those who lose their deposits when a
bank fails. FDIC protection for bank accounts is not costless—banks must pay insurance
premiums to the FDIC, and they pass this cost on to their depositors and borrowers.
Additionally, FDIC insurance weakens bank managers’ incentives to act responsibly, and
increases the need for banking regulation.
Chapter 12
Money is one of the ways we can hold our wealth. Given a fixed total amount of wealth,
if we want to hold more wealth as money, we must hold less wealth in other forms. To
keep things simple, we can imagine that individuals choose how to divide wealth between
two assets: money and bonds. Money can be used as a means of payment but earns no
interest, while bonds earn interest but cannot be used as a means of payment. The price
level, real income, and the interest rate determine how much money an individual will
decide to hold. The demand for money by businesses follows the same principles as the
demand for money by individuals.
The economy-wide quantity of money demanded is the amount of total wealth in the
economy that all wealth holders, together, choose to hold as money, rather than as bonds.
The money demand curve shows the total quantity of money demanded in the economy at
each interest rate. A change in the interest rate moves us along the money demand curve,
while a change in real income or the price level will cause the money demand curve to
shift.
The economy’s money supply curve shows the total money supply at each interest
rate. This line is vertical because once the Fed sets the money supply, it remains constant
until the Fed changes it. Open market purchases of bonds inject reserves into the banking
system and shift the money supply curve rightward. Open market sales have the opposite
effect.
In the short run the equilibrium interest rate is determined in the money market.
Equilibrium in the money market occurs when the quantity of money people are actually
holding is equal to the quantity of money they want to hold. When the interest rate is
above its equilibrium level, people try to get rid of their excess supply of money by
buying bonds. This raises bond prices and lowers interest rates until people are satisfied
with their money holdings. A similar process drives up the interest rate when it is below
its equilibrium level.
When the Fed controls or manipulates the money supply in order to achieve any
macroeconomic goal it is engaging in monetary policy. When the Fed increases the
money supply, the equilibrium interest rate falls and spending on plant and equipment,
new housing, and consumer durables increases. This produces a multiplier effect that
increases equilibrium GDP. Decreasing the money supply has the opposite effect.
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Fiscal policy (like any other spending changes) leads to an initial change in
equilibrium GDP, which is partially offset by a second change in equilibrium GDP that
occurs in response to money market changes. An increase in government spending, for
example, raises the interest rate and crowds out some private investment. It may also
crowd out consumption spending. There is an important difference between crowding out
in the classical model and the effects in the short-run. In the classical, long-run model,
there is complete crowding out, while here the crowding out effect is not complete. This
analysis assumes that the Fed does not change the money supply in response to shifts in
the aggregate expenditure line.
Our view of the interest rate depends on the time period we are considering. The
market for loanable funds determines the interest rate in the long-run (classical) model,
while the money market determines the interest rate in the short run.
Another source of interest rate changes is a shift in the money demand curve due to a
change in expectations about future interest rates. For instance, a general expectation that
interest rates will rise in the future will cause the money demand curve to shift rightward
in the present, driving up the interest rate in the present.
A Using the Theory section shows how the Fed used monetary policy to save the
economy from a more severe and longer lasting recession in 2001.
Chapter 13
This chapter shows that we can improve our understanding of economic fluctuations by
building a model that allows for changes in the price level. The relationship between the
price level and output is a two-way relationship. Changes in the price level cause changes
in real GDP, but changes in real GDP also cause changes in the price level. The aggregate
demand (AD) curve illustrates the first causal relationship, while the aggregate supply
(AS) curve illustrates the second.
The AD curve tells us the equilibrium real GDP at any price level. This is the level of
output at which total spending equals total output. Movements along the AD curve occur
when the price level changes. The AD curve shifts when anything other than a change in
the price level causes equilibrium GDP to change. These other influences include
changes in government purchases, autonomous consumption spending, investment
spending, net exports, taxes, and the money supply.
The AS curve tells us the price level consistent with firms’ unit costs and their
percentage markup at any level of output over the short run. Movements along the AS
curve occur when a change in total output causes a change in the price level. A change in
output affects unit costs and the price level in three key ways: it will cause a change in
nonlabor input prices, it will cause a change in input requirements per unit of output, and
it will cause a change in the nominal wage. Since nominal wages respond slowly to
changes in output, the AS curve is derived while assuming that the nominal wage rate is
given.
The AS curve shifts when anything other than a change in real GDP causes the price
level to change. Short run changes in unit costs that are not caused by changes in output
(such as changes in world oil prices or the weather) and changes in nominal wage rates
cause the AS curve to shift. Unit costs change in the short run because of changes in
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world oil prices, the weather, technology, and, if it were not constant, the nominal wage.
(A later section of the chapter examines a change in the nominal wage.)
Short-run equilibrium is at the intersection of the AD and AS curves.
A demand shock is an event that causes the AD curve to shift. A positive demand
shock shifts the AD curve to the right and increases both real GDP and the price level in
the short run. A negative demand shock shifts the AD curve to the left and decreases both
real GDP and the price level in the short run.
When a demand shock pulls the economy away from full-employment, changes in the
wage rate will shift the AS curve, eventually causing the economy to self-correct and
return to full-employment output. A vertical long-run AS curve illustrates this result. This
long-run AS curve shows that the economy pehaves as the classical model predicts after
the self-correcting mechanism has done its job. Demand shocks cannot change
equilibrium GDP in the long run. An increase in government purchases, for instance,
causes a complete crowding out effect that leaves total output and total spending
unchanged. Since it can take several years to return the economy to full-employment after
a demand shock, governments are reluctant to rely on the self-correcting mechanism
alone to keep the economy on track, and rely on fiscal and monetary policies to return to
full-employment more quickly.
A supply shock is an event that causes the AS curve to shift. A negative supply shock
shifts the AS curve upward, causing stagflation in the short run, while a positive supply
shock shifts the AS curve downward, increasing output and decreasing the price level. In
the long run, however, supply shocks self-correct in the same way as demand shocks, so
that the economy returns to full employment.
In the real world, several things complicate the adjustment process as described in the
chapter. To draw the AS curve, the chapter assumes that output prices are completely
flexible in the short run, and that nominal wages are completely rigid in the short run. But
in some markets, output prices are not completely flexible, and nominal wages are not
completely rigid, in the short run. In addition, recovering from a demand or supply shock
requires adjustments other than changes in prices and wages. While these observations
complicate the adjustment process in the real world, they do not change the basic outlines
of that process as described in the chapter.
The AD and AS curves are tools that help us understand important economic events. This
chapter closes by using these tools to explain the forces behind the recessions of 1990–91
and 2001, and jobless expansions.
Chapter 16
This chapter examines the markets where Americans exchange dollars for other
currencies, and expands the text’s analysis of the macroeconomy to include trading with
other nations. It explores the relationship between foreign exchange markets and our
economy, and the effects of monetary policy in an open economy.
One country’s currency is traded for that of another in a foreign exchange market.
The exchange rate is the rate at which one currency is traded for another. So that we can
think of the exchange rate as the price (in dollars) of foreign currency, this chapter always
defines the exchange rate as “dollars per unit of foreign currency.”
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This chapter develops a model of supply and demand for British pounds, under the
assumption that American households and businesses are the only buyers of pounds, and
British households and businesses are the only sellers of pounds. The demand curve for
British pounds is downward sloping because as the exchange rate falls British goods and
services are less expensive to American buyers. The lower the price of the pound, the
more British goods Americans will buy, and the more pounds they will need to make
their purchases. This demand curve will shift in response to changes in U.S. real GDP,
the U.S. price level relative to the British price level, Americans’ tastes for British goods,
relative interest rates in the United States, and expectations about future exchange rates.
The supply curve for British pounds is upward sloping because as the exchange rate
rises the British will get more dollars for each pound traded. This makes U.S. goods less
expensive to British buyers. As they buy more American goods, they will need to supply
more pounds in order to get dollars. The variables that will shift the supply curve include
real GDP in Britain, the U.S. price level relative to the British price level, British tastes
for U.S. goods, relative interest rates in the United States, and expectations about changes
in the interest rate.
A floating exchange rate is freely determined by the forces of supply and demand,
without government intervention to change it or keep it from changing. When the
exchange rate floats, equilibrium occurs at the price where the quantity of foreign
currency (pounds) demanded equals the quantity supplied.
An increase in the demand for pounds or a decrease in the supply of pounds leads to
an appreciation of the pound (and a depreciation of the dollar). A decrease in the demand
for pounds or an increase in the supply of pounds leads to a depreciation of the pound
(and an appreciation of the dollar).
There are three types of exchange rate movements: very short-run changes, short-run
changes, and long-run trends.
Decisions by banks and other large financial institutions to move billions of dollars
from one country to another are responsible for exchange rate changes in the very short
run. These decisions to move “hot money” are made in split seconds in response to
changes in relative interest rates and expectations of future exchange rates.
Economic fluctuations are the main cause of short-run exchange rate changes.
Generally, a country whose GDP rises relatively rapidly will experience a depreciation of
its currency, and vice versa.
In the long run, according to the purchasing power parity (PPP) theory, an exchange
rate will adjust until the average price of goods is roughly the same in both countries. The
existence of non-tradable goods, high transportation costs, and artificial trade barriers all
limit such perfect price adjustment. An important implication of PPP theory is that the
currency of a country with a higher inflation rate will depreciate against the currency of a
country whose inflation rate is lower.
Governments sometimes intervene in foreign exchange markets involving their
currency. They may choose to intervene in foreign exchange markets when high
exchange rates are harming export-oriented industries, when falling exchange rates are
leading to a general rise in domestic prices, and when volatile exchange rates are making
trading arrangements risky. Under a managed float, a country’s central bank buys its own
currency to prevent a depreciation, and sells its own currency to prevent an appreciation.
A more extreme form of intervention is a fixed exchange rate, in which a government
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declares a particular value for its exchange rate with another country and then, through its
central bank, commits itself to intervene anytime the equilibrium exchange rate differs
from the fixed rate.
A foreign currency crisis is a loss of faith that a country can prevent a drop in its
exchange rate, and leads to a rapid depletion of its foreign currency. Thailand’s financial
crisis of 1997-1998 is explained using the concept of a foreign currency crisis. The
International Monetary Fund (IMF) resolved this crisis—an organization formed in large
part to help nations avoid such foreign currency crises and help them recover when crises
occur. Such a rescue is controversial, however, since it creates a moral hazard problem.
Moral hazard occurs when a decision maker expects to be rescued in the event of an
unfavorable outcome, and then changes their behavior so that the unfavorable outcome is
more likely. The problem of moral hazard helps explain the IMF’s response to
Argentina’s foreign currency crisis of 2001-2002.
One answer to the problems that countries have encountered in managing their own
currencies is to adopt another country’s currency or an international currency. In 2001,
both Ecuador and El Salvador adopted the U.S. dollar as their official money. And on
January 1, 2002, 12 European nations adopted a new currency called the euro. The
chapter explains the advantages and disadvantages of this change, and develops the idea
of an optimum currency area.
Exchange rates can have important effects on the macroeconomy—largely through
their effect on net exports. A dollar depreciation causes net exports to rise and leads to an
increase in real GDP in the short run. A dollar appreciation does just the opposite. When
we include the impact on exchange rates and net exports, we find that monetary policy
has a stronger effect on the economy than initially described.
A country’s trade deficit measures the extent to which its imports exceed its exports.
When exports exceed imports, a nation has a trade surplus.
The United States has a trade deficit with the rest of the world since the early 1980s
because of a massive capital inflow that arose in the early 1980s and has grown larger
since. A rise in U.S. interest rates relative to interest rates abroad, coupled with
America’s lead in exploiting the Internet, led to this net financial inflow. The net
financial inflow has contributed to an appreciation of the dollar. This appreciation causes
exports to fall and imports to rise, leading to an increase in the trade deficit.
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