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CHAPTER 1
Introduction to Money and Banking
TEACHING OBJECTIVES
Goals of Chapter 1
A.
B.
C.
D.
E.
Provide an introduction to the textbook.
Discuss two main themes in the book
Describe the value of money and banking for everyday life.
Discuss why government policy is so crucial for money and banking.
Examine ten surprising facts about money and banking that will be discussed in
greater detail in the book.
TEACHING NOTES
A. Introduction
1. Money flows around the world and is affected by government policy
2. People encounter money and the financial system frequently
3. If economic policy is poor, the economy does not work well
4. The Federal Reserve is a key policy institution; its decisions have worldwide
implications
B. What Is in This Text?
1. The Value of Money and Banking for Everyday Life
a) The amount you must repay on a student loan is affected by decisions of
the Federal Reserve
b) The interest rate on mortgage loans depends on many factors, including
the Federal Reserve’s decision
c) The returns from investing in the stock market depend on the profits of
corporations, which in turn depend on economic growth
d) Understanding interest rates and returns to the stock market will help you
make better decisions
Chapter 1: Introduction to Money and Banking
2. Why Is Government Policy So Crucial for Money and Banking?
a) Why do we care about economic policy?
(1) Economic policy affects everyone in her or his everyday life
(2) Policy matters more for the financial system than for other industries
because of externalities
b) Who are the policymakers and why are they so important?
(1) Policymakers are a diverse group, including the Securities and
Exchange Commission, accounting rule-makers, and the FDIC
(2) They are important because their decisions affect the nation in many
ways
c) What is the Federal Reserve?
(1) The Federal Reserve determines the money supply, sets rules for check
clearing, distributes currency, supervises and regulates banks
(2) A major decision by the Fed is to change the target for the federal
funds rate
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Chapter 1: Introduction to Money and Banking
C. Ten (Surprising) Facts Concerning Money and Banking
1. Most financial formulas—no matter how complicated they look—are based
on the compounding of interest
a) Complicated formulas related to financial transactions are based on the
simple idea of compounding
b) Borrowing requires repayment plus interest
c) Interest compounds over time; interest today is earned on interest
earned previously
d) Compounding makes a large difference over long periods
e) Compounding is the major principle in finance
2. More U.S. currency is held in foreign countries than in the United States
a) More U.S. dollars circulate outside our borders than within
b) Foreigners use U.S. dollars to avoid problems caused by inflation in their
own countries
c) U.S. taxes are lower because foreigners use our currency, as the U.S.
government profits from the sale of currency to foreigners
3. Interest rates on long-term loans are generally higher than interest rates on
short-term loans
a) There are many different interest rates
b) The longer the time before a loan is repaid, the higher the interest rate
usually is
c) The higher interest rate on long-term loans arises from lender’s
preferences and the increased riskiness of long-term loans
4. To understand how interest rates affect economic decisions, you must
account for expected inflation
a) People do not care about how many dollars they earn from lending; they
care about what they can buy
b) How much a lender can buy in the future depends on the expected
inflation rate
c) People form expectations of inflation in different ways, depending on
circumstances
d) The real interest rate is of concern to investors; policymakers can change
the nominal interest rate, but changes in the real interest rate depend on
changes in people’s inflation expectations
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Chapter 1: Introduction to Money and Banking
5. Buying stocks is the best way to increase your wealth—and the worst
a) Deciding how to invest your savings depends on your willingness to take
risk
b) Investing in the stock market may yield high returns but it is very risky
c) Stock investors should understand both how the stock market works
within the financial system and what a particular investment will yield
6. Banks and other financial institutions made major errors that led to the
financial crisis of 2008
a) Banks were relatively healthy in the 1990s and the early 2000s
b) Rapid growth in housing prices led banks and mortgage brokers to make
loans to people who did not have sufficient income to pay back the loans
c) When housing prices dropped, banks lost money on subprime loans and
mortgage-backed securities
d) The global financial system froze up and a deep recession followed
7. Recessions are difficult to predict
a) A recession occurs when overall business activity declines
b) Recessions are difficult to predict; indicators that seem to predict
recessions at one time lose their predictive ability at other times
c) But analysis can reveal the economy’s susceptibility to a shock that may
lead to a recession
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Chapter 1: Introduction to Money and Banking
8. The Fed creates money by changing a number in its computer system
a) Money is created when the Federal Reserve buys government securities,
which it does by writing down a larger number in its computer system
b) Dollar bills come into being when the Federal Reserve gives them to banks
in exchange for reducing the number in the computer system
representing banks’ deposits
c) If the Federal Reserve creates too much money, the inflation rate rises, so
the Federal Reserve limits money creation
9. In the long run, the only economic variable the Federal Reserve can affect is
the rate of inflation—the Fed has no effect on economic activity
a) The Fed can change economic activity in the short run by changing the
money supply and interest rates
b) In the long run, the Fed’s policy does not affect economic activity, but
only determines the inflation rate
10. You can predict how the Federal Reserve will change interest rates using a
simple equation
a) We can use our knowledge about the Fed’s actions in the short run and
long run to predict its behavior
b) The Fed’s decisions largely depend on the level of output relative to
potential and the inflation rate relative to its desired level
c) The Taylor rule is an equation that describes the Fed’s behavior
reasonably well
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. Ask your students which of the ten facts they found most surprising. For those of
us who teach money and banking or macroeconomics, none of the facts are
surprising at all. But students with little backgrounds in economics are often
quite surprised by many of the ten facts. In giving speeches as a Federal Reserve
economist, I found that fact number 9, that the Fed can only affect inflation in
the long run, comes as a surprise to almost everyone.
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Chapter 1: Introduction to Money and Banking
2. It may be interesting to talk about fact number 5, “buying stocks is the best way
to increase your wealth—and the worst” now, then come back to it when you
get to Chapter 7. It seems that almost everyone who has not looked at the data
on stock returns thinks that if only they had some wealth, they could make a
fortune in the stock market. Giving them a healthy dose of reality is a goal of the
book and should be clear in Chapter 7.
3. The idea that recessions are difficult to predict, which is idea number 7, is one
that many people struggle with. A useful class discussion can arise from the
question: How can the government use policy to prevent recessions if they are
not predictable in the first place? That is a tough one to answer!
ADDITIONAL TEACHING NOTES
Policy Issue: How Much Should Policymakers Do?
A key question that every policymaker faces is: how much should I do? That
decision influences everyone, because how policymakers answer that question
determines whom citizens vote for and how they perceive government.
In this textbook, we will look at both sides of the coin, divided between activist
policy, in which the government does a lot, and passive policy, in which the
government does little. In some cases, it will be clear that activist government
policy is wrong. But in others (such as setting up accounting rules), it is equally clear
that government policy actions are valuable.
In 2000, for example, the Securities and Exchange Commission (SEC) passed a new
rule about “fair disclosure.” It stopped the practice that many companies had
engaged in of telling some people (usually investment analysts from Wall Street)
useful information about the company and its future prospects. Why did the SEC
adopt this rule? Because it gave the Wall Street guys a big advantage over the
average investor, who did not have access to the same information. Prior to the
rule, it would be common for an analyst from a large Wall Street firm to call the
president of a company with questions, the president would disclose valuable
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Chapter 1: Introduction to Money and Banking
information, and the analyst would then often write a favorable report on the
company. The average investor might eventually learn the same information, but in
the meantime the Wall Street firm and its clients would have already benefited by
purchasing the company’s stock. This gave an unfair advantage to Wall Street firms
and their clients. The new rule levels the playing field for all investors.
We will spend a lot of time in this textbook discussing monetary policy, and address
the tremendous debate over how activist policy should be. Keynesian theory in the
1970s suggested that monetary policy could offset many disturbances in the
economy. But the Great Inflation of the 1970s caused economists to rethink the
ability of policymakers to fine-tune the economy. On the other hand, the deep
recession of 2008-2009 led to resurgence of Keynesian policies. If policymakers are
to be less activist, how much should they do? Should they act based on their
discretion, keeping in mind the failures of the past? Chairman Bernanke testified
that the Fed should do its best with the models it has to help the economy. But
some economists think the Fed should instead eliminate its discretion and follow a
simple rule, such as, “make the money supply grow 5 percent each year.”
Others, such as Mickey Levy of Bank of America Securities, argue that, “The Fed
must avoid being sidetracked from its long-run objectives; in the past, attempts to
over-manage the economy by smoothing short-run fluctuations, calming financial
market turmoil, stabilizing currency fluctuations, or responding to fiscal policy have
been destabilizing.” Levy thinks that most of the Fed’s actions are
counterproductive, doing more harm than good. He would rather see the Fed focus
on its long-run goals and stop engaging in policy to affect the economy in the short
run. Levy did admit, however, that after the financial shock of the fall of 2008,
“financial markets have stabilized and the economy has adjusted, benefiting
primarily from the Federal Reserve’s extraordinary liquidity provisions. ”
In research studies on monetary policy, economists have found some support for
that argument. In comparing the performance of different rules for monetary
policy, a number of studies have shown that when the Fed tries to respond to shortrun fluctuations in economic growth, it tends to have worse overall performance
than if it focuses solely on inflation.
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Chapter 1: Introduction to Money and Banking
In the past, macroeconomic theory has suggested that policymakers can do exactly
what Levy cautions against. As a discipline, macroeconomics was really begun by
John Maynard Keynes, who was responding to depressed economic conditions
worldwide. Keynesian theory, as it was subsequently developed, showed that there
was a large range of government policies that could be useful in getting an
economy out of recession or depression. Indeed, graduate schools in economics
today teach students how government policy works to manipulate the economy in
the short run. Keynes argued however, that “in the long run, we’re all dead,” and so
did not worry too much about the permanent consequences of the policies he
advocated. That argument was a cop out—we care about our children and our
children’s children, so we care about the long run.
So, what should monetary policymakers do? Should they try to correct short-run
problems, if doing so has adverse long-run consequences? Is there a way to act in
the short-run that will not be detrimental in the long run? As we will see in Chapters
17 and 18, monetary policy has a big impact on the short-term growth rate of the
economy, but in the long run it can only affect inflation. We will examine the
constraints on setting monetary policy, how the long run and the short run are
related, and offer some advice for making policy. As usual, there is some truth to
both sides of the argument about activism, but Levy’s cautionary words are worth
heeding.
Policy Matters
To convince you that policy matters, let’s look at some examples of recent events in
which major problems were either caused by or strongly affected by policy
decisions. These include the Great Depression, the Great Inflation of the 1970s, and
Japan’s Depression in the 1990s.
The Great Depression. From 1929 to 1939, the U.S. economy performed poorly.
The number of unemployed workers rose to very high levels, with the
unemployment rate (the number of unemployed workers divided by the number of
people willing and able to work) rising from about 4 percent in 1928 to about 9
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Chapter 1: Introduction to Money and Banking
percent in 1930, then rising to the range of 20 to 25 percent in the early 1930s. An
economic recovery began in 1933, but the unemployment rate declined only
gradually, and was still almost 20 percent in 1938. Preparations for World War II
finally began to drive down the unemployment rate, which fell below 5 percent in
1942 and was about 1 percent during the war in 1944.
Economists do not agree on the exact cause of the Great Depression, but many
point to the contribution of several government policies: monetary policy, trade
policy, and industrial policy.
First, monetary policy helped drag the economy down. The Federal Reserve System
had come into being in 1915, but Fed leaders did not really understand what
monetary policy could and could not do. They thought that monetary policy was
helping the economy, but their conceptual models were flawed, and they were
actually contributing to the downturn by causing the supply of money in the
economy to decline. Federal Reserve policymakers thought that the demand for
money was declining, but they did not realize that it did so because the amount of
money they were supplying was falling.
Second, the U.S. government pursued a trade policy that was also a major
contributing factor. With the passage of the Smoot-Hawley Tariff Act in 1930, the
United States imposed strong tariffs on imported goods. Not surprisingly, other
countries retaliated. The result was a severe contraction in U.S. trade with foreign
countries, which was another force driving the U.S. economy into depression.
Third, in response to the depth of the Great Depression, the United States modified
its industrial policy to help businesses, but the policy changes were
counterproductive. Some economists argue that the National Industrial Recovery
Act of may have prevented an economic recovery from occurring because it allowed
many industries to gain monopoly power and gave workers large pay increases. The
result was a reduction in output and the demand for workers, thus choking off the
economy’s recovery.
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Chapter 1: Introduction to Money and Banking
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The Great Depression thus stands as the greatest policy disaster in U.S. history. The
Great Depression only ended when the United States entered World War II and
wartime production brought an economic recovery. Though there was no clear
cause of the depression, errors in monetary policy, trade policy, and industrial
policy definitely contributed to it.
The Great Inflation of the 1970s. In the United States in the 1960s, Keynesian
economic theory (which we will discuss in Chapter 12) was used by government
policymakers, who were able to successfully fine-tune the economy—or so it
appeared. In the early 1970s, President Richard Nixon declared that “we’re all
Keynesians now” and leading economists thought that there might never again be
an economic recession because policymakers could control the economy with great
precision. Suddenly, however, the economy went into a tailspin at the same time
that inflation was rising. The rise in both unemployment and inflation was
impossible, according to the dominant Keynesian theory of the era. And there was
worse to come throughout the 1970s. Two major oil-price shocks caused major
restructuring in the economy, leading many firms to change the way they produced
goods. Inflation jumped from about 2 percent in the first half of the 1960s to nearly
10 percent in the second half of the 1970s and early 1980s. This was the largest
sustained increase in the inflation rate in U.S. history, thus deserving the name
Great Inflation.
What happened? Was the failure one of theory, or policy, or both? Most likely, it
was a combination of both, influenced heavily by our economy’s past history and
proclamations by economists that they had solved the business cycle. Because
inflation is caused by the Federal Reserve when it allows the money supply to grow
too rapidly, the blame rests clearly on the Fed. But why did the Fed allow inflation
to become so high, when inflation is the only major economic variable that the Fed
can influence in the long run? Why was the Fed so complacent? The Fed itself
believed the current state-of-the-art economic theory, which was the Keynesian
view that recessions could be offset by increasing the growth rate of money in
circulation. The Fed tried to combat the recessions of the late 1960s, mid 1970s,
and early 1980s with faster and faster money growth. But because people’s
expectations of inflation changed in response, the Fed’s policies were ineffective at
Chapter 1: Introduction to Money and Banking
11
increasing economic growth and instead simply fueled inflation. So, the blame
might instead be placed on incorrect economic theory, rather than on the Federal
Reserve itself. Of course, had the Fed reduced the growth rate of money, the Great
Inflation would not have occurred, but the recessions in the 1960s, 1970s, and
1980s would likely have been deeper and longer, for which the Fed would have
taken the blame.
The Great Inflation finally ended in the early 1980s, when the Federal Reserve, led
by Chairman Paul Volcker, stepped on the money brakes, reducing the growth rate
of the money supply dramatically. However, a period with two sharp recessions
followed, and the economy took quite some time to recover. The episode
convinced many economists that inflation, when allowed to become very high, was
very costly to the economy. It also convinced many monetary policymakers that
they must never allow inflation to rise significantly because the costs of reducing
inflation are tremendous.
Japan’s Depression in the 1990s. Japan’s experience in the 1990s represents yet
another policy failure. It is also a shocking event, given Japan’s history. In the 1980s,
Japan’s economy appeared close to overtaking the U.S. economy as the dominant
force in the world. But there were deep-rooted problems under the surface.
Corporations were heavily involved in the banking business, to the point where
many investments were made without being questioned by the financiers. The
government was entangled in private industry and did everything it could to
prevent business firms from failing. Financial markets were poorly developed, in
part because the accounting rules were not as clear as in the United States. These
elements did not hold Japan back in the 1980s, as its pace of economic growth
increased sharply. Japan, after all, did many things right, especially in organizing
production in the manufacturing industry—techniques that were copied throughout
the world. But with cozy lending practices, a poorly developed financial sector, and
government interference in the economy, the system was set for failure. In the late
1980s, a speculative frenzy arose in Japan in which the price of land rose to
unbelievable levels. At one point, the plot of land on which the Imperial Palace sits
in Tokyo was worth more than all the land in Manhattan. The Japanese stock
Chapter 1: Introduction to Money and Banking
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market rose very sharply in the 1980s, but much of that was based on the inflated
value of real estate.
Japan went bust in the 1990s. The downturn began when monetary policymakers
tried to take some air out of the bubble in real-estate prices by tightening monetary
policy. People began to realize that corporate profits were based on rising land
values, not profitable production. As the Japanese stock market fell, and land prices
fell, investors learned that the economy lacked a strong financial framework. Over
the following decade, the Japanese government tried to prop up the economy using
traditional methods, but never understood the fundamental problems in the
economy. Japan’s economy remained in a depression for over a decade, thanks in
large part to a failure of policy.
So, government policy is important. It can influence the short-term direction of the
economy for many years. Policy can induce good or bad behavior on the part of
people in the economy, with far-reaching consequences. That is why we will spend
a significant amount of time on it throughout this textbook.
The Importance of Economic Theory
Good economic policy requires good economic theory. There is nothing worse than
well-meaning, intelligent, but uninformed people making policy decisions. Without
a framework for understanding how policy works and what its consequences are, a
policymaker is adrift. Economic theory is valuable because it gives the policymaker
options within a rigorous foundation. Economists may not have all the answers, but
they know when the answers are wrong, and that knowledge can prevent policy
errors.
For example, as we will see in Chapter 18, monetary policymakers often set policy
by choosing a short-term real interest rate. (You will recall that the real interest rate
is the nominal interest rate minus the expected inflation rate.) Economists think
that the difference between the level of this short-term real interest rate and its
long-run equilibrium level can be used as a measure of the impact of monetary
policy on the economy in the short run. The higher the real interest rate is relative
Chapter 1: Introduction to Money and Banking
13
to its long-run equilibrium value, the tighter is monetary policy. But what is the level
of this real interest rate in long-run equilibrium? We might guess that the long-run
equilibrium real interest rate is the historical average of the real interest rate, which
is about 2 percent. While that is a reasonable first guess, the problem is that, on
average, monetary policy was historically too easy and inflation was undesirably
high. If we look at periods in which inflation was relatively stable or declined, we
see that the real interest rate averaged 3 to 4 percent in those periods. So, we
might guess that the equilibrium real interest rate is about 3 percent (because rates
above 3 percent are associated with declining inflation).
But the problem is not as simple as this. So far, we have been assuming that the
equilibrium real interest rate is constant over time. However, we know that the
economy has changed in significant ways. In particular, economic growth was much
more rapid in the 1950s and 1960s than it was in the 1970s, 1980s, and early 1990s.
Economic theory tells us that when economic growth is faster, the equilibrium real
interest rate is higher. So, policymakers trying to think about the equilibrium real
interest rate need to understand that the real interest rate was higher in the 1950s
and 1960s than it was in the 1970s, 1980s, and early 1990s. Because the late 1990s
brought economic growth back up to the levels it achieved in the earlier period, the
equilibrium real interest rate also likely rose in that period. Thus, policymakers
thinking about setting interest rates benefit from economic theory in helping them
determine the equilibrium level of the real interest rate.
In addition to its value in helping policymakers, economic theory is valuable of its
own accord, because it helps us understand how the world works. This textbook is
written in a policy context, and policy is important because it influences the
economy, but the economy on its own is even more worthy of study.
REFERENCES
The Great Depression
Chapter 1: Introduction to Money and Banking
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Cole, Harold L., and Lee E. Ohanian. “The Great Depression in the United States
from a Neoclassical Perspective,” Federal Reserve Bank of Minneapolis Quarterly
Review (Winter 1999), pp. 2–24.
Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States,
1867–1960
(Princeton, N.J.: Princeton University Press, 1963).
Prescott, Edward C. “Some Observations on the Great Depression,” Federal Reserve
Bank of
Minneapolis Quarterly Review (Winter 1999), pp. 25–31.
The Great Inflation of the 1970s
DeLong, J. Bradford. “America’s Peacetime Inflation: The 1970s,” in Reducing
Inflation: Motivation and Strategy, edited by Christina D. Romer and David H.
Romer (Chicago: University of Chicago Press, 1997), pp. 247–80.
Lansing, Kevin J. “Exploring the Causes of the Great Inflation,” Federal Reserve Bank
of San
Francisco Economic Letter 2000-21, July 7, 2000.
Japan’s Depression in the 1990s
Krugman, Paul. “Time on the Cross: Can Fiscal Stimulus Save Japan?” On the Web at
web.mit.edu/krugman/www/scurve.htm.
Roubini, Nouriel. “Japan’s Economic Crisis,” November 12, 1996. On the Web at
http://www.stern.nyu.edu/globalmacro/japan.pdf.
The Economist. “Japan’s Economic Plight: Fallen Idol.” June 20th, 1998, pp. 21-23.
How Much Should Policymakers Do?
Chapter 1: Introduction to Money and Banking
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Greenspan, Alan. “Rules vs. Discretionary Monetary Policy,” speech on September
5, 1997 at Stanford University, posted on the Web at
http://www.federalreserve.gov/boarddocs/speeches/1997/19970905.htm.
Levitt, Arthur. “The Importance of High Quality Accounting Standards,” speech on
September 29,
1997, reported on the Web at http://www.iasc.org.uk/news/cen8_108.htm.
Levitt, Arthur. “Renewing the Covenant with Investors,” speech on May 10, 2000,
reported on the
Web at http://www.sec.gov/news/speeches/spch370.htm.
Levy, Mickey. “Don’t Mix Monetary and Fiscal Policies: Why Return to an Old,
Flawed
Framework?” Bank of America Securities Economic and Financial Perspectives,
October 19, 2000.
Levy, Mickey. “Monetary and Fiscal Policies Following Crisis Management.” Shadow
Open Market Committee, September 30, 2009. On the Web at
http://www.cmc.edu/somc/ 090930_mickey_levy.pdf.
Securities and Exchange Commission. “Final Rule: Selective Disclosure and Insider
Trading,” on the Web at http://www.sec.gov/rules/final/33-7881.htm.