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Macroeconomics: the study of the behavior and decision making of entire economies
(C + I + G + X = GDP) Chapters 10-18
Chapters 10-11: Money and Banking
Chapters 12-13: Measuring Economic Performance
Chapter 10 Notes: Money and Banking
We use electronic money, currency, and near monies. 90% of our money supply is
electronic.
3 Functions of Money:
1. Medium of Exchange: anything that is used to determine value during the
exchange of goods and services. (w/o $ we must barter)
2. Unit of Account: a means for comparing the values of goods and services; the
money can be distinguished from one another as to their value. $1; $5; $10…or
amount of a check.
3. Store of Value: something that keeps its value if it is stored rather than used. It is
not a perfect store of value due to inflation.
6 Characteristics of Money:
1. Durability
2. Portability
3. Divisibility
4. Uniformity
5. Limited Supply
6. Acceptability
Sources of Money’s value:
1. Commodity money
2. Representative money
3. Fiat money
The history of banking:
Hamilton vs. Jefferson in regards to the nation’s first central bank. Central authority vs.
State’s rights.
Wildcat banking, a perfectly competitive banking environment; bank runs, panics, fraud,
different currencies.
Civil war – greenbacks
1870s on the gold standard; went off in 1971
Federal Reserve act of 1913 established the Nation’s Central banking system
Structure: a unique blend of private and public structures; main public committee is the 7
Governors of the Federal Reserve System, they plus 5 (private) Presidents of the District
banks serve as the FOMC and conduct monetary policy.
Great Depression, worst economic crisis in our history
Fed role is controversial.
FDIC is passed which stabilized the banking industry
Federal Deposit Insurance Corporation (FDIC): insures individual accounts up to
$100,000 in the event of a bank failure.
Primary Jobs of the Fed:
1. control the nation’s money supply (practice monetary policy)
2. serve as a banker’s bank (and monitors “bad banks”, lender of last resort)
3. clearinghouse for all checks
4. serve as the Government’s bank
Money is measured, M1 & M2 are the primary measurements used. M1 = demand
deposits + currency
M2 = M1 + Savings accounts = money market funds (near monies)
Commercial banking in the US:
Banks are financial institutions originally formed to serve businesses but now provide
services to households as well.
Banks either get a State or National charter. All banks with national charters are
members of the Fed.
US banks operate on a fractional reserve banking system. AR-RR=ER
Money multiplier effect: how the fractional reserve system creates money 1/RR
Largest banks in the US are: Citigroup (C), Bank of America (BAC), J.P. Morgan &
Chase (JPM), and Banc One (ONE). JP Morgan recent purchased Banc One.
Chapter 11: Financial markets
Investment: the act of redirecting resources from being consumed today so that they may
create benefits for the future
Financial intermediary: institution that helps channel funds from savers to borrowers
Portfolio: a collection of financial assets
Coupon rate: the interest rate that the bond issuer will pay to a bondholder
Maturity: the time at which payment to a bondholder is due
Junk bond: a lower-rated, potentially higher-paying bond
Securities and Exchange Commission: an independent agency of the government that
regulates financial markets and investment companies
Capital market: market in which money is lent for periods longer than a year
Money market: market in which money is lent for periods of less than a year
Primary market: market for selling financial assets that can only be redeemed by the
original holder
Secondary market: market for reselling financial assets
Share: a portion of stock
Equities: claims of ownership in a corporation
Capital gain: the difference between a higher selling price and a lower purchase price
resulting in a financial gain for the seller
Capital loss: the difference between a lower selling price and a higher purchase price
resulting in a financial loss for the seller
Stock split: the division of a single share of stock into more than one share
Stockbroker: a person who links buyers and sellers of stock
NASDAQ: National Association of Securities Dealers Automated Quotations – the
American market for Over-the-Counter securities.
Futures: contracts to buy or sell at a specific date in the future at a price specified today
Options: contracts that give investors the choice to buy or sell stock and other financial
assets
Call option: the option to buy shares of stock at a specified time in the future
Put option: the option to sell shares of stock at a specified time in the future
Dow: index that shows how 30 key companies have traded
S&P 500: index that show the prices changes of 500 different stocks
E.6.1
E.6.2
E.6.3
Explain the basic functions of money.
Identify the composition of the money supply of the United States.
Explain the role of banks and other financial institutions in the economy of the
United States. (History)
E.6.4
Describe the organization and functions of the Federal Reserve System.
(Civics and Government)
E.6.5
Compare and contrast credit, savings, and investment services available to the
consumer from financial institutions.
E.6.6
Demonstrate how banks create money through the principle of fractional
reserve banking.
Chapter 12: Gross Domestic Product
GDP = the dollar value of all final goods and services produced within a country’s
borders (regardless of who owns them) in a given year.
Real GDP per capita is considered the single best economic indicator of
nation’s standard of living.
Expenditure Approach (AD):
GDP = C + I + G + X
(fiscal policy)
Keynesian Economics
C = consumer goods
Durables, non-durables, services
These are items used by consumers for final consumption
I = investment goods
New plants, equipment, private housing, inventories*
G = government spending
All 3 levels, local, state and federal
X = Exports and imports; net exports
Income Approach (AS):
Calculating all the incomes earned by members of the economy
GDP is the same, theoretically, regardless of the method it is calculated, it the economy is
in equilibrium, AD=AS*
Problems in assessing the value of GDP:
1. It does not take into account the KIND of goods produced; public or private
(Being hotly debated as we speak)
2. It does not tell us how much is available per person. (per capita)
3. It does not measure how goods are distributed. (socio-economic status)
4. It doesn’t show unpaid household work; non-market activities
5. It does not include bartering.
Underground economy – trades made to avoid taxes, and it doesn’t include
the value of Black Market activities
6. It doesn’t measure Quality of goods
7. It doesn’t recognize the value of leisure time; or the quality of life
8. The value of dealing with negative externalities is not fully reflected; e.g. the
cost of equipment to reduce pollution is counted, but not the value of the cleaner
air.
Aggregate Supply (AS): the total amount of goods and services in the economy available
at all possible price levels
Aggregate demand (AD): the amount of goods and services in the economy that will be
purchased at all possible price levels
Price level: the average of all prices in the economy
See graph:
Business cycle: a period of macroeconomic expansion followed by a period of
contraction (equilibrium changes, shortage to surplus to shortage)
1. expansion 2. peak 3. contraction 4. trough
There have been 9 business cycles since 1942.
Recession: real GDP falls for 2 consecutive quarters; unemployment typically falls
between 6 – 10 %
Depression: Deep recessions
Stagflation: a decline in real GDP combined with a rise in the price level
Business cycle variables:
1.
Business investment (I)
2.
interest rates and credit
a. lower rates encourages investment
3.
Consumer expectations
a. Self-fulfilling prophecies
4.
External shocks
a. 9/11, war, droughts
Business cycle forecasting thru examining leading economic indicators
The stock market is a leading indicator, see pages 538-539
Elkhart County is a leading county
Ways to grow a modern economy:
1. Capital deepening: process of increasing the amount of capital per worker; this is the
means by which a modern economy grows
Population growth, Government, Foreign Trade
2.
Technological Progress; scientific research, innovation, scale of the market,
education and experience, natural resource use
Production possibility frontiers
AD=AS macro equilibrium model, graphically:
Role of Savings
Savings = income put aside to be consumed later
Leakages: savings and taxes
In terms of national income accounting:
Savings represent leakages from the circular flow
When Banks, NYSE, bond markets, etc. use the savings to expand economic
activity, it is called injection.
So a way to determine macroeconomic equilibrium is to examine leakages and
injections.
Def. = what results when the sum of savings and taxes equals the sum of
investment and government spending.
Our market economy seeks that level where AS = AD, and/or leakages =
injections
E.5.1
E.5.2
E.5.3
E.5.4
Define aggregate supply and demand, Gross Domestic Product (GDP),
economic growth, unemployment, and inflation.
Explain how GDP, economic growth, unemployment, and inflation are
calculated.
Explain the limitations of using GDP to measure economic welfare.
Explain the four phases of the business cycle.
E.5.5
E.5.6
E.5.7
E.5.8
E.5.9
E.5.10
Analyze the impact of events in United States history, such as wars and
technological developments, on business cycles. (History)
Identify the different causes of inflation and explain who gains and loses
because of inflation.
Analyze the impact of inflation on students’ economic decisions.
Recognize that a country’s overall level of income, employment, and prices
are determined by the individual spending and production decisions of
households, firms, and government. (Civics and Government; Individuals,
Society, and Culture)
Illustrate and explain how the relationship between aggregate supply and
aggregate demand is an important determinant of the levels of unemployment
and inflation in an economy.
Analyze the unemployment rate in the community.
Chapters 13: Economic Challenges
Section 1: Unemployment
Civilian labor force: the total number of people in the working age group (16 years and
over) who are either employed or actively seeking work.
Unemployment: the condition of those who are willing and able to work and are actively
seeking work but who do not currently work
Unemployment rate: the percentage of the nation’s labor force that is unemployed
Add employed + unemployed = total labor force; divide the number of
unemployed by the total labor force X 100 = unemployment rate
BLS: Bureau of Labor Statistics; agency responsible for counting the employment and
unemployment rates
Labor Department conducts a survey. Of 50,000 households, people 16 or older who did
any work for pay or profit in the week before the survey count as employed. Anyone 16
or older who looked for work in the 30 days before the survey and who is in the job
market but not working counts as unemployed.
Most recent report in your text shows 135.3 million people employed and 6.4 million
unemployed. Thus the total labor force is 141.7 million . Divide 6.4 million by 141.7
million, multiply by 100 = 4.5 % unemployment for April 2001.
Latest Numbers
CPI:
+1.2% in Sep 2005
Unemployment Rate:
5.1% in Sep 2005
Payroll Employment:
-35,000(p) in Sep 2005
Average Hourly Earnings:
+$0.03(p) in Sep 2005
PPI:
+1.9%(p) in Sep 2005
ECI:
+0.8% in 3rd Qtr of 2005
Productivity:
+1.8% in 2nd Qtr of 2005
U.S. Import Price Index:
+2.3% in Sep 2005
Employment Act of 1946 states that the federal government should take full
responsibility for full employment, price stability, and economic growth. (Keynesian)
Unemployment benefits last 26 weeks. States determine exact benefits, however most
states consider people who have worked for 26 weeks out of the past year eligible for
services. Labor Department has estimated that the average payment to unemployed
workers is about 40% of previous pay.
4 types of unemployment:
Structural unemployment: unemployment resulting from skills that do not match the jobs
that are available or from being geographically separated from job opportunities.
5 major causes:
1. The development of new technology
2. The discovery of new resources
3. Changes in consumer demand (Attitudes)
4. Globalization
5. Lack of education
Government response: job-training programs
Cyclical unemployment: unemployment that rises during economic downturns and falls
when the economy improves
Frictional unemployment: unemployment of people who are taking time to find a job
Seasonal unemployment: unemployment of people who are out of work because of
factors that vary with the time of year, such as, harvest schedules, vacations, industries
shutting down for a season
Full employment: the level of employment reached when there is no cyclical
unemployment (usually around 4-6% unemployed is full employment)
Underemployed: working at a job for which one is over-qualified, or working part-time
when full-time work is desired
Discouraged workers: a person who wants a job but has given up looking
Section 2: Inflation
Inflation: a general increase in prices
Purchasing power: the ability to purchase goods and services
Price index: a measurement that show how the average price of a standard group of
goods changes over time
Extreme levels of inflation can destroy an economy, this is called hyper-inflation; low
levels of inflation can stimulate an economy.
Inflation can lead to speculation. If people believe that rapid levels of rising prices for
particular commodities are certain, they may buy large amounts of a good and hope to
resell it a much higher price. Debtors can benefit from inflation. Debtors are people who
have borrowed money from someone else. Inflation will result in their paying back the
loan which will now buy less than when they borrowed it. This is a benefit to the debtor.
People on fixed incomes are hurt by inflation. Creditors are hurt by inflation, they loaned
others money who got a greater benefit from the money than they will on its’ return.
Price index: a number that compares prices in one year with some earlier base year
Inflation rate: the percentage rate of change in price level over time
Core inflation rage: the rate of inflation excluding the effects of food and energy prices.
CPI: Consumer Price Index, a number used to calculate changes in the average level of
prices for a number of items typically bought by urban families (4,800). The Bureau of
Labor Statistics chooses about 400 items that represent the goods and services (a market
basket) typically bought by urban families (80% of families live in urban settings).
CPI:
Housing 41.2%
Apparel 5.7%
Transportation 17.1%
Medical care 7.3%
Food and beverages 17.4%
Entertainment
Education and communication
Other 7.0%
Calculation of inflation rate: updated cost divided by Base period cost, multiplied by
100.
Currently the BLS is using 1982-1984 prices. The cost of the market basket for that
period is assigned the index number of 100.
Core inflation rate: the rate of inflation (CPI) excluding the effects of food and energy
prices
Types of Inflation:
Quantity theory: states that too much money in the economy cause inflation. The
money supply should be used to control price levels in the long term. (mismanagement of
money supply problem)
Demand-pull theory: states that inflation occurs when demand for goods and
services exceeds existing supplies. Shift to the right of the demand curve
Cost-push theory: states that inflation occurs when producers raise prices in order
to meet increased costs. Shift to the left of the supply curve
Deflation: a decline in the average level of prices
Monetary and fiscal policy can impact demand-pull inflation. Cost-push is much more
difficult to attempt to control. How much control does Government want to take to
impact producer’s cost? Anti-trust laws become the main mechanism to control this
Section 3: Poverty
Poverty threshold: the income level below which income is insufficient to support a
family or household; for a family of 4 the threshold is $17,463
Poverty rate: the percentage of people who live in households with income below the
official poverty line; page 346.
Causes of Poverty:
Lack of education; location; race and gender discrimination; economic shifts; shifts in
family structure
Income distribution: how the nation’s total; income is distributed among its population
Lorenz curve: lowest fifth own 3.6
Second fifth 8.9
Third 5th 14.9
Fourth 5th 23.2
Fifth 5th 49.4
Anti poverty policies:
Enterprise zones: area where companies can locate free of certain local, state and federal
taxes and restrictions
Block grant: federal funds given to states in lump sums
Workfare: a program requiring work in exchange for temporary assistance
Chapter 14: Government Spending
Taxation Principles
The power to tax comes from Article 1, Section 8, and Clause 1 of the US Constitution.
There are limits on the power to tax. A tax base is the income, property, good, or service
that is subject to a tax.
Characteristics of a good tax: Simplicity, Efficiency, Certainty, Equity
2 major taxing principles:
1. Benefit Principle of taxation: those that benefit from the spending of tax dollars
should pay the taxes to provide the benefits (gas tax)
2. Ability-to-pay principle: those who can best afford to pay taxes should pay most
of the taxes (progressive income tax)
3 types of taxing structures which can be either of the above principles:
1. Progressive: a tax for which the percentage of income paid in taxes increases as
income increases.
a. For example: Federal income tax
2. Regressive: a tax for which the percentage of income paid in taxes decreases as
income increases.
a. For example: sales tax
3. Proportional: a tax for which the percentage of income paid in taxes remains the
same for all income levels.
a. For example: flat tax
Tax incidence: refers to the group upon which the tax burden actually falls
Taxes can be direct and indirect (passed on to you by someone else who pays the tax bill)
Government federal spending:
Mandatory spending: spending on certain programs that is mandated or required by
existing law
Discretionary spending: spending category about which government planners can make
choices
Entitlement programs: social welfare program that people are entitled to if they meet
certain eligibility requirements
State & local spending programs
Operating budgets: budget for day-to-day expenses
Capital budget: budget for major capital or investment expenditures
Unlike federal government, states have laws that require balanced budgets
E.4.3
E.4.4
E.4.5
E.4.6
E.4.7
E.4.8
E.4.9
E.4.10
Describe major revenue and expenditure categories and their respective
proportions of local, state, and federal budgets. (Civics and Government)
Explore the ways that tax revenue is used in the community. (Civics and
Government)
Identify taxes paid by students. (Civics and Government)
Define progressive, proportional, and regressive taxation. (Civics and
Government)
Determine whether different types of taxes (including income, sales, and
social security) are progressive, proportional, or regressive. (Civics and
Government)
Describe how costs of government policies may exceed benefits, because
social or political goals other than economic efficiency are being pursued.
(Civics and Government)
Predict possible future effects of the national debt on the individual and the
economy. (Civics and Government)
Predict how changes in federal spending and taxation would affect budget
deficits and surpluses and the national debt. (Civics and Government)
Government Involvement in the Economy
I.
II.
III.
Monetary Policy – Fed
Fiscal Policy - Executive & Legislative
Wage & Price controls policy – Executive & Legislative
Chapter 15: Fiscal Policy
Section 1: Understanding Fiscal policy: the use of government spending and revenue
collection to influence the economy
Federal budget: a plan for the federal government’s revenues and spending for the
coming year; planning takes approximately 18 months
Fiscal year: a twelve-month period that can begin on any date
Office of Management and Budget (OMB): government office that manages the federal
budget
Congress Budget Office(CBO)government agency that provides economic data to
Congress
Appropriations bill: a bill that sets money aside for specific spending
President proposes a budget, Congress adopts initial plan by May 15, specific funding of
the appropriations bill is due by September 15; the former bill runs out September 30th; if
agreements aren’t met temporary funding has to be passed, if not government “shuts
down” and all but the most essential offices close.
Classical economics: the idea that free markets can regulate themselves (Adam Smith)
Keynesian economics: a form of demand-side economics that encourages government
action to increase or decrease demand and output (In some contexts, this is refereed to as
classical; and the supply-siders are the “new” breed)
Fiscal Policy:
Expansionary fiscal policy: causing the economy to run more rapidly primarily by
increasing aggregate demand
A. Cut taxes
B. Increase spending
GDP = C + I + G + X; if C decreases, increase G by the amount C decreased so that
GDP remains constant (Keynesian)
Multiplier effect: any change in fiscal policy affects total demand and total income by an
amount larger than the original amount of change in spending and taxing.
Contractionary fiscal policy: causing the economy to run more slowly primarily by
reducing aggregate demand
A. Raise taxes
B. Reduce Government spending
Limits on the use of fiscal policy:
Nearly 60% of the federal budget is set aside Medicaid, social security and veteran’s
benefits, i.e. mandatory spending.
It is difficult to know the current state of the economy.
Delayed results:
Inside time lag: the time it takes to decide on a policy (long, at least 18 months)
Outside time lag: the time it takes for the effects of a policy change to be completely felt
in the economy (short)
Political pressures can also reduce the effectiveness of fiscal policy. Inflationary bias in
fiscal policy: the natural tendency for Congress to favor expansionary policies over
restrictive policies. Coordination problems can reduce effectiveness, state and local
governments may not be doing the same as the federal; businesses may be working in the
opposite direction. Also the short-term and long-term effects of the same policy can be
different. Sometimes, slow growth or even recession can lead to prosperity in the future.
Section 2: Fiscal Policy Options
The key to Keynesianism working is if the jobs created by government are in fact
perceived as productive.
Automatic stabilizers: a government program that changes automatically depending on
GDP and a person’s income. When the market sector grows, so does income so less, so
do tax receipts, and less transfer payments are made; the opposite also occurs when the
economy slows, less incomes means less tax receipts and means an increase in transfer
payments which gets more money into consumers hands which reverses the trend.
Fiscal policy and unemployment:
Expansionary fiscal policy will lower demand deficiency unemployment, but may or may
not impact structural unemployment. The kind of fiscal policy implemented effects
different regional areas, which may or may not impact unemployment.
Tax cuts and unemployment – a personal income tax will probably be fairly evenly
spread throughout the Country. A corporate income tax will more likely effect the
industrial areas of the Country.
Fiscal policy and inflation:
Fighting inflation requires restrictive fiscal policy. Population growth and general
economic growth push aggregate demand up every year. Restrictive policies will be
aimed at stabilizing prices. If demand is the cause of the inflation, this tactic will work.
If inflation is cost-push, fiscal policy will not help. Usually wage and price controls or
anti-trust policies will be pursued.
Unemployment/Inflation trade-off. During some of our economic history it seemed there
was a tradeoff between unemployment and inflation. Fiscal and monetary policies can
be used to target certain problems, but our goal is low rates of each. The problem of the
tradeoff is unsolved.
Supply side economics: A cut in corporate income taxes may increase both supply and
demand and may increase job creation and investment in both human and physical
capital.
A personal income tax reduction may increase savings, which could result in
lower interest rates, greater investment, and a corresponding increase in supply. As firms
hire more workers, the income tax base could increase, thus raising more tax dollars even
though the tax rate was decreased. (Laffer curve)
Increased Government spending may increase aggregate supply as well as
aggregate demand.
E.G. Spending on roads, airports, education and other infrastructure items may
increase productivity, which could increase supply.
Council of Economic Advisers (CEA) a group of three respected economists that advise
the President on economic policy
The US embraced Keynes fully during WW2. Walter Heller, JF Kennedy’s chief
financial policy adviser convinced Kennedy to try to reduce taxes to stimulate economic
growth, a tax cut was followed by economic growth.
Wage and Price controls: Government controls on the levels of wages and prices. (also
called Incomes policy) These are wage-price freezes, wage-price guideposts (voluntary),
and mandatory wage-price guidelines with penalties for violators. These may be used to
counteract cost-push inflation.
The most recent historical examples of their use in the U.S. are during WW2 price
controls and rationing, and Nixon wage-price freezes in the 1970s. Artificial control of
prices will eliminate the market from providing accurate signals to the economy, which
created shortages, thus rationing became necessary during WW2. The Fed was handling
$5 billion ration coupons a month, the Government hired 50,000 paid employees and
more than 200,000 volunteers helped manage the rationing system during WW2. The
attempt successfully managed the economy during highly irregular times, success in
peacetime is questionable.
Nixon’s experiment during the height of the Vietnam War was less successful.
Nixon froze wages, prices, rents, and salaries for 90 days. Then in the next 14 months
wages could rise only up to 5.5% and prices up to 2.5%. Then a period of voluntary
guidelines began. Prices shot up. Nixon froze all prices 60 days. Prices shot up at the
end of the 60 days. Of course it is effective during the control time frame, but after the
limits are removed, prices usually soar. Wage and price controls block the price signals
from the market, thus interrupting the workings of equilibrium forces. Prices set
artificially low create shortages (price ceilings). Shortages create black market systems.
People spend their time trying to get around the controls, which usually is not a
productive use of time.
Some economists argue wage-price controls could be effective if used in the longrun. Some argue they could be effective if control is on the right parts of the economy.
Most economists do not favor the use of wage-price controls.
* Would you favor passing the balanced budget amendment?
Section 3: Budget deficits and the National Debt
Balanced budget: a budget in which revenues equal spending
Budget Surplus: amount by which revenue exceeds spending (2 surplus’ in 20th century)
Budget deficit: amount by which federal spending exceeds revenues in a year
Our largest deficit was 1992, $290billion
Government must create money or borrow money to finance this. Creation of money can
be inflationary, sometimes hyperinflationary. So more commonly governments borrow
to deal with deficits, these are called Treasury bills (3 months to one year), Treasury
bonds (30 years), and Treasury notes (2 to 10 years).
National debt: amount of money the federal government owes to bondholders; the sum
total of the annual budget deficits; currently the debt is $6 trillion
The national debt is a political problem, but some feel it is not an economic one. Others
feel that the crowding out effect and opportunity cost of the interest payments are a
problem.
Our Government borrows money from itself (Fed), from Insurance companies, other
countries, wealthy business people around the globe, from the savings of Americans thru
bond market. 90% of the debt is internal (held by Americans)
10% is external debt
Crowding Out: the effect on private businesses when increased government spending
(borrowing) raises interest rates on bonds (thus it attracts investors to governmental
bonds) and reduces private investment. Financial investment flows to G instead of I.
Interest must be paid to the bondholders it is mandatory spending. Interest on $6 trillion
is 13% of the total federal budget this year. What is the opportunity cost of this? Is this
a redistribution of taxpayers to the wealthy?
E.7.1
E.7.2
E.7.3
E.7.4
E.7.5
Define and explain fiscal and monetary policy. (Civics and Government)
Define the tools of fiscal and monetary policy. (Civics and Government)
Describe the negative impacts of unemployment and unintended inflation on
an economy and how individuals and organizations try to protect themselves.
(Individuals, Society, and Culture)
Illustrate and explain cost-push and demand-pull inflation.
Explain how monetary policy affects the level of inflation in the economy.
E.7.6
E.7.7
E.7.8
Analyze how the government uses taxing and spending decisions (fiscal
policy) to promote price stability, full employment, and economic growth.
(Civics and Government)
Analyze how the Federal Reserve uses monetary tools to promote price
stability, full employment, and economic growth. (Civics and Government)
Articulate how a change in monetary or fiscal policy can impact a student’s
purchasing decision.
Chapter 16: The Federal Reserve and Monetary Policy
The Fed is a privately owned, publicly controlled central bank. The issue of central
banking has been hotly debated in the US since 1790. The first bank issued a single
currency & reviewed banking practices, but Congress refused to renew its charter in
1811. The 2nd Banks was set up in 1816 to restore the monetary system. The bank was
toppled in 1836. The panic of 1907 finally convinced Congress to establish a new central
bank. The Federal Reserve Act of 1913 was finally passed to stabilize the nation’s
money supply. The Fed’s actions during the great depression were problematic, partly
because the 12 independent banks did not work in concert with one another. In 1935
Congress adjusted the Act to strengthen and centralize the Fed.
Board of Governors: 7 appointed members, staggered over 14 year terms, conduct the
nation’s monetary policy. The President nominates, the Senate confirms. The President
also nominates one of the seven to be chair, and Senate confirms this too. Alan
Greenspan is the current Chairman. Only one full 14-year term can be served, however
you can fill that plus unfinished term of another.
Federal Reserve Districts: the 12 banking districts of the Federal reserve act, see page
417 of text.
Member Banks: nationally chartered banks must become members of the Fed, statechartered banks can choose. Approximately 4,000 banks are members of the Fed.
FAC: Federal Advisory Council, the research arm of the Federal Reserve
FOMC: Federal Open Market Committee, Fed committee that makes key decisions
about targeting the federal funds rate (and setting the discount rate) and growth rates of
the United States money supply. The FOMC is the 7 Governors, and 5 of the district
Presidents, where the NY President is a permanent member and the other 4 positions
rotate thru the other 11 banks.
4 primary jobs of the Fed:
1. Federal Government’s Bank
a. Treasury auctioneer of bills, notes, and bonds
b. Issues currency
2. Serving Banks
a. Check clearing
b. Supervising lending practices
c. Lender of last resort
3. Regulating banks
a. Sets required reserves
b. Bank examinations
4. Control the nation’s money supply
a. Closely assess demand for money
i. Asset demand
ii. Transaction demand
b. Stabilize the economy
Recall how banks create money:
Fractional Reserve Banking System:
A system that requires banks to keep some fraction of their deposits in the form of
reserves.
Actual Reserves: the actual amount of deposits that come into a bank
Required Reserves: the dollar amount banks keep on reserve
Excess Reserves: the difference between actual reserves and required reserves
Reserve Ratio: the fraction of deposits that the Fed determines banks must keep on
reserve
Banks keep the required reserves on hand and loan out the rest. Most of which is
deposited back into the demand deposit accounts and is available to loan out again.
Deposit expansion multiplier = 1 divided by the reserve ratio
Monetary policy: the actions the Federal Reserve takes to influence the level of real GDP
and the rate of inflation in the economy. The FED has three tools to accomplish this:
changing reserve ratios, changing discount/federal funds rate, and open market operations
Loose monetary policy/ Expansionary policy
A policy of the FED that causes the money supply to increase by:
1. decrease reserve ratios
2. decrease interest rates (discount rate or federal funds rate)
3. Fed buys government bonds from authorized bond brokers, this is part
of open market operations (FOMC)
Tight monetary policy/ Contractionary policy
A policy of the FED that causes the money supply to decrease by:
1. increase reserve ratios
2. increase interest rates (discount and federal funds rate)
3. Fed sells government bonds to authorized brokers, part of open market
operations
Some have added a fourth tool of the FED: Greenspeak
Interest and Investment in factories and equipment:
At lower interest rates it is more profitable for business to invest in factories and
equipment than at higher rates. However, this could be inflationary. Much depends upon
whether the individual producer has an elastic or relatively inelastic investment schedule.
Interest and Inventory Investment:
Businesses vary as to the inventory kept on hand, at lower interest rates more inventory
can be kept than at higher rates. Inventories have high storage costs, plus risk of damage
is greater with more inventory. So at lower interest rates, more can be afforded. This
encourages economic growth.
Interest and the Housing market:
At lower interest rates more people can build and buy homes. A 3% interest rate increase
can mean as much as $50,000 additional cost over a 30 year mortgage. As people buy
more homes, more people are employed and growth occurs.
Interest and Personal spending:
At lower interest rates consumer buy more of the products they finance such as cars,
appliances, computers, furniture, vacations, etc. The more we buy, the more producers
make, and this encourages growth. Employers will hire more people; the opposite is true
at higher interest rates.
The true effect of money in the economy is not yet known for certain.
Evaluation of monetary policy, different economic schools of thought:
1. Changing the money supply has no lasting effect on output or employment.
Its main effect is on price levels. Thus monetary policy should only be used
to match the rate of real growth in the economy.
2. Monetary policy should be the main tool used to control the economy, due to
the effectiveness of the inside time lag.
3. Only loose monetary policy should ever be conducted to keep the economy
growing. These people feel inflation is only a cost-push type.
Inside time lag: the time it takes the FED to decide on a policy
Outside time lag: the time it takes the FED for the effects of the policy change to be
completely felt in the economy (6 to 24 months)
Fed’s advantage would be due to the inside time lag. Its ineffectiveness would likely be
due to the outside time lag.
Concern is rising regarding whether or not people are reacting to what they believe the
FED will do.
What is known – TOO MUCH of an increase in the money supply will cause inflation.
Monetary policy is effective if it works toward slow, sustained economic growth and
smoothes out the business cycle.
How Monetary policy and interest rates affect GDP:
C + I + G + X = GDP
C = consumers quantity demanded is greater at lower interest rates
I = An investment in new plants and equipment will occur only if producers believe it is
possible to profit from the investment, rate must be low enough or this will not occur
An investment in larger inventories will occur at lower interest rates than higher ones
An investment in private homes will be greater at lower interest rates, this will increase
activity in all related industries. The vice versa is true of all these statements.
G = Government planners will invest more when interest rates are lower.
X = The international market place will seek out that country with the lowest costs, this
includes interest rates.
Chapters 17 & 18
International Trade
Global GDP= C + I + G + X for every nation
Specialization and the division of labor, followed by increasing world trade, will
increase the total production of world goods and services.
Exports: goods and services that are sent to another country for sale
Imports: goods and services that are brought in from another country for sale
Barriers to trade
1. tariffs
a. protective
b. revenue producing
2. quotas
3. Voluntary export restraints
Who trades?
1. Individual consumers in one country with producers or individuals of another
country
2. Producers to producers
3. Government to government
Why do nations trade?
Because both parties believe they will gain from the trade
Should a nation trade if it has the absolute advantage in producing goods? Yes
Absolute advantage: when one country can produce a good more efficiently than another
country. The ability to produce more of a given product using a given amount of
resources.
E.G. Alpha and Beta (Each nation should produce those goods at which they have the
lower opportunity costs.)
Comparative advantage: the ability to produce a product most efficiently given all the
other products that could be produced.
Law of Comparative Advantage (developed by David Ricardo in 1817):
The principle that a country benefits from specializing in the production at which it is
relatively most efficient thus has the comparative advantage. This is true because of
lower opportunity costs.
Page 446, what are major US imports and exports? Why are the lists so similar? What
are the only 2 different items within each list?
The biggest trading partners of the US are Canada, Mexico, Japan and China. The US is
the world’s leading exporter, followed by Germany and Japan. The US is also the
world’s biggest importer, by twice the size of the next two biggest importers, Germany
and Japan.
Impact of specialization on employment: it can cause a loss of jobs; require retraining to
get employment, or relocating to a place where your skills are needed. (Structural
unemployment & immigration) One impact of this from the 1970s to 1990s, there has
been a population shift from the manufacturing states of the Midwest to the Sunbelt states
of the South and Southwest.
Many barriers to trade exist (language and culture, etc.); in addition Governments can
interfere in trading. Major tools to interfere:
1.
Tariffs, a tax on imported goods; also custom duty, a tax on certain
items purchased abroad
2.
Quotas, a limitation on the number of goods that can be imported
or exported
3.
Voluntary export restraints, a self-imposed limitation on the
number of products shipped to a particular country
Effects of trade barriers: limited supply, thus higher prices for consumers; and higher
prices for producers. Consumers lose, producers win, but what if this leads to producers
losing their competitive incentives, then everyone loses.
2 types of tariffs:
1. Protective; 2. Revenue producing
Currently, exports account for 20% of GDP. Over half of our exports go to Canada,
Japan, or countries in the European Community.
Trade wars: a cycle of increasing trade restrictions. (Right now in the news, steel)
Examples: Smoot-Hawley Tariff of 1930 (50% increase in tariffs), Chicken Tariff of
1963 (EEC increased chicken tariff and resulted in a 50% reduction in exports, we
retaliated), Pasta Tariff of 1985 (We raised pasta tariff they raised tariffs on our lemons
and walnuts), and Beef War of 1999 (EU banned buying hormone treated beef from US,
we imposed a tariff on their clothes, cheese, some meats and mustard, this is part of the
ongoing banana war with Europe).
PROs and CONs of Free Trade
Protectionism: the idea that we should limit international trade to protect our own selfinterest
Protectionist arguments:
1.
National security argument
a. If a Country becomes too specialized it will lose its’ independence
2.
Infant industry argument
a. To encourage competition
3.
Diversified economy argument
a. Don’t put all eggs in one basket
4.
Protection of domestic wages argument, protecting jobs
a. “Buy American”
Free Trade arguments:
1.
Tariffs and quotas hurt consumers by shifting the supply curve to the left, thus
raising prices
2.
Tariffs and quotas interfere with the efficient functioning of supply and demand
which may result in the misallocation of resources
3.
Free traders argue that the protectionist arguments are not valid
a. The national security argument applies to a limited number of industries
b. Infant industry argument applies up to a point
c. We already have a diversified economy
d. Protection of domestic labor for the “cheap” jobs, does not account for the
capital usage that makes USA labor more productive
4.
It takes an act of Congress to change the tariff and quota rates, which can be
hard to change
5.
Limiting world trade thru tariffs and quotas only helps the domestic country if
other nations do not do the same thing
6.
No one would benefit from the increased efficiency caused by specialization
and division of labor
Protective tariffs work only if demand for the product is elastic
Revenue tariffs work only if demand for the product is inelastic
History of International Trade:
1913 the world hit a high point in international trading, it has been working to get back to
that point.
International Free trade agreement: agreement that results from cooperation between at
least two countries to reduce trade barriers and to trade with each other.
1930 Hawley Smoot bill increased the price of imported goods by 70%, designed to
protect American producers. Other nations followed suit. This actually made the great
depression worse. So the US passed the Reciprocal Trade Agreement Act, which allows
the president to reduce tariffs up to 50%, and allowed Congress to grant most-favored
nation status to US trading partners.
GATT: General Agreement on Tariffs and Trade, signed in 1947 by 23 countries that
indicated support for improving trade among nations. Today 100 countries belong to
GATT. WTO: World Trade Organization was formed in 1995, a worldwide
organization whose goal is freer global trade and lower tariffs; organized thru GATT to
ensure compliance. Thus it also serves as a kind of referee.
European Union: a group of European countries that have banned together to improve
trade for its members
Euro: a single currency that replaces individual currencies among members of the EU
The EU has formed a parliament and a council; has its own flag, anthem and is writing a
constitution.
In direct response to this competitive economic move on the part of the EU, the US
finally ratified NAFTA.
NAFTA: North American Free Trade Agreement established in 1993 between USA,
Canada and Mexico to promote economic growth and prosperity for all three economies
by eliminating tariffs and quotas by 2009.
Today the US government is working to expand NAFTA to the entire western
hemisphere (if you are a non-communist nation).
There are many other such groups worldwide (page 455), APEC, MERCOSUR,
CARICOM
Multinationals: companies that sell and manufacture in more than one country. Avoid
shipping fees; bring their culture to other countries, etc.
Financing International Trade:
How the foreign exchange market works, i.e. global banking procedures
Each nation trades in their own currency. In order to buy an import, you must use US
dollars to buy the currency from the country you wish to buy a product. In order to sell
an export, others must use their currencies to buy US dollars.
The foreign exchange market operates somewhat like the stock market. It involves the
buying and selling of currencies. Over 2,000 banks and other financial institutions
facilitate the buying and selling of currencies. One country’s currency gets converted into
its’ equivalent in another currency. This is referred to as the exchange rate.
e.g. See Conversion Chart (Exchange Rate Table page 459)
Appreciation: an increase in the value of a currency
Depreciation: a decrease n the value of a currency
International trade financial history:
Gold standard: 1920-1944; a fixed exchange rate system where the value of each nations
money was set in terms of ounces of gold. E.g. US dollar was worth 1/36 oz. Of gold;
UK pound was worth 1/18 oz. Of gold. Nations could not add dollars to its economy
unless it bought more gold.
Exchanges were easier under this system, but it often interfered in the domestic economy
of trading nations. If a nation had a trade deficit, its dollars left the domestic economy
(creating unemployment) and the only was to get them back was to have a trade surplus.
If a nation experienced a trade surplus, too many dollars would return to the nation
causing inflation. The only way to balance this was to run a deficit.
Trade deficit: import more than export
Trade surplus: export more than import
WW2, the monopoly of gold by USA, and years of deficits and surpluses, finally broke
down the gold standard. It was replaced with the Bretton Woods system in 1944. The
IMF – International Monetary Fund (the global bank) was created.
The US dollar replaced gold as the standard by which currencies were valued. Each
country’s currency was set according to its US dollar equivalent and nations were
required to maintain international reserves (dollars) in order to back the value of its
currency. The US dollar remained tied to the value of gold. Monetary values were
allowed to fluctuate by 1%. Countries could ask the IMF to move the value by 10% if
necessary. This is the beginning of a flexible exchange rate system, but it was still
primarily a fixed system.
In 1971 the Bretton Woods system broke down, The US stopped the sale of gold. We
lowered the value of our dollar by 9%, and lowered again in 1973. Other nations
followed suit. The world moved to the system in place now:
Flexible exchange rate: a system in which the laws of demand and supply and allowed to
determine the prices of money; prices are updated every 15 seconds, just like the stock
market.
Balance of payments: the total flow of money into a country minus the total flow of
money out of a country, due to its balance of trade
Trade deficit: import more than export
Trade surplus: export more than import
Classical economics teaches that the market will tend to balance itself out. The idea is
that trade will balance out in the long run. The forces of demand and supply tend to
automatically correct the balance of payments. (See graphs)
When the US dollar is strong it buys more of other nations currencies, thus making
imports less expensive. The more imports we buy will eventually weaken the dollar
making our exports less expensive. Which will eventually strengthen the
dollar…………… This is the microeconomic equilibrium, shortage to surplus to
shortage eventually balancing itself. The same forces apply to international trade.
Large and sustained trade deficits will cause an imbalance in our circular flow. If the US
dollar stays very strong for sustained periods of time, Americans will import more than it
exports. Most economists believe this situation will be corrected in time. Politically
these times can be painful for some American producers, which can prompt Congress to
increase tariffs and establish quotas to reduce imports. Most economists argue that this
will only make a bad situation worse.
If the US Congress increases tariffs while the US is experiencing trade deficits due to a
strong dollar, we will experience both decreased imports and exports. All sectors of the
economy will now be hurt.
Page 463, for the last 20+ years the US has been running large trade deficits.
If the forces of demand and supply tend to automatically correct the balance of payments,
why has the US been struggling with a very long deficit cycle?
Greenspan says: “we do not know how long net imports and US external debt can rise
before foreign investors become reluctant to continue to add to their portfolios of claims
against the United States.”
To reduce, we cut back on our spending and save more; thus you hear more on the news
about how critical the US savings rate is.
International Trade – Global Economic Growth and Development
Chapter 18: Economic Development and Transition
Development: the process by which a nation improves the economic, political, and social
well-being of its people
Developed nation: nation with a higher average level of material well-being
LDC: Less-developed country, nation with a low level of material well-being
Based on a comparison of per capita GDP (gross domestic product), any Country with a
GDP per capita lower than $3,000 is considered a LDC; per capita means divided by the
population size
USA GDP per capita is approximately $36,000
1999 GDP per capita of some LDCs
Thailand
$1,618
Tanzania
$ 96
Peru
$2,090
Nigeria
$ 242
Mexico
$2,506
India
$ 303
China
$1,327
Colombia
$1,187
Mozambique $ 74
Industrialization: the extensive organization of an economy for the purpose of
manufacture; requires high levels of energy consumption
NIC: newly industrialized country, less developed country that has shown significant
improvement in the measures of development
LDCs tend to have low levels of energy consumption, and make their living in
subsistence agriculture; in the US one farmer feeds 80 people, in LDCs one farmer is
struggling to feed his own family
Consumer goods per person is an indicator of how its people live
Literacy rates, the number of people over 15 that can read and write; the higher the
literacy rate the higher its standard of living
Life expectancy: the average expected life span of an individual; the longer the life
expectancy the higher the nations standard of living
Infant mortality rate: the number of deaths that occur in the first year of life per 1,000
live births
Infrastructure: the services and facilities necessary for an economy to function;
transportation, communication, roads, power plants, schools and banks, etc.
Newly Industrialized countries (NICs) include Mexico, Brazil, Malaysia, Thailand,
Singapore, Hong Kong, South Korea, and Taiwan
Levels of Development:
1. Primitive equilibrium: A tradition economy that reaches an equilibrium
2. Transition: Cultural traditions begin to crumble and people adopt new living
patterns
3. Takeoff: New industries from and profits are reinvested
4. Semi-development: Economy expands and enters international market
5. Highly developed: Basic human needs are met easily. Economy is focused on
consumer goods and public services
Dual Economy: a country with two separate economies that do not interact with each
other, one tends to be poor the other rich; the theory was first put forth by W. Arthur
Lewis in 1954
Effects of Poverty in LDCs (1994 stats)
1. Individuals have fewer goods and services
a. Persons per car
i. USA
1.7
ii. Thailand
69
iii. Uruguay
16
iv. Ecuador
134
b. TVs per 1,000 people
i. USA
814
ii. Thailand
114
iii. Uruguay
231
iv. Ecuador
84
v. China
31
2. Health Care
a. Infant mortality rate, deaths per 1,000 live births of children under one
year of age
i. USA
6.4
ii. Thailand
37.1
iii. China
52.1
iv. Afghanistan
155.8
b. Life Expectancy – the average age people in a country reach
i. USA
75.9
ii. China
67.9
iii. Thailand
68.4
iv. Uganda
37.5
v. Afghanistan 44.9
3. Political problems are magnified in LDCs
a. Dual economy – an economy in which a modern market exists side by side
with a primitive subsistence economy
i. The poor stay poor and the rich get richer, there is no middle class
4. Poverty in LDCs affects advanced countries
a. Opportunity cost for advanced economies is the revenue lost because
people cannot be customers in the market system
b. Failure of LDCs to repay loans
c. Opportunity cost of the foreign aid monies which could be spent other
ways, politically debated because these funds could be used for domestic
concerns
Barriers to Economic Development – economic, social, and political characteristics that
prevent an economy from developing
1. Limited Natural Resources – usually resources are agricultural; only 10% of the
land on Earth is arable, some nations’ have a much larger share of this land than
others
2. Low Level of Human capital – the level of education and training that people
have
a. Adult literacy rates
i. USA over 95%
ii. Thailand
93%
iii. China 73%
iv. Afghanistan 29%
v. Uganda
47%
3. Shortage of Investment capital; some nations must turn to foreign nations in order
to get the physical capital to grow
4. Rapid population growth, a nation needs to match its population growth with its
economic growth
a. Uganda & Pakistan’s populations double every 23 years, thus its economy
has to double every 23 years
b. US population doubles every 80 years, thus its economy needs to double
every 80 years
5. Unfavorable Political Environment
a. If Governments were helping they could increase educational investment
and direct investment capital to where it would most benefit its people
b. Transition from colonial dependency to central planning
c. Government corruption
d. Political instability
e. Debt; between 1970 and 1984 the total debt of LDCs increased by 1,000%
Internal financing: financing derived from the savings of a country’s citizens
Foreign investment: investment originating from other countries
Foreign direct investment: Multinational Corporations build factories in LDCs in the
search for profit; technology, jobs, labor force training, and improved living standards
often follow
Foreign portfolio investment: Mutual funds can be purchased that fund managers invest
in LDCs
Foreign Aid can promote Economic Development (grants, not loans)
The Marshall Plan was primarily a grant program, which rebuilt much of Western Europe
after ww2. Many argue that the same is occurring now in Iraq.
Net Flow of Money to Developing Nations (1990 stats)
Canada$ 4 billion
France $ 6.1 billion
Germany
$13.1 billion
Japan
$25 billion
US
$20.8 billion
The World Bank is also a source of aid to developing nations. Established officially in
1944 under the United Nations, it serves as a trust bank, which borrows from rich nations
and loans to poor nations at discount rates.
United Nations Development Program: dedicated to the elimination of poverty through
economic development; it devotes 90% of its resources to 66 low-income nations where
90% of the world’s poor live.
International Monetary Fund: (IMF) Established to stabilize exchange rates in 1946.
Since then its role has also expanded to facilitate economic development of LDCs.
Much of the globalization debate today surrounds around the fact that implementing
market reforms which many believe will help substantially in the long run often in fact do
hurt many in the short-run, while richer nations appear to be profiting off the pain of the
poorer members of the world. This is clearly a philosophical debate that each of us must
understand and determine on our own which perspective we prefer, capitalist or socialist
economic policies.
Global trends currently are toward capitalist systems. (Map page 490)
Privatization: the sale or transfer of state-owned businesses to individuals
Market reforms cannot work unless government sets up viable protections systems for
property rights. This is one of the biggest obstacles for LDCs; in highly developed
nations there are very complicated systems of valuing and transferring property rights and
enforcing these rights. Transition times are politically tense times.
Transition in Russia:
Glasnost: a policy of political “openness” introduced in the Soviet Union in the 1980s
Perestroika: Soviet leader Gorbachev’s plan for economic restructuring
Some of the best deals of the 20th century occur within the Soviet Union during
privatization. (Commanding Heights Clip, from Volume 2)
Transition in China:
Deng Xioping replaced the People’s Communes with the contract responsibility system, a
move to provide incentives to grow more. In an effort to encourage greater light
industry, more control was given over to factory managers.
Special economic zones: designated regions in China where foreign investment is
encouraged, businesses can make most of their own investment and production decisions,
and foreign companies are slowed to operate. Most of these operate along China’s east
coast; the first ones were located near Hong Kong and Taiwan. 120 million Chinese
migrated to these Zones. China is now the fastest growing economy on earth.
E.8.1
E.8.2
E.8.3
E.8.4
E.8.5
E.8.6
E.8.7
E.8.8
E.8.9
E.8.10
Explain the benefits of trade among individuals, regions, and countries.
(Geography; Individuals, Society, and Culture)
Define and distinguish between absolute and comparative advantage.
Define trade barriers, such as quotas and tariffs. (Civics and Government)
Explain why countries sometimes erect barriers to trade. (Civics and
Government)
Explain the difference between balance of trade and balance of payments.
Compare and contrast labor productivity trends in the United States and other
developed countries.
Explain how most trade occurs because of a comparative advantage in the
production of a particular good or service.
Explain how changes in exchange rates impact the purchasing power of
people in the United States and other countries. (Individuals, Society, and
Culture)
Evaluate the arguments for and against free trade.
Identify skills individuals need to be successful in the workplace. (Individuals,
Society, and Culture)