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Business and Economics
It is the fun
It is the reality
It is the true leader of the world
People shouldn't bury themselves in the
mathematics, because the mathematics
are only tools," says Kenneth Froot, a
professor at Harvard Business School
who teaches courses in risk management.
"One needs to have a wide and robust
vocabulary to talk about risk, simply
because no single mathematical formula
is going to capture all of what risk is."
"
Meaning of Money
• Money (money supply)—anything that is
generally accepted in payment for goods or
services or in the repayment of debts;
• Wealth—the total collection of pieces of
property that serve to store value
• Income—flow of earnings per unit
of time
Copyright © 2007 Pearson
Addison-Wesley. All rights
reserved.
3-3
Evolution of the Payments System
• Commodity Money
( Gold Standard & Breton Wood)
• Fiat Money
• Checks
• Electronic Payment
• E-Money
Copyright © 2007 Pearson
Addison-Wesley. All rights
reserved.
3-4
Functions of Money
• Medium of Exchange—promotes economic efficiency by
minimizing the time spent in exchanging goods
and services
–
–
–
–
–
Must be easily standardized
Must be widely accepted
Must be divisible
Must be easy to carry
Must not deteriorate quickly
• Unit of Account—used to measure value in
the economy
• Store of Value—used to save purchasing power; most liquid
of all assets but loses value during inflation
Copyright © 2007 Pearson
Addison-Wesley. All rights
reserved.
3-5
The Price of Gold 1830-2000
700
600
500
400
300
200
100
0
1850
1875
1900
1925
1950
GOLDPRICE
1975
2000
Composite Price Index 1750-2003 Based on 1974 British Pounds Sterling
US Gold Reserves between 1944 and 2004
(millions of ounces)
Purchasing Power of the Currencies of the Ten Leading
Industrial Nations from 1980-1999 (in 1980 adjusted values)
120.00%
100.00%
‫اليابان‬
‫ألمانيا‬
‫سويسرا‬
‫النمسا‬
‫أمريكا‬
‫فرنسا‬
‫كندا‬
‫بريطانيا‬
‫أسبانيا‬
‫إيطاليا‬
80.00%
60.00%
40.00%
20.00%
0.00%
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Exchange Rate
•
•
•
•
You can not have them all
Fixed Exchange rate
Free International Financial System
Independent Monetary Policy.
The Business Cycle
Phases of the Business Cycle
O 7.1
Peak
Level of Real Output
Peak
Peak
Trough
Trough
Time
Money and Business Cycles
• Evidence suggests that money
plays an important role in generating
business cycles
• Recessions (unemployment) and booms
(inflation) affect all of us
• Monetary Theory ties changes in the money
supply to changes in aggregate economic
activity and the price level
Copyright © 2007 Pearson
Addison-Wesley. All rights
reserved.
1-12
English Price Level and Real Wage, 12642002 (1270 = 100)
Consumer Prices in the United States,
1776-2003
Inflation Has Remained Low and Stable in
Recent Years
Money and Hyperinflation in Germany,
1922-1924
The Evolving U.S. Economy
– Figure interprets
the changes in real
GDP and the price
level each year
from 1960 to 2005
in terms of shifting
AD, SAS, and LAS
curves.
– In 1960, the price
level was 21 and
real GDP was $2.5
trillion.
The Evolving U.S. Economy
– By 2005, the price
level was 112 and
real GDP was
$11.1 trillion.
– The dots show
three features:
 Business cycles
 Inflation
 Economic growth
The Evolving U.S. Economy
– Business Cycles
– Over the years,
the economy
grows and
shrinks in
cycles.
– The figure
highlights the
recessions since
1960.
The Evolving U.S. Economy
– Inflation
– The upward
movement of the
dots shows
inflation.
– Economic Growth
– The rightward
movement of the
dots shows the
growth of real
GDP.
Inflation Cycles
– In the long run, inflation occurs if the quantity of
money grows faster than potential GDP.
– In the short run, many factors can start an
inflation, and real GDP and the price level interact.
– To study these interactions, we distinguish two
sources of inflation:
 Demand-pull inflation
 Cost-push inflation
Inflation Cycles
– Demand-Pull Inflation
– An inflation that starts because aggregate demand
increases is called demand-pull inflation.
– Demand-pull inflation can begin with any factor
that increases aggregate demand.
– Examples are a cut in the interest rate, an increase
in the quantity of money, an increase in
government expenditure, a tax cut, an increase in
exports, or an increase in investment stimulated
by an increase in expected future profits.
Inflation Cycles
• Initial Effect of an
Increase in Aggregate
Demand
– Figure (a) illustrates
the start of a
demand-pull
inflation.
– Starting from full
employment, an
increase in aggregate
demand shifts the AD
curve rightward.
Inflation Cycles
– The price level rises,
real GDP increases,
and an inflationary
gap arises.
– The rising price level
is the first step in
the demand-pull
inflation.
Inflation Cycles
• Money Wage Rate
Response
– Figure (b) illustrates the
money wage response.
– The money wages rises
and the SAS curve shifts
leftward.
Real GDP decreases back to
potential GDP but the price
level rises further.
Inflation Cycles
• A Demand-Pull
Inflation Process
– Figure illustrates a
demand-pull inflation
spiral.
Aggregate demand keeps
increasing and the process
just described repeats
indefinitely.
Inflation Cycles
– Although any of several
factors can increase
aggregate demand to
start a demand-pull
inflation, only an
ongoing increase in the
quantity of money can
sustain it.
– Demand-pull inflation
occurred in the United
States during the late
1960s.
Inflation Cycles
– Cost-Push Inflation
– An inflation that starts with an increase in costs is
called cost-push inflation.
– There are two main sources of increased costs:
– 1. An increase in the money wage rate
– 2. An increase in the money price of raw
materials, such as oil
Inflation Cycles
• Initial Effect of a Decrease
in Aggregate Supply
– Figure illustrates the start
of cost-push inflation.
– A rise in the price of oil
decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
– Real GDP decreases and
the price level rises.
Inflation Cycles
• Aggregate Demand Response
– The initial increase in costs creates a one-time rise in
the price level, not inflation.
– To create inflation, aggregate demand must increase.
– That is, the Fed must increase the quantity of money
persistently.
Inflation Cycles
– Figure illustrates an
aggregate demand
response.
– Suppose that the Fed
stimulates aggregate
demand to counter
the higher
unemployment rate
and lower level of real
GDP.
– Real GDP increases
and the price level
rises again.
Inflation Cycles
• A Cost-Push
Inflation Process
– If the oil producers
raise the price of oil
to try to keep its
relative price
higher,
– and the Fed
responds by
increasing the
quantity of money,
– a process of costpush inflation
continues.
Inflation Cycles
– The combination of
a rising price level
and a decreasing
real GDP is called
stagflation.
– Cost-push inflation
occurred in the
United States
during the 1970s
when the Fed
responded to the
OPEC oil price rise
by increasing the
quantity of money.
Inflation Cycles
• Expected Inflation
– Figure illustrates an
expected inflation.
– Aggregate demand
increases, but the
increase is
expected, so its
effect on the price
level is expected.
Inflation Cycles
– The money wage rate
rises in line with the
expected rise in the
price level.
– The AD curve shifts
rightward and the SAS
curve shifts leftward
so that the price level
rises as expected and
real GDP remains at
potential GDP.
Inflation Cycles
• Forecasting Inflation
– To expect inflation, people must forecast it.
– The best forecast available is one that is based on
all the relevant information and is called a rational
expectation.
– A rational expectation is not necessarily correct
but it is the best available.
Business Cycles
• Initially, potential GDP is $9 trillion and the
economy is at full employment at point A.
• Potential GDP increases to $12 trillion and
the LAS curve shifts rightward.
Business Cycles
• During an expansion, aggregate demand increases
and usually by more than potential GDP.
• The AD curve shifts to AD1.
Business Cycles
• Assume that during this expansion the price level
is expected to rise to 115 and that the money
wage rate was set on that expectation.
• The SAS shifts to SAS1.
Business Cycles
• The economy remains at full employment at
point B.
• The price level rises as expected from 105 to
115.
Business Cycles
• But if aggregate demand increases more slowly
than potential GDP, the AD curve shifts to AD2.
• The economy moves to point C.
• Real GDP growth is slower and inflation is less than
expected.
Business Cycles
• But if aggregate demand increases more quickly
than potential GDP, the AD curve shifts to AD2.
• The economy moves to point D.
• Real GDP growth is faster and inflation is higher
than expected.
Business Cycles
• Economic growth, inflation, and business cycles
arise from the relentless increases in potential
GDP, faster (on the average) increases in aggregate
demand, and fluctuations in the pace of aggregate
demand growth.
The Federal Budget
– The federal budget is the annual statement of the
federal government’s outlays and tax revenues.
– The federal budget has two purposes:
– 1. To finance the activities of the federal government
– 2. To achieve macroeconomic objectives
– Fiscal policy is the use of the federal budget to
achieve macroeconomic objectives, such as full
employment, sustained economic growth, and price
level stability.
The Supply-Side: Employment and
Potential GDP
– Fiscal policy has important effects employment,
potential GDP, and aggregate supply—called
supply-side effects.
– An income tax changes full employment and
potential GDP.
The Supply-Side: Employment and
Potential GDP
• Tax Revenues and the
Laffer Curve
– The relationship
between the tax rate
and the amount of tax
revenue collected is
called the Laffer
curve.
– For a tax rate below
T* a rise in the tax
rate increases tax
revenue.
The Conduct of Monetary Policy
• The Federal Funds Rate
– The Fed’s choice of policy instrument (which is the
same choice as that made by most other major
central banks) is a short-term interest rate.
– Given this choice, the exchange rate and the
quantity of money find their own equilibrium
values.
– The specific interest rate that the Fed targets is
the federal funds rate, which is the interest rate
on overnight loans that banks make to each other.
The Conduct of Monetary Policy
• Hitting the Federal Funds Rate Target: Open
Market Operations
– An open market operation is the purchase or sale of
government securities by the Fed from or to a
commercial bank or the public.
– When the Fed buys securities, it pays for them with
newly created reserves held by the banks.
– When the Fed sells securities, they are paid for with
reserves held by banks.
– So open market operations influence banks’ reserves.
Origins and Issues of Macroeconomics
– Economists began to study economic growth, inflation, and
international payments during the 1750s.
– Modern macroeconomics dates from the Great
Depression, a decade (1929-1939) of high unemployment
and stagnant production throughout the world economy.
– John Maynard Keynes book, The General Theory of
Employment, Interest, and Money, began the subject.
Origins and Issues of Macroeconomics
• Short-Term Versus Long-Term Goals
– Keynes focused on the short-term—on
unemployment and lost production.
– “In the long run,” said Keynes, “we’re all dead.”
– During the 1970s and 1980s, macroeconomists
became more concerned about the long-term—
inflation and economic growth.
Economic Growth and Fluctuations
–Economic growth is the expansion of the economy’s
production possibilities—an outward shifting PPF.
–We measure economic growth by the increase in real
GDP.
–Real GDP (real gross domestic product) is the value of
the total production of all the nation’s farms, factories,
shops, and offices, measured in the prices of a single
year.
Economic Growth and Fluctuations
• Economic Growth in
the United States
–Figure shows real GDP in
the United States from
1960 to 2005.
The figure highlights:
 Growth of potential GDP
 Fluctuations of real GDP
around potential GDP
Economic Growth and Fluctuations
–Growth of Potential GDP
–Potential GDP is the value
of production when all the
economy’s labor, capital,
land, and entrepreneurial
ability are fully employed.
–During the 1970s, the
growth of output per
person slowed—a
phenomenon called the
productivity growth
slowdown.
Economic Growth and Fluctuations
–Fluctuations of Real
GDP Around Trend
–Real GDP fluctuates
around potential GDP in
a business cycle—a
periodic but irregular upand-down movement in
production.
Economic Growth and Fluctuations
–Every business cycle has two phases:
–1. A recession
–2. An expansion
–and two turning points:
–1. A peak
–2. A trough
–Figure on the next slide illustrates these features of
the business cycle.
Economic Growth and Fluctuations
– Most recent business cycle in the United States
Economic Growth and Fluctuations
–A recession is a period during which real GDP
decreases for at least two successive quarters.
–An expansion is a period during which real GDP
increases.
Economic Growth and Fluctuations
– Figure 4.3 shows the long-term growth trend and cycles.
Economic Growth and Fluctuations
• Economic Growth
Around the World
–Figure 4.4(a) compares
the growth rate of real
GDP per person in the
United States with that
for the rest of the world
as a whole.
Economic Growth and Fluctuations
–Figure 4.4(b)
compares economic
growth in the United
States with that in other
countries and regions
from 1996 to 2006.
–Among the advanced
economies, Japan has
grown slowest and the
newly industrialized
Asian economies have
grown fastest.
Economic Growth and Fluctuations
–Among the developing
economies, Central and
South America have
grown slowest and Asia
has grown fastest.
–The world has grown a
bit faster than the
United States.
Economic Growth and Fluctuations
• The Lucas Wedge and Okun Gap
– How costly are the growth slowdown and the
lost output over the business cycle?
– To answer that question we measure:
 The Lucas wedge
 The Okun gap
Economic Growth and Fluctuations
• The Lucas Wedge
– The Lucas wedge is
the accumulated
loss of output from
the productivity
growth slowdown of
the 1970s .
– Figure 4.5(a) shows
that the Lucas
wedge is $72 trillion
or 6.5 times the real
GDP in 2005.
Economic Growth and Fluctuations
• The Okun Gap
– Real GDP minus
potential GDP is
the output gap.
– A negative output
gap is called an
Okun gap.
– Figure 4.5(b)
shows the Okun
gap from
recessions since
1973 is $3.3 trillion
or about 30
percent of real
GDP in 2005.
Economic Growth and Fluctuations
• Benefits and Costs of Economic Growth
– The Lucas wedge is a measure of the dollar value of
lost real GDP if the growth rate slows. This cost
translates into real goods and services.
– It is a cost in terms of less health care for the poor and
elderly, less cancer and AIDS research, worse roads,
and less to spend on clean air, more trees, and cleaner
lakes.
– But fast growth is also costly. Its main costs is forgone
current consumption. To sustain growth, resources
must be allocated to advancing technology and
accumulating capital rather than to current
consumption.
Jobs and Unemployment
• Jobs
– In 2006, 143 million people in the United States
had jobs.
– This number is 16 million more than in 1996 and
33 million more than in 1986.
– But the pace of job creation fluctuates.
– During the recession, the number of jobs shrinks.
– During the 19901991 recession, more than 1
million jobs were lost and during the 2001
recession, 2 million jobs disappeared.
Jobs and Unemployment
• Unemployment
– Not everyone who wants a job can find one.
– On an average day in a normal year, 7 million
people in the United States are unemployed.
– In a recession, the number is larger. For example,
in 1990-1991 recession, 9 million people were
looking for jobs.
– The unemployment rate is the number of
unemployed people expressed as a percentage of
all the people who have jobs or are looking for
one.
Jobs and Unemployment
– The unemployment rate is not a perfect measure of
the underutilization of labor. For two reasons:
– The unemployment rate
– 1. Excludes people who are so discouraged that
they have given up looking for jobs.
– 2. Measures unemployed people rather than
unemployed labor hours. So it does not tells us
about the number of part-time workers who want
full-time jobs.
Jobs and Unemployment
• Unemployment in in United States
– Figure 4.6 shows the unemployment rate from
1926 to 2006.
Jobs and Unemployment
– During the 1930s, the unemployment rate hit 25 percent.
Jobs and Unemployment
– The lowest rate occurred during World War II at 1.2 percent.
Jobs and Unemployment
During recent recessions, the unemployment rate increased but
was not as high as in the Great Depression.
Jobs and Unemployment
The unemployment rate is never zero. Since World War II, it has
averaged 5 percent.
Jobs and Unemployment
• Unemployment
Around the World
– Figure 4.7 compares
the unemployment
rate in the United
States with those in
Japan, Western
Europe, and Canada.
– The U.S.
unemployment rate
has been lower than
that in Western
Europe and Canada
but higher than that
in Japan.
Jobs and Unemployment
– The cycle in
unemployment in
Canada is similar to that
in the United States.
– The cycle in
unemployment in
Western European is out
of phase with that in the
United States.
– Unemployment in Japan
has drifted upwards
since the mid-1990s.
Jobs and Unemployment
• Why Unemployment Is a Problem
– Unemployment is a serious economic, social, and
personal problem for two main reasons:
 Lost production and incomes
 Lost human capital
– The loss of a job brings an immediate loss of
income and production—a temporary problem.
– A prolonged spell of unemployment can bring
permanent damage through the loss of human
capital.
Inflation and the Dollar
– We measure the level of prices—the price level— as
the average of the prices that people pay for all the
goods and services that they buy.
– The Consumer Price Index—the CPI—is a common
measure of the price level.
– We measure the inflation rate as the percentage
change in the price level.
– Inflation arises when the price level is rising
persistently.
– If the price level is falling, inflation is negative and we
have deflation.
Inflation and the Dollar
Inflation in the United States
– Was low
in the
1960s.
– Increased
in the
1970s
and early
1980s.
– Fell
during
the 1980s
and
1990s.
– Increased
after
2002.
Inflation and the Dollar
• Inflation Around the
World
– Figure (a) shows the
inflation rate in the
United States
compared with that in
other industrial
countries.
– U.S. inflation is similar
to that in other
industrial countries.
Inflation and the Dollar
– Figure (b) shows the
inflation rate in
industrial countries
has been much lower
than that in
developing countries.
Inflation and the Dollar
• Hyperinflation
– The most serious type of inflation is hyperinflation—
an inflation rate that exceeds 50 percent a month.
– Why Inflation is a Problem
– Inflation is a problem for many reasons, but the main
one is that once it takes hold, it is unpredictable.
– Unpredictable inflation is a problem because it
 Redistributes income and wealth
 Diverts resources from production
Inflation and the Dollar
– Unpredictable changes in the inflation rate
redistribute income in arbitrary ways between
employers and workers and between borrowers and
lenders.
– A high inflation rate is a problem because it diverts
resources from productive activities to inflation
forecasting.
– From a social perspective, this waste of resources is a
cost of inflation.
– Eradicating inflation is costly because it brings a
period of greater than average unemployment.
Inflation and the Dollar
• The Value of the Dollar
– The value of the U.S. dollar in terms of other
currencies is called the exchange rate—a measure
of how much your dollar will buy in other parts of
the world.
– An example is the number of pesos that 1 U.S.
dollar will buy.
Surpluses, Deficits, and Debts
– Figure shows the U.S.
dollar exchange rate.
– When value of the
dollar decreases, the
U.S. dollar
depreciates against
other currencies.
– When value of the
dollar increases, the
U.S. dollar
appreciates against
other currencies.
Inflation and the Dollar
• Why the Exchange Rate Matters
– When the U.S. dollar appreciates, U.S. consumers
pay less for imported goods.
– But the higher dollar makes it harder for U.S.
producers to complete in foreign markets. A
higher dollar hurts U.S producers.
– When the U.S. dollar depreciates, U.S. consumers
pay more for imported goods. So a lower dollar
hurts consumers.
– But the lower dollar makers it easier for U.S.
producers to complete in foreign markets.
Surpluses, Deficits, and Debts
• Government Budget Balance
– If a government collects more in taxes than it spends,
it has a government budget surplus.
– If a government spends more than it collects in taxes,
it has a government budget deficit.
Surpluses, Deficits, and Debts
– Figure 4.11(a) shows
the U.S. federal
government budget
balance from 1960 to
2005.
– The budget deficit as
a percentage of GDP
increases in
recessions and
shrinks in expansions
– In 1998, a budget
surplus emerged, but
the budget deficit
reappeared in 2001.
Surpluses, Deficits, and Debts
• International Surplus and Deficit
– If a nation imports more than it exports, it has an
international deficit.
– If a nation exports more than it imports, it has an
international surplus.
– The balance on the current account equals U.S.
exports minus U.S. imports but also takes into account
interest payments paid to and received from the rest
of the world.
Surpluses, Deficits, and Debts
– Figure 4.11(b) shows
the U.S. current
account balance
from 1960 to 2005.
– During the 1980s
expansion, a large
deficit appeared but
it almost
disappeared during
the 1990–1991
recession.
– The current account
deficit in 2005 was
6.3 percent of GDP.
Surpluses, Deficits, and Debts
• Deficits Bring Debts
– A debt is the amount that is owed.
– When a government or a nation has a deficit, its
debt grows.
– A government’s or a nation’s debt equals the sum
of all past deficits minus past surpluses.
– A government’s debt is called national debt.
Surpluses, Deficits, and Debts
– Figure (a) shows the
U.S. government
debt from 1945 to
2005.
– Budget surpluses
and rapid economic
growth shrink the
debt.
– Budget deficits and
slower economic
growth swelled the
debt.
Surpluses, Deficits, and Debts
– Figure (b) shows the
U.S. international debt
from 1975 to 2005.
– Until 1986, the United
States was a net
lender to the world.
– But with increased
deficits, the United
States is now a net
borrower from the
world.
Creating a Bank
• Creating a Bank
• Vault Cash
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets
Cash
Liabilities and Net Worth
$250,000
Stock Shares
$250,000
Creating a Bank
• Acquiring Property and
Equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$10,000 Stock Shares
$240,000
$250,000
Creating a Bank
• Accepting Deposits
–Receive $100,000 as a
Checkable Deposit
Accepting Deposits
Balance Sheet 3: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$110,000 Checkable
Deposits
$240,000
Stock Shares
$100,000
$250,000
:
Creating a Bank
• Depositing Reserves in a
Federal Reserve Bank
–Required Reserves
–Reserve Ratio
Reserve
Ratio
=
Commercial Bank’s
Required Reserves
Commercial Bank’s
Checkable-Deposit Liabilities
Creating a Bank
Type of Deposit
Checkable Deposits:
$0-$7.8 Million
$6-$48.3 Million
Over $48.3 Million
Noncheckable Nonpersonal
Savings and Time Deposits
Current
Requirement
Statutory
Limits
0%
3
10
3%
3
8-14
0
0-9
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
$110,000
Deposits
$100,000
Property
$240,000 Stock Shares
$250,000
Creating a Bank
Excess Reserves
Excess
Reserves
=
Actual
Reserves
-
Required
Reserves
Creating a Bank
• Clearing a Check
–$50,000 Check Presented
for Payment
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets
Reserves
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
$240,000
Stock Shares
$50,000
$250,000
Money
Creating
Transactions
:
• Granting a Loan
–$50,000 Loan Deposited to
Checking Account
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
$50,000
$100,000
$240,000 Stock Shares
$250,000
Money
Creating
Transactions
:
• Using the Loan
W 13.1
–$50,000 Loan Cashed From
Checking Account
After a Check is Drawn on the Loan
Balance Sheet 6b: Wahoo Bank
Assets
Reserves
Loans
Property
Liabilities and Net Worth
$10,000 Checkable
Deposits
$50,000
$50,000
$240,000 Stock Shares
$250,000
A Single Bank Can Only Lend An Amount
Equal to their Preloan Excess Reserves
Money Creating Transactions
• Buying Government Securities
From Dealer
–Deposits Payment Into Checking
Account
Buying Government Securities
Balance Sheet 7: Wahoo Bank
Assets
Reserves
Securities
Property
Liabilities and Net Worth
$60,000 Checkable
Deposits
$50,000
$100,000
$240,000 Stock Shares
$250,000
The Banking System
Bank
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
Bank H
Bank I
Bank J
Bank K
Bank L
Bank M
Bank N
Other Banks
(1)
Acquired
Reserves
and Deposits
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
The
Monetary
Monetary
MultiplierMultiplier
or CheckableDeposit Multiplier
Monetary
Multiplier
=
Required Reserve Ratio
1
m =
or in Symbols…
Graphic
Example
1
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
R
$20
Required
Reserves
$100
Initial
Deposit
Interest
Rates
• Equilibrium Interest Rate
G 14.1
• Interest Rates and Bond Prices
–Bond Prices Fall When
Interest Rates Rise
–Bond Prices Rise When
Interest Rates Fall
–Inverse Relationship Between
Interest Rates and Bond
Prices
W 14.2
Consolidated Balance Sheet
Federal Reserve Banks
• Assets
–Securities
–Loans to Commercial Banks
• Liabilities
–Reserves of Commercial Banks
–Treasury Deposits
–Federal Reserve Notes
Outstanding
Consolidated Balance Sheet
Federal Reserve Banks
Consolidated Balance Sheet of
the 12 Federal Reserve Banks
March 29, 2006 (in Millions)
Assets
Securities
Loans to Commercial
Banks
All Other Assets
Total
Liabilities and Net Worth
$758,551
19,250
59,967
$837,768
Reserves of Commercial
Banks
Treasury Deposits
Federal Reserve Notes
(Outstanding)
All Other Liabilities and
Net Worth
Total
$ 14,923
4,463
754,567
63,615
$837,768
Source: Federal Reserve Statistical Release, H.4.1, May 7, 2003
Tools of Monetary Policy
• Open Market Operations
–Buying Securities
O 14.2
• From Commercial Banks
• From the Public
–Selling Securities
W 14.3
• To Commercial Banks
• To the Public
• When the Fed Sells Securities,
Commercial Bank Reserves are
Reduced
Tools of Monetary Policy
Fed Buys $1,000 Bond from a
Commercial Bank
New Reserves
$1000
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
Tools of Monetary Policy
Fed Buys $1,000 Bond from the
Public
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
Tools
of
Monetary
Policy
• The Reserve Ratio
–Raising the Reserve Ratio
–Lowering the Reserve Ratio
• The Discount Rate
–Borrowing from the Fed by
Banks Increases Reserves and
Enhances Lending Ability
• Relative Importance of Each
Monetary
Policy Policy
Expansionary
Monetary
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed Buys Bonds, Lowers Reserve
Ratio, or Lowers the Discount Rate
Excess Reserves Increase
Federal Funds Rate Falls
Money Supply Rises
Interest Rate Falls
Investment Spending Increases
Aggregate Demand Increases
Real GDP Rises
Monetary
Policy
Restrictive
Monetary
Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed Sells Bonds, Increases Reserve
Ratio, or Increases the Discount Rate
Excess Reserves Decrease
Federal Funds Rate Rises
Money Supply Falls
Interest Rate Rises
Investment Spending Decreases
Aggregate Demand Decreases
Inflation Declines