PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 9 (LECTURES 23 & 24, plus second midterm exam)
March 27 - 31, 2000

0. IMPEDIMENTA

* Pick up (short) Problem Set 6, Solutions to Problem Set 5
---- Both of these are also posted on the web.

* SECOND MIDTERM EXAM IS THIS FRIDAY, MARCH 31

* Today: Money and monetary policy (continued)
I. The money supply
II. How banks create money
III. Bank balance sheets, in brief

I. THE MONEY SUPPLY

The money supply is controlled by the Federal Reserve. Official measures of the money supply:
-- The narrowest, sometimes called "transactions money," is:
M1 = currency + checking account deposits + travelers' checks = \$1.1 trillion (~13% of GDP)
-- A much larger and broader measure is:
M2 = currency + checking account deposits + travelers' checks + Savings deposits + Small CD's (time deposits) + money-market mutual funds (MMF's) + money-market deposit accounts (MMDA's) = ~\$4 trillion
-- There are still-broader measures such as M3, L, and "Debt," but we won't be getting into those.

Note that both are considerably smaller than GDP, which is about \$9 trillion. That is because GDP is measured over the course of a year, whereas the money stock is measured a single point in time. Nearly every item bought and sold in GDP is financed by an exchange of money, but money "turns over" several times in the course of a year. (Just imagine, for example, how many times the \$1 bill in your pocket will get used, by different people and in different transactions, in the course of the next year.)

II. HOW BANKS CREATE MONEY

While the most obvious form of money is cash (paper money) and coins, most of the money supply consists of bank account deposits. Before we go any further, here are a couple key definitions:

Defns.

FINANCIAL INTERMEDIARIES: Banks and other institutions that act as links between those who have many to lend and those who want to borrow money.

BANK: A financial intermediary that accepts deposits and makes loans.

The total amount of bank account deposits is more than ten times larger than the total amount of cash that banks keep as reserves (e.g., in their vaults). We call this banking system...

FRACTIONAL RESERVE BANKING: the modern system of banking, in which banks do not keep all of their deposits as cash reserves but instead loan or invest most of them so as to earn interest.

How do banks do that? It sounds kind of like a shell game, doesn't it?It wasn't always this way; instead, this system evolved over time. Way back in the 15th and 16th centuries, people used gold as money. Because gold coins and bars were too heavy and bulky to carry around conveniently, people looked for a safe place to store it, and many of them stored it with goldsmiths for safekeeping. The goldsmith was providing a valuable storage service, so he charged a fee for it.
-- So far, the goldsmith was acting as no more than a warehouse, but eventually the paper receipts that he issued to each depositor began to be traded, from a depositor to someone who was selling goods. The receipts took the place of gold coins in some exchanges, and why not? They were lighter, easier to conceal from potential thieves, and were readily accepted in transactions. So the depositors did not need to make frequent trips to the goldsmith to withdraw their gold.
---- At some point, the goldsmiths realized that they were sitting on a potential profit opportunity. Gold withdrawals were infrequent, and their stocks of golds were always fairly large, so it occurred to them that they could lend out some of their extra gold and receive interest on it, because they always had more than enough on hand to meet normal deposit outflows.
------ At that point, modern banking, or fractional reserve banking, basically began. By issuing those gold receipts, or gold certificates, the goldsmiths made the monetary system more efficient than it had been. But the real change came when they started making loans: the goldsmiths would loan out their surplus gold, the borrowers would spend it and then the merchant who received their payment in gold would deposit it with another goldsmith, who would issue a receipt and loan out some of that gold.
-------- The goldsmiths had gained the power to create money. The same "chain of deposit creation" that characterizes modern banking - banks loan out their excess reserves, they get redeposited, the re-deposits get loaned out again, etc. - was now in place. The total amount of gold in the economy was the same, but the amount of money in circulation was much larger.
---------- With more money available to facilitate transactions, the volume of trading became much larger as well, so the beginning of modern banking did much to promote Renaissance Europe's economic development.

III. BANK BALANCE SHEETS, IN BRIEF

The standard accounting tool for listing a bank's assets and liabilities is called a T-account, so named because it's a table that you begin by drawing a big letter "t." A bank's balance sheet is just a listing of the bank's assets and liabilities. Assets (how the bank uses its funds; what the bank OWNS) go on the left side, while liabilities (sources of funds, or how the bank gets its funds, or what the bank OWES) go on the right side.

The first rule of accounting is that both sides add up to the same amount; in other words, the two sides of the balance sheet must balance. Yet a bank whose assets and liabilities are exactly equal would not be a very healthy bank - a bank likes to have some kind of cushion of funds so that a sudden dip in its assets doesn't make it insolvent. So a bank wants to have more assets than liabilities, but the balance sheet must balance. The way we make it balance is to add the bank's net worth (assets minus liabilities) to the liabilities side, as in the balance sheet below. So remember:

Assets - Liabilities = Net Worth (or Bank Capital);

Assets = Liabilities + Net Worth

The following table, showing the combined balance sheet of all U.S. banks and noting the relative share of each item in the totals, will be familiar to anyone who's taken accounting:

 ASSETS LIABILITIES AND NET WORTH Reserves 5% Deposits 66% Securities (Government bonds) 21% Borrowings (loans from others) 26% Loans to firms, individuals, other banks, etc. 68% Other assets (physical capital, etc.) 6% ___________________________ ___% TOTAL ASSETS 100% TOTAL LIABILITIES + NET WORTH 100%

(The blank line, which is the difference between Total Assets and Total Liabilities, is Net Worth, 8%. Since total liabilities {= Deposits + Borrowings = 66% + 26%} are equal to 92% of total assets, then Net Worth is 8%.)

(Total bank assets are about \$5 trillion.)

The first item on a bank's balance sheet is reserves, which banks keep to meet deposit outflows (withdrawals, checks drawn on the bank, etc.) and because they're required to do so by the Federal Reserve.
-- Banks are required by the Fed to hold a certain proportion of their deposits as reserves, mainly to guard against "runs on the bank" and to allow the Fed to manipulate the money supply. Reserves can be held either as cash or in accounts at the Fed. Currently, the required reserve ratio (RRR) is 10% on checking accounts and zero on savings and money-market accounts.

The difference between a bank's total reserves and its required reserves is its excess reserves:
excess reserves (ER) = actual reserves - required reserves
= actual reserves - (.10)(checking deposits)

Excess reserves are mainly kept by banks as a precaution. In good times, banks generally try to keep as few excess reserves as possible, since they earn no interest on them. The Fed's reserve requirements are typically much higher than what banks actually need in order to be able to handle deposit outflows. In fact, adhering to the Fed's reserve requirements, which are set considerably higher than the amount most banks actually net to meet the normal demand for withdrawals, is costly to banks, because they earn no interest on their reserves, whereas they could earn interest by loaning those reserves out.

***

WEEK 9, LECTURE 24
Wed., March 29, 2000

0. IMPEDIMENTA

* Get solutions to (short) Problem Set 6

* SECOND MIDTERM EXAM IS THIS FRIDAY, MARCH 31
---- What to focus on, in order:
(1) Problem Sets 4, 5, and 6
(2) lectures, Mon., Feb. 21 - Wed., March 29 (including quizzes)
(3) Chapters 8, 11, 15

* Course withdrawal deadline is Friday, March 31

* Today: Money and monetary policy (continued)
I. Money supply, money demand, and the equilibrium interest rate
II. How money affects the economy

I. MONEY SUPPLY, MONEY DEMAND, AND THE EQUILIBRIUM INTEREST RATE

Defn. INTEREST RATE -- the annual interest payment on a loan expressed as a % of the loan. It is equal to the amount of interest received per year divided by the amount of the loan.
-- It is the "price" of money, or rather the price of borrowing someone else's money.
-- Notation: i = interest rate
-- Ex.: If you borrow \$100 and must pay \$105, i = (interest payment)/(loan amount) = \$5/\$100 = .05 = 5%
---- (We don't count the repayment of the original \$100, which is called the principal on the loan. The interest rate is the net payment you make; we say that the gross interest rate = 105%, but that usage is uncommon.)

One of the best ways to understand movements in interest rates is through the money market -- a representation of the supply and demand of money and the resulting equilibrium point. So the money market is just another supply-and-demand diagram, with the price of money on the vertical axis, the quantity of money on the horizontal axis, and a downward-sloping money-demand curve.
-- The only variations on the usual supply-and-diagram are that:
(1) the supply curve of money is perfectly vertical, instead of upward-sloping, because the supply of money is fixed by the Fed without regard to the interest rate;
(2) the "price of money" is not a dollar amount but rather is the interest rate. The interest rate is the opportunity cost of holding money, since money pays no interest and alternative assets like bonds, savings accounts, and CD's do pay interest. When you hold money, you are giving up the interest that you could be receiving if that money were in a bond or savings account or CD. The higher the interest rate, the more interest you lose out on by holding money, so you'll carry less money and keep more in the bank. Likewise, when the interest rate is very low, you don't lose much by carrying a lot of money, so you will carry (or demand) more money.
The quantity of money demanded is a negative function of the interest rate (i)
--> the money demand curve slopes downward.

[-- I drew a diagram of the money market in class.  It's much like the one in Figure 12.6 (p. 261) of Case & Fair's book.  (No, this does not mean you suddenly have to read Chapter 12 before the exam.)]

Q: Considering that money earns a lower rate of return (0%) than virtually every other asset there is, why hold money at all? Even when i is low, as long as it's greater than 0, holding money means that you are losing out on the interest that you could be earning on bonds, CDs (certificates of deposit), or savings accounts, not to mention the positive returns you could be earning on things like stocks or real estate.

A: There are at least four good MOTIVES FOR HOLDING MONEY. They are:

(1.) Transactions demand (the most obvious motive) -- We need it to buy things, since money is the universal medium of exchange.
---- Corollary: the more you earn, the more money you'll demand.
------ After a Mets game in the mid-1980s, it was reported that pitcher Ron Darling's wife lost purse at the game, and that the Darlings were upset because the purse had over \$400 of cash in it. Why would she have been carrying so much money in the first place? (Probably because her husband was a multimillionaire.)
--------> The greater your income and wealth, the greater your consumption will be, hence the greater your transactions demand for money will be.

(2.) Precautionary demand ("save it for a rainy day")
---- Ex.: Say I normally spend about \$20/day --> then if I go to the bank every 5 days, I should withdraw \$100 every time, right? Not necessarily -- even though \$100 is what I'd need on average, I might have some abnormal expenses -- unexpected emergencies, bills, great sales, etc. So I might withdraw more than \$100.
------ Money is the most liquid of assets, thus you might want to set some aside to be ready for any emergencies that might arise.

(3.) Avoid transactions costs of bank trips (ATM fees, time and inconvenience of trips to the bank). Because of those costs, it is often desirable to make very large withdrawals of cash when you visit the bank, so that you won't have to visit the bank again for a long while. The larger your average bank withdrawal, the greater your money demand. Putting those two observations together, money demand will be greater when the transactions costs of bank trips are high.

(4.) Asset demand - money is a riskless asset and is extremely liquid. Thus, money is somewhat useful as a store of value.

Despite all of these good reasons to hold money, it's still true that money earns a lower rate of return than bonds and other interest-bearing assets, so people will try to economize on their holdings of money somewhat, by keeping only small amounts of money as cash or in their checking accounts, while keeping the rest of their unspent income in bonds or other assets that earn competitive rates of interest. In particular, the higher the interest rate, the less money people will want to hold; the demand curve for money slopes downward.
[-- The money-demand curve I drew in class is much like Figure 12.4, on p. 255, in Case & Fair's book.]

The intersection of the money demand and (vertical) money supply curves is the equilibrium in the money market and determines the equilibrium interest rate. (The equilibrium quantity of money, by the way, is always equal to the supply of money -- since the money supply curve is vertical, the equilibrium quantity of money will not be affected by shifts in the demand curve for money.)
[-- Again, refer to Figure 12.6, on p. 261 of Case & Fair's book.]

II. HOW MONEY AFFECTS THE ECONOMY (THE MONETARY TRANSMISSION MECHANISM)

Monetary policy affects the economy because changes in the money supply affect interest rates, and interest rates affect GDP by affecting consumption (C), planned investment (Ip or I), and net exports (EX-IM).
-- The unemployment rate (which rises when real GDP falls), the price level (P, which tends to rise when GDP rises), and the inflation rate (which tends to rise when unemployment falls, as in the Phillips Curve) will also be affected.

Monetary policy can be:
(1) expansionary - when the Fed increases the money supply and lowers interest rates in order to raise real GDP and reduce unemployment;
[-- The diagram I drew in class is similar to Figure 12.7 (p. 262) of Case & Fair's book.]
(2) contractionary - when the Fed contracts the money supply and raises interest rates in order to reduce inflation;
[-- Unfortunately the diagram I drew in class, showing the money supply curve moving leftward and the equilibrium interest rate increasing, has no counterpart in Case & Fair's book.]
(3) neutral - just trying to keep the economy on an even keel, with interest rates and the unemployment rate remaining close to the NAIRU.

The step-by-step process by which changes in monetary policy affect real GDP and the price level is as follows, considering first the case of an expansionary monetary policy:

(1) The Fed increases the level of bank reserves, using one of its three tools of monetary policy.
-> (2) Banks loan out their excess reserves to firms (planned investment increases) and households (consumption increases, especially durable goods consumption).
---> (3) As loans are redeposited back into bank accounts (usually after the loan money is spent - i.e., money loaned for the purchase of a new car is deposited by the car dealer into his bank account), the money supply increases, since the money supply is cash plus bank accounts. The bank will loan out most of the new deposits, and those loan monies will be redeposited somewhere else, and the cycle of reserves->loans->deposits->reserves will continue. Eventually the money supply will increase by a multiple of the original increase in reserves.
-----> (4) The increase in the money supply (Ms) causes the equilibrium interest rate to fall
(increased Ms --> i decreases)
-------> (5) With lower borrowing costs, and a lower opportunity cost of spending one's money, planned I and durable-goods consumption both increase (decreased i --> Ip, Cdurables both increase)
---------> (6) Real GDP (Y) increases, , since C and I are two key components of GDP, and the price level (P) increases, too, since increases in real GDP tend to be associated with increases in P (similar to the Phillips Curve relationship between unemployment and inflation).

In sum:

• Monetary policy affects output by changing the levels of (planned) investment and consumption.
• Expansionary monetary policy raises real GDP by reducing interest rates, which increases interest-sensitive spending:
increased reserves -> Ms increases --> i decreases --> I, C increase --> Y, P increase
• Contractionary monetary policy reduces inflation by raising interest rates, which decreases interest-sensitive spending:
decreased reserves -> Ms decreases --> i increases --> I, C decrease --> Y, inflation decrease

***

FRI., MARCH 31, 2000: SECOND MIDTERM EXAM