CH-13-15 Fiscal Policy – Macroeconomics : Book Guide

This Document Contains Chapters 13 to 15 CHAPTER 13 FISCAL POLICY Chapter Overview We started this chapter by looking at why the government might want to change fiscal policy to counteract economic fluctuations. When the economy is in a recession, expansionary fiscal policy—cutting taxes, increasing spending, or both, as with the 2009 stimulus plan—can increase aggregate demand and speed up recovery. Unemployment remained high even in the first years after the stimulus, but ultimately there is no way of knowing for certain whether it would have been even higher without it. We also looked at how the government can borrow and how deficits lead to public debt. Debt adds to government flexibility, but it can be costly and slow down economic growth. It also raises questions about the fairness of expecting future generations to bear the burden of paying off the debt. Governments have an alternative to fiscal policy when they want to influence the economy: monetary policy. Monetary policy works through the financial system, so before we get into monetary policy, we will cover the basics of finance in the next chapter. Learning Objectives LO 13.1 Explain the difference between contractionary fiscal policy and expansionary fiscal policy. LO 13.2 Explain how fiscal policy can counteract short-run economic fluctuations. LO 13.3 Identify the time lags that complicate the formulation of fiscal policy. LO 13.4 Discuss how stabilizers can automatically adjust fiscal policy as the economy changes. LO 13.5 Describe the theory and evidence about Ricardian equivalence and what it implies for the effectiveness of fiscal policy. LO 13.6 Describe how revenue and spending determine a government budget and how the U.S. budget deficit occurs. LO 13.7 Explain the difference between the government deficit and debt. LO 13.8 Understand how Treasury securities work and why people value them. LO 13.9 Identify the benefits and costs of government debt. Chapter Outline FROM HOUSING BUBBLE TO GREAT RECESSION Fiscal Policy Expansionary or Contractionary (LO 13.1) Policy Response to Short-Run Economic Fluctuations (LO 13.2) Real-World Challenges (LO 13.3) BOX FEATURE: REAL LIFE – A TIMELINE OF THE 2009 STIMULUS PLAN Policy Tools—Discretionary and Automatic (LO 13.4) Limits of Fiscal Policy: The Money Must Come From Somewhere (LO 13.5) BOX FEATURE: REAL LIFE – SPENDING YOUR STIMULUS CHECK The Government Budget Revenue and Spending (LO 13.6) The U.S. Budget Deficit BOX FEATURE: REAL LIFE – AND THE PROJECTION IS … The Public Debt Size of the Debt (LO 13.7) How Does the Government Go Into Debt? (LO 13.8) Is Government Debt Good or Bad? (LO 13.9) Beyond the Lecture Class Discussion: Expansionary or Contractionary (LO 13.1) Show students this brief clip from the TV show The Colbert Report, which highlights expansionary fiscal policy. Colbert is having a conversation with the mayor of a relatively small town in Pennsylvania regarding the fiscal stimulus package from 2009. Discuss the following: 1. What is the goal of expansionary fiscal policy? 2. How does the government decide on implementing fiscal policy? 3. How does expansionary fiscal policy differ from contractionary fiscal policy? Writing Assignment/Class Discussion: Time Lags (LO 13.3) Consider having students view this brief article from The Economist on the effectiveness of fiscal stimulus. The article presents some of the challenges to fiscal policy, including the idea that you can never run controlled experiments to assess the impact of fiscal policy (as nearly all situations are somewhat unique). 1. Ask students to consider the challenges to employing fiscal policy to combat recessions and poor economic conditions. Class Discussion: Size of the Debt (LO 13.6) Have students consider the impact of government debt using numbers from the White House and online debt clocks. Students generally enjoy this discussion, but often do not understand the meaning of government debt. Discuss the following: 1. What is the difference between government deficit and government debt? 2. What are the potential problems associated with government debt? 3. What benefits does the U.S. receive as the result of government debt? What does government debt pay for? Class Discussion and Media: Fiscal Stimulus as a Response to Financial Crisis (LO 13.1, 13.2, 13.5, 13.6, 13.7) Have students view the popular “Keynes vs. Hayek Round 2” video. You may want to provide a little bit of background on the philosophy of Keynes and Hayek first. 1. What would Keynes generally prescribe to fix a recession? 2. What would Hayek suggest? 3. Are there costs if a government continually tries to steer the economy? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. Fiscal policy considers government decisions about_________ [LO 13.1] A. Government spending and taxes B. Interest rates and money supply C. Taxes and inflation D. Transfer payments and interest rates 2. Which of the following is contractionary fiscal policy? [LO 13.1] A. An increase in interest rates B. A decrease in interest rates C. An increase in taxes D. An increase in government expenditures Feedback: Higher taxes will shift the AD left. Note that interest rates are NOT fiscal policy related. 3. Why would a government want to enact contractionary fiscal policy? [LO 13.2] A. To make life harder for citizens and make them appreciate government more B. To slow down inflation from an economy that is growing too fast C. To increase price levels D. To increase the LRAS Feedback: Too rapid of growth may create “bubbles”, or highly inflated prices. We may want to rein in the inflation before it gets out of hand. The economy can get overheated. 4. Which of the following is an automatic stabilizer? [LO 13.3] A. Progressive tax rates B. The minimum wage C. Social security D. The business cycle Feedback: As people earn more, they are taxed at a higher percentage. This can slow down rapid income growth and therefore spending. 5. If the MPC = 0.8, find the taxation multiplier. [LO 13.4] A. -2 B. -3 C. -4 D. -5 Feedback: Taxation multiplier = (-MPC)/(1-MPC). In this case, (-.8)/(.2) = -4 Solutions to End-of-Chapter Questions and Problems Review Questions 1. What is the best fiscal policy for a country suffering from high inflation? [LO 13.1] Answer: Contractionary fiscal policy, which decreases aggregate demand, is the appropriate response. To do this, the government can increase taxes (reducing disposable income, affecting GDP indirectly) or decrease spending (with a direct effect on GDP). 2. If the government wants to reduce GDP by $500 million, should it increase or decrease its spending? Must it increase or decrease spending by exactly $500 million, some amount more than $500 million, or some amount less than $500 million? Would this be expansionary or contractionary fiscal policy? [LO 13.1] Answer: To reduce GDP by $500 million, the government should enact contractionary fiscal policy, which it can do by increasing taxes or—in this case—reducing government spending. Due to the multiplier effect, it does not need to reduce its spending by the full $500 million, but rather by a smaller amount. The specific amount will be determined by the marginal propensity to consume (MPC)—the higher the MPC, the smaller the required decrease in government spending. 3. President Obama said the following in November 2010 when announcing a two-year pay freeze for civilian federal employees: “After all, small businesses and families are tightening their belts. Their government should too.” What do you think the intended effect of this policy would be, assuming the economy was in a recession at the time? Do you think it was the appropriate response? Why or why not? [LO 13.2] Answer: Paying less to federal employees reduces government spending. The intended effect was likely to reduce the government deficit and the likelihood of crowding out (higher interest rates caused by government borrowing, discouraging other types of spending). However, a decrease in government spending is contractionary fiscal policy. Reducing government spending will have a negative effect on GDP and income, which is the opposite of the usual remedy for recessionary conditions. Whether you think this is an appropriate response will depend on your opinion about the relative priorities that should be placed on keeping the public debt low versus avoiding especially painful recessions. 4. If unemployment is high and spending is sluggish, what type of fiscal policy should be enacted? How would this be enacted via taxes? Via government spending? What is the intended effect of this policy on aggregate demand? [LO 13.2] Answer: In response to these recessionary conditions, the government would want to enact expansionary fiscal policy through increasing government spending or decreasing taxes. An increase in government spending would increase the “G” component of aggregate demand directly, whereas a decrease in taxes would affect “C” indirectly by changing disposable income. Successful expansionary fiscal policy would shift the AD curve to the right. 5. “The problem with democracy,” your friend tells you as you debate politics, “is the time it takes to get approval for every action the government takes. If the president didn’t have to spend so much time arguing back and forth with Congress, policy wouldn’t take so long to affect the economy.” Is your friend right or wrong? What would your response be? [LO 13.3] Answer: Assuming a benevolent leader who made choices that were good for the economy, the situation your friend describes would shorten or even eliminate one type of lag in policy implementation: formulation lag. However, two types of lag would still exist. Information lag comes about because it takes time to perceive and correctly identify problems in the economy; implementation lag comes about because once policies are passed, they take time to affect economic variables. Because of these lags, delays would not be eliminated— not to mention the controversies that would swirl around having an all-powerful president! 6. Explain the difference between tax rates and tax revenues, and how each is related to recession and policy enacted to counteract it. Do you expect to see tax rates rise or fall during recession? What about tax revenues? Explain your answer. [LO 13.4] Answer: Tax rates refer to the percentage of income that is taxed. It is the tax rate that is adjusted as part of fiscal policy, and in a recession (or when the government feels that a recession is a pressing threat) it is likely that those rates will be lowered. By doing so, consumers will have more disposable income, and some portion of that will be spent on goods and services, supplying income for their providers and stimulating further spending according to the multiplier effect. Tax revenues, on the other hand, refer to the dollars collected by government in taxes. Tax revenues are an automatic stabilizer; unlike tax rates, they do not require active government policy to change. In a recession, as overall income falls, so do the dollars paid in taxes by households. This increases the money left for spending, acting as a stimulus to the economy that needs no specific government action. This also means that tax revenues are not as susceptible to the information, formulation, and implementation lags that slow down discretionary policy. 7. The government decides to reduce income taxes due to a recession in the economy over the past nine months. Will the reduction in income taxes boost spending in the economy? Why or why not? [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. However, the theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit (unless it had been running a surplus). This means that in the future, the government will have to increase taxes to pay off the debt. The evidence on whether Ricardian equivalence holds is mixed—often people spend a portion of any tax cut or rebate, in which case the reduction in taxes will boost spending in the economy. 8. Use the theory of Ricardian equivalence to explain why cutting taxes during a recession may not always be an effective expansionary fiscal policy. [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. The theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit (unless it had been running a surplus). This means that in the future, the government will have to increase taxes to pay off the debt. The evidence on whether Ricardian equivalence holds is mixed—often people spend a portion of any tax cut or rebate. Cutting taxes is only an effective strategy if people decide to increase spending in response to the tax cut. 9. Why have budget deficits been so high in the United States since 2007? [LO 13.6] Answer: There are several reasons for this, but the most important is recession: In a recession, the government pays more in transfer payments; government spending may increase or taxes may decrease because of expansionary fiscal policy; and since fewer people are employed during recession, overall incomes fall, bringing down tax revenues. All of these add up to perfect conditions for high budget deficits! 10. You hear on the nightly news that the president has vowed to decrease the nation’s debt. “We’ll have to buckle down and learn to do without, both the government and private citizens,” he says. How can a nation lower its debt? How will the government and private citizens be affected? [LO 13.6] Answer: In order to reduce its debt, a nation must run lower deficits (or turn them into surpluses). This can happen by increasing taxes (bringing in more tax revenue for the government) or decreasing government spending. But there will be costs involved—less government spending means fewer public works and lower transfer payments, and more taxes means less money available for households to spend. 11. A friend of yours looks at the state of the U.S. debt in 2011 and tells you, “Since the debt is so high, we must be running an incredibly large deficit every year.” Is your friend’s analysis valid? Why or why not? [LO 13.7] Answer: The public debt is the sum of all deficits and surpluses run by the government over time. The debt can be high even when the deficit for an individual year is small (or even when the government runs a surplus for this year). Therefore, a high amount of debt does not necessarily imply a deficit in a given year. 12. Is it possible for a nation’s government to run a budget deficit in some years but not have national debt? Explain your answer. [LO 13.7] Answer: The correct answer lies in the distinction between a budget deficit (the excess of government spending over taxes in some year) versus national debt (the total of all budget deficits and surpluses). It is indeed possible for a nation to run a budget deficit in some year without national debt—for example, if the economy started with a surplus at the beginning of the year and the year’s deficit is less than or equal to the national surplus. 13. Explain the differences and similarities among Treasury bills, Treasury notes, and Treasury bonds. [LO 13.8] Answer: Treasury bills mature in less than a year. Treasury notes mature in anywhere from 2 to 10 years. Treasury bonds mature in 30 years. All three offer a known rate of return because they specify the amount for which the security can be sold back to the government upon maturity. Given the rate of return is known, they are all less risky than stocks or mutual funds, whose value changes depending on market activity. None of the securities guarantees a rate of return that exceeds inflation. There is a Treasury inflation-protected security that guarantees a rate of return higher than the rate of inflation. 14. Your friend thinks buying Treasury bills is riskier than leaving money in a savings account. You disagree. Who is right? [LO 13.8] Answer: You are correct—Treasury bills offer the same level of risk as a savings account. When you place money into a savings account, you are paid some rate of interest that is in the vast majority of cases a positive rate. Therefore, your money will increase in value over time. When you buy a Treasury bill, you are guaranteed a fixed payment on a particular date (the maturity date). Given you paid an amount that was less than the fixed payment, you will increase the value of your money over time. In both cases, you end up with a sum of money that is larger than what you started with 15. Taxpayers are clamoring for their government to be more responsible, and many strongly support a balanced-budget amendment. This would mean the country could no longer spend more than it takes in each year. Discuss the primary advantages and disadvantages of such a law. [LO 13.9] Answer: There are advantages and disadvantages to this type of law, making the decision whether to pass it not nearly as clear-cut as it may originally seem. A balanced-budget amendment will force the government to cut back on its spending, reducing the direct (interest) and indirect (pushing the burden of the debt onto future generations) costs of borrowing to fund public spending increases. However, it will also limit the flexibility of the government in engaging in expansionary fiscal policy. When recession exists or threatens, an increase in government spending can stimulate the overall economy through the multiplier effect. Money spent by the government puts income into the pockets of those it buys from, and some of this money will be spent, resulting in additional increases in GDP. Without the ability to borrow as it likes, the government will be less able to respond to recessionary conditions, and as a result recessions may be more painful and protracted. 16. Is government debt good or bad for the economy and the nation as a whole? Give one argument for each side of the debate. [LO 13.9] Answer: Government debt is good for the economy and nation in that it gives the government the flexibility to respond to economic conditions by changing its spending— specifically, by being able to increase its spending as part of expansionary fiscal policy in response to recessionary conditions. Without the ability to incur debt, the government would be limited to what it collects in taxes, and therefore it might not be able to increase spending as necessary to push GDP back up to its potential level. However, government debt can have negative effects as well. Crowding out can occur when government spending financed by debt increases interest rates, pushing up the cost of borrowing and discouraging spending by businesses and households. Also, debt must be repaid, which implies direct costs (in the form of interest) and indirect costs (pushing the burden of the debt onto future generations, who may suffer in several ways, including increased taxes). Problems and Applications 1. Is each of the following policies an example of expansionary or contractionary fiscal policy? Explain your answers in terms of the effect on aggregate demand. [LO 13.1] a. The government slashes funding for the Environmental Protection Agency, without changing any other spending. b. The government raises taxes on households making more than $250,000. c. The government decides to fill gaps in Medicare by making it available to more people. Answer: a. This is contractionary fiscal policy because it involves a reduction in government spending, directly lowering aggregate demand. b. This is contractionary fiscal policy because it increases taxes, indirectly lowering aggregate demand via consumption. c. This is expansionary fiscal policy because it increases government spending, which increases aggregate demand directly. 2. The economy is growing far too quickly, as high aggregate demand is causing inflation. What fiscal policy should be pursued in this instance—expansionary or contractionary? What will be the effect of the appropriate policy on aggregate demand? [LO 13.1] Answer: Contractionary fiscal policy is appropriate in this instance. This policy will slow down spending, reducing aggregate demand and shifting the aggregate demand curve to the left. 3. Assuming that unemployment is high and spending is low, answer the following questions. [LO 13.2] a. Should the government pursue expansionary or contractionary fiscal policy? b. What will the appropriate policy do to the aggregate demand curve? Will the curve shift to the right or to the left? c. Through which component(s) of aggregate demand (C, I, G, or NX, or some combination of the preceding) will the change occur? Answer: a. Expansionary fiscal policy (increasing government spending or decreasing taxes) is the appropriate response to these recessionary conditions. b. Expansionary policy will shift the AD curve rightward. c. If government spending is increased, AD will increase directly through its G (government spending) component. If taxes are lowered, AD will increase indirectly through its C (consumption) component—lower taxes will increase disposable (spendable) income, allowing households to spend more. 4. The diagram in Figure 13P-1 shows aggregate demand for New Caprica last year (AD1) and this year (AD2). If you were to advise the president of New Caprica on economic policy, how would you answer the following? [LO 13.2] a. How large is current output? How large is potential output? What is the difference, if any, between the two? b. Is New Caprica in a recession or a boom? c. Given your findings, should the president enact expansionary or contractionary fiscal policy, or no policy at all? d. Which direction would the aggregate demand curve shift if the president used contractionary fiscal policy? Answer: a. Current output is $60 million, found at the intersection of the current aggregate demand curve AD2 and the short-run aggregate supply curve SRAS. Potential output, found where the long-run aggregate supply curve LRAS intersects the aggregate demand curve (note that it doesn’t matter which—any AD curve will intersect the LRAS at potential output), is $80 million. This leaves us with a shortfall of output of $80 million – $60 million = $20 million. b. Since current output is less than potential output, New Caprica is experiencing a recession. c. To correct the recession, the president should enact expansionary fiscal policy. d. Contractionary fiscal policy would reduce spending, shifting the AD curve leftward. This would further increase the shortfall between actual and potential GDP in New Caprica, making the current situation worse rather than better. 5. “Our fiscal policy was unsuccessful,” an economic analyst says, “due to partisan bickering in Congress that delayed the passing of the appropriate measures and our failure to realize we were headed into recession until it was too late.” What type of lags is the analyst describing? [LO 13.3] Answer: The analyst is describing an information lag (related to recognizing the current economic situation, in this case, realizing when we are in recession) and a formulation lag (related to deciding on and passing policy through Congress). 6. Assume that the government in some nation intended to respond to low employment via fiscal policy. What type of policy would this require? Assume that this policy ended up having an undesirable outcome. How could this happen in terms of formulation and implementation lags? [LO 13.3] Answer: By the time legislation is decided on and passed (formulation lag) and affects the economy (implementation lag), economic conditions may have changed. The government was trying to respond to recessionary conditions with expansionary policy, which would increase prices and employment in the short run. Apparently, these lags took up enough time that economic conditions changed in the meantime, meaning that inflation became the major threat. Expansionary policy would make that inflation worse by stimulating spending when it should have been lowered, causing prices to rise even higher. 7. Brenda earns $62,000 a year and pays an average tax rate of 15 percent. [LO 13.4] a. Calculate Brenda's disposable income and the amount of tax she pays to the government. b. Suppose a recession hits the economy and Brenda's income falls to $50,000 per year due to the fact that she is earning a smaller annual bonus. If she now pays an average tax rate of 12 percent, what is her disposable income and the amount of tax she pays to the government? c. Calculate how much Brenda's annual salary and disposable income fell by due to the recession. d. Explain how income taxes are an automatic stabilizer in this example. Answer: a. If Brenda pays an average tax rate of 15%, then she takes home 85% of her salary. Her disposable income is 0.85 × $62,000, or $52,700. She pays 0.15 × $62,000, or $9,300, to the government in taxes. b. If Brenda pays an average tax rate of 12%, then she takes home 88% of her salary. Her disposable income is 0.88 × $50,000, or $44,000. She pays 0.12 × $50,000, or $6,000, to the government in taxes. c. Brenda's annual salary fell by $62,000 - $50,000, or $12,000, and her disposable income fell by $52,700 - $44,000, or $8,700. d. Income taxes are an automatic stabilizer because when Brenda's annual salary fell, her tax rate also fell. This caused her disposable income to fall by a smaller amount than her annual salary. 8. True or false? If the amount of time a person is eligible for unemployment compensation is reduced from 26 weeks to 4 weeks, people will have an incentive to quickly find a new job. This occurs because unemployment compensation is an important automatic stabilizer for the economy. [LO 13.4] Answer: True. If a person is only eligible for unemployment compensation for 4 weeks, then he or she will need to quickly find a new job. If people receive unemployment compensation when they lose their jobs, then their spending does not fall by as much as it would if they received no compensation. 9. Consider three countries. The first country runs small budget surpluses each year. The other two countries run large budget deficits each year. In one of the deficit countries the national debt-to-GDP ratio has been steady, whereas in the other deficit country the national debt-toGDP ratio has been rising. Suppose each of these countries decides to reduce income taxes. Is Ricardian equivalence likely to hold in all of these countries? Why or why not? [LO 13.5] Answer: A reduction in income taxes will increase disposable income. If people decide to spend a portion of the increase in disposable income, then aggregate demand will increase and GDP will increase. The theory of Ricardian equivalence suggests that in some cases, people will choose not to spend any of the increase in disposable income and will instead save the extra income. They will choose to do this because they are forward looking and know that if the government reduces taxes and does not cut spending at the same time, then the government will have to borrow money to pay for the deficit, unless it had been running a surplus. Ricardian equivalence is less likely to hold in the surplus country—since the country had a surplus, the tax cut is potentially sustainable. People are likely to spend the extra income. Ricardian equivalence is more likely to hold in the country where the debt-to-GDP ratio has been rising. Not only has this country been running deficits, but the debt amount has been rising relative to GDP, indicating that the tax cut will be unsustainable in the future. The government is more likely to have to increase taxes to pay off, or reduce, the debt in the near future. People are more likely to save the extra income to prepare for higher taxes in the future. 10. A country is in the midst of a recession with real GDP estimated to be $1.8 billion below potential GDP. The government’s policy analysts believe the current value of the marginal propensity to consume (MPC) is 0.90. [LO 13.5] a. If the government wants real GDP to equal potential GDP, by how much should it increase government spending? Alternatively, by how much should it reduce taxes? b. Suppose that during the recession people have become less confident and decide they will spend only 50 percent of any additional income. In this case, if the government increases spending by the amount calculated in part a, will real GDP end up less than, greater than, or equal to potential GDP? By how much? c. With the same decrease in consumer spending described in part b, if the government decreases taxes by the amount calculated in part a, will real GDP end up less than, greater than, or equal to potential GDP? By how much? d. Why is it difficult for the government to predict exactly how a change in spending or taxes will affect GDP? Answer: a. The government wants to increase GDP by $1.8 billion. Given the MPC is equal to 0.90, the expenditure multiplier is equal to 1/(1 - 0.9), or 10. This means that for every one-dollar increase in government spending, GDP will increase by $10. Therefore, the necessary change in government spending is $1.8 billion/10, or $0.18 billion. A decrease in taxes will increase GDP indirectly by increasing disposable income and, therefore, consumption. The impact of a one-dollar decrease in taxes is equal to 0.90/(1 - 0.90), or 9. This means that for every one-dollar decrease in taxes, GDP will increase by $9. Therefore, the necessary change in taxes is $1.8 billion/9, or $0.20 billion. b. If the MPC is 0.50, then the impact of a one-dollar change in government spending is 1/(1 - 0.50), or 2. If the government increases spending by $0.18 billion, then GDP will increase by $0.36 billion. Therefore, GDP will still be less than potential by $1.8 billion - $0.36 billion, or $1.44 billion. c. If the MPC is 0.50, then the impact of a one-dollar decrease in taxes is 0.50/(1 - 0.50), or 1. If the government decreases taxes by $0.20 billion, then GDP will increase by $0.20 billion. Therefore, GDP will still be less than potential by $1.8 billion - $0.20 billion, or $1.60 billion. d. The value of the MPC depends on the behavior of consumers, and this is difficult to predict. The smaller the value of the MPC, the smaller the impact of a change in government spending or taxes on GDP. In this case, the government overestimated the value of the MPC, so GDP ended up less than potential GDP. 11. If in some year a nation’s budget deficit is $9.56 trillion and government spending is $12.19 trillion, how much must it have earned in tax revenue this year? [LO 13.6] Answer: A nation’s budget deficit is calculated by subtracting government spending from tax revenues. Remember that a deficit implies that the result of this calculation will be a negative number, so we can set up our calculation as follows: -$9.56 trillion = Tax revenues - $12.19 trillion We find that tax revenues must have been $2.63 trillion. 12. “The government shouldn’t borrow so much,” your uncle claims. “Look at that national debt! It’s no different from someone borrowing on credit cards they can’t pay.”? [LO 13.6] a. Is your uncle right? b. How is government debt spending like someone borrowing on a credit card? c. How is government debt spending different from someone borrowing on a credit card? Answer: In some ways, your uncle is right. After all, the government is spending more than it brings in when it runs a deficit, and it must borrow to fund the rest, like when someone finances purchases with credit card debt. However, there are two major differences. First, the government has an almost unlimited capacity to borrow by issuing Treasury bonds, which are desirable due to their relatively low risk and decent return. That is certainly a much greater capacity to borrow than any individual has! Second, not all government borrowing is done from other nations. Some of it is intragovernmental borrowing, when the government temporarily uses money from one of its own accounts to pay for another type of spending. This type of borrowing is more similar to someone temporarily using funds from her savings account to buy groceries rather than purchases on a credit card; it’s not an external lender that must be repaid, but the government’s other account. 13. Econo Nation started 2013 with no national budget debt or surplus. By the end of 2013, it had a budget surplus of $304 million; in 2014, it had a budget deficit of $452 million; in 2015 it had a budget surplus of $109 million, and the amount of its budget deficit or surplus in 2016 is unknown. If at the end of 2016 Econo Nation's national debt totaled $50 million, did it run a deficit or surplus in 2016? How much? [LO 13.7] Answer: National debt is the total of all deficits and surpluses over time. If the result is negative, the nation has debt; if it is positive, the nation is running an overall surplus. Therefore, in our calculations, we must take care to make deficit and debt figures negative and surplus figures positive. We can set up our equation in the format National debt = (Sum of surpluses and deficits), using X as the amount of deficit or surplus for 2016: –$50 million = $304 million surplus – $452 million deficit + $109 million surplus + X (Note that we have subtracted the $452 million deficit because that’s the same as adding – $452 million.) Now we just solve for X, being careful about positive and negative values: –$50 million = –$39 million + X X therefore equals –$11 million. Since the figure is negative, it’s a budget deficit, so we can say that in 2016, Econo Nation ran a deficit of $11 million. 14. “Though the national debt has increased, don’t worry,” the president says in a televised speech. “We will not have to pay these funds back to bond buyers.” How is this possible? How must the government have financed its debt in this case? [LO 13.7] Answer: If the government has funded its spending via borrowing, but not from issuing bonds, it must have engaged in intragovernmental debt, in which the government borrows money from one of its own funds. The funds will have to be repaid, but this will be the government paying itself back (putting the borrowed money back into the fund from which it came), as opposed to paying bond buyers. 15. You buy a Treasury note for $1,000. Every 6 months you receive a payment of $40. [LO 13.8] a. What is the annual rate of return? b. What would be the annual rate of return if the payment was instead $30? c. What would be the annual rate of return if the payment was instead $45? Answer: a. If you receive $40 every six months, then you receive $80 for the whole year. The annual rate of return is $80/$1,000 = 0.08, or 8%. b. If you receive $30 every six months, then you receive $60 for the whole year. The annual rate of return is $60/$1,000 = 0.06, or 6%. c. If you receive $45 every six months, then you receive $90 for the whole year. The annual rate of return is $90/$1,000 = 0.09, or 9%. 16. Your friend believes buying Treasury bills or Treasury notes will offer protection against rising inflation in comparison to buying stocks or mutual funds, because the rate of return on the Treasury bills and notes is known at the time of purchase. Do you agree? Why or why not? [LO 13.8] Answer: There is no protection against rising inflation unless you buy a bond where the rate of return is guaranteed as a specific percentage plus the rate of inflation. In this case, the rate of return varies with the inflation rate. Although the rate of return on the Treasury bill or note is known at the time or purchase, it can still end up higher or lower than the rate of inflation. This is true for stocks and mutual funds also. 17. Which of the following are examples of the negative effects associated with government debt? [LO 13.9] a. Increased interest rates. b. Increased taxes or lower spending in the future. c. Increased investment in the economy. Answer: Increased interest rates and increased taxes or lower spending in the future are possible negative effects associated with government debt. Interest rates may increase if crowding-out occurs, in which government spending financed by debt pushes up interest rates by competing with other types of spending for a fixed amount of loanable funds. Government debt must also be repaid, which will entail increasing taxes or lowering spending in the future, reducing the government’s ability to respond to recessionary threats with expansionary fiscal policy. Increased investment in the economy is not a correct answer because increases in investment are generally good, not bad, for the economy, especially when recession is the most pressing threat. Additionally, if crowding-out occurs we expect to see decreases in investment as opposed to increases. 18. If the government could borrow as much as it liked with a 0 percent interest rate, would the government debt be cost-free? Explain your answer. [LO 13.9] Answer: If the interest rate were 0 percent, there would be no direct costs of debt. However, there would still be indirect costs. These would include higher interest rates (even at a 0 percent interest rate, when the government borrows, this reduces public savings and lowers the supply of loanable funds, increasing the real interest rate). These higher interest rates can discourage investment and the types of consumption that require borrowing, so that slower economic growth is another indirect cost of this debt. CHAPTER 14 THE BASICS OF FINANCE Chapter Overview In this chapter we’ve explored the basic framework of financial markets and the financial system: how buyers find sellers, how interest rates set the price of borrowing and the return on lending, and how the various players interact. We’ve also learned about a few of the major financial-asset classes and explored some of the ways that investors attempt to evaluate the risk and return potential of their investments. You’ve seen that financial markets mostly operate like other markets. However, financial markets can sometimes behave in mysterious and opaque ways. We’ll see more examples in Chapter 34, “Financial Crisis.” Now that we’ve covered the basics of how financial markets and the financial system work, it’s time to look at the bigger picture: how the financial system fits into the overall economy. In the next chapter, we’ll look at the origins of money and how the modern financial system is responsible for both creating and destroying money. We’ll also learn about the people who oversee much of the financial system, including influencing the money supply, and how their actions affect economic growth in ways both enormous and subtle. Learning Objectives LO 14.1 Define a financial market and describe the information asymmetry problems that can occur in them. LO 14.2 Discuss the three main functions of financial markets. LO 14.3 Describe the market for loanable funds, including the price of loanable funds, and differentiate between savings and investment. LO 14.4. List the factors that affect the supply and demand of loanable funds. LO 14.5 Understand how interest rates on loans vary with the length of the loan and the riskiness of the transaction. LO 14.6 Describe why it is important for the financial system to intermediate between buyers and sellers, provide liquidity, and diversify risk. LO 14.7 Differentiate between debt and equity and define the major types of assets in each category. LO 14.8 Name the main institutions in financial markets and describe the role that each plays. LO 14.9 Explain the trade-off between risk and return in financial assets and describe how risk can be measured. LO 14.10 Give arguments for and against the assumption that markets are efficient. LO 14.11 Describe why savings equals investment in a closed economy and how government spending and foreign capital flows affect the saving-investment relationship. Chapter Outline HENRY LEHMAN AND HIS BROTHERS The Role of Financial Markets What Is a Financial Market? (LO 14.1) Information Asymmetries and Financial Markets Functions of Banks and Financial Markets (LO 14.2) The Market for Loanable Funds: A Simplified Financial Market Savings, Investment, and the Price of Loanable Funds (LO 14.3) Changes in the Supply and Demand for Loanable Funds (LO 14.4) A Price for Every Borrower: A More Realistic Look at Interest Rates (LO 14.5) The Modern Financial System Functions of the Financial System (LO 14.6) Major Financial Assets (LO 14.7) Major Players in the Financial System (LO 14.8) BOX FEATURE: REAL LIFE – THE INCREDIBLE INDEX FUND BOX FEATURE: WHAT DO YOU THINK? – ARE SPECULATORS A GOOD INFLUENCE ON MARKETS? Valuing Assets The Trade-off between Risk and Return (LO 14.9) Predicting Returns: The Efficient-Market Hypothesis (LO 14.10) BOX FEATURE: REAL LIFE – BEHAVIORAL FINANCE AND THE EFFICIENT-MARKET HYPOTHESIS Bubbles A National Accounts Approach to Finance (LO 14.11) The Savings-Investment Identity Private Savings, Public Savings, and Capital Flows BOX FEATURE: FROM ANOTHER ANGLE – SAVINGS GLUT? Beyond the Lecture Class Media: The Role of Financial Markets (LO 14.1) Consider showing this brief clip from the TV show Seinfeld. In the episode, Kramer decides to save his own blood to avoid fees from the blood bank. (You can also watch the entire episode, for a small fee, here.) This clip/episode can be used to start a discussion about borrowers, savers, and financial markets. Reading Assignment/Class Discussion: Major Financial Assets (LO 14.3) Ask students to read this article about Apple’s decision to offer bonds in 2013. Discuss the following: 1. What is the difference between debt and equity? 2. Why might Apple have chosen to offer debt? Class Discussion: The Trade-off between Risk and Return (LO 14.5) Have students watch Trillion Dollar Bet, a documentary that explores the Black-Scholes-Merton options pricing model and the rise and subsequent fall of Long-Term Capital Management. (The entire documentary is 48 minutes, so you may choose to assign this outside of class or schedule one day around solely this topic.) Discuss the following: 1. What is the tradeoff between risk and return? 2. How did Long-Term Capital Management try to eliminate risk but earn returns? 3. What happened to Long-Term Capital Managements? Are there any similarities between this situation and the recent financial crisis? Class Discussion: Predicting Returns: The Efficient-Market Hypothesis (LO 14.6) Examine the performance of the S&P 500 over time with your students; data can be found here. (You may need to first provide a brief explanation of what the S&P 500 is.) Discuss the following: 1. What arguments can be made to support the efficient-market hypothesis? 2. What are the arguments against the efficiency of markets? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. In the loanable funds market, who are the suppliers of loanable funds? [LO 14.1, 14.2] A. Borrowers B. Savers C. Banks D. The stock markets Feedback: Savers supply the funds, borrowers demand them. Banks act as a clearinghouse. 2. The interest rate can be thought of as _______. [LO 14.2] A. The reward for borrowing money B. The profit banks earn C. The price of money D. The growth rate in the supply of available funds Feedback: More specifically, the price to borrow money is the interest rate. You borrow money today, but you’ll to pay it back later, with interest. The interest is the price you pay me in order to borrow my money. 3. Which of the following assets is most liquid? [LO 14.3] A. An apartment property with 10 units B. A 10-year old car C. A 10-year savings bond D. A $10 bill Feedback: Liquidity refers to how easily an asset can be converted to cash. The $10 is already cash! 4. What role do commercial banks play in the financial system? [LO 14.4] A. They act as intermediaries between borrowers and savers B. They print money for borrowers C. They determine interest rates D. They introduce risk (and therefore returns) in investing 5. Public savings is equal to________. [LO 14.7] A. Y – C – T B. T – G C. Y – C – G D. C + I + G Feedback: Government revenue is taxes (T) and government spending is (G). Solutions to End-of-Chapter Questions and Problems Review Questions 1. In financial markets, who are the sellers? Who are the buyers? [LO 14.1] Answer: The sellers in financial markets are people or organizations that have accumulated savings and are willing to let others use it. In return, the sellers have an opportunity to earn interest. Sellers are individuals, businesses, and government entities that are willing to forgo spending right now and choose, instead, to save money in return for repayment in the future. The buyers in financial markets are people or organizations that have a need to spend on something now but don’t have sufficient funds. Examples of buyers are college students needing funds for college; families buying new houses or cars or paying college tuition; businesses building new facilities, starting new ventures, or expanding facilities; and the government when it needs to finance public spending. 2. Identify the two types of information asymmetry defined in the chapter. What is the difference between them? [LO 14.1] Answer: Adverse selection refers to a state that occurs when buyers and sellers have different information about the quality of a good or the riskiness of a situation, and this asymmetric information results in failure to complete transactions that would have been possible if both sides had the same information. Moral hazard refers to the tendency for people to behave in a riskier way or to renege on contracts when they do not face the full consequences of their actions. It’s an asymmetric information problem that arises once a transaction takes place. 3. Explain how a country with poorly developed financial markets might have a hard time sustaining economic growth. [LO 14.2] Answer: A well-developed financial system helps transfer savings to those who want to engage in economic investment. Without such a system in place, savers will not find a safe place to put their funds and will miss out on the opportunity to earn some interest, and economic investors will not be able to get the funds they need to expand businesses, take on new projects, add to inventories, etc. Therefore, we would expect a country with a poor financial system to grow more slowly than one with a good financial system. 4. Is it savings or investment when Collins Inc. uses the proceeds from issuing bonds to purchase equipment needed to start a new product line? If Daisy buys some of the Collins Inc. bonds, is her purchase savings or investment? [LO 14.3] Answer: It is investment when Collins, Inc. uses the proceeds from issuing bonds to purchase equipment needed to start a new product line. Collins can buy new buildings, machinery, or other assets used to produce with the proceeds from this bond issue. It is savings if Daisy buys some of the Collins, Inc. bonds. Daisy’s funds not used for consumption of goods and services can be used to purchase securities such as the bonds (or stock in Collins or other companies). These purchases would allow Daisy to put those dollars somewhere safe and earn an acceptable rate of interest. 5. When the real interest rate increases, what happens to the quantity of loanable funds supplied? What happens to the quantity of loanable funds demanded? [LO 14.3] Answer: The (saving) supply curve in the loanable funds model is upward-sloping, so an increase in the real interest rate will increase the quantity of funds supplied as we move up along the (saving) supply curve. The (investment) demand curve in the loanable funds model is downward-sloping, so an increase in the interest rate will decrease the quantity of funds demanded as we move up along the (investment) demand curve. 6. Why might a government want to encourage saving among its citizens? If the government enacts a successful policy aimed at encouraging saving, what would be the likely effect on the interest rate and the quantity of investment? [LO 14.4] Answer: The savings-investment identity shows that the amount of investment in an economy depends on the amount of saving, so efforts to encourage saving translate into efforts to increase investment and therefore economic growth. Policy that successfully encourages saving would increase the supply of loanable funds, decreasing the real interest rate and pushing up the equilibrium quantity of investment, all else equal. 7. The government of a small country has enacted new regulations that make it more difficult to obtain a loan from a bank. How does this affect savings, investment, and the interest rate in the country? [LO 14.4] Answer: If it becomes more difficult to obtain a loan, the demand for funds (investment demand) will decrease and shift to the left. This will reduce the equilibrium interest rate and reduce the quantity of funds saved (a downward movement along the supply of saving curve). 8. Using the concept of default, explain why the interest rate on credit card debt is higher than the interest rate on a mortgage. [LO 14.5] Answer: A default happens when a borrower fails to pay back a loan according to the agreed-upon terms. If lenders think that a particular borrower might default, they will demand a higher interest rate to make it worth taking that risk. People are less likely to default on their mortgages because if they do then they will lose their house to the bank. When people default on credit card debt, it is difficult for the credit card company to get the money back from the people and they have no asset they can seize as an alternative to payment. Therefore, credit card companies charge higher interest rates to balance against any cases of default. 9. Your friend claims that there is no such thing as a risk-free interest rate because all loans are risky. Do you agree? Why or why not? [LO 14.5] Answer: The risk-free rate is usually approximated by interest rates on U.S. government debt because the U.S. government is considered extremely unlikely to default. All other borrowers must pay higher rates to compensate lenders for the higher possibility that they will default. 10. Is the stock exchange an example of a financial intermediary? Why or why not? [LO 14.6] Answer: Various institutions act as financial intermediaries—they channel funds from people who have them to people who want them. A bank is this kind of intermediary. A different kind of intermediary is a stock exchange, which matches people wanting to buy ownership shares of companies with people wanting to sell those shares. 11. In a famous bet known as the Simon-Ehrlich wager, Paul Ehrlich bet that over the course of 10 years, the prices of five commodities would be higher than they were at the start of the decade; Julian Simon believed the price of these goods would be lower. The loser had to pay the difference of the price from the starting point. What type of financial asset does this wager resemble? Why? [LO 14.7] Answer: This resembles the type of derivative known as a futures contract, in which financial investors essentially bet that the future price of a commodity will be higher than its current price. 12. What is securitization? How did it contribute to the recent housing-market crisis? [LO 14.7] Answer: Securitization refers to combining several loans or other financial assets into a bundle and then selling that bundle in whole or in parts to financial investors. The idea behind securitization is to reduce risk—after all, the chance of 1,000 borrowers all defaulting on their mortgages is much less than the chance of a single borrower defaulting. However, during the recent housing market crisis lenders relied too much on securitization to diversify their financial investments, resulting in over-lending to borrowers who weren’t able to keep up on their loans. 13. How do economists generally define a bank? What kind of bank exemplifies this definition? Does an investment bank meet this definition? [LO 14.8] Answer: The economic definition of a bank is an entity that takes deposits and makes loans. A commercial bank exemplifies this definition, but an investment bank does not. It neither takes deposits nor makes loans; instead, it underwrites securities and it buys and sells those securities, while providing a wide range of advice to firms. 14. What is an index fund, and why would a financial investor consider buying one? [LO 14.8] Answer: An index fund mirrors the performance of securities in a financial index such as the S&P 500. They are low-cost (requiring little active management and few transactions compared to other financial investment options), and some have high returns, making them attractive to financial investors. 15. Which is likely to have more risk, a government bond from a developing country or one from France? Which should have a higher return? [LO 14.9] Answer: The government bond from a developing country will have more risk, at least in part because the chance of default (not receiving interest or principal) is higher in a nation with lower GDP and growth. Also, we probably don’t know as much about the developing country as we do France, which has a long-established history of low default and other types of risk. Since risk and return tend to rise together, all else equal we would expect a higher return from the bond from a developing nation. But remember that all else is not equal in the real world. We can say with a good amount of certainty that the bond from the developing nation will pay a higher interest rate, but whether that will suffice to result in an overall higher return remains to be seen. 16. Define diversification and comment on how successful it is at managing market risk and idiosyncratic risk. [LO 14.9] Answer: Diversification refers to putting one’s savings into a variety of financial investments—different maturities, different industries, different risk profiles, and so on. The idea is to avoid “putting all your eggs in one basket,” with a view to minimizing risk on the premise that, while one security may not pay off, it is less likely that we will experience default or other problems with many securities at once. Diversification is therefore a good way of handling idiosyncratic, or firm-specific, risk. It does not, however, do as good of a job at handling market wide risk, which affects the entire market or economy. 17. During the 1990s, securities related to technology and other dot-com firms experienced skyrocketing market prices, but around 2000 the market crashed. Was that crash an example that supports or offers evidence against the efficient-market hypothesis? [LO 14.10] Answer: The answer here depends on how you look at it. The efficient market hypothesis states that all relevant information will be built into securities prices, so that no one can “beat the market.” We can argue that this example supports the efficient markets hypothesis in that the high demand for and perceived good chances of high returns from these “dot com” securities were incorporated into their prices, and then when sentiments changed, the prices quickly fell to incorporate this. But others use this example to argue against the hypothesis, suggesting that bubbles such as this one could be the result of herding (going along with the crowd – everyone else buys tech stocks, so you do too) or paying too much attention to recent events (seeing how well tech stocks are doing clouds memories of the fact that what goes up in markets must eventually go down). 18. Describe the difference between fundamental analysis and technical analysis. Which, if any, does the efficient-market hypothesis suggest financial investors engage in? [LO 14.10] Answer: Fundamental analysis refers to finding out as much information as possible about the firms or governments that issue securities. It might include research on economic growth, industrial performance, or anything that helps investors better understand risk and return. Technical analysis bases predictions for future security performance on past performance. The efficient-market hypothesis would support neither—it implies that all relevant market information will already be built into prices, and financial investors would be better off picking securities at random rather than incurring the time, money, and opportunity costs of either type of analysis. 19. Does the level of taxation in a closed economy have an impact on national savings? Explain. [LO 14.11] Answer: Public savings is defined as taxes minus government spending, so if taxes increase and government spending does not change, then public savings will increase. Private savings is defined as income minus taxes minus consumption, so an increase in taxes will reduce private savings. National savings is defined as public savings plus private savings, and is also defined as income minus consumption minus government spending. National savings will not change as long as income, consumption, and government spending remain the same. If individuals reduce their consumption when their taxes increase, then national savings will increase. 20. Explain how a persistent government budget deficit can hurt a closed economy’s ability to engage in economic investment. [LO 14.11] Answer: In a closed economy, national savings is equal to investment. When the government runs a budget deficit—in other words, when it spends more than it brings in via taxes—public savings is negative. This will lower national savings for any given level of private savings, and because national savings will be lower, so will investment. This can cause a nation to grow more slowly than it otherwise would because the capital stock is growing more slowly. Additionally, when the government is running a budget deficit, then it must borrow funds to pay for the extra spending. In a closed economy, the government will borrow from the private sector and this will result in fewer funds being available for firms to borrow. As a result, investment spending is lower. Problems and Applications 1. For each scenario, indicate whether it is an example of moral hazard or adverse selection. [LO 14.1] a. You decide to buy a new car instead of a used car because you are worried about the quality of the used car. b. You sell your condominium because you fear there will be a large special assessment next year. There has been no official notice of an upcoming assessment. c. The owner of a company has just secured a new line of credit from the bank. He decides to change his business plan and open a second office in a foreign country. d. A firm that has purchased a large insurance policy becomes careless about setting the security alarm. e. A number of households find themselves owing more on their mortgages than their houses are currently worth. Some of them decide to abandon the house and walk away. f. The owners of a company suspect there will be more competition from foreign producers in upcoming years. They have just issued new shares of stock in their company. Answer: Moral hazard refers to a situation where people behave in risky ways or renege on contracts. People who have insurance tend to be less risk averse. A business owner changes his plan to one that is more risky after he secures a loan. Owners of homes who owe more than the house is worth decide to walk away from their contractual obligation. In each of these cases, the individual changes his behavior after entering into a contractual relationship. Adverse selection refers to a situation where buyers and sellers have different information about the quality of a good, or riskiness of a situation. As a result, some transactions do not take place, or the price the good sells for might not be reflective of the missing information. People are often reluctant to buy used cars because they lack reliable information about the quality of the car. A condo owner may sell in anticipation of future negative events. If these events are not public knowledge, then the condo owner may receive a price that is higher than it should be. The stock may be overvalued because the buyers are unaware of the impending competition from foreign producers. a. adverse selection b. adverse selection c. moral hazard d. moral hazard e. moral hazard f. adverse selection 2. The chapter discusses three main functions of a banking system. Classify each of the following by the function it best represents. [LO 14.2] a. Aaron can get cash out of the ATM at any time of day or night. b. Instead of lending all her savings out to one borrower, Barbara’s bank makes the money in her savings account available to a variety of firms, with different characteristics and risk profiles, wishing to invest. c. When Charlie’s car suddenly breaks down, he can quickly withdraw funds from his savings account to pay the mechanic and rent a car. d. Donna can get start-up funds for her new hair salon from a bank, instead of having to find people in her neighborhood willing to lend their extra money. Answer: a. Aaron’s bank provides liquidity through the ATM, allowing Aaron to access his money quickly and without (much, if any) cost so that he can spend when and on what he likes. b. Barbara’s bank assists with diversification. It allows her savings to be loaned to several different borrowers so that the chance of all of them defaulting is much smaller than the chance of just one loan to a single borrower going unpaid. Without banks, default by one borrower would leave Barbara with nothing. c. Charlie can get money in this situation quickly and at minimum cost because his bank provides liquidity. Therefore, he can keep his savings in a safe place and earn interest when he doesn’t need the money, but quickly acquire and use it when he does. d. Donna’s bank acts as an intermediary between savers and borrowers—in this case, allowing Donna to borrow the funds she needs all at once instead of inquiring about and receiving small loans from many individuals with savings to spare. a. Aaron’s bank provides liquidity though the ATM, allowing Aaron to access his money quickly and without (much, if any) cost so that he can spend when and on what he likes. 3. After graduating, you take an unusual job: consulting with the queen of a small, newly populated island in the middle of the sea. You’ve provided advice to her on matters related to government and the economy, and while she has taken your advice most of the time, she has so far turned down your suggestion to have a banking system. She claims that banks will make the economy more complicated and do little to make the lives of her subjects easier. Over the past several months, though, the queen has discussed with you several issues that have arisen in the newly formed economy. For each of the three quotes from the queen below, refer to one of the three functions of banks discussed in this chapter to explain how a banking system could help with the issue described. [LO 14.2] a. “When my subjects have money left over after spending, they want to keep it somewhere safe and earn some interest on it. But that’s hard for most of them because they have no way of finding out who wants to borrow and whether it would be a good idea to lend to them.” b. “My subjects are lucky that we have very little crime, so they can safely keep their extra money inside their houses and take only what cash they need for a day’s spending. However, many of them have complained that if an emergency occurs when they’re all the way on the other side of the island, they can’t access their funds.” c. “Some of my subjects who are in the know about good borrowers have been making loans and earning interest. But lately there have been a couple of borrowers who defaulted on loans, and when they did, the lenders were totally out of luck. All that money just disappeared! And those bad experiences have made other potential lenders afraid, so that now borrowing and lending have dried up almost completely. If only there were some easy way for them to divide their savings among several different borrowers, they might feel safe enough to start lending again!” Answer: Each of these problems could indeed be solved by introducing a banking system into the kingdom. The function of banks that would best address each issue is listed below, with a brief explanation. a. This situation could be remedied by banks acting as an intermediary between borrowers (firms that want to invest) and lenders (savers with funds left over after consumption). Banks can take on the task of locating and assessing potential borrowers for the funds deposited by savers. b. Liquidity, the ability to access funds quickly and without excessive cost, is what’s missing here that banks could provide. If an unforeseen emergency arises, the kingdom’s inhabitants won’t need to go all the way back home to retrieve their money (and they won’t have to worry about what happens if crime on the island increases and savings are no longer safe left unguarded inside homes). c. The function of banks called diversification could assist with this issue. It’s true that when funds are loaned to only one borrower, the lender loses everything in the case of that borrower’s default, and as the queen described even those who aren’t personally affected by a particular default may eventually start to fear making loans. By relying on banks to lend out small portions of an individual’s savings to many borrowers with different risk profiles and characteristics, the chance of all of those borrowers defaulting is much less than the chance of any single one of them not being able to pay. 4. Categorize each of the following as a type of savings or investment in the economic sense. [LO 14.3] a. You buy 100 shares of Apple Computer stock. b. You place part of your income in a mutual fund. c. A delivery service buys 1,000 new trucks. d. You put $1,000 in a certificate of deposit by giving money to the bank in exchange for a set amount of return. Answer: Savings is the portion of income that is not immediately spent on consumption of goods and services. Funds that are saved can be placed into a savings account or can be used to buy stock or other financial assets. Economists use the word investment, or, more properly, investment spending, to refer to spending on productive inputs, such as factories or machinery, by firms. a. Savings. b. Savings. c. Investment. d. Savings. 5. Use the following words to fill in the blanks in the statements below about the market for loanable funds. Choose from: demanded, supplied; left, right; higher, lower. [LO 14.4] a. A change that makes people want to save less will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. b. A change that makes people want to save more will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. c. A change that makes people want to invest more will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. d. A change that makes people want to invest less will shift the quantity of loanable funds ________ to the ________. The resulting new equilibrium in the market for loanable funds would be a ________ interest rate and a ________ quantity of funds saved and invested. Answer: Saving is the portion of income that is not immediately spent on consumption of goods and services. Funds that are saved are supplied to the loanable funds market. Investment refers to spending by firms on productive inputs and this creates a demand for loanable funds by firms that need to borrow to pay for the investment spending. a. A change that makes people want to save less will shift the quantity of loanable funds supplied to the left. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a lower quantity of funds saved and invested. b. A change that makes people want to save more will shift the quantity of loanable funds supplied to the right. The resulting new equilibrium in the market for loanable funds would be a lower interest rate and a higher quantity of funds saved and invested. c. A change that makes firms want to invest more will shift the quantity of loanable funds demanded to the right. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a higher quantity of funds saved and invested. d. A change that makes firms want to invest less will shift the quantity of loanable funds demanded to the left. The resulting new equilibrium in the market for loanable funds would be a lower interest rate and a lower quantity of funds saved and invested. a. A change that makes people want to save less will shift the quantity of loanable funds supplied to the left. The resulting new equilibrium in the market for loanable funds would be a higher interest rate and a lower quantity of funds saved and invested. 6. Consider the market for loanable funds. Graphically illustrate the impact on the equilibrium interest rate and the equilibrium quantity of funds saved and invested in each of the following scenarios. [LO 14.3, 14.4] a. Due to slow growth in the economy, fewer workers are receiving pay increases and more workers are losing their jobs. b. The government decides to reduce the number of weeks a person is eligible for unemployment compensation. c. Numerous firms remain concerned about growth prospects in the economy. d. The government decides to reduce income tax rates, and this reduction leads to an increase in the size of the budget deficit. Answer: a. In this case, workers are not confident about the economy so they will elect to save more. The supply of saving curve shifts to the right, the equilibrium interest rate falls, and the quantity of funds saved and invested increases. b. Workers will decide to save more so they have funds to use in the event they lose their jobs. The supply of saving curve shifts to the right, the equilibrium interest rate falls, and the quantity of funds saved and invested increases. c. If firms are not confident about the economy, then they are reluctant to invest in new capital. The demand for funds (investment) curve shifts to the left, the equilibrium interest rate falls, and the quantity of funds saved and invested decreases. d. If the government reduces taxes and this increases the deficit, then they need to borrow more funds. The demand for funds (investment) curve shifts to the right, the equilibrium interest rate rises, and the quantity of funds saved and borrowed rises. Note in this case that because the interest rate is higher, investment spending will be lower. 7. You go to the bank and purchase a $1,000 certificate of deposit (CD). [LO 14.5] a. Who is doing the borrowing? Who is doing the lending? b. Which is higher, the interest rate paid on the 6-month CD or the 2-year CD? Why? Answer: When you purchase a CD, you are lending your money to the bank. The bank is borrowing the right to use your money for a period of time, and in return they pay you interest. The interest rate on the 2-year CD will be higher because the opportunity cost is higher—you are giving up the right to have that money back for a longer period of time so you prefer to be compensated at a higher rate. Both CDs are equally risky (or not) because you will get your money back in both cases with a predetermined interest rate. 8. What does the risk premium measure? During a recession, what is likely to happen to the risk premium? [LO 14.5] Answer: The difference between the risk-free rate and the interest rate a particular investor has to pay is called the credit spread or risk premium. During a recession, there is a higher risk of default because economic activity has slowed down. Therefore, investors will demand a higher interest rate in order to compensate for the higher risk of default. 9. You have a sum of funds sitting in a savings account earning a modest interest rate of 3 percent. A good friend wants to borrow half of this sum, and he has agreed to pay you an interest rate of 5 percent. Should you lend your friend the money? Why or why not? [LO 14.6] Answer: In general, we assume the goal of saving is to earn interest and allow for higher levels of consumption at some future date. Lending to a friend is risky because there is no guarantee your friend will be able to pay the loan back in a timely manner. You should only lend to the friend if you think the extra 2% interest will compensate you for the extra risk. 10. In your spare time, you help out with a magazine for high schoolers that focuses on current events related to economics and politics. While the magazine aims to be readable and entertaining, it also wants to use terminology correctly. Knowing that you’ve taken an economics class, the editor turns to you to look over a paragraph in a story focusing on the roles of saving and investment after the recent crisis in the housing market. Go through the following paragraph and correct any errors in economic vocabulary, including an explanation for the editor about why the original was incorrect. [LO 14.3, 14.6] “When Americans invest by buying securities such as stocks and bonds or putting money in a bank, they provide funds for firms wishing to engage in diversification by buying assets used to produce goods and services. Households with extra money left over after buying things they want or need consume by purchasing securities or putting their funds in savings accounts, and banks help transfer those funds to firms. By matching and working with these borrowers and lenders, banks act as a source of liquidity.” Answer: When Americans (a.) save by buying securities such as stocks and bonds or putting money in a bank, they provide funds for firms wishing to engage in (b.) investment by buying assets used to produce goods and services. Households with extra money left over after buying things they want or need purchase securities or put their funds in savings accounts. Banks help transfer those funds to firms. By matching and working with these borrowers and lenders, banks act as (c.) an intermediary. (a) Although it’s common to refer to buying stocks and bonds as “investment” in everyday speech, economists instead call it “saving.” (b) Investment is the term for firms buying productive assets such as buildings and machines used to produce goods and services. Diversification, on the other hand, refers to the method by which savers lend funds to several investors, on the premise that several borrowers with different characteristics are much less likely to default at the same time, compared to a single borrower. (c) Banks provide liquidity when they make funds easily and cheaply available to their depositors, but that is not what’s described here. This portion of the article describes banks acting as an intermediary between savers with extra funds available to lend and borrowers like firms that want to invest in productive assets like buildings and machinery. 11. In each of following examples, name the financial product being described. [LO 14.7] a. A family borrows money to pay for a house. b. A new tech start-up offers investors the ability to purchase a small part of the company to raise needed capital. c. The U.S. government offers to pay investors a 3 percent return rate next year if they finance its debt today. Answer: Equity is ownership in a company, and the most common form of such ownership is stock. As partial owners, stockholders are entitled to receive a portion of a company’s profits, in the form of dividends, in proportion to the size of their ownership. A mortgage is a loan agreements between a lender and a borrower in which the lender lends money to the borrower in exchange for a promise to repay the amount loaned. A bond is a loan that has been standardized into a more easily tradable and liquid asset. a. Mortgage. b. Stock. c. Bond. 12. Evaluate each of the following statements and say whether it describes a loan, a bond, and/or a stock. [LO 14.7] a. It implies ownership in the issuing firm. b. Small businesses use these to raise funds for investment. c. This is also known as equity financing. d. We can think of this as a more liquid version of a loan. e. It pays some form of interest, and principal is paid at maturity. Answer: Equity is ownership in a company, and the most common form of such ownership is stock. As partial owners, stockholders are entitled to receive a portion of a company’s profits, in the form of dividends, in proportion to the size of their ownership. The most basic type of debt is a loan. Loans are an agreement between a lender and a borrower in which the lender lends money to the borrower in exchange for a promise to repay the amount loaned. A bond is a loan that has been standardized into a more easily tradable and liquid asset. The holder of the bond is paid interest periodically, and then the face value is repaid at the maturity date. a. Stock. b. Loan. c. Stock. d. Bond. e. Bond. 13. Match each of the following players in the financial system with the financial product(s) they are most associated with. [LO 14.8] a. Commercial banks. i. Stocks. b. Savers. ii. Bonds. c. Investment banks. iii. Loans. Answer: a. iii. Loans. b. i. Stocks and ii. Bonds. c. i. Stocks and ii. Bonds 14. Rank the following actors in financial markets by the level of liquidity they are providing. [LO 14.8] a. Entrepreneurs offering equity in their businesses. b. The Federal Reserve offering banks the chance to borrow short-term money through the discount window. c. Investment banks offering shares in mutual funds, which penalize you if you withdraw your money within 30 days. d. A bank offering you a no-minimum reserve requirement checking account. Answer: From most liquid to least liquid: d. Checking account balances are among the most liquid assets in our economy. b. Banks are borrowing reserves here, which are very safe and liquid, though less so than actual money as in d. This also increases liquidity available to bank customers. c. Because of the penalty for early withdrawal, mutual funds are not as liquid as checking accounts or bank reserves. a. Because the businesses are new and therefore there is little information about them available, equity is the least liquid of all options given. It may be difficult to turn the shares of this firm into cash. 15. Rank the following assets based on their expected return. Then repeat the exercise, this time ranking the assets based on their expected risk. [LO 14.9] a. Real estate. b. Commodities. c. U.S. equities (stocks). d. Cash. e. U.S. fixed-income bonds. Answer: Cash is very low risk and provides an expected low return. Although assets like equities and real estate provide a relatively higher return, they are less risky when compared to commodities (such as gold, silver, or oil). In general, there is a direct relationship between expected risk and expected return. 16. Evaluate whether the following statements are true or false. [LO 14.9] a. Risk is measured by looking at the expected value (average) of an asset’s returns over time. b. Market risk can be minimized with a well-diversified portfolio. c. Idiosyncratic risk is unique to a particular asset, rather than to the market as a whole. d. A portfolio of well-diversified assets will often be less risky for the same level of return when compared to an individual asset. Answer: a. In financial markets, the simplest way to measure risk is to look at the standard deviation of an asset’s return over time. b. Market risk, or systemic risk, refers to any risk that is broadly shared by the entire market or economy. Because all businesses will face the consequences of rising prices, market risk is hard to eliminate via diversification. c. Idiosyncratic risks are unique to a particular company or asset—for example, the risk that a particular company will make a bad business decision, causing the value of its stock to fall. Idiosyncratic risks are the easiest to lower or even eliminate via diversification. d. A portfolio—a collection or group of many different assets—will often have a higher return for a given level of risk than any individual asset could offer (or, in other words, will be less risky for the same level of return as any individual asset). 17. “Listen,” your buddy says. “Have you ever noticed that you can get the same type and size of tire for $30 cheaper in the next county over? I’ve got a way to make profits for years—we’ll buy the tires where they’re cheaper and bring them back here to sell.” What is the term for the transaction your friend wants to make? Would the efficient-market hypothesis predict it will be as profitable as he says? Explain. [LO 14.10] Answer: Your friend is describing arbitrage, where commodities are bought at a lower price in one location and then resold at a higher price elsewhere. The efficient markets hypothesis would not have much faith in the long-term profitability of such a plan. The hypothesis implies that all market information will be built into prices very quickly— including the information your friend has that tires are cheaper in one county than in the next. Soon others will enter the tire-reselling business to take advantage of the difference in prices, and profits will disappear. 18. In each of the following examples say whether the market is behaving within the principles of the efficient-market hypothesis. [LO 14.10] a. The day after unrest in the Middle East, the source of supply for much of the world’s oil, the price of oil falls. b. Investors find very few opportunities for arbitrage in the foreign exchange market. c. The Dow Jones Industrial Average, a major stock market index, changes in value by 5 percent for an entire week, even though very little economic news is released. Answer: a. No. We would expect the expected decrease in the supply of oil to push oil prices upward, not downward. b. Yes. The efficient market hypothesis predicts that all arbitrage opportunities will quickly dry up as market information is fully reflected in securities prices. c. No. The efficient markets hypothesis says that changes in securities prices should be reflecting news about markets and securities. 19. In 2015, U.S. government spending was $3.8 trillion, tax revenue was $4.5 trillion, GDP was $14.12 trillion, and total consumer spending was $10.5 trillion. If the economy has no exports or imports, what was the national savings in 2015? How much was public savings? How much was private savings? [LO 14.11] Answer: Three equations will help us find these answers: Public savings = Taxes – Government spending Private savings = Income – Taxes – Consumer spending National savings = Public savings + Private savings Here, government spending is $3.8 trillion, taxes are $4.5 trillion, GDP (income) is $14.12 trillion, and consumption (consumer spending) is $10.5 trillion. We can therefore plug in these numbers as follows: Public savings = $4.5 trillion – $3.8 trillion = $0.7 trillion Private savings = $14.12 trillion – $4.5 trillion – $10.5 trillion = –$0.88 trillion National savings is therefore public savings of $0.7 trillion plus private savings of –$0.88 trillion = –$0.18 trillion. 20. A country’s government has been running a deficit for the past few years. Suppose this country decides to increase its government spending. [LO 14.4, 14.11] a. Compare the impact of the increase in government spending in a closed economy and an open economy. b. Are you more likely to observe crowding out in a closed economy or an open economy? Explain. Answer: In a closed economy, an increase in government spending will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate. In an open economy, an increase in government spending will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate. As a result of this change in the interest rate, capital inflow can be expected to increase and this will cause the supply of loanable funds curve to shift to the right. Considering your answers to the above questions, crowding out is more likely to be observed in a closed economy because investment spending will be lower. Crowding out occurs when an increase in government spending leads to an increase in the demand for loanable funds, and an increase in the equilibrium interest rate. The increase in the interest rate will cause investment spending to fall, or, in other words, the higher interest rate crowds out investment. In an open economy, the increase in capital inflow will push the interest rate back down towards its original level, and this will cause investment spending to fall by a smaller amount in an open economy. 21. Consider the U.S. market for loanable funds in a closed-economy model. Answer the following questions about each scenario. [LO 14.4, 14.11] a. The government starts offering a national savings bond to increase private savings, which pays a higher return than many other options available on the market. Which way will the supply of loanable-funds curve shift? Will the interest rate increase or decrease? Will there be more or less borrowing? b. Suppose the economy is now open. Due to rapid economic expansion in China, the Chinese government decides to invest in U.S. Treasury notes with some of its surplus. Which way will the supply curve shift? c. A new computer software program is introduced into the market, which offers businesses that purchase it promising returns on their investment. Which curve will shift? Which way will it shift? d. The government reduces the capital gains tax, which taxes earnings on assets in the stock market. Which curve will shift? Which way will it shift? Answer: a. A relatively low-risk, high-return bond will encourage savings, shifting the supply curve to the right. This will lower the equilibrium interest rate and increase the amount of borrowing. b. The supply curve will shift to the right due to this net capital inflow. c. Investment is represented by the demand curve in the loanable funds model, and it will shift rightward as expectations about higher returns encourage more investment at any given interest rate. d. This will encourage more saving via stocks, increasing the overall level of national savings, all else equal. This will shift the supply curve of loanable funds rightward. CHAPTER 15 MONEY AND THE MONETARY SYSTEM Chapter Overview In this chapter, we’ve explored one of the most fundamental concepts in modern economics: money. We’ve looked at the roles money plays in the economy. We’ve also looked at how central banks and the private banking system interact to determine the size of the money supply. Finally, we’ve seen some of the tools the central bank has to manage the money supply and how those tools allow it to exert considerable influence over the broader economy. This unique power gives the Fed (and central banks in other countries) incredible responsibility for the economy. As you’ll see in the next few chapters, this responsibility usually comes down to two main tasks: keeping price levels stable and acting as a lender of last resort. The Fed is the last line of defense when a financial crisis threatens an economy. Learning Objectives LO 15.1 Describe the three main functions of money. LO 15.2 Describe the characteristics that make something a good choice as money and distinguish between commodity-backed and flat money. LO 15.3 Explain the concept of fractional-reserve banking and the money multiplier. LO 15.4 Describe M1 and M2. LO 15.5 Understand the role of a central bank and discuss the idea of the Federal Reserve’s dual mandate. LO 15.6 Explain the tools the Federal Reserve uses to conduct monetary policy. LO 15.7 Understand how monetary policy affects the prevailing interest rate and supply of money. LO 15.8 Explain how expansionary or contractionary monetary policy influences the broader economy. Chapter Outline CIGARETTE MONEY What Is Money? Functions of Money (LO 15.1) What Makes for Good Money? (LO 15.2) BOX FEATURE: REAL LIFE – BANKING WITH A CELL PHONE Commodity-Backed Money versus Fiat Money BOX FEATURE: WHAT DO YOU THINK? – BACK TO THE GOLD STANDARD? Banks and the Money-Creation Process “Creating” Money (LO 15.3) BOX FEATURE: REAL LIFE – BANK RUNS AND THE BANKING HOLIDAY Measuring Money (LO 15.4) Managing the Money Supply: The Federal Reserve The Role of the Central Bank (LO 15.5) BOX FEATURE: FROM ANOTHER ANGLE – IS BITCOIN THE CURRENCY OF THE FUTURE? How Does the Federal Reserve Work? Tools of Monetary Policy (LO 15.6) The Economic Effects of Monetary Policy Interest Rates and Monetary Policy: The Liquidity-Preference Model (LO 15.7) Interest Rates and the Economy (LO 15.8) Beyond the Lecture Class Discussion: What Makes For Good Money? (LO 15.2) Have students examine this brief article from Wired regarding the use of mackerel, coffee, stamps, and locks as money in some prisons. Discuss the following: 1. Why would these things be chosen as money in some prisons? 2. What is necessary for something to be used as money? 3. Why do prisoners need money at all? 4. How did money evolve throughout history? Class Media: “Creating” Money (LO 15.3) Consider showing students this brief clip from the movie It’s a Wonderful Life. In this scene, George returns to his Building & Loan to find there’s a run on the bank, and tries to explain how the banking system works to depositors. This provides a good foundation to discuss fractionalreserve banking. Class Media: Tools of Monetary Policy (LO 15.6) Consider showing students this brief clip from the TV show The Colbert Report. In the clip, Colbert jokes about the goals and responsibilities of the Federal Reserve and addresses concerns that the Fed is failing as a regulator. This can help start a discussion about what exactly the Fed is responsible for, and why it is important as a creator of monetary policy. Class Activity: Tools of Monetary Policy and the Liquidity-Preference Model (LO 15.6, LO 15.7) During class, split your students into groups and have them conduct a brief imitation of a Federal Open Market Committee (FOMC) meeting. First, have your students examine some economic statistics: unemployment and CPI data, real GDP data, and manufacturing data (check new orders, shipments, and unfulfilled orders). They can also review the FOMC meeting calendar and notes. You can add in any other national or local statistics you want students to review. Ask groups to come to a decision about what the Fed should do regarding monetary policy, and ask them to explain how they came to that decision and why they support it. Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. People like to use dollars as money since they provide a simple and standard comparison for which many goods can be assigned a price (in terms of dollars). Which function of money does this situation describe? [LO 15.1] A. Store of value B. Medium of exchange C. Unit of account D. Standard of deferred payment 2. Which describes the dollar? [LO 15.2] A. Backed by gold B. Fiat money C. Commodity-backed money D. Intrinsically valuable Feedback: The only real value of the dollar is the trust that people have in it. We believe that other people will accept dollars for goods and services. It isn’t intrinsically valuable – it’s just made of green paper rather than something valuable like gold or silver. 3. How do banks “create” money? [LO 15.3] A. Lending out deposits within a fractional reserve system B. Printing dollars and minting coins C. By holding savings of customers in savings accounts and CDs D. By charging interest on loans Feedback: If you deposit money at the bank, the bank will lend it to a borrower. This creates money. You can still withdraw your money from the bank, but now another person received money from the bank in the form of a loan. Money was created. 4. What is the only state with two Federal Reserve Banks? [LO 15.5] A. New York B. Ohio C. California D. Missouri Feedback: Kansas City and St. Louis 5. How could the Federal Reserve engage in expansionary monetary policy? [LO 15.6] A. Raise the interest rate B. Increase government spending C. Selling treasury bonds D. Buying treasury bonds Feedback: It buys the bonds from holders (could include banks, firms, or individuals). This puts money back into the money supply. Solutions to End-of-Chapter Questions and Problems Review Questions 1. Describe how money contributes to economic activity and allows for a more complex society than barter does. [LO 15.1] Answer: In an economy without money, goods and services are traded directly via barter. But barter is inefficient because each time you want to make a trade you have to find a partner who has something you want and wants what you have to offer. Money acts as a medium of exchange (meaning we can trade it for goods and services), a unit of account (meaning we can use it to measure relative value), and a store of value (meaning that we can use it to store up purchasing power over time and spend it when and on what we like). 2. Explain how cigarettes fulfilled the three functions of money in the POW camps during World War II. [LO 15.1] Answer: They acted as a medium of exchange in that the cigarettes could be exchanged for staple foods, chocolate, or anything else the POWs might have and offer for trade. They acted as a store of value in that prisoners could save up many cigarettes and trade them in for large purchases (although cigarettes can go stale, they keep for a relatively long time). And they acted as a unit of account in allowing relative values to be read from prices—it’s easy to see that if a tin of potted meat sells for 10 cigarettes and a magazine sells for 20 cigarettes, the magazine is valued roughly twice as highly as the tin of meat. 3. Throughout time, metals such as gold have been popular choices for money across various societies. Explain why this might be, using our criteria for what makes good money. [LO 15.2] Answer: Gold has made for good money because of its stability of value and convenience. Gold’s value is relatively stable because the supply of gold is fairly constant over time, although using gold doesn’t offer the control a fiat money like the dollar in the United States does, where the supply can be carefully controlled by the central bank. When and where gold has been used as money, it has been widely accepted, at least in part because it can be used both as a commodity (such as jewelry) and as money. Also, gold can easily be melted down into smaller parts and is fairly portable, adding to its convenience. 4. On the Yap Islands in the middle of the Pacific Ocean, giant stone wheels, weighing as much as a small car, were used as currency. What were some of the likely problems with this currency? [LO 15.2] Answer: The giant stone wheels may have had stable values (and been widely accepted), but they lacked one of the main criteria that determine whether something makes good money: convenience. The size and weight of the wheels would hurt the money’s portability—not to mention the question of making change! After a while, it is likely that these portability issues would start to hurt the stone wheels’ wide acceptance, and the money would likely give way to another. 5. Explain why keeping a reserve ratio of zero could be a very bad idea. [LO 15.3] Answer: A reserve ratio of 0 would mean that the bank keeps 0 percent of customer deposits on hand for withdrawals. While it’s true that the amount of money withdrawn in a given day is less than 100 percent of deposits (meaning that a reserve ratio of 1 would be a bad idea too), the amount is no doubt higher than 0 percent! The bank would quickly find itself unable to meet its customers’ liquidity needs and would not be in business long. 6. If banks keep 100 percent of deposits on hand as reserves, what would this imply about the reserve requirement and the multiplier? What would it imply about banks’ ability to create new money? [LO 15.3] Answer: If banks keep 100 percent of deposits on hand, the reserve requirement ratio and the multiplier would be 1, and banks would not be able to create new money. Banks create new money by making loans, and if they were required by law to keep 100 percent of deposits on hand, there would be no dollars to lend and therefore no ability to change the money supply. 7. Explain the role of base money and the money multiplier in the Federal Reserve System’s enactment of monetary policy. [LO 15.4] Answer: Base money (also called hard money) consists of currency in circulation and reserves held by banks at the Federal Reserve. The money multiplier determines the effect on the overall money supply of changes in base money. The Federal Reserve conducts monetary policy by changing the amount of base money in the economy, typically by conducting open-market operations. Although the Federal Reserve can change the required reserve ratio in order to change the value of the money multiplier and therefore the level of the money supply, it does not in practice conduct monetary policy in this way. For example, during a recession, the Fed is likely to conduct expansionary monetary policy—it will purchase government bonds to increase base money and the money supply in order to stimulate spending in the economy. The increase in base money (reserves) will reduce interest rates and at lower interest rates banks will make more loans. The increase in loans will increase the money supply, and as the loan money is spent this will increase output in the economy. 8. Give an example where depositors changing the way they hold assets could increase the M1 measure of the money supply while leaving M2 unchanged. [LO 15.4] Answer: It’s important to remember in answering this question that M1 is part of M2. Therefore, one way M1 could increase while leaving M2 unchanged would be if depositors moved assets from savings to checking. This would reduce the savings component of M2 but increase the M1 component (since M1 is made up of cash, demand deposits, and traveler’s checks) by the same amount. Therefore, M1 would rise and M2 would remain unchanged. 9. What is one key way in which the mission of the Federal Reserve differs from the mission of the European Central Bank? [LO 15.5] Answer: The Federal Reserve System (the central bank of the United States) has a dual mandate: full employment and stable prices. The European Central Bank, on the other hand, focuses only on price stability. 10. What do we mean when we say that the Federal Reserve System is politically independent, and how might this independence be a good thing for the U.S. economy? [LO 15.5] Answer: The Federal Reserve System is independent in that the members of the Board of Governors serve long terms and are not elected by popular vote. This frees them from the need to appease voters and allows them to undertake measures that would not be popular; also, it allows politicians to leave necessary monetary policy to the Federal Reserve and may increase the public’s faith in the central bank knowing that economic experts, not just popular politicians, are making difficult policy decisions. 11. Explain why using changes in reserve requirements to conduct monetary policy is generally not a good idea for the United States. [LO 15.6] Answer: The major disadvantage of using changes in reserve requirements to conduct monetary policy is that they are too powerful. A small percentage change in the reserve requirement results in a massive change in reserves, making this tool of monetary policy inappropriate for day-to-day maintenance. Also, frequently changing or unpredictable reserve requirements make it difficult for bank managers to plan for the future and manage funds as they like. 12. Which tool of monetary policy is used most frequently by the Federal Reserve System? What makes this tool the best choice in most circumstances? [LO 15.6] Answer: Open-market operations (the buying and selling of government bonds to and from banks) are the primary way the Federal Reserve System enacts monetary policy. Openmarket operations are conducted on a daily basis, which allows policy to change direction or magnitude without it looking like the Federal Reserve has made a mistake, enhancing the Fed’s credibility. Open-market operations don’t inconvenience bank managers the way that changing reserve requirements does, and they don’t require banks to take loans from the Fed as changing the discount rate for policy does. Given open market operations can be conducted daily, this policy option provides greater flexibility to the Fed when deciding what type of policy change should be made. 13. Are there any differences in the effects of fiscal policy versus monetary policy on aggregate demand in the short-run aggregate demand and supply model? [LO 15.7] Answer: Both fiscal and monetary policy will shift the aggregate demand curve: rightward for expansionary policy and leftward for contractionary policy. Just as with fiscal policy, a rightward shift of the AD curve from expansionary monetary policy will increase prices and output in the short run, and a leftward shift from contractionary policy will reduce prices and output. One important difference between monetary and fiscal policy has to do with the lag between implementing policy and the shift of the AD curve. Monetary policy tends to have shorter lags because it does not require such a broad consensus from so many people to be enacted, nor are the members of the Board of Governors popularly elected. Therefore, they need not consider voters in the same way that Congress and the president do. This means the effects on prices and output from monetary policy may be felt more quickly than those from fiscal policy. However, there is also a greater chance that the change in monetary policy will not affect the economy at all whereas a change in fiscal policy will always have some impact. If government spending rises or tax rates fall then aggregate demand will increase. If the Federal Reserve pursues expansionary monetary policy and takes action to lower interest rates, aggregate demand will only increase if businesses and people decide to take out loans, such that the extra spending will increase output. It is possible that interest rates can fall and people and businesses can decide not to increase borrowing in which case expansionary monetary policy is not very effective. 14. Describe the slope of the money supply curve in the liquidity-preference model. Are the assumptions behind the supply curve realistic? [LO 15.7] Answer: In the liquidity-preference model, the supply curve is vertical, reflecting the assumption that the Federal Reserve completely controls the supply of money. In reality, its control is nowhere near that complete or direct. The Federal Reserve directly controls the amount of base money in the economy. The exact level of the money supply then depends on the amount of loans the banking system elects to make. 15. Under the liquidity-preference model, how would the slope of the money demand curve affect the power of a central bank to conduct monetary policy? [LO 15.8] Answer: The slope of the money demand curve reflects the relationship between the nominal interest rate and the quantity of money demanded. Because the demand curve slopes downward, we know that this relationship is inverse; when the interest rate rises, the quantity demanded falls, and vice versa. However, the slope of the curve will indicate the strength of this relationship. A very flat money demand curve would mean that when the central bank conducts expansionary monetary policy by shifting the supply of money curve to the right, there will only be a small decrease in the interest rate. If the money demand curve is steeper, the same type of policy will result in a much larger decrease in the interest rate. All else the same, monetary policy is more effective when the money demand curve is steeper because the change in the interest rate will be larger. It is the change in the interest rate that leads to changes in borrowing and spending and therefore output. 16. Use the liquidity-preference model to explain how the Federal Reserve can react to the threat of exceedingly high inflation via monetary policy. Be sure to include the intended effect on the interest rate and quantity of money. [LO 15.8] Answer: When inflation is the major threat, the Fed can pursue contractionary monetary policy. It is likely to sell government bonds in order to reduce base money and therefore the supply of money. The money supply curve will shift to the left and the interest rate will rise. This action will shift the AD curve to the left, reducing output and the price level. The AD curve will shift to the left if people and businesses decide to take out fewer loans due to the higher interest rates. If loans fall, then there is less spending and output will fall. Problems and Applications 1. Determine whether each of the following would fulfill the three functions of money. If the item does not fulfill all three, name at least one function of money that it violates. [LO 15.1] a. Salt. b. The barter system. c. Baseball cards. Answer: a. Salt could fulfill the medium of exchange function as long as people were willing to accept it in exchange for goods and services. It could be a good unit of account as long as people agreed on the prices in terms of salt that goods and services would sell for. And it could also be a good store of value because salt keeps for a long time. If there aren’t major changes in the supply of salt that cause the purchasing power of a given unit of salt to vary a great deal over time, salt could be an acceptable form of money. b. The barter system does not fulfill all three functions of money. There are problems with the medium of exchange function, because not everyone will accept what we offer in return for the goods and services they offer. Goods and services traded directly under the barter system may not keep their worth, making them a poor store of value as well. If people agreed on the ratios via which one good or service would trade for another, the unit of account function could be satisfactorily fulfilled, but as a whole the barter system is not money and does not fulfill its functions. c. Baseball cards could fulfill the medium of exchange function if everyone agreed to accept them for goods and services, but this may be a difficult agreement to secure! Baseball cards can keep fairly well over time, as long as they are protected from acidic conditions and moisture, so from this point of view they could act as a good store of value; however, the baseball card market is volatile, meaning the cards may not keep a roughly constant level of purchasing power over time (not fulfilling the store of value function). Moreover, rapidly changing prices make them a poor tool for gauging relative values (not fulfilling the unit of account function). 2. Imagine you own a lawn-mowing business. Identify the main function of money exhibited in each situation below. [LO 15.1] a. You swipe your debit card to purchase gasoline for your lawn mower. b. You stuff your earnings from mowing lawns into a piggy bank. c. You pay your friend Cornelius $5 to help you mow lawns. d. You calculate your net earnings for the year on your tax return. e. You determine how much value your new lawn mower has added to your business. Answer: When money is exchanged for a good or service, it is being used as a medium of exchange. When we calculate values in dollar terms, we are using money as a unit of account. When we save dollars for a later use, we are using money as a store of value. a. Medium of exchange. b. Store of value. c. Medium of exchange. d. Unit of account. e. Unit of account. 3. From 2004 to 2009 the country of Zimbabwe underwent hyperinflation, in which prices rise rapidly. The government began printing bills as large as 100 billion Zimbabwe dollars. Explain how this situation would have affected the characteristics of good money discussed in this chapter. [LO 15.2] Answer: Hyperinflation affects all three characteristics of good money. It makes the value of money unstable, which will eventually lower its acceptability (put yourself in the shoes of a seller: would you take money for the goods and services you sell if its value is decreasing rapidly?). When money is not commonly accepted, and using it means keeping up with constant changes in value, it is no longer convenient. 4. Suppose you live in a country perfect for growing tulips and governed by King Balthazar, who proposes that you use the tulips for your currency. After all, says Balthazar, they are widely accepted in the community, they’ve been valuable for years, and they are highly portable. If you were Balthazar’s economic advisor, would you recommend using the tulips? If yes, list the traits of good money they satisfy. If no, list the trait(s) of good money they do not satisfy. [LO 15.2] Answer: Using an item for money is a good choice if the item has stability of value and is convenient to carry and exchange. Using tulips as money is not likely to be a good choice. Frequent changes in the demand for and supply of tulips will occur if they are being used as money, which will result in their value not being stable. The fact that tulips are perishable, must be carefully handled, and must be stored within a small range of temperatures will make them an inconvenient choice. 5. You decide to take $300 out of your piggy bank at home and place it in the bank. If the reserve requirement is 5 percent, how much can your $300 increase the amount of money in the economy? [LO 15.3] Answer: When you deposit the $300 into your bank, 5% of your deposit ($15) must be held on reserve and the rest ($285) can be lent out. When people take out loans and use the loan money to purchase goods and services, and the loan money is then redeposited into the banking system by the sellers of the goods and services, we have a multiplier process. Here the money multiplier equals 1/0.05 = 20, so your $300 can ultimately increase the money supply by $285 × 20 = $5,700. Note the increase in the money supply is $5,700 and not $6,000 because the $300 cash was part of the original money supply. When $300 cash is deposited into the bank, it can lead to the creation of $6,000 of deposits, but the amount of new money is only $5,700. 6. Assume that $1 million is deposited in a bank with a reserve requirement of 15 percent. What is the money supply as a result? What would change if the government decides to raise the reserve requirement to 40 percent? [LO 15.3] Answer: Here the money multiplier equals 1/0.15 = about 6.67, so your $1 million deposit will lead to the creation of $1 million × 6.67 = about $6.67 million of deposits in the banking system. The $6.67 million can be divided into $1 million, which was your initial deposit, plus $5.67 million, representing the creation of new money (the increase in the money supply) resulting from loans and the money creation process. If the reserve requirement is increased to 40 percent, the new money multiplier will be 1/0.40 = 2.5, and a $1 million deposit will result in a money supply of $2.5 million ($1 million is the original deposit and $1.5 million is the new money created through the money multiplier process). 7. Say whether each of the following are types of M1 or M2, or both. [LO 15.4] a. Checkable deposits. b. Dollar bills. c. Money in your checking account. d. Money in your savings account. e. Certificates of deposit under $100,000. f. Traveler’s checks. Answer: M1 includes hard money (currency) plus checkable deposits (which are not exactly cash but are readily accessible for most people). M2 includes everything in M1 as well as other items such as savings accounts and CDs (certificates of deposit) that are generally harder to access immediately and so slightly less liquid than other forms of money. a. M1 and M2. b. M1 and M2. c. M1 and M2. d. M2. e. M2. f. M1 and M2. 8. Which of the following statements are true regarding the differences between M1 and M2? Check all that apply. [LO 15.4] a. M1 includes cash and reserves, whereas M2 does not. b. M2 represents a broader measure of the money supply compared to M1. c. Numerically, M1 is larger than M2. d. All items in M1 are more liquid than all items in M2. e. M2 includes savings deposits, whereas M1 does not. f. Checking account balances are part of M2 but not M1. Answer: b, d, and e. M1 includes cash (hard money) plus checking account balances (demand deposits, which are not exactly cash but are readily accessible for most people). M2 is broader still. M2 includes everything in M1 plus savings accounts and other financial instruments where money is locked away for a specified period of time. Because these forms of savings can’t be accessed quickly without penalty fees, they are slightly less liquid than other forms of money. (Certificates of deposit are an example of a less-liquid form of money.) 9. The following quotation comes from remarks given by Ben Bernanke, former chairman of the Federal Reserve: “The substantial ongoing slack in the labor market and the relatively slow pace of improvement remain important reasons that the Commit-tee continues to maintain a highly accommodative monetary policy.” The Federal Reserve has a dual mandate. Which mandate does the quote refer to? [LO 15.5] Answer: The dual mandate refers to the Federal Reserve's twin goals of price stability and full employment. This quote is focusing on full employment (note its references to the labor market). 10. Look back to the POW camps described at the beginning of this chapter. Who played the role of the central bank? [LO 15.5] Answer: The central bank decides the money supply, so since it was the Red Cross that decided how many cigarettes were in circulation, the Red Cross would be the central bank. 11. Which tool of monetary policy is most likely being described by each of the following statements? [LO 15.6] a. It’s the major way the Federal Reserve System enacts monetary policy. b. This tool is good for emergency situations that require major, large-scale action. c. This tool goes through the Federal Reserve’s role as lender of last resort. d. This tool is best for everyday monetary policy. e. A major disadvantage of this tool is that it requires that banks want to borrow from the Fed. f. Even if they aren’t interested in buying, selling, or borrowing from the Fed, changes in this tool may inconvenience bank managers. Answer: a. Open-market operations. b. Changing the reserve requirement. c. Discount window policy. d. Open-market operations. e. Discount window policy. f. Changing the reserve requirement. 12. Name the monetary policy tool being used in each of the following examples. [LO 15.6] a. The central bank buys government securities from banks. b. The central bank raises the cost of borrowing money. c. The central bank changes the amount of money banks must hold from their depositors. Answer: a. This is an example of open-market operations. b. This is changing the discount rate, the interest rate charged when banks borrow from the Federal Reserve System via the discount window. c. This refers to a change in reserve requirements. 13. The economy is in recession and the Federal Reserve wants to increase the money supply. Should it increase or decrease the following? [LO 15.6] a. Reserve requirements. b. The discount rate. c. Purchases of bonds in the open market. Answer: a. The Federal Reserve should decrease reserve requirements to allow banks to create more money by making loans. When the reserve requirement falls, banks will have more excess reserves and these excess reserves can be used to make loans. b. The Fed should lower the discount rate to make it easier for banks to take loans from the Federal Reserve system; this will increase the credit available to others in the economy and hopefully increase spending. c. The Fed should increase its purchases of bonds in the open market because when it does, it increases reserves in the banking system, and ultimately credit available from banks to households and firms. 14. Using Figure 15P-1, answer the following questions. [LO 15.7] a. Is this economy in recession, just right, or overheating? b. What is the correct monetary policy in this situation—expansionary or contractionary? c. What is the effect on prices of that policy—will they increase or decrease? Answer: a. Output is above potential, so the economy is overheating. b. Contractionary monetary policy will cool down spending and stave off inflation. c. Prices will decrease. When the Federal Reserve pursues contractionary monetary policy, it will sell some of its government bonds in an open-market sale. This will decrease reserves in the banking system and interest rates will rise. The increase in interest rates will reduce spending and the aggregate demand curve will shift to the left. 15. What would happen to each of these components of the liquidity-preference model if the Federal Reserve decides to raise the reserve requirement? [LO 15.8] a. Money supply. b. Interest rates. c. Quantity of money in the economy. d. Money demand curve. Answer: a. Requiring banks to hold more money as reserves will hurt their ability to create new money, shifting the money supply curve leftward. b. The decrease in the supply of money will push interest rates upward, all else equal. c. The equilibrium quantity of money will fall, all else equal. d. There will be a leftward movement up along the money demand curve as the decrease in the money supply pushes interest rates upward. 16. For each of the following situations, identify whether the Federal Reserve is likely to pursue an expansionary or a contractionary monetary policy. [LO 15.8] a. The unemployment rate is at 0.5 percent. b. The economy is experiencing record growth in GDP. c. The unemployment rate is at 15 percent. d. Inflation has reached 10 percent, a recent high. e. A hurricane recently demolished a major city, causing a major recession. Answer: a. Since the Fed’s goal is not 0% unemployment, the economy is likely producing more than potential output, in which case the Fed would engage in contractionary policy to slow down the growth in spending and stave off inflation. b. The Federal Reserve would likely engage in contractionary policy to ward off excessive inflation. c. The Fed would likely engage in expansionary policy to stimulate spending and therefore employment. d. The Fed would likely engage in contractionary policy to bring down inflation. e. The Fed would want to engage in expansionary policy to increase spending—particularly economic investment—and create jobs. Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436