CH-3-4 National Income: Where It Comes From and Where It Goes – Macroeconomics : Chapter Notes

This Document Contains Chapters 3 to 4 CHAPTER 3 National Income: Where It Comes From and Where It Goes Notes to the Instructor Chapter Summary Chapter 3 of the Mankiw text presents an important but relatively straightforward classical model of the real side of the economy. Much of the material in the chapter (such as marginal products, factor demands, consumption and investment functions, and the like) is likely to be a review of materials covered in principles courses. The material can probably be presented in two lectures to students with a suitable grounding from principles; three lectures might be more appropriate for less-well-prepared students. The model of the chapter provides a complete description of how the real side of the economy works, in the sense that it explains all the markets and transactions illustrated in the circular flow diagram (Figure 3-1). The model is set up as follows: Production: Capital and labor stocks are fixed and, together with the production function, determine GDP. Distribution: GDP is paid to factors of production according to their marginal products. Euler’s theorem ensures that these factor payments exactly exhaust GDP. Allocation: GDP is allocated to consumption, investment, and government purchases according to a consumption function [C = C(Y – T)]), an investment function [I = I(r)], and fiscal policy. The real interest rate adjusts to ensure equilibrium in the goods (equivalently the loans) market. The model is long run in the sense that it assumes that prices are flexible and that markets clear. At the same time, however, it presents only a snapshot of the economy at a point in time because it assumes a fixed capital stock, labor force, and technology. The chapter has three primary goals: 1. To introduce students to some of the basic terms and concepts that will be used throughout the book, such as the production function, the consumption function, and the investment function. 2. To provide long-run answers to four questions: (a) What determines the level of real GDP? (b) What determines how GDP is distributed to labor and owners of capital? (c) What determines how GDP is allocated to consumption, investment, and government purchases? (d) What ensures equilibrium of the flows in the circular flow diagram? 3. To develop a model that is both a basis for further analysis and a benchmark for comparison as the book goes on to consider topics such as the determination of prices (Chapter 5), the open economy (Chapter 6), the Solow growth model (Chapters 8 and 9), and the IS–LM model (Chapters 11 and 12). Comments The lecture notes introduce notation for private saving and public or government saving that does not appear in the textbook: Sp and Sg, respectively. This facilitates presentation of equilibrium in the loans market. Students must clearly understand the distinction between public 49 and private saving. For example, students are often confused by the fact that decreases in taxes decrease saving, because they focus on the effect on private saving and miss the effect on the government deficit. The lecture notes emphasize the circular flow as the reference point for the analysis. The household’s budget constraint (C + Sp = Y – T), the equality of income and output (Y = Wages + Profits), the definition of the deficit (Sg = –DEF = T – G), the goods market equilibrium condition (Y = C + I + G), and the loans market equilibrium condition (S = Sp + Sg = I) can all be introduced in terms of the circular flow diagram. Like the text, the lecture notes emphasize the loanable funds interpretation of equilibrium. As well as being simple to present and illustrate in terms of a savings/investment diagram, this approach makes it clear why the real interest rate is the key equilibrating variable. The classical model of this chapter provides a benchmark. Many of the other models in the book take this model as a starting point, and we refer back to this analysis many times. Many of the concepts introduced in this chapter (for example, consumption and investment functions) are used throughout the book. Use of the Web Site Since the classical model does provide a benchmark, it is probably a good idea to give the students many analytical exercises using this model. The curve-shifting exercises are relatively simple so that the exercises of this chapter allow the students to familiarize themselves with the software. Use of the Dismal Scientist Web Site Use the Dismal Scientist Web site to download data for the past 40 years on national income, national saving, the government budget surplus, and the current account surplus. Compute private saving by subtracting the government budget surplus and the current account surplus from national saving. Now, express private saving, the government budget surplus, and the current account surplus as a share of national income. Discuss how the shares have changed over time. Chapter Supplements This chapter includes the following supplements: 3-1 How Long Is the Long Run? Part One 3-2 What Is Capital? 3-3 Labor’s Share of Output in the United Kingdom 3-4 The Consumption Function 3-5 Economists’ Terminology 3-6 Public and Private Saving 3-7 Wars and Interest Rates 3-8 A First Look at Nominal and Real Interest Rates Lecture Notes Introduction We now move from measurement to the deeper question of the explanation of the behavior of the economy. This chapter develops a basic model of the long-run behavior of a well-functioning economy (one in which prices are flexible, so all markets are always in equilibrium). This Supplement 3-1, classical model explains “How Long Is the Long Run? Part One” 1. The determinants of the level of output (income), 2. how income is distributed, 3. how output is allocated among alternative uses, and 4. what ensures that the supply of and demand for goods are equal. Figure 3-1 The starting point is the circular flow of income from Chapter 2, complicated somewhat by the addition of the government but kept simple by restricting attention to a closed economy (net exports equals zero). Some accounting relationships from Chapter 2 show up here. From the goods market (remembering that NX = 0), Y = C + I + G. Looking at firms, we have Profits + Wages = Y; and considering the government, we obtain the definition of the government deficit: DEF = G – T. Finally, from the financial markets (letting Sp represent private saving), Sp = DEF + I. 3-1 What Determines the Total Production of Goods and Services? The Factors of Production The economy has certain resources, most notably its labor and its stock of machines and Supplement 3-2, factories (its capital stock). Firms in the economy use labor and capital as inputs to produce “What Is goods and services (GDP). To keep things simple, we take K and L as fixed and exogenous ( Capital?” K = K;L = L ). We do not yet wish to explain variations in employment or in the capital stock. The Production Function We express the economy’s ability to produce goods and services from its resources as Y = F(K, L). This says simply that the amount of GDP an economy can produce depends on its capital stock K and its labor L. More capital or more labor allows the economy to produce more output. An example of a production function is Y = (KL)1/2. Thus, if K = 40 and L = 10, Y = (400)1/2 = 20. If the economy were suddenly to have exactly twice the amount of all its inputs, we would expect that it could produce exactly twice as much output, simply by using the new resources in exactly the same way as the old resources. If a factory can produce 20 automobiles using 40 machines and 10 workers, then it should be possible to produce 40 automobiles with 80 machines and 20 workers, simply by building a second factory identical in all respects to the first one. More generally, if the amount of all inputs is increased by some constant percentage, output should be changed by the same percentage. This means that the production function should exhibit constant returns to scale. This is written mathematically as zY = F(zK, zL) for any positive number z. Doubling the amount of inputs from the earlier example, so that K = 80 and L = 20, gives Y = (1,600)1/2 = 40, illustrating that this function does have constant returns to scale. The Supply of Goods and Services Since we are supposing that K and L are fixed, it follows that we can calculate GDP immediately from the production function 𝑌 =𝐹 𝐾, 𝐿 =𝑌. 𝑌 is called the natural rate of output. At any point in time, the long-run or natural rate of output is determined by the available resources and technology. 3-2 How Is National Income Distributed to the Factors of Production? The overall determination of income is straightforward. More interesting, perhaps, is the question of how this income is divided up between workers, who supply labor and receive wages, and the owners of capital, who supply capital and obtain profits. The modern economic explanation is the neoclassical theory of distribution, which explains how much workers are paid per unit of labor and how much owners of capital are paid per unit of capital. Factor Prices Figure 3-2 As all markets are in equilibrium in the classical model, the markets for labor and capital— factors of production—determine factor prices. The price of each of these factors is determined by demand and supply. Since factor supplies are fixed, the supply curves are vertical, so our main task is to explain factor demands. The Decisions Facing a Competitive Firm The demand for factors comes from the firms in the economy that use them to produce goods. We suppose that there are many identical competitive firms. This means that they are small relative to the markets in which they trade, and so they take as given and as outside their control both the price at which they can sell output and the cost of factors of production. Each firm has a production function Y = F(K, L). We treat labor and capital symmetrically: Households own both labor and capital, which they sell (rent) to firms. In reality, the ownership of capital is indirect, since firms own capital, but these firms are, in turn, owned by households. Firms obtain revenues from selling their goods and incur the cost of labor and capital. The difference between their revenues and their cost is their profit. Profit depends on the price at which they can sell their output (the price of a unit of GDP, or P), the rental price of capital in dollars (R), and the dollar wage rate (W): Profit = PY – RK – WL = PF(K, L) – RK – WL. The firm’s problem is to choose K and L to maximize its profits. The Firm’s Demand for Factors Suppose that a firm with K units of capital and L units of labor hires an extra worker. The extra output it obtains is called the marginal product of labor (MPL): MPL = F(K, L + 1) – F(K, L). If the number of machines is fixed but the firm employs more and more workers, each additional Figures 3-3, 3-4 worker will probably contribute less extra output. Production functions generally exhibit diminishing marginal product. Firms compare the extra revenue from one more worker (P × MPL) with the cost of that worker, which is the nominal (dollar) wage (W). If P × MPL > W, the firm will want to hire more workers, and conversely, if P × MPL < W, the firm will want to hire fewer workers. The firm has the optimal number of workers when P × MPL = W, or when the marginal product of labor equals the real wage (W/P): MPL = W/P. The real wage represents the compensation of workers in terms of goods—units of real GDP— rather than in terms of dollars. Since labor and capital are treated symmetrically, an exactly analogous argument leads to the conclusion that the firm employs capital up to the point where the marginal product of capital (MPK) equals the real rental price (R/P), where R represents the dollar cost of a unit of capital: MPK = F(K + 1, L) – F(K, L) = R/P. The Division of National Income Since each factor of production is paid an amount equal to its marginal contribution to output, total real payments to labor equal (W/P) × L = MPL × L and total real payments to capital equal (R/P) × K = MPK × K. Total output equals Y. Real economic profit is the difference between real output and total real payments to factors of production; it equals the earlier expression for profit divided through by P: Real Economic Profit = Y – [(R/P) × K] – [(W/P) × L]. If the production function is constant returns to scale, real economic profit is zero. Proving this in general requires calculus, but it can be illustrated in terms of the earlier example, where K = 40, L = 10, and F(K, L) = (KL)1/2 = (KL) . MPK = (41)(10)− (40)(10) = 410 − 20 20.25− 20 = 0.25 MPL = (40)(11)− 20 = 440 − 20 21-20 =1. So MPK × K + MPL × L = 0.25(40) + 1(10) = 10 + 10 = 20 = Y. Case Study: The Black Death and Factor Prices We can carry out comparative static experiments with this model. For example, suppose that a major earthquake destroys some of the economy’s capital stock. Then the supply of capital in the economy would shift to the left, and we would expect the rental price of capital to rise. A vivid example comes from the 1300s, when the bubonic plague was rife in Europe. Within a few years, the population fell by almost one-third. This would suggest that real wages should have risen, as indeed they did. A peasant who managed to survive the plague ended up prospering financially! The Cobb–Douglas Production Function One feature of U.S. data is that factor shares—the division of income between capital and Figure 3-5 labor—have been more or less constant over time. This constancy of factor shares was noted in 1927 by economist Paul Douglas, who later went on to become a U.S. senator from Illinois. Suppose that the economy is competitive so that factors are paid their marginal products. What production function then implies that factor shares are constant? MPK × K = αY; MPL × L = (1 – α)Y. The answer supplied by mathematician Charles Cobb was that the function has to be of the form Y = AKαL1–α, where A is an arbitrary positive constant. Regardless of the actual values of K and L, this function will satisfy the equations we wrote above. It became known as the Cobb–Douglas production function and is widely used in economics. Since labor’s share of total output in the United States is approximately 0.7, the production possibilities of the U.S. economy can be approximated by the function Y = K0.3L0.7. The earlier example [Y = (KL)1/2] is a special case of the Cobb–Douglas production function, where A = 1 and α = 1/2. Going back to that example, we can see that MPK × K = MPL × L = 10 = (1/2)Y, so it does indeed exhibit constant factor shares. Case Study: Labor Productivity as the Key Determinant of Real Wages The neoclassical theory of distribution states that the marginal product of labor will equal the Table 3-1 real wage. The Cobb–Douglas production function has the property that the marginal product of labor is proportional to average labor productivity (Y/L). So the theory predicts that real wages should equal average labor productivity and thus should rise over time with average labor productivity. For the United States, the data confirm this prediction. Over the past half century, Supplement 3-3, average labor productivity and real wages have each risen about 2 percent per year. Furthermore, “Labor’s Share during shorter periods of time, when growth in labor productivity has been higher or lower than of Output in the United Kingdom” the long-term average, real wages likewise have risen in line with productivity. The Growing Gap Between Rich and Poor Income inequality between high-wage workers and low-wage workers is much greater today than it was in the 1970s. As measured by the Gini coefficient, inequality among family incomes fell from 1947 to 1968 but then reversed course and rose in subsequent decades. One explanation argues that skill-biased technological change has increased the demand for skilled workers faster than the education system has supplied such workers. As a result, the wages of skilled workers have grown relative to those of unskilled workers. A recent study by economists Claudia Goldin and Lawrence Katz, discussed in Chapter 3 of the textbook, estimates that in 2005 each year of college raised a person’s wage by 12.9 percent compared with only 7.6 percent in 1980. 3-3 What Determines the Demand for Goods and Services? So far, we have looked at the top part of the circular flow, finding that, given factor supplies K and L, total output is Y = F(K, L) and that the real wage and real rental rate of capital are determined by the marginal product of labor and capital. We now examine the demand for output, which, as the circular flow diagram illustrates, comes from consumption, investment, and government spending. To simplify our analysis, we ignore net exports and focus on a closed economy that does not trade with the rest of the world. Chapter 6 extends our framework to the open economy. Consumption Consumption is the largest source of demand and so is a natural starting point. Individuals receive wage and profit income, totaling Y. Some of this income is paid to government in the form of taxes. The government also gives transfer payments (for example, unemployment insurance, Social Security) to individuals. For aggregate purposes, only the net flow from individuals to the government matters: T = Taxes – Transfer Payments. Disposable income (after-tax income) is Y – T. The consumption decision is a decision between consuming now or saving to consume at some time in the future. Consequently, the decision depends on expectations about future economic conditions as well as on current circumstances. For now, however, we postpone detailed discussion of these issues until Chapter 16 and concentrate on the simplest story of consumer behavior. The primary determinant of consumption is disposable income, and the relationship between consumption and disposable income is known as the consumption function (C): C = C(Y – T). This notation simply means that consumption depends on disposable income. An example of a Supplement 3-3, consumption function is “The C = a + b(Y – T), Consumption Function” where a and b are parameters. The amount that consumption changes when disposable income changes is the marginal Figure 3-6 propensity to consume (MPC). In the example above, the MPC is a constant equal to b. More generally, it might be different at different income levels. Since we expect that someone who gets an extra dollar will save some of it and spend some of it, we expect the MPC to be a number between zero and one. Investment The main determinant of investment is the interest rate. (We suppose that there is a single interest rate in the economy. This is a reasonable assumption because, although there are many Supplement 3-4, different interest rates in the economy, they tend to move fairly closely together.) “Economist’s Investment depends on the interest rate because investment decisions are made with an eye Terminology” to the future. Firms face a number of different investment opportunities or projects with differing returns. Firms compare the return on these projects with the cost of borrowing to finance them— in other words, with the interest rate. The interest rate is the cost of investment. The interest rates that are quoted in the newspapers are nominal interest rates, meaning that they are quoted in dollar terms. A nominal interest rate of 10 percent means that if you borrow $100 this year, you must repay $110 next year. But economics emphasizes that people ultimately care not about the dollar cost of things but rather about what those dollars represent in terms of real goods. In a time of inflation, the nominal interest rate does not measure the true real cost of borrowing. To see this, suppose that the inflation rate is also 10 percent and that the price of a typical good today is $1. Then $100 will buy 100 units today. But now, if you have to repay $110 next year, that still only represents 100 units of GDP, since 10 percent inflation means that the new price level is 1.1. The nominal cost of the loan is 10 percent, but the real interest rate is zero. Figure 3-7 Firms look at the real interest rate when making their investment decisions. They compare the real return on an investment project (how many extra goods can be produced tomorrow if goods are given up today) with the real cost. Thus, we write I = I(r), where r denotes the real interest rate. Government Purchases The final component of expenditure is government spending. This is the purchase by federal, state, and local governments of goods and services. It does not include transfer payments; these contribute indirectly to the demand for goods and services through their effect on consumption. Governments’ choices of G and T determine their fiscal policy. One measure of a government’s fiscal policy stance is the deficit (DEF = G – T). If the government takes actions to increase the deficit (increasing G or decreasing T), this is known as an expansionary policy; the converse is a contractionary policy. The current analysis takes G and T as exogenous ( G=G, T =T ). FYI: The Many Different Interest Rates The textbook speaks throughout of “the” interest rate. Yet we know that, in the real world, there are many different interest rates. Interest rates differ because of term to maturity, credit risk, and tax treatment. But for most macroeconomic analysis, we can ignore these distinctions because different interest rates tend to move together. 3-4 What Brings the Supply and Demand for Goods and Services Into Equilibrium? From the circular flow diagram, the supply of goods, Y, equals the demand for goods (C + I + G). But Y is determined by the technology, tog ether with the stocks of capital and labor, while C, I, and G depend on the choices of households, firms, and government. What guarantees that supply equals demand? From microeconomics, we should expect that some price will match up supply and demand. A natural candidate for the equilibrating price might seem to be P, since it represents the price of a unit of GDP in terms of dollars. But in fact, neither the supply nor any component of the demand for goods depends on the general price level because people care about real values. If, say, the price level increases, then everything costs more in dollar terms, but real prices are not affected. Instead, the price that ensures equilibrium in the goods market is actually the real interest rate. (We will see in Chapter 7 that the price level is actually determined in the money market. Since P is the price of goods in terms of dollars, 1/P is the price of dollars in terms of goods, or the real price of money.) Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output The following equations summarize the demand and supply of goods and services for the economy: Since Y = C + I +G C = C(Y −T ) I = I(r) G = G T = T Y = F(K,L) =Y . Using these equations and noting that G and T are fixed by policy and Y is fixed by the factors of production and the production function, we can derive the following relationship: Y = C(Y −T )+ I(r)+G where the supply of output equals the demand for output. Since Y, C, and G are fixed in this equation, equilibrium must be achieved by adjustment of the interest rate. If the supply of goods and services exceeds the demand for goods services, then the interest rate will fall, encouraging investment and increasing the demand for goods and services. Conversely, if the supply of goods and services falls short of the demand for goods and services, then the interest rate will rise, reducing investment and decreasing the demand for goods and services. Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds We can rewrite the equilibrium condition as Y – C(Y –T ) – G = I (r). Now add and subtract T: Supplement 3-6, “Public and Private Saving” Figure 3-8 Figure 3-9 Supplement 3-7, “Wars and Interest Rates” Supplement 3-8, “A First Look at Nominal and Real Interest Rates” Figure 3-11 Figure 3-12 Y – C(Y –T )–T +(T – G)= I(r). This can be rewritten as: Sp + Sg = I(r). where Sp = Y – C(Y –T )–T is private saving and Sg = T – G is public saving. Combining the saving terms into national saving, S, we obtain: S = I (r). From this equation, we can see that when the goods market equilibrium condition is rewritten in terms of saving and investment, it has an interpretation in terms of equilibrium in the financial markets. Saving and investment represent the supply of and demand for loanable funds. Individuals and governments save, making funds available for investment. If the interest rate is high, there will not be very much demand for investment, implying too little investment relative to the amount of saving. The interest rate will then fall. The opposite occurs if the interest rate is too low. Changes in Saving: The Effects of Fiscal Policy We can now use our simple model to carry out comparative static experiments. Among the most interesting are those that entail a change in government policy variables. Suppose that the government carries out an expansionary fiscal policy by increasing spending or cutting taxes. Then, the government deficit will increase, so Sg will fall. To restore equilibrium in the goods market, the interest rate must rise: Since there is a greater demand for goods, but a fixed supply, the interest rate has to rise to decrease investment demand. Expressed in terms of the loans market, there is less saving available, so there will be less investment in equilibrium. This is known as crowding out. Notice that if there is an increase in government spending of ∆G, there must be an exactly equal decrease in investment spending. Government spending crowds out investment completely. Analogous results hold for a change in T. Given a decrease in taxes equal to ∆T, disposable income will increase by ∆T, so consumption will increase by ∆C = MPC × ∆T. National saving, thus, falls by this amount. (Equivalently, private saving rises by (1 – MPC)∆T and government saving falls by ∆T, so the net change is MPC × ∆T.) A tax cut thus reduces saving, increases the real interest rate, and crowds out investment by an amount equal to MPC × ∆T. Changes in Investment Demand The model emphasizes that investment is endogenous, since it depends on the interest rate, but there may also be exogenous changes in investment demand. For example, a technological innovation might lead firms to wish to invest in new capital goods (such as computers), or governments might change the tax laws in ways that affect firms’ incentives to invest. These can be represented as shifts in the demand for investment. Perhaps surprisingly, the model predicts that actual investment will be unchanged in equilibrium. Since investment must equal saving, and since the supply of saving is fixed exogenously, the change in investment demand results in a change in the real interest rate but no change in the amount of investment. This conclusion depends on the assumption that the supply of saving is unaffected by changes in interest rates. The supply of saving might also depend on the interest rate. If interest rates are high, people might be more inclined to defer consumption into the future and so would save more to take advantage of these high rates. Implicitly, this would mean that C = C(Y – T, r), where C depends negatively on the interest rate. In this case, the supply of saving curve is upward sloping. 3-5 Conclusion Chapter 3 presents a classical long-run model of the economy in which the level of output is determined by the available technology and the available factors of production. Factor prices adjust to ensure that factor markets are in equilibrium. Adjustment of the real interest rate ensures that the supply of goods equals the demand for goods (or, equivalently, that the supply of loanable funds equals the demand for loanable funds). Much of the rest of the book involves extending or refining this basic model. LECTURE SUPPLEMENT 3-1 How Long Is the Long Run? Part One The models of the economy presented in Parts II and III of the book are models of the long run, whereas the models in Part IV are short-run models. So how long is the long run? The answer is that it depends both on the world and on the model. The key feature of the classical model (Chapter 3) that makes it a long-run model is that prices are flexible. In other words, prices are assumed to adjust in that model to ensure equality of supply and demand in all markets. In the short-run models of Part IV, by contrast, it is often assumed that prices are instead sticky and so do not adjust to equilibrate all markets. The most basic answer to the question is then that the long run is however long it takes for prices to be free to adjust in all markets in the economy. Whereas prices can move instantaneously in some markets, they may be fixed for months (or even years, in the case of labor contracts) in other markets. As a rule of thumb, most economists believe price stickiness is relevant over a time horizon of a few months up to a couple of years, but not over a large number of years. LECTURE SUPPLEMENT 3-2 What Is Capital? The economist Robert Solow wrote, “If the Lord had intended us to analyze three variable systems, she would have made the page three dimensional.” The classical model of Chapter 3 (influenced by God or Solow?) indeed supposes that there are two factors of production— capital and labor. The decision as to how many factors of production to include in a model is at the discretion and judgment of the economist who is building the model. As always in economics, different assumptions are appropriate depending upon the questions that the model is designed to address. We could write the production function for the economy in terms of hundreds of different factors of production: Y = F(Trucks, Personal Computers, Jackhammers, Sewing Machines, . . . , L). But distinguishing between a jackhammer and a sewing machine is not important to the macroeconomist who is trying to understand the overall workings of the economy, however relevant the distinction might be to a seamstress or a construction worker. Eighteenth- and nineteenth-century economists often assumed that there were three factors of production: capital, labor, and land. For the theories that these economists were developing, the distinction between capital and land was appropriate and necessary. Modern economic theories do not rest in any essential way upon this distinction, and so they usually assume just two factors of production. Modern economics does suggest, however, that we should take a broad view of the meaning of capital. Along with physical capital—machines, factories, and the like—we should also view the acquired skills of workers as human capital. Increases in human capital, just like increases in physical capital, allow a given quantity of labor to produce more output. Workers and firms invest in human capital just as firms invest in physical capital. In each case, the investment entails forgoing consumption today to have increased income in the future. Workers can increase their human capital by investing in college-level education, for example, while firms can increase the human capital of their workers by means of on-thejob training. By some estimates, human capital accounts for more than half of the total U.S. capital stock. One simple way to incorporate human capital into the model of Chapter 3 is to suppose that the efficiency of workers can vary as well as the number of workers. If workers are more skilled, they have more human capital and so are able to produce more output. Thus, we could write Y = F(K, E × L), where E measures the efficiency of labor. The efficiency of labor depends on the stock of human capital (overall skill level) in the economy; and this in turn depends on investment in education and training. We return to this idea that the efficiency of labor may vary in Chapters 7 and 9. LECTURE SUPPLEMENT 3-3 Labor’s Share of Output in the United Kingdom Figure 3-5 in the textbook reveals that the division of U.S. output between capital and labor has been roughly constant for the last 60 years, suggesting that the Cobb–Douglas production function is a useful approximation. This stylized fact can be observed in other countries as well: Figure 1 graphs labor’s share of output in the United Kingdom over the last century and a half. Source: Constructed by Charles Bean from data in B.R. Mitchell, British Historical Statistics (Cambridge, MA: Cambridge University Press, 1988). ADDITIONAL CASE STUDY 3-4 The Consumption Function It is easy to find the consumption function in the data. Figures 1A and 1B use annual data from the national income accounts on consumption per person and disposable income per person to illustrate the U.S. consumption function in two different ways. Figure 1A, a scatterplot of the level of income and the level of consumption, emphasizes the long-run relationship between these two variables. As income has risen over time, so has consumption. Figure 1B, a scatterplot of the year-to-year changes in disposable income and the year-to-year changes in consumption, emphasizes the short-run relationship. In those years when income rises by a large amount, consumption also rises by a large amount; in those years when income stays the same or falls, consumption also stays the same or falls. Regardless of how we look at the data, we see a close relationship between consumption and income—a relationship summarized by the consumption function. Figures 2, 3, and 4 show the consumption–income correlation for the United Kingdom, Germany, and Japan. Figure 1a Figure 1b Change in Consumption and Income: United States, 1959–1995 (1992 chained dollars) LECTURE SUPPLEMENT 3-5 Economists’ Terminology Like all sciences, economics has a well-developed terminology, or jargon. Such a language is important because it allows economists to talk precisely about the economy and to avoid ambiguity. But this terminology presents pitfalls for the uninitiated, since economists have an annoying habit of taking terms that are used in everyday speech and giving them a precise meaning that may not exactly match their everyday meanings. We consider some examples here. Saving and Investment In everyday speech, people use the term “investment” to refer to any purchase of an asset, such as stocks and bonds, works of art, old or new housing, and the like. Macroeconomists usually use the term much more precisely to refer only to certain purchases of newly produced final goods and services. If a firm buys a new machine, or if an individual buys a new house, then that is investment as far as the macroeconomist is concerned. If an individual buys IBM shares or a Renoir painting, that is not investment in the macroeconomic sense; it is rather an individual act of saving. Such purchases merely reallocate existing assets among individuals and do not represent any net change in the assets of society. If a person purchases an existing house, then the transaction represents saving for the purchaser and dissaving for the seller. There is no net change in private saving, and so there will be no change in investment. Money and Income In everyday speech, a rich individual might be described as having a great deal of money. To the economist, however, money is not a synonym for income or wealth. Money is the name given to a particular asset or set of assets used for transactions. The detailed definition of money is discussed in Chapter 4, but it is sufficient to think of money as simply being dollar bills and deposits in checking accounts. A person with a large amount of money, to an economist, is someone who walks around with a large number of $100 bills or has a large value of deposits in a checking account. The distinction is important because changes in income and changes in money have very different effects in macroeconomic models. For example, increases in income induce people to consume more, but an individual’s consumption will not be higher simply because he or she holds more money. Profit As discussed in Chapter 3, economists distinguish between economic profit and accounting profit. Euler’s theorem tells us that a constant-returns-to-scale production function will imply that economic profit is zero if factors are paid their marginal products. The idea that economists conclude that firms don’t make any profit may seem baffling. Again, this arises because economists’ use of the term “profit” differs from the everyday use of the term. What is normally counted as profit by a firm, the economist thinks of as a payment to a factor of production. In reality, individuals own firms, and firms own capital. Firms then hire workers and produce goods using their capital and these workers. The revenue that they have left after they have paid their workers is the accounting profit of the firm, and this is usually not zero. These profits will then be distributed to the stockholders of the firms as dividends. But from the economist’s perspective, these payments to stockholders are simply their return for their ownership of the firm’s capital. In other words, they are a payment to a factor of production and do not represent economic profit. Real and Nominal Variables One of the most important distinctions in macroeconomics, and one that recurs throughout the textbook, is that between real and nominal variables. The distinction is actually very simple; acquiring the habit of keeping this distinction clear is more difficult, yet crucial to a good understanding of the economy. A nominal variable is measured in dollar terms. A real variable is measured in terms of goods (units of GDP). The difference matters whenever there is inflation or deflation. In times of inflation or deflation, the general price level is changing. Since the price level represents the price of a typical unit of GDP, changes in the price level represent changes in the dollar value of GDP, or, equivalently, changes in the real value of a dollar. Stocks Versus Flows Economists distinguish between variables know as “stocks” and variables known as “flows.” Stocks are measured at a point in time, whereas flows are measured over time. In the loanable funds model, saving is measured as a flow variable since it is the difference between income and spending, which are flows. Likewise, investment is a flow variable reflecting the purchase of new capital goods. A positive level of saving will increase a person’s wealth, which is a stock and is measured at point in time. A positive level of investment will increase the capital stock. The classical model discussed in this chapter abstracts from changes in the stock of wealth and capital, taking their values as given. In Chapters 8 and 9, the model of economic growth relaxes this assumption. ADDITIONAL CASE STUDY 3-6 Public and Private Saving The classical model of Chapter 3 discusses equilibrium in terms of the equality of investment and national saving. In interpreting this model, it is crucial to remember that national saving includes both private saving and the saving of the government. Private saving can in turn be subdivided into personal saving— the saving of individuals—and business saving, or saving by corporations. Public or government saving can be subdivided into the saving of the federal government and that of state and local governments. Figure 1 shows these components of saving as percentages of GDP for the period 1960–2013. One notable feature of these numbers is that business saving is large. Most of this saving goes to replacement investment, which is the replacement of worn-out or depreciated capital. In 1997, for the first time since the 1970s, the federal government had positive saving. While expenditures of the federal government exceeded current receipts (the federal government had a current budget deficit), this did not exceed the federal government’s expenditures for investment. Macroeconomists tend to focus most on personal saving and the saving of the federal government, because these components of saving are most directly affected by macroeconomic policies. In 1996, the Bureau of Economic Analysis revised the way in which it calculated public investment to make it consistent with the manner in which private investment is calculated. Business expenditures on equipment and structures are considered investment. Prior to the 1996 revision these expenditures, if undertaken by the government, were considered government consumption expenditures. Thus, a new office building purchased by the private sector would increase investment, whereas the same building if purchased by the government would not increase investment. Now, expenditures on equipment and structures regardless whether by the private or public sector are considered investment expenditures. This change not only treats expenditures by the private and public sectors comparably, but it also makes the calculations of investment and saving more comparable to those of other nations. The revised method of calculating government expenditures raises the amount of gross investment and saving in the economy. Prior to the 1996 revisions, the national income accounts identity was Y – C – G = I. Now, the national income accounts identity can be expressed as Y – C – GC = I + GI, where GC is consumption expenditures of the public sector and GI is investment expenditures of the public sector and G = GC + GI. Source: U.S. Department of Commerce, Bureau of Economic Analysis. ADDITIONAL CASE STUDY 3-7 Wars and Interest Rates Wars provide a good illustration of our theory, since government expenditures usually increase greatly in wartime. Also, wars are occasions when we can be reasonably confident that changes in government spending are really exogenous. Often, governments’ fiscal policies may actually be responses to the state of the economy. Between the mid-eighteenth century and the early twentieth century, the United Kingdom was involved in a number of wars, during each of which military spending rose. As predicted by the model, interest rates were also high at those times. Are there other explanations for the observed correlation (in British data) between government spending in wartime and interest rates? Robert Barro discusses two issues in his Journal of Monetary Economics article. One possibility is that interest rates in wartime include a risk premium, because investors fear that the government may default on its debt. Barro argues that this possibility can be eliminated because there is no evidence that interest rates were markedly higher in cases when defeat, and, hence, default, were relatively likely. In particular, Barro points to the Napoleonic Wars and World War I. Barro analyzes the behavior of nominal interest rates. He notes that we cannot rule out the possibility that some of the movement in nominal interest rates does not reflect changes in real interest rates but, instead, is the result of changes in expected inflation. The average inflation rate was low over the period he considers—0.4 percent per year between 1701 and 1918—which suggests that expectations of inflation might have been negligible but does not entirely rule out the possibility that expected inflation was sufficiently variable to have a significant effect on nominal interest rates. Finally, Barro notes that the British government used price and interest rate controls in Great Britain during World War I. This, according to Barro, may explain why interest rates did not rise even further, given the substantial increase in military spending. LECTURE SUPPLEMENT 3-8 A First Look at Nominal and Real Interest Rates The text describes how investment depends on the real interest rate—the rate adjusted for inflation—and simply states that it represents the true cost of borrowing, putting aside for now the question of exactly how real interest rates are measured. As we will see in Chapter 17, the appropriate real interest rate for investment decisions is the ex ante or expected real interest rate, which is equal to the nominal rate minus the inflation rate expected for the future. Thus, in making decisions about how much to invest, businesses do not directly observe the real interest rate they face since it depends on the value of inflation in the future. We can, however, measure the ex post real interest rate by subtracting actual inflation from the nominal interest rate. Table 1 provides data on the nominal interest rate (one-year constant maturity Treasury yield), the inflation rate, and the ex post real interest rate between 1962 and 2013. The high real interest rates of the 1980s are apparent. The real interest rate was just over 5 percent on average during the 1980s, twice as high as the average for any of the other decades shown. Furthermore, the real interest rate peaked at slightly more than 9 percent in 1982, more than double its highest level for any single year outside of the 1980s. Some observers point to this pattern of higher ex post real interest rates in the 1980s as evidence that the shift toward large budget deficits (reduction in government saving) during the Reagan administration had the effect of raising the real interest rate. Such a rise is what the simple classical model described in this chapter predicts following a decline in government saving. Others, however, argue that the ex ante real interest rate did not follow the pattern of the ex post real interest rate because people expected the high inflation of the 1970s to continue even as it fell sharply during the first half of the 1980s. According to this view, the ex ante real interest rate did not rise as much (if at all) compared to the ex post real interest rate. In contrast to the 1980s, the real interest rate was negative during much of the 1970s, averaging about negative 1 percent, as an increase in the nominal interest rate was more than met by a surge in inflation following the two oil-price shocks. During the early 2000s, the real interest rate again was negative, but for different reasons. The Federal Reserve eased monetary policy, pushing the nominal interest rate to what was at the time a 50-year low. With inflation relatively low and stable, the decline in the nominal interest rate implied a decline in the real interest rate below zero. Several years later, the Federal Reserve lowered short-term nominal interest rates to nearly zero and kept them at that level for more than six years in response to the Great Recession and the sluggish recovery that followed. Although inflation fell somewhat during these years, it remained above zero. With the nominal interest rate close to zero and inflation positive, the real interest dropped below zero from 2009 through 2013. Table 1 Nominal and Real Interest Rates, 1962–2013 (percent) Year One-Year Treasury Rate Annual Rate of Inflation Real Interest Rate Decadal Average 1962 3.1 1.3 1.8 1963 3.4 1.3 2.1 1964 3.9 1.6 2.3 1965 4.2 2.9 1.3 1966 5.2 3.1 2.1 1967 4.9 4.2 0.7 1968 5.7 5.5 0.2 1969 7.1 5.7 1.4 1970 6.9 4.4 2.5 1.6 1971 4.9 3.2 1.7 1972 5.0 6.2 -1.3 1973 7.3 11.0 -3.7 1974 8.2 9.1 -0.9 1975 6.8 5.8 1.0 1976 5.9 6.5 -0.6 1977 6.1 7.6 -1.5 1978 8.3 11.3 -3.0 1979 10.7 13.5 -2.9 1980 12.0 10.3 1.7 -0.9 1981 14.8 6.2 8.6 1982 12.3 3.2 9.1 1983 9.6 4.3 5.3 1984 10.9 3.6 7.3 1985 8.4 1.9 6.5 1986 6.5 3.6 2.9 1987 6.8 4.1 2.7 1988 7.7 4.8 2.9 1989 8.5 5.4 3.1 1990 7.9 4.2 3.7 5.2 1991 5.9 3.0 2.9 1992 3.9 3.0 0.9 1993 3.4 2.6 0.8 1994 5.3 2.8 2.5 1995 5.9 3.0 2.9 1996 5.5 2.3 3.2 1997 5.6 1.6 4.0 1998 5.1 2.2 2.9 1999 5.1 3.4 1.7 2000 6.1 2.8 3.3 2.5 2001 3.5 1.6 1.9 2002 2.0 2.3 -0.3 2003 1.2 2.7 -1.5 2004 1.9 3.4 -1.5 2005 3.6 3.2 0.4 2006 4.9 2.8 2.1 2007 4.5 3.8 0.7 2008 1.8 -0.4 2.2 (Continued on next page) Table 1 Nominal and Real Interest Rates, 1962–2013 (percent) (Continued) Year One-Year Treasury Rate Annual Rate of Inflation Real Interest Rate Decadal Average 2009 0.5 1.6 -1.1 2010 0.3 3.2 -2.9 0.0 2011 0.2 2.1 -1.9 2012 0.2 1.5 -1.3 2013 0.1 1.6 -1.5 -1.6 Note: The interest rate is the one-year constant maturity Treasury yield. Inflation is annual percent change in the consumer price index over the subsequent year. Real interest rate is computed as nominal rate minus inflation. Sources: Board of Governors of the Federal Reserve System and Department of Labor, Bureau of Labor Statistics. CHAPTER 4 The Monetary System: What It Is, and How It Works Notes to the Instructor Chapter Summary This chapter presents standard material defining what money is and explaining how the money supply process works. The chapter begins by describing the functions and types of money along with how money is controlled and measured. Next, the chapter discusses the role of banks in the monetary system. Finally, the chapter closes with an analysis of how central banks influence the money supply and problems in monetary control. Comments The material in this chapter can be covered in one or two lectures. Students sometimes confuse the money multiplier with the concept of aggregate demand multipliers presented in Chapter 11 (and which they may have studied in a principles of economics course). I find it useful to highlight the difference between these multipliers. Use of the Web Site The data plotter can provide students the opportunity to explore the relative importance of currency compared with demand deposits in measuring the money supply. Use of the Dismal Scientist Web Site Go to the Dismal Scientist Web site and download monthly data over the past two years for the money supply (M1) and the monetary base (currency held by the public plus reserves held by banks). Compute the money multiplier as the ratio of M1 to the monetary base. What happened to the money multiplier during the last several months of 2008? Discuss implications for the ratio of reserves to deposits at banks. How did banks respond to the financial crisis? Chapter Supplements This chapter includes the following supplements: 4-1 Money as a Medium of Exchange: “The Search Model” 4-2 If You Think the Island of Yap Has Problems… (Case Study) 4-3 More on Credit Cards 4-4 Financial Innovation, Near Money, and the Demise of Monetary Aggregates 4-5 Checks Without Banks: The Irish Banking Strike 4-6 Additional Readings Lecture Notes Introduction This chapter introduces the concept of money and discusses how the money supply is determined, highlighting the role of commercial banks in the monetary system. The chapter also describes how central banks influence the money supply and considers problems of monetary control. Case studies on the 1930s and the recent financial crisis provide opportunities to use the money supply framework to assess the effectiveness of policy responses. The chapter sets the stage for detailed discussion of long-run price determination and inflation in Chapter 5, as well as the more complex, short-run effects of monetary policy in later chapters. 4-1 What Is Money? Economists make a sharp distinction between money and income. Money, to an economist, represents the stock of assets that are used to carry out transactions. Most important, money includes currency—dollar bills and coins—as well as other assets, such as bank accounts. Understanding money would seem to be central to understanding macroeconomics, but this task Supplement 3-5, “Economist’s is not straightforward. The mystery of money is the following: We carry around little pieces of Terminology” paper that are intrinsically worthless, yet we can go into a store, give up some of these pieces of paper, and receive goods that have some intrinsic value. Why are people willing to give up valuable goods in exchange for intrinsically worthless pieces of paper? To answer this question, we need to know what money is. Essentially, money, or a monetary system, is something that allows people to carry out transactions with each other. It is a social arrangement, like language. An economy without a commonly agreed-upon money resembles a society without a commonly agreed-upon language; a lot of effort has to go into the everyday business of dealing with other people. The Functions of Money The traditional starting point for an analysis of money is in terms of the different functions that money can serve. To develop an understanding of money, economists focus on three aspects, or functions, of money: medium of exchange, store of value, and unit of account. The medium-of-exchange function of money emphasizes that money makes exchange easier. In an economy without money (a barter economy), people would spend a lot of time carrying out exchanges. In such an economy, an economics professor who wanted a beer might have to hunt around a long time for a bar that was willing to give her a beer in exchange for a lecture on economics or an offprint of one of her articles. But in a monetary economy, she can accept little green pieces of paper from her employer and use these to buy beer. The bar will accept these pieces of paper because it, in turn, believes that others will accept the pieces of paper, and so on. From this perspective, money has value because people expect it to have value. This sounds tenuous, and it is. Monetary systems have often collapsed through hyperinflation, where prices rise by many thousands of times a year. Once people believe that money no longer will be accepted, it ceases to have value. People, therefore, want to get rid of any money they may have, which means they will give up more and more money in exchange for goods. This pushes up prices, further decreasing the value of money, until the system falls apart. (We consider hyperinflations later on.) The idea that money can serve as a medium of exchange is thus linked to the role of money as a store of value. People will hold money only if they believe it will continue to have some value in the future, so money can operate as a medium of exchange only if it serves as a store of value as well. But the store-of-value function of money also recognizes that people can choose to hold some of their wealth in the form of money. The unit-of-account function of money identifies the convenience of having a widely recognized measure for accounting and transactions. People negotiate contracts in dollars and post prices in dollars because it is convenient and because they know that others will understand. A store in the United States could decide to quote all its prices in terms of English pounds, or Zambian kwacha, or kilograms of Colombian coffee if it wanted to, but that would obviously be Supplement 4-1, “Money as a Medium of Exchange: The Search Model” Supplement 4-2, “If You Think the Island of Yap Has Problems…” foolish. It is simpler to have a commonly agreed-upon and well-understood unit for recording prices and obligations. The Types of Money Historically, many different things have performed the roles of money, including seashells, cigarettes, and precious metals such as gold, as well as little pieces of paper. The use of pieces of paper was a gradual development as the government took a greater and greater interest in the monetary system. Today, other pieces of paper— checks—also serve to facilitate payments, and many transactions take place without any paper changing hands at all, in the form of electronic transfers. Money that has no intrinsic value—such as dollar bills—is known as fiat money; it is money because the government says so. It is distinct from commodity money, which exists when some intrinsically valuable good also serves as money. Many of the monies listed previously— most notably gold—are examples of commodity monies. Case Study: Money in a POW Camp In prisoner of war camps during World War II, cigarettes evolved as a form of commodity money. Prisoners used cigarettes to trade the goods they received in Red Cross parcels because this eliminated the need for a coincidence of wants before trade could take place. The Development of Fiat Money Fiat monies can arise as a natural evolution from commodity monies. If gold is serving as a commodity money, then the government can step in and mint gold coins that are of a specified and guaranteed purity and weight. Then, the government can issue promissory notes backed by gold—pieces of paper that can be exchanged for gold. Finally, it may no longer be necessary for these pieces of paper to be backed by gold if everyone is willing to accept them. Case Study: Money and Social Conventions on the Island of Yap The island of Yap in the Pacific used large stone wheels for money. Since these were difficult to transport, transactions often took place without these stone wheels actually being moved at all; instead, islanders simply traded claims to the stones for goods. FYI: Bitcoin: The Strange Case of a Virtual Money Bitcoin is a type of money that exists only in electronic form. Created in 2009 by anonymous computer expert(s), bitcoin is not commodity money, since it has no intrinsic value, nor fiat money, since it is not issued by government action. It is a medium of exchange that relies on people’s accepting it in exchange. In this way, it is similar to the primitive money used on the island of Yap. The value of bitcoin in terms of U.S. dollars has fluctuated sharply, ranging from less than 10 cents during its first year of trading to more than $1,200 in 2011, before falling to less than $500 in 2014. Although bitcoin is a medium of exchange, the volatility in its dollar price makes it a poor store of value and an inconvenient unit of account. Hence, whether it becomes the money of the future or a short-lived speculative fad remains to be seen. How the Quantity of Money Is Controlled For a commodity money system, the supply of money is determined simply by the amount of the commodity in existence, whereas for a fiat money system, the supply of money is controlled by the government. The government’s control over the money supply is referred to as monetary policy. In many countries, monetary policy is managed by an institution known as a central bank. Sometimes the central bank is merely a branch of the government, while in other cases it is partially independent of the political system, like the Federal Reserve (Fed) in the United States. The Fed’s Federal Open Market Committee (FOMC) meets about every six weeks to make decisions about monetary policy. This committee consists of the seven members of the Fed’s Board of Governors and five of the twelve presidents of the regional Federal Reserve Banks. The president of the Federal Reserve Bank of New York always has a vote, while the other four votes rotate annually among the remaining eleven bank presidents. Nonvoting regional bank presidents attend FOMC meetings and contribute to the discussion about policy. Although members of the Board of Governors are appointed by the President of the United States and confirmed by Congress, they have a 14-year tenure, so the Board is not completely under the control of the current administration. The presidents of the regional Fed banks are chosen by the banks’ boards of directors. The primary way in which the Fed influences the supply of money is by buying and selling government bonds, which the government has issued to the public to finance its deficits. To increase the money supply, the Fed purchases bonds from the public—thus exchanging bonds for dollars—and increases the quantity of money in circulation. This is known as an open-market operation. Conversely, the Fed decreases the money supply by selling bonds and taking money out of circulation. Although open-market operations are a powerful tool at the Fed’s disposal, the Fed, as discussed next, has only imperfect control over the supply of money. How the Quantity of Money Is Measured Table 4-1 There are many different assets that have some money-like characteristics, such as currency, Supplement 4-3, checking accounts, savings accounts, money market funds, and other assets. Some of these serve “More on Credit principally as a means of payment; others serve principally as a store of value; most fulfill both Cards” functions to differing degrees. Thus, it is impossible to give a single precise measure of the amount of money in the economy; there are several different measures. First, and most obviously, we have currency—bills and coins. If we add demand deposits and other checkable deposits to currency, we get M1. When we talk of money in macroeconomics, this is what we usually mean. As we add in other, less liquid deposits, we get M2 (M1 plus saving deposits, money market funds, and small time deposits). FYI: How Do Credit Cards and Debit Cards Fit into the Supplement 4-4, Monetary System? “Financial Innovation, Near Although credit cards are used to make purchases, they are not really a method of “payment” but Money, and the instead a method of “deferring payment.” In effect, the credit card company is making a loan to Demise of you. When you pay off the credit card bill at the end of the month by writing a check against Monetary your checking account, you finally are making a payment. The balance in your checking account Aggregates. is part of the money supply, but the outstanding debt on your credit card is not. A payment with a debit card, on the other hand, is drawn directly from the balance in your bank account, similar to writing a check. Accordingly, the account balance behind the debit card is part of the money supply. Even though credit card balances are not part of the money supply, increased use of credit cards to purchase goods and services may reduce the amount of money people hold and thus affect the demand for money. 4-2 The Role of Banks in the Monetary System The definition of the money supply that we generally use in macroeconomics is M = C + D, where M is the supply of money, C is currency in the hands of the public, and D is demand deposits (that is, deposits in banks that can be used for transactions, such as those held in checking accounts). 100-Percent-Reserve Banking If there were no banks in the economy, there would be no demand deposits, and so the money supply would simply equal the amount of currency. The same is true if all the currency was deposited in banks and the banks did not make any loans. Such banks would be operating under a system of 100-percent-reserve banking. In other words, they would accept deposits and simply store them in their vaults as reserves, or else they would deposit them in turn at the Federal Reserve, which acts as a bank for banks. If the public took all their currency and deposited it in the banking system, there would no longer be any currency in the hands of the public—all notes and coin would be held as reserves—but there would instead be demand deposits equal to the amount of currency. This can be illustrated in terms of the balance sheet of the banking sector, which we assume consists of one bank. This bank has assets equal to the reserves it holds and liabilities equal to the deposits of its customers. Under 100-percent-reserve banking, banks have no influence on the money supply. Fractional-Reserve Banking In the real world, banks also make loans. Since banks do not anticipate that all their depositors will want to withdraw all their money at once, they do not need to hold reserves equal to the amount of deposits. Instead, they only hold a fraction of their deposits as reserves and loan out the rest. This is known as fractional-reserve banking. Suppose that, as before, the public deposits all its currency in the banking system. Thus, Supplement 4-5, there is no currency in the hands of the public. But now suppose that banks adopt a reserve– “Checks without Banks: The Irish deposit ratio (rr) of 20 percent, so that for every $1 of deposits, the banks hold $0.20 in reserves Banking Strike” and lend out the remaining $0.80. The money supply has now increased, since there is still $1 worth of deposits, and there is now an additional $0.80 of currency back in the hands of the public. The money supply now equals $1.80 for every dollar of deposits. Moreover, the process does not stop here. If the $0.80 is in turn deposited back in the banking system, then banks will hold 20 percent ($0.16) as reserves and loan out the remaining 80 percent ($0.64). The money supply increases further. We can again illustrate this by looking at the balance sheets of banks. If we follow this process through, we find that each dollar of reserves contributes 1/rr dollars to the money supply, since 1 + (1 – rr) + (1 – rr)2 + (1 – rr)3 + ... = 1/rr. In our example, the reserve–deposit ratio equals 0.2, so the money supply equals $5 for every dollar of reserves. Bank Capital, Leverage, and Capital Requirements The model of the banking system presented above ignores the need for bank owners to have some financial resources, known as bank capital, representing their equity stake in the bank. A more realistic balance sheet for a bank would account for bank capital on the liability side and would also include the debt issued by the bank in addition to deposits as liability items. The asset side of the balance sheet would include bank investments in securities of the government and private sector in addition to reserves and loans. Banks will allocate resources to these assets based on the risk and return each provides and any regulations that may restrict the type of investments. In effect, a bank uses a strategy of leverage to augment its capital for the purposes of investment—that is, it borrows money (through deposits and debt) to increase the resources available for investment. The leverage ratio is the ratio of total assets to bank capital. In bad times, the bank can lose a large amount of its capital very quickly. For a bank with a high leverage ratio, a relatively small percentage drop in the value of the bank’s assets can result in a dollar loss that easily equals or exceeds the value of its bank capital. Because depositors and debt holders legally have to be paid first, the capital of the bank’s owners can be wiped out. Concern that bank capital is running short may lead depositors to demand their money and, in the absence of deposit insurance, cause a bank run. Bank regulators, therefore, require banks to hold sufficient capital, under what are known as capital requirements, to ensure that they can pay off their depositors. Many banks ended up with too little capital during 2008 and 2009 as a result of losses on investments they had made in mortgage loans and mortgagebacked securities. This capital shortage in turn led banks to reduce lending, contributing to the downturn in the economy. To counteract this, the Treasury and Federal Reserve began to put public funds into banks in an attempt to recapitalize the banking system. 4-3 How Central Banks Influence the Money Supply Having described the functions of money, how it is measured, and the way in which the banking system affects the amount of money in the economy, we now analyze how a central bank influences the money supply. This role of the central bank is the key element of monetary policy. A Model of the Money Supply We now examine fractional-reserve banking more carefully, taking into account the interactions among the central bank (Federal Reserve), households, and commercial banks. Some of the economy’s notes and coin—the monetary base—is in general held by the public (C) and some is held by banks as reserves (R). Letting B denote the monetary base, we have, by definition, B = C + R. Recall also that M = C + D. Now define the currency–deposit ratio (cr) as cr = C/D and note that the reserve–deposit ratio is rr = R/D. The currency–deposit ratio and the reserve–deposit ratio describe the behavior of the public and of banks, respectively. We can now use these equations to find how the money supply depends upon these two variables and on the monetary base. First, divide the second equation by the first to get M  C + D =  B  C + R ⇒ M = + D B.  C  C + R Now divide the numerator and denominator of the term in brackets by D: M = C / D+ D / D B  C / D+ R / D  = cr +1  B.  cr +rr The term (cr + 1)/(cr + rr) is known as the money multiplier, since it shows how each dollar of the monetary base is multiplied up to give a larger value for the money supply. For example, if the reserve–deposit ratio is 10 percent and the currency–deposit ratio is 40 percent, then the money multiplier equals 2.8—the money supply is almost three times the monetary base. Increases in the reserve–deposit ratio and the currency–deposit ratio both decrease the money multiplier. Note also that if the currency–reserve ratio is zero, then the money multiplier is 1/rr, as we found before. The Instruments of Monetary Policy This chapter makes the simplifying assumption that the Federal Reserve controls the money supply directly. But in reality, the Fed has only indirect control over the money supply using a variety of instruments. These instruments can be categorized as those that affect the monetary base and those that affect the reserve–deposit ratio and thereby the money multiplier. The Fed’s primary instrument for changing the monetary base is open-market operations—that is, the purchase and sale of government bonds. If the Fed buys a government bond, then it increases the monetary base, and vice versa. The Fed can also change the monetary base by lending reserves directly to banks. This has traditionally been done through the Fed’s discount window, and the interest rate that the Fed charges to banks is known as the discount rate. A reduction in the discount rate lowers the cost to banks of borrowing reserves and increases the incentive for banks to borrow from the discount window. In response to the financial crisis of 2008–2009, the Fed developed new mechanisms for banks to borrow reserves, including the Term Auction Facility. Under this facility, the Fed sets the quantity of reserves it desires to lend and banks then bid for the funds. The last auction under this facility was held in 2010. Changes in the minimum reserve–deposit ratio that the Fed imposes on banks through regulations, known as reserve requirements, lead to changes in the money multiplier and thereby the money supply. This tool is the least used of the Fed’s policy instruments. Furthermore, because banks in recent years have often held excess reserves, this instrument has become less effective. Since the end of 2008, the Fed has paid interest on reserves held on deposit at the Fed. By paying interest on reserves, the Fed aims to influence the amount of reserves held on deposit, thereby affecting the reserve–deposit ratio. An increase in the interest rate on reserves would raise the reserve–deposit ratio, lower the money multiplier, and lower the money supply. Case Study: Quantitative Easing and the Exploding Monetary Base The monetary base has typically grown gradually over time, but from 2007–2014 it expanded rapidly, increasing about fivefold in size. This explosion in the monetary base resulted from the Federal Reserve acting boldly during the financial crisis and economic recession as a lender of Figure 4-1 last resort. Initially, the Fed purchased mortgage-backed securities to help stabilize the mortgage market so that potential homeowners could borrow. Later, the Fed purchased long-term government bonds with the goal of keeping long-term interest rates low. This policy of quantitative easing is similar to an open-market operation, except that long-term, somewhat riskier securities are purchased rather than short-term Treasury bills. Despite the enormous expansion in the monetary base, broader measures of the money Supplement 20-6, “The Money supply did not increase nearly as much. Although the monetary base increased about 400 percent Multiplier During from 2007–2014, M1 increased by only 100 percent, and M2 increased by only 55 percent. The the Financial Crisis reason was that the money multiplier fell sharply as banks increased their reserve–deposit ratio, of 2008-2009” holding large amounts of excess reserves. This increase in excess reserves reflected in part a Supplement 20-7, response by banks to tighten credit standards as a result of losses on bad loans made prior to the “Banks Hoard financial crisis. The increase also reflected the reduced profitability of bank loans as interest Reserves During rates on such loans fell to very low levels, discouraging banks from lending. the Financial CrisisSupplement ” 20-11, future inflation if With the huge expansion in the monetary base, some observers raised concerns about interest rates reached normal levels and banks stepped up their lending, “Exit Strategies for increasing the money supply. The Fed, however, believed it could “exit” by selling Treasury the Fed” bonds and other securities in its portfolio and by raising the interest rate paid on reserves to discourage bank lending. Problems in Monetary Control By using its various instruments, the Fed can powerfully influence the money supply. But it does not have perfect control. Bank decisions to increase holdings of excess reserves will increase the reserve–deposit ratio and lower the money supply. The Fed also cannot fully control the amount that banks borrow from the discount window. If banks reduce their borrowing, the monetary base and money supply will decrease. Case Study: Bank Failures and the Money Supply in the 1930s Chapter 12 discusses how some economists believe that a large decline in the money supply during the early 1930s was the main cause of the Great Depression. But exactly why did the Table 4-2 money supply fall so dramatically? Interestingly, between August 1929 and March 1933 the monetary base rose by 18 percent, even though the money supply fell by 28 percent. Thus, the fall in the money supply is attributable to a decline in the money multiplier, which in turn was the result of a rise in both the currency–deposit ratio and the reserve–deposit ratio. A large number of bank failures occurred in the early years of the Great Depression. These failures are the probable result of the changed behavior of individuals and banks. The likelihood of bank failure makes currency seem like a safer way to hold wealth, increasing the currency– deposit ratio. Meanwhile, bank managers who fear a run on their bank are likely to increase their holdings of reserves. The Fed, therefore, was not directly responsible for the fall in the money supply, in the sense that it did not reduce the monetary base. However, it could have increased the monetary base further to offset the fall in the money multiplier. It also could have acted more aggressively to prevent runs on banks by being a lender of last resort to banks that were in difficulty. Since the 1930s, many policies have been adopted that reduce the likelihood of a sudden, large decline in the money multiplier. The most important is the system of federal deposit insurance that protects depositors when a bank fails, thereby supporting public confidence and preventing a sharp increase in the currency–deposit ratio. During the financial crisis of 2008– 2009, the Federal Deposit Insurance Corporation raised the insured deposit amount to $250,000 from $100,000 so as to stabilize the banking system and money supply. 4-4 Conclusion This chapter has explained the nature of money and how central banks influence its supply. The next chapter develops an understanding of how changes in the money supply affect the economy in the long run. Later in the text, the discussion will turn to monetary policy as a tool for stabilizing the economy in the short run. Our ultimate goal is to provide an appreciation of both the abilities and limitations of central bankers for improving the functioning of the economy. LECTURE SUPPLEMENT 4-1 Money as a Medium of Exchange: The Search Model Nobuhiro Kiyotaki and Randall Wright have developed a theory of money that explicitly recognizes how fiat monies may evolve to facilitate transactions. That is, they show how a generally accepted money can alleviate the “double coincidence of wants” problem that arises in a barter economy. Kiyotaki and Wright imagine a world in which individuals must search for one another to carry out trades. Think of a world with lots of different commodities, which we can think of as fruit. Suppose for simplicity that everyone owns a fruit tree. Unfortunately, nobody likes the fruit of their own tree, and everyone likes only some fraction of the other fruits in the economy. (For example, you might own a banana tree but like only apples and pears, while your neighbor has a cherry tree but eats only mangoes and papaya.) Suppose also that trading involves a transaction cost. Now imagine you set off with your banana and look for someone with whom to trade. If you meet someone who has an apple or a pear, you will be willing to trade. But if you meet someone who has a mango, you won’t want to trade, because trading is costly, and it’s just as likely that the next person you meet will want a banana as it is that they will want a mango. Similarly, no one will trade with you unless they want a banana. So trade will take place only if there is a double coincidence of wants. But now suppose someone offers you a piece of paper with a picture of a cherry tree on it in exchange for your banana. Will you accept it? The answer depends upon whether or not you think other people will accept it from you in turn. If you think no one will accept this piece of paper from you, you won’t accept it. If you are confident that others will accept this piece of paper, you will accept it, too, because then you can trade with anyone who has an apple or a pear, irrespective of their fondness for bananas. The story here is analytically very similar to that of thick-market externalities. We could have a coordination failure, where no one accepts money because they think no one else will. This is selffulfilling, but it leads to an inefficient outcome. Or we can have a good equilibrium, where everyone accepts money, and trade is much easier. The benefits of money for trade are so great that societies generally succeed in coordinating on acceptable monies. 81 CASE STUDY EXTENSION 4-2 If You Think the Island of Yap Has Problems…. “[T]here are three freely convertible currencies in the Galaxy, but none of them counts. The Altairian dollar has recently collapsed, the Flainian Pobble Bead is only exchangeable for other Flainian Pobble Beads, and the Triganic Pu has its own very special problems. Its exchange rate of eight Ningis to one Pu is simple enough, but since a Ningi is a triangular rubber coin six thousand eight hundred miles along each side, no one has ever collected enough to own one Pu. Ningis are not negotiable currency, because the Galactibanks refuse to deal in fiddling small change.” 1 82 LECTURE SUPPLEMENT 4-3 More on Credit Cards As discussed in the text, although credit cards are used to make transactions, they are not a method of payment but instead are a mechanism for deferring payment. Unlike a check or debit card, a credit card does not represent a claim on funds in a deposit account. Accordingly, measures of the money supply, such as M1 and M2, which are defined to include deposits in checking and saving accounts, do not include credit limits or outstanding debts on credit cards. But, as discussed in this chapter, the expansion of credit in the economy has an important role to play in determining the supply of money. In particular, banks make loans using a portion of the deposits on hand, and these loans then give rise to subsequent deposits, increasing the money supply. So, if a creditcard “loan” were deposited into a bank account (for example, using one of the ubiquitous “convenience checks” often sent to credit-card holders), then total bank deposits would rise and the money supply would increase. Hence, credit card loans may play a role in the determination of the money supply to the extent that their use gives rise to changes in outstanding deposit balances. 83 84 | CHAPTER 4 The Monetary System: What It Is, and How It Works LECTURE SUPPLEMENT 4-4 Financial Innovation, Near Money, and the Demise of the Monetary Aggregates The distinction between monetary and nonmonetary assets is becoming more blurred over time, largely as a result of rapid financial innovation in recent years. Assets included in a narrow definition of money, such as checking accounts, were once a good medium of exchange but a poor store of value. But now that checking accounts pay interest, they are a better store of value. Assets such as mutual funds were once a good store of value but a poor medium of exchange. Now depositors often can write checks on these accounts, so they also serve as a medium of exchange. Such assets are often called near money. A consequence is that the velocity of money, by any given definition, is likely to be unstable, because near money assets are good substitutes. This makes policymaking difficult for the Federal Reserve. In recent decades, the Fed has moved to a policy that places less emphasis on fluctuations in the money supply and instead targets a value for the federal funds rate—the rate on overnight loans among banks. The dynamic model of aggregate demand and aggregate supply developed in Chapter 15 incorporates an interest-rate rule for the central bank into the analysis of short-run economic fluctuations. The increased use of near money during the 1980s caused the velocity of money to become unstable. As a result, analysts have focused less on narrow definitions of money, such as M1, and more on broader measures of money, such as M2. Figure 1 shows that the velocity of M2 was much more stable in the late 1980s and early 1990s than that of M1. Still, it is clear that M2 velocity is also subject to some fluctuation. There is probably no single monetary variable that accurately indicates the state of aggregate demand in the economy, so the Fed is obliged to look at a number of different indicators. Note also from Figure 1 that the velocities of M1 and M2 sometimes move together (as in much of the 1980s) and sometimes move in opposite directions (as in the early 1990s), further complicating the task of the Fed. Source: Federal Reserve Board and U.S. Department of Commerce, Bureau of Economic Analysis. Note: Data are an index of the ratio of quarterly nominal GDP to the quarterly average of the respective monetary aggregate. 84 ADDITIONAL CASE STUDY 4-5 Checks Without Banks: The Irish Banking Strike Since banks create money under fractional-reserve banking, we would expect the closure of banks to severely disrupt the functioning of an economy. The Irish experience in 1970 (studied by the Irish economist Antoin Murphy) provides an interesting counterexample. In that year, a major strike closed all Irish banks for six and a half months. All the indications from the start, moreover, were that this would be a long closure. As a consequence of the strike, the public lost direct access to about 85 percent of the money supply (M2). Irish currency still circulated, of course; British currency was also freely accepted in Ireland, and some North American and merchant (commercial) banks provided banking facilities. Increases in Irish and British currency and in deposits in these banks, however, accounted for less than 10 percent of M2. Somewhat remarkably, checks on the closed banks continued to be the main medium of exchange during the dispute. Despite the increased risk of default, individuals continued to be willing to accept personal and other checks. Murphy summarizes the situation as follows: “a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system.” According to Murphy, it was the small size of the Irish economy (the population of Ireland was about 3 million at that time) and the high degree of personal contact that allowed the system to function. Stores and pubs took over some of the functions of the banking system. “It appears that the managers of these retail outlets and public houses had a high degree of information about their customers—one does not after all serve drink to someone for years without discovering something of his liquid resources. This information enabled them to provide commodities and currency for their customers against undated trade credit. Public houses and shops emerged as a substitute banking system.” Presumably as a result of this spontaneous alternative banking system, economic activity in Ireland was not substantially affected by the banking strike. Detrended retail sales did not differ much on a monthby-month basis from average levels in the absence of banking disputes, and a central bank survey concluded that the Irish economy continued to grow over the period (although the growth rate fell). A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. Murphy notes that currency and deposit accounts with the affected banks formed 85 percent of M2 in 1970. Murphy, “Money in an Economy without Banks”: 43. Some individuals were also able to utilize banking facilities in Britain and Northern Ireland. Ibid., p. 44. Ibid., pp. 44–45. Murphy presents evidence on retail sales and also quotes from the survey. A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. Murphy notes that currency and deposit accounts with the affected banks formed 85 percent of M2 in 1970. Murphy, “Money in an Economy without Banks”: 43. Some individuals were also able to utilize banking facilities in Britain and Northern Ireland. Ibid., p. 44. Ibid., pp. 44–45. Murphy presents evidence on retail sales and also quotes from the survey. A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. A. Murphy, “Money in an Economy without Banks: The Case of Ireland,” The Manchester School (March 1978): 41–50. Murphy notes that currency and deposit accounts with the affected banks formed 85 percent of M2 in 1970. Murphy, “Money in an Economy without Banks”: 43. Some individuals were also able to utilize banking facilities in Britain and Northern Ireland. Ibid., p. 44. Ibid., pp. 44–45. Murphy presents evidence on retail sales and also quotes from the survey. 85 LECTURE SUPPLEMENT 4-6 Additional Readings Two general interest books on the Federal Reserve under Alan Greenspan are Steven K. Beckner, Back From the Brink: The Greenspan Years, John Wiley & Sons, New York, 1996, and Robert Woodward, Maestro: Greenspan’s Fed and the American Boom, Simon and Schuster, New York, 2000. Both books explore the interaction of politics with monetary policy. 86 Instructor Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058