Unformatted text preview: 5/14/2011 Economics 1B UC Davis UC D i Professor Siegler Spring 2011 Exam #2
Tuesday night, May 17 Tuesday night, May 17 Lectures 713 and the corresponding material in Chapters 510 of Taylor. Similar in structure and format to Exam #1 I'll post specifics in SmartSite this weekend. Chat Room on Monday evening at 9:30 p.m. Chat Room on Monday evening at 9:30 p.m. Remember to bring a #2 pencil, scantron form, calculator with exponent key, and a handwritten 3 by 5 inch note card (both sides).
2 1 5/14/2011 "Inflation is always and everywhere a monetary Inflation is always and everywhere a monetary phenomenon." Milton Friedman "Persistently high inflation is always and y p everywhere a fiscal phenomenon." Thomas Sargent 3 I. Introduction
Tonight we are going to introduce money into our Tonight we are going to introduce money into our longrun model of the macroeconomy economy. In the long run, money is neutral, meaning that changes in the money supply do not affect real variables. It only affects other nominal variables. The quantity theory of money is useful is determining longrun rates of inflation. Massive government spending and fiscal deficits, however, must be added to explain periods of very high and persistent inflation (hyperinflation).
4 2 5/14/2011 II. What is Money?
Money is not the same thing as income or wealth, Money is not the same thing as income or wealth, but economists use the term "money" to signify assets that serve three functions. Economists use the Forrest Gump definition of money, "money is what money does." Because there is no distinct line between what is money and what is not money, the Federal Reserve publishes two main definitions of money: M1 and M2. 5 II. What is Money?
Medium of Exchange g
A medium of exchange is an asset that is readily accepted as payment for goods and services or repayment of debt. The medium of exchange function of money solves the problem of "double coincidence of wants" that occurs in a barter economy. Until 1963, the U.S. had a commodity money system U l 1963 h U S h d di where you could exchange dollar bills for silver. Since 1964, it is a fiat money system with no intrinsic value, except that each bill says, "This note is legal tender for all debts public and private."
6 3 5/14/2011 II. What is Money?
Unit of Account Unit of Account
The second function of money is that it serves as a unit of account. That is, everything is quoted in dollars which makes relative price comparisons easy. Imagine how many relative prices we would need if we needed a relative price for each pair of goods and services. With 100,000 goods in a typical Walmart services With 100 000 goods in a typical Walmart store, we could need 4,999,950,000 relative prices. 7 II. What is Money?
Store of Value Store of Value
A store of value is a way of transferring purchasing power from the present to the future. Money is not the best store of value since most of money does not pay interest (i.e., currency and most checking account deposits), and inflation reduces its ability to serve as a store of value. ability to serve as a store of value 8 4 5/14/2011 III. Measures of the Money Supply
M1 emphasizes the medium of exchange (means of emphasizes the medium of exchange (means of payment) function of money. M1 includes the most liquid assets (assets you can turn into a means of payment easily without loss of value):
Currency held by the public Demand deposits (checking account deposits that do not pay interest) t i t t) Other checkable deposits (checking account deposits that pay interest) Traveler's checks (about of 1 percent of M1)
9 III. Measures of the Money Supply
M2 includes all of M1 plus: M2 includes all of M1 plus:
Savings deposits Time deposits (less than $100,000) Individual money market deposit accounts (invests in securities and bonds with maturities of less than one year), which may have some check writing privileges Individuals money market mutual funds I d d l k lf d 10 5 5/14/2011 III. Measures of the Money Supply
Different Measures of the U.S. Money Supply 2010 Different Measures of the U S Money Supply 2010 (billions of dollars)
C MB M1 M2 currency monetary base = currency plus reserves currency plus demand deposits (e.g., checking accounts) ( h ki t ) M1 plus savings deposits, small time deposits, and individual money market accounts $915.7 $2,008.5 $1,832.2 $8,816.4 Source: Economic Report of the President, 2011. 11 IV. The Federal Reserve
The History and Structure of the Federal Reserve The History and Structure of the Federal Reserve System
Founded by the Federal Reserve Act of 1913, after the banking panic of 1907 The primary mission of the Fed is to promote economic growth, low inflation, and stable financial markets. markets The Fed is "independent within government." 12 6 5/14/2011 IV. The Federal Reserve
The Structure of the Federal Reserve
12 Regional Federal Reserve Banks
Assess economic conditions in their regions to assist in national policymaking Provide service to the commercial banks in their districts Board of Governors
Seven governors Appointed by the president and confirmed by the Senate to A db h d d f db h 14year staggered terms Chairman of the Board of Governors (Ben Bernanke) Selected by the president from the governors Serves a fouryear term
13 IV. The Federal Reserve
Federal Open Market Committee (FOMC) Federal Open Market Committee (FOMC)
The seven Fed governors President of the New York Fed Four presidents, chosen on a rotating basis, from the remaining Federal Reserve Banks The FOMC meets about eight times a year (on The FOMC meets about eight times a year (on Tuesdays from 9 a.m. to 1 p.m.) to determine monetary policy primarily by setting a target interest rate for the federal funds rate.
14 7 5/14/2011 V. Money Creation
Bank assets and liabilities in a T account Bank assets and liabilities in a Taccount
Assets are things the bank owns Liabilities are things the bank owes In a Taccount, assets go on the lefthand side, while liabilities go on the righthand side. The primary tool the Federal Reserve uses change interest rates and the money supply is openmarket operations (the buying and selling of U.S. Treasury bonds by the Federal Reserve) 15 V. Money Creation
Let's examine the case of money creation without y currency by looking at the balance sheet (Taccount) for a particular commercial bank (Bank A). Reserves are deposits that commercial banks hold in the vaults (vault cash) or in an account at the Federal Reserve. The required reserve ratio is the fraction of q commercial banks' deposits that it is required to hold as reserves. Suppose that the required reserve ratio is 10 percent (0.10) and that Bank A holds no excess reserves.
16 8 5/14/2011 V. Money Creation
Balance Sheet for Bank A Assets Liabilities Loans $600 Deposits $1,000 Bonds $300 Reserves $100 17 V. Money Creation
Now suppose that the Fed engages in an open N th t th F d i market purchase of bonds of $100. After the purchase the balance sheet for Bank A is: Balance Sheet for Bank A Assets Liabilities Loans $600 L $600 Deposits $1,000 D it $1 000 Bonds $200 Reserves $200 18 9 5/14/2011 V. Money Creation
Bank A now has excess reserves of $100, which is can B kA h f $100 hi h i loan out: Balance Sheet for Bank A Assets Liabilities Loans $700 L $700 Deposits $1,000 D it $1 000 Bonds $200 Reserves $100 19 V. Money Creation
In this economy without currency, the loan of $100 In this economy without currency, the loan of $100 gets deposited into another commercial bank, call it Bank B, and the same process continues from bank to bank:
Bank Bank B Bank C B kC Bank D . . . . Final Sum Deposits $100 $90 $81 . . . . $1,000 Loans $90 $81 $72.90 . . . . $900 Reserves $10 $9 $8.10 . . . . $100
20 10 5/14/2011 V. Money Creation
Recall that deposits are money since they are part of M1. Therefore, the initial openmarket purchase of $100 has Therefore the initial open market purchase of $100 has expanded the money supply, in this case, tenfold:
Money multiplier y p In the real world, commercial banks may decide to hold some excess reserves, and households will decide to hold some of the loans as currency, both of which reduce the magnitude of the monetary expansion from a given openmarket purchase of bonds.
21 VI. The Quantity Equation
The quantity equation of money is: The quantity equation of money is: We can use our growth rate rules to write it in terms of growth rates: In words,
money growth + velocity growth = inflation + real GDP growth
22 11 5/14/2011 VII. The Quantity Theory of Money
The quantity equation of money is true by definition. q y q y y To go from the quantity equation to the quantity theory of money, we need three additional assumptions:
The velocity of money is constant, so the growth rate of velocity is zero. In the long run, the growth rate of real GDP depends g , g p only on the growth of inputs and the growth of technology (Lecture 12). Causation runs primarily from the growth rate of money to the inflation rate.
23 VII. The Quantity Theory of Money
Let s start with the quantity equation and impose the Let's start with the quantity equation and impose the three assumptions to yield the quantity theory of money: With constant velocity: y Solving for the inflation rate: 24 12 5/14/2011 25 26 13 5/14/2011 VIII. Hyperinflations
Faster rates of monetary growth are associated with yg higher inflation rates in the longrun. But why would money growth be high?
Friedman is only halfright. The underlying cause hyperinflation is fiscal policy. Government spending can be financed by three potential methods: (1) collecting taxes, (2) borrowing by issuing , ( )p g y( g g ) bonds, or (3) printing money (seigniorage). Countries with high inflation rates usually experience a fiscal emergency (e.g., war) that causes G to increase dramatically. If the increase in G cannot be financed by raising taxes or borrowing, then M increases, which causes inflation.
27 28 14 5/14/2011 Selected Episodes of Hyperinflation
Country y Hungary Zimbabwe Germany Greece Nicaragua g Yugoslavia U.S. Period 19451946 20012008 19191923 19411944 19861991 19931994 17771780 Cumulative Inflation Rate 1.3x1024 8.53x1023 0.5x1012 1.60x1011 1.20x1010 1.60x109 2,702 Maximum Monthly y Inflation Rate 4.19x1016 7.96x1010 3,250,000 8.5x109 261 5x1015 1,342 29 VIII. Hyperinflations
One way to see the fiscal causes of hyperinflation is One way to see the fiscal causes of hyperinflation is to examine the uses and sources government budget constraint, where G is government purchases, TR is transfer payments, iB is interest on the debt, T is taxes, B are newly issued bonds, and M is the change in the money supply: Uses of Funds Sources of Funds 30 15 5/14/2011 IX. Costs of High Inflation
Price Confusion and Money Illusion (when people Price Confusion and Money Illusion (when people mistake changes in nominal prices for changes in real relative prices) Redistributes Wealth (unexpected inflation benefits borrowers and hurts lenders) Menu costs Shoe leather costs 31 Question 13.1
In an economy without currency and without y y commercial banks holding any excess reserves, suppose the required reserve ratio is 20 percent (rr = 0.20). If the Federal Reserve purchases $10 billion in Treasury bonds from commercial banks, the money supply eventually increases by: A) $10 billion. B) $100 billion $100 billion. C) $2 billion. D) $50 billion. Answer: D
32 16 5/14/2011 Question 13.2
Using the quantity theory of money, if the growth Using the quantity theory of money, if the growth rate of real GDP is 3 percent per year, and the money supply is growing at 3 percent per year, what is the inflation rate in this economy? A) 0 percent per year. B) 3 percent per year. C) 6 percent per year. D) 9 percent per year. Answer: A
33 Question 13.3
There are ______ voting members of the Federal There are voting members of the Federal Open Market Committee (FOMC) A) 7 B) 12 C) 19 D) 24 Answer: B 34 17 5/14/2011 Question 13.4
The quantity theory of money was derived from the The quantity theory of money was derived from the quantity equation by asserting that: A) real output was fixed. B) the money supply was fixed. C) the velocity of money was fixed. D) the velocity of money was zero. D) the velocity of money was zero. Answer: C 35 Question 13.5
According to the quantity theory of money, deflation According to the quantity theory of money, deflation will occur if the A) money supply is less than real GDP. B) money supply is more than real GDP. C) money supply grows at a slower rate than real GDP. D) money supply grows at a faster rate than real GDP. Answer: C
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