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Transcript of Chapter 10 Financial Markets and the Economy. Financial Markets are markets in which funds...
![Page 1: Chapter 10 Financial Markets and the Economy. Financial Markets are markets in which funds accumulated by one group are made available to another group.](https://reader036.fdocuments.us/reader036/viewer/2022081516/5519fbae550346ab0c8b489d/html5/thumbnails/1.jpg)
Chapter 10
Financial Markets and the Economy
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Financial Markets are markets in which funds accumulated by one
group are made available to another group.
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The bond market is a market in which institutions and individuals borrow and lend money. They do
this through buying and selling bonds.
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For example, the U.S. government wishes to borrow money. They issue a bond like this one. It will have a date of maturity,
or when you can turn it back into the government and get your money back
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It will also have the amount of money you get paid back, in this case $100. So let’s say the maturity on this bond
is one year.
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You buy it now and turn give it to the government in one year to be paid $100. You are loaning them your money for one year. What is the
interest rate you are getting?
That depends on how much you paid for it.
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Let’s say you pay $90 for it. In one year, you get back $100.
You have lent $90 for a year and got back $100. That is equal to an interest
rate of (Face Value – Bond Price)/Bond Price
($100-$90)/$90 = $10/$90 = .1111= 11.11%
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The higher the price you pay for the $100 bond 1 year bond, the lower the interest rate you get.
Pay $90, then i = 11.1%Pay $95, then i = 5.3% Pay $99, then i = 1.0%
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So now we face a choice. Do we want to think of the bond market
as one where people lend and borrow money at a certain interest
rate, or buy and sell bonds at a certain price?
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Both of these are correct ways of illustrating the same thing
happening. Textbook guy uses the 2nd way. I find the 1st way much
more intuitive.
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Here are both ways side-by-side. We will primarily use the diagram on the right.
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You’ve seen the 2nd diagram before back in unit 2, where I called it the supply and demand diagram for the credit market.
Interest rate
Loanable Funds
Supply (savings)
Demand (borrowing)
iE
QE
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Here is one way that a change in interest rates can effect the macroeconomy.
Much investment spending done by businesses is financed through
borrowing. The higher the interest rate you have to pay on a loan to get the
money to build a new factory, the less likely you are to build the factory.
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Suppose for some reason there is an increase in the amount available for lending. This is an increase in supply in the credit market.
Interest rate
Loanable Funds
S1
D1
S2i1
i2
Q1 Q2
Interest Rates Fall
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Q
P
The extra investment spending will increase AD (GDP=C+I+G)
AD1
SRAS
P1
QN
AD2
This could help get us
out of a recession
P2
Q1 Q2
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You have a demand for money. Do you always want more?
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What can you do with your purchasing power? 3 things.
1) Buy Goods2) Buy bonds (or other high
interest investments)3) Hold it as money
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1) Why buy goods?That’s obvious. You want them.
2) Why buy bonds?To earn interest.
3) Why hold money?Purchase future goods and services
easily. Money is very liquid.
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3 Reasons to be holding money
1) Holding money to make expected purchases later is the transactions
demand for money.
2) Holding money to protect against unexpected purchases (emergencies) is the precautionary demand for money.
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3) The speculative demand for money you expect to invest in
bonds or stocks but are waiting for a better price.
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If we look just at the choice to hold money or bonds, we can think of the interest rate as the opportunity cost
or “price” of holding money.
If the money itself earns interest, such as an interest earning checking
out, it is the difference in the two interest rates that matters.
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The higher the interest rate goes on the bonds you have to give up
to hold money, the less money you want to hold.
Or the more bonds you want to hold. The two statements are
functionally equivalent.
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Demand curve for money in terms of interest for bonds.
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What else affects the demand for money?
1) Expected inflation – the more you expect prices to rise, the less cash you want to hold (remember the wealth
effect?)2) Confidence in the future – if you fear
losing your job or that the bond you buy may not pay off, you wish to hold
more cash.
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Textbook guy lists a few more, but you do not have to memorize the
others on the list.
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I fear losing my job.
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What about the supply of money. Let’s assume the federal reserve
board can create as much or little money as it wishes through
open market operations.
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Equilibrium in the money market is when people want to hold exactly
as much money as the fed has created. Suppose the interest rate is very high. People won’t want to
hold much money, they will want to hold bonds instead. If the Fed has created a lot of money, people will
have “too much” money.
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They will get rid of the excess by saving it into the bond market.
They will do this by buying bonds. The interest rate will fall until
people no longer feel they have “too much” money.
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Do people really think they have too much money? Well, imagine you
have a huge cash stash in the cookie jar and read that Ford Auto Co. is
paying 100% on Ford bonds.
Wouldn’t you say I have too much cash sitting around doing nothing when it could be earning 100%?
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If they have “too little” money, they will get more by saving less
into the bond market (selling bonds) and interest rates will rise.
There will be an interest rate at which people want to hold the
exact amount of money created by the Fed.
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When we get to that interest rate, there will be equilibrium in the money market.
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The money market graph and the credit market graphs are two sides of
the same coin.
Interest rate
Loanable Funds
Supply (savings)
Demand (borrowing)
iE
QE
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If the demand curve for money shifts, the interest rate will shift. Suppose
people fear a big rise in inflation.
More money goes into the bond market and interest rates fall.
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If the Fed creates more money, people put some of that money into the bond
market and interest rates fall.
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Here we see what is simultaneously happening in the credit market.
Interest rate
Loanable Funds
S1
D1
S2i1
i2
Q1 Q2
Interest Rates Fall
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Q
P
Why might the Fed want to do this? AS/AD diagram showing the effect of more investment caused by
lower interest rates.
AD1
SRAS
P1
QN
AD2
This could help get us
out of a recession
P2
Q1 Q2
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Chapter 11
Monetary Policy and the Fed
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What are the Fed’s goals?
1) Low Inflation2) Low Unemployment
3) High Growth
The same 3 variables that we said determine if the macroeconomy is
working well back at the beginning of chapter 5.
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But what weight does it assign to each goal? In the 1960’s and 70’s, it was lower unemployment. Since then, it has been lower inflation.
This comes from the feeling among many bankers and economists that
the fed paid to little attention to inflation in the 60’s/70’s.
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If it did, it was probably acting on the feeling that the fed paid too
little attention to unemployment in the 1930’s.
Some economists are arguing that this “don’t make the same mistake
we made last time” mentality is causing the fed to pay too much
attention to inflation now.
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In theory, Congress can legally set the goals for the fed whenever it wants. It has given the fed a dual mandate of low unemployment
and low inflation.
In practice, this has left the fed almost completely independent.
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So what should the fed do? Suppose we are in a recession. In our model,
Q is in the recessionary gap.
How can we get out of the recession? We could wait until
wages adjust, but with sticky wages, that could take years … and years.
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Q
P
A quicker way out would be if the fed could get AD to move right.
AD1
SRAS
P1
QN
AD2
P2
Q1
Can they do this?
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The short answer is yes. 1) Fed buys government securities.2) Banks have more funds to loan.
3) Drop in interest rates.4) People borrow the new money
from the banks and buy things.
Voila, recession over!
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This is known as expansionary monetary policy. The fed creates
money and drives down the interest rate to increase buying.
AD moves to the right and increases output and lowers
unemployment.
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We’ve already seen what simultaneously is happening in the
credit market.Interest rate
Loanable Funds
S1
D1
S2i1
i2
Q1 Q2
Interest Rates Fall
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What about in the money market? And
buy this, I don’t mean the financial market sometimes
known as the money market. I mean
people’s choice of how much money to
hold.
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Interest rates fall, people want to hold more money and less bonds.
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So as the fed increases the money supply, people will hold more in their cash stash. The increase in money to
be lent will not be as large as the amount created by the fed, since
people will respond by saving less and holding more cash. But it is unlikely this effect will be large enough to cancel out
the effect of the fed’s action.
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But what if the problem is we are in the inflationary gap part of the diagram. Can we get back to QN without inflation? Not if we wait
for the natural long-run adjustment and the shifting SRAS curve. But what if we move AD to
the left?
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Q
P
Out of the inflationary gap without inflation.
AD2
SRAS
P2
QN
AD1
P1
Q1
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To do this, we use contractionary monetary policy. The fed decreases the money supply, this decreasing AD. After all, what is money used for? So less money, less buying.
1) Sell government securities.2) raise r.
3) raise the discount rate.
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So to sum up:
To fight recessions, expansionary monetary policy to move AD right.
To fight inflation, contractionary monetary policy to move AD left.
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Well, that sounds easy. In fact, it sounds too easy. If
macroeconomics is that simple, why do we have such a hard problem with recessions and
inflation?
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There are problems.
The first we are going to talk about is lags. Lags are the time between something happening and the end
effect of that thing happening.
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The first lag we are going to talk about is called recognition lag.
Recognition lag is the delay between the time a
macroeconomic problem occurs and the time policy makers
become aware of it.
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The textbook discusses 1990 recession as an example, but I will
go more recent than that. Minutes from fed meetings are released with a 5 year lag, so we are just
seeing what the fed was doing in 2008/2009 as the economy went
into the tank.
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We see that even as the economy was entering the worst recession
since the great depression, the fed in September 2008 couldn’t decide
if recession or inflation was the biggest danger. So they decided to
do nothing. No discount rate changes, no major open market
operations.
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In retrospect a big mistake. When they realized this, they lowered the discount rate and did major open
market buying, but now the recession was rolling and its harder
to stop a rolling boulder than to keep it from starting to roll in the
first place.
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Then comes the implementation lag. Implementation lag is the delay between the time policy
makers become aware of a problem and the time they enact a
policy to deal with it.
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For the Fed, the implementation lag is quite short. They can decide
what to do and then do it quite quickly. But remember this lag when we get to the last chapter and talk about actions congress
can take.
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Finally comes the impact lag. Impact lag is the delay between the time a policy is enacted and the time it has its effect on the
macroeconomy.
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So the fed decides to create a lot of new money to increase AD and buys a lot of government securities from banks. This first step accomplishes nothing by itself. We have to wait
for the banks to lend out the money. And even this first effect will be
small because …
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Much of the effect happens when the banks get the money back and lend it out again … and again … and
again. It could take many months for the buying of securities to result in
people having a lot more money and buying lots more stuff.
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The textbook says conventional wisdom is it takes from 6 months
to 2 years for open market operations or a change in the
discount/federal funds interest rate to have its full effect on the
macroeconomy
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Putting these 3 lags together:1) Recognition Lag
2) Implementation Lag3) Effect lag
We can see that the fed has to either risk being too late or act on its predictions about the future,
which could be wrong.
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There is a view that in the 1970’s, the fed made things more unstable instead of less because lags were making their decisions the wrong
ones.
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While the fed looks at many things in setting policy, it is accurate to say that the most important thing they have looked at in setting policy in
the 21st century has been inflation. The fed has “targeted” a goal of 2% inflation. They don’t try to hit 2%
inflation every month, but over what they call the medium term.
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When inflation has gone above 2%, the fed has decreased the money
supply to decrease AD and when it has been below 2% they have
increased the money supply … in general.
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Now textbook guy writes “The FOMC does not decide to increase
or decrease the money supply. Rather, it engages in operations to nudge the federal funds rate up or down.” So why did I just say the fed increases or decreases the
money supply?
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Suppose you are selling hamburgers. Currently the price is
$1.20 and you are selling 300 a day. You lower the price to $1.00 and sales rise to 350 a day. Now,
have you changed the price of hamburgers or have you changed
the number you sell?
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P
Q
$1.20$1.00
300 320
Are the sellers picking the price or the quantity?
D
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These are not separate decisions that can be analyzed separately. To decide to do one means to decide
to do the other. We chose between describing the outcome as changing the price or changing the quantity merely as a matter of
convenience.
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i
Q
5%4%
3 Trillion 3.6 Trillion
Now money has a demand curve. If the fed wants to lower the interest rate from 5% to 4%, what do they have to do?
D
Money Market
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It doesn’t matter that the fed may describe this as a lowering of the interest rate, it is just as much a decision to increase the money
supply. That is what they have to do to support the lower interest
rate.
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Another problem the fed may have in a bad recession beyond lags is
something called a liquidity trap or the zero bound problem.
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The usual way this works is that the fed creates bank reserves, the
banks lower interest rates and people borrow the new money and
spend it.
But what if the interest rate is already zero?
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The new money would just sit in the bank vault unspent. In fact, it
is worse than that, because the fed pays interest on bank deposits at
the fed. Very little interest (0.25%), but still a positive amount.
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The monetary base is currency (both inside and outside banks)
and bank deposits at the fed.
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The fed has greatly expanded the monetary base as part of its
expansionary monetary policy.
https://research.stlouisfed.org/fred2/series/BASE/
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And what has happened to the money supply?
https://research.stlouisfed.org/fred2/series/M2/
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The monetary base has gone from 800 billion dollars to 4,000. That is an increase of 500%. The money supply (M2) has risen from 8,000 to 11,000. An increase of 37.5%
How is this possible?https://research.stlouisfed.org/
fred2/series/EXCSRESNS
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Almost as fast as the fed has been shoveling money into the economy, the banks have been shoveling it out again.
Normally, they would loan it out to businesses and consumers, but
remember, we are almost at 0% interest, so there is no benefit to doing so. Better
to be safe and store it at the fed
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In any case, people wouldn’t want to borrow it unless the interest rate fell, but the bank won’t loan at negative
interest.
If businesses had confidence in the future, they would be willing to pay
higher interest rates than the fed does to finance investment projects, but they
don’t, so they don’t.
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So here we sit, stuck in a bad economy despite expansionary
monetary policy.
So what can we do? There are 2 things we could try. One is the
subject of chapters 12 and 13. Before we look at the other, we have to learn
one of the two most famous equations in macroeconomics
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We are skipping over rational expectations in the textbook here
to talk about the equation of exchange. We will cover rational
expectations, but in the next chapter.
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Imagine a society with no checks or credit, only cash. This economy
has $1 million cash in existence. Is it true that in the course of a year,
the people of this country must buy exactly $1 million dollars
worth of things?
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A dollar can be spent more or less than 1 time during a year. How many times the average dollar is
spent on final goods and services is the velocity of money.
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Now suppose $1 million dollars exists and each dollar is spent 4
times during the year. Do we know that the people bought $4 million
dollars worth of stuff?
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Yes.
M x V = GDP
M = Money SupplyV = Velocity of Money
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It is also true that GDP=(Pa)(Qa)+(Pb)(Qb)+…+(Pz)(Qz)
soGDP = P x Q
P = Average Price of ThingsQ= Quantity of Things Made
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Put these together and you get M x V = P x Q
This is called the equation of exchange.
Textbook guy uses Y in place of Q.
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M x V = P x QWhy do this? Because now we have an equation relating the
amount of money to the things we really care about, namely Q and P. But it is not helpful yet, because at
this stage, an infinite number of things could still happen. This model needs more structure.
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The Simple Quantity Theory of Money is that if V and Q are fixed, then changes in the money supply cause equal percentage changes in
prices.
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Let’s assume V and Q are fixed and start moving the money supply around.M x V = P x Q
$100 x 4 = $2 x 200 $200 x 4 = $4 x 200
Ms up 100%, P up $100%$300 x 4 = $6 x 200
Ms up 50%, P up 50%$250 x 4 = $5 x 200
Ms down 16.67%, P down 16.67%
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Why does this happen? Imagine you go to the store and spend $10
to buy 10 apples every month. Now the money supply is doubled
so you have twice as much money. If V is fixed, you now spend $20
trying to buy 20 apples. Are there more apples for you to buy?
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No, because Q is fixed also. Now if it was just you, you would buy 20 apples; but it is not just you, it is everybody trying to buy twice as
many apples. There will be an apple shortage. What does the
price of apples have to rise to until $20 buys 10 apples again?
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So double the money supply, double prices.
While the simple quantity theory is too simple for many cases, it does
answer some questions. For example, why does the
government need taxes when it can just print up the money it needs?
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And, in fact, long-term inflations or hyperinflations are almost always
the result of the government increasing the money supply (a lot)
to pay for things.
1) Germany after World War I2) South American countries in the
1950’s/60’s
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But will Q stay fixed when the government increases M?
Let’s investigate. To keep things simple, let’s assume V does stay
fixed fixed.
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M x V = P x Q$100 x 4 = $2 x 200
Now double the money supply$200 x 4 = $? x ?
There are an infinite number of P’s and Q’s that would solve this, so
what to do? Bring in our old friend, the AS/AD diagram.
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Q
P
M x V = P x Q$200 x 4 = $2 x 200
AD1
SRAS
$2
200
What are Q and P on the diagram?
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M x V = AD
Assuming V stays the same, doubling the money supply means doubling buying or doubling AD.
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Q
P
AD1
SRAS
$2
AD2
Now we can just read the
new Q off the diagram
?
200 250
AD2 is a doubling of AD1
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M x V = P x Q
$100 x 4 = $2 x 200
$200 x 4 = ? x 250
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M x V = P x Q$100 x 4 = $2 x 200$200 x 4 = P x 250
P = $3.2
Money supply rose 100%.Quantity rose 25%.
Prices rose 60%.
Why aren’t prices doubling here?
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Q
P
AD1
SRAS
$2
AD2
Assume Q = 200 is Qn.
What is P3?3.2
200250
What about the long-run?
P3
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P3 is $4. The assumption that Q is fixed is a better long-run assumption
than short-run.
M x V = P x Q$100 x 4 = $2 x 200
$200 x 4 = $3.2 x 250$200 x 4 = $4 x 200
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What if V is not fixed? We would do the same trick of figuring the new M x V to find AD and shift to the new AD on the diagram, but it would be harder. How does the
change in M affect V?
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Factors That Affect V1) Expected Inflation.
2) Interest Rates3) Confidence in the Future
More money probably means higher expected inflation, so V increases.
At least in the short-run, more money might mean lower interest rates, so V falls.
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You would probably need a computer model to sort this out.
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Here is what has happened to V
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The rise in the money supply of 37.5% has been offset by a drop in
velocity of around 18%.
So increase the monetary base by 500%, have most of that go to
excess reserves and have velocity drop by almost 20%, and you get a
weak recovery.
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Could the fed had done more? Some monetarists say yes.
Monetarists are a school of economists that believe the most important thing that determines
nominal GDP is the money supply.
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The most famous and first monetarist was an economist named Milton Friedman. He
looked at the relationship between NGDP and the money supply from
1867-1960 and believed he found a close relationship, implying V was
stable.
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He also found there had been a large drop in the money supply
during the Great Depression, which he posited as its largest cause. Why would there be a drop?
People grew fearful of banks and closed their checking accounts.
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Out of this, he proposed a money supply growth rule.
M x V = P x Q
If you think V is relatively stable, and Q grows at an average of 3% a year, and you want stable prices,
what should M grow at?
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So Friedman proposed replacing the people on the federal reserve
board with a computer programed to buy and sell government
securities to cause the money supply to grow at 3% a year.
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When V dropped, you would still have a recession, but Friedman felt this was better than what the fed
was doing in the 1970’s, which was guessing wrong and causing
recessions
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Such a rule might not work well for long persistent recessions, like this
one.
The new thing in macroeconomics is called market monetarism. It is
a, perhaps, logical extension of Friedman’s ideas.
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Market monetarism, most closely associated with an economist named Scott Sumner at Bentley University in
Massachusetts. I mention this Bentley is not usually considered a heavy hitter in economics. Usually
important new ideas come from Yale, Princeton, University of
Chicago, M.I.T, that sort of place.
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So how did Scott Sumner get influential? He used his blog –
“The Money Illusion”
It is the first case of a blog being important in macroeconomic
theory.
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Market Monetarism says the fed should target the level of NGDP, and specifically target a growth
path of 5% a year. Why 5%? That allows for 3% real growth and 2%
inflation in a typical year.
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He wants to stop things like this.
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Critics say the fed can not do this, because the zero bound problem
means the fed can not raise NGDP when interest rates hit 0%.
The Market Monetarists have two answers.
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One is simply to say, yes they can, through brute force if necessary.
Critics point out that at the zero bound, the creation of monetary
base is not very effective at creating new money, so that creating 500% more monetary base created only
37.5% more money.
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Market Monetarists say, so what? If creating $20 in new base creates only $1 in new money, that’s fine, we just figure out how much new
money we want and create 20 times that in currency and bank
reserves. Can the fed create that huge amount of base? Sure
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Sumner’s challenge to the critics is, “ Do you really believe the fed can go out and buy an essentially unlimited amount of short term bonds, and if that doesn’t work, long-term bonds, and if that doesn’t work, stocks, and
if that doesn’t work, gold and property, and refrigerators, and so, and prices and output will not be
affected?
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I have never seen that challenge effectively answered.
If you have a car with hydraulic steering and the power goes out so the wheel doesn’t work nearly as well, that doesn’t mean you can’t
steer to the right, it just means you have to steer more powerfully and
emphatically.
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Towards the end of his life, Friedman was asked about the inability of the
Japanese central bank to increase AD by buying short-term bonds because their zero bound problem. He said, “they should buy long-term bonds”.
Sumner is taking that to its logical conclusion.
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But there is a second part to this, which is the beauty part, and
means the fed shouldn’t have to create that much more money
after all.
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Everyone does believe that things will get back to normal eventually, with
interests back well above zero, and the fed will have the power to create
inflation.
With NGDP level targeting, the fed will use that power, at least a little. So
people should expect inflation when things get back to normal.
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But of course if you expect inflation in the future, what should you do
now?
So what will happen to velocity now?
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And once you raise velocity now, do you even have to create much money to increase AD?
The point of the fed announcing it is standing ready to create as much money as necessary
to get some inflation in the future is they won’t have to, because the belief they are
ready and willing to do that will increase V
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So the macroeconomy will become mostly self-correcting. When
NDGP is rising above 5% because of inflation, people will believe the fed will decrease the money supply to stop that, so future inflation will be less and V will drop, decreasing
AD and inflation.
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When a recession begins and NGDP starts rising less than 5%,
people will expect the fed to create more money to raise inflation to get back to the 5% NGDP growth
path and so V will increase, increasing AD to get us back to the
5% nominal growth path.
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This is not utopia, because when higher oil prices cause SRAS to
decrease, we will get inflation at say 4% and real growth will be
slow at 1%; but it will at least stop recessions or high inflations caused by changes in AD.
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While the fed has not embraced market monetarism totally, and
might never do so, since at the end it would lead to Friedman’s dream
of a fed run by a computer to achieve a simple result, it has
moved in that direction. It has recently started using “forward
guidance”.
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This is the fed announcing it will continue expanding the monetary
base even after it “normally” would.
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There is more to say about good monetary policy, but it will be easier after we have learned a
thing called the Phillip’s Curve. So let’s jump ahead to chapter 16.
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Chapter 16
Inflation and Unemployment
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The more you increase AD, the higher inflation is and the lower unemployment
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Q
P
What does the shape of SRAS have to be to make the Phillip’s a U
SRAS
P1
QN
The more unused
resources, the flatter the SRAS
curve.
P2
Q1,2
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An increase in AD deep in the recessionary gap will primarily increase output and decrease
unemployment with only a small increase in P. An increase in AD far
into the inflationary gap will primarily increase P with only a small
increase in Q and decrease in U
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If a hardware store gets a large increase in orders for hammers and puts an ad in the paper for
more workers, does anyone show up or not? If not, what does the
store do to “accept” all the additional hammer money
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In 1969, Milton Friedman gave an address to the AEA saying the
Phillip’s curve is about to go all to hell. He based this on the topic of
expectations and the question, “How stupid are people?”
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Look at the Phillip’s curve this way. When the government causes 3% inflation by printing up money and
the worker’s have a fixed wage, from the viewpoint of the business
owner, workers just got cheaper relative to the sales price of the
product, so he hires more of them.
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But how long will this go on? Won’t people eventually expect 3%
inflation and demand 3% cost of living raises? Now how much cheaper are workers getting compared to the price of the
product? None. And how many extra workers will be hired because
they are cheaper? None.
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Un
People start expecting 3% inflation.
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Q
P
At first people are caught by surprise by the inflation and Q rises, U falls.
AD1
SRAS
P1 AD2
P2
Q1 Q2
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Q
P
But then they catch on and get compensating raises.
AD1
SRAS1
P1AD2
P2
Q1,2
We’ve seen this before, but this time they are happening at the same time, not one after the other.
SRAS2
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Q
P
Can the government still get lower unemployment? How?
AD1
SRAS1
P1AD2
P2
Q1
SRAS2
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Q
P
Can the government still get lower unemployment? How?
AD1
SRAS1
P1
AD2
P2
Q1 Q2
SRAS2 Move AD farther right. If people expect 3% inflation, give them 6%.
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Un
Ex. Inf. = 1% Ex. Inf. = 3%
New Phillip’s at expected inflation =3%
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Un
Ex. Inf.=1%
Ex. Inf.=3%
Long-run Phillip’s Curve
The Long-run Phillip’s Curve at Un
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Points from 1961 to 2011
76
77
78
79
8988 87
86
81
82
83
07
08
09 10
11
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Rational Expectations are expectations about the future that are, on average
correct. They do not contain systematic errors. They take into account all known
significant information.
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Predicted ActualInflation Inflation
Y1 4% 6%Y2 5% 8%Y3 3% 5%Y4 3% 6%
What simple change would you make to this program to get better predictions?
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What happens to our AS/AD model of the macroeconomy if people
have rational expectations?
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Q
P
People see the increase in AD coming and get pre-arranged raises.
AD1
SRAS1
P1AD2
P2
Q1,2
Instead of first AD moving and then SRAS moving, they both move together. The government can’t increase output.
SRAS2
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Friedman saw this happening, but only after a couple of years had
passed and people had caught on. Robert E. Lucas Jr. asked why can’t people catch on right away. The
information about what the fed is doing is public.
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In the Rational Expectations model, the long-run becomes the short-
run. There are not 2 Phillip’s curves, there is only one.
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U
π
The Rational Expectations Phillip’s Curve is a line straight up and down at Un
UN
This is the long-run Friedman curve, but
now it is the only curve.
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This does not mean we are always on the line and never have a recession. People still make
mistakes in predicting the future, even with rational expectations. It
does mean the government can not correct the problem.
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For example, if people think inflation is going to be 4%, but it is
actually 1%, there will be a recession. The government can
not fix this by printing money until inflation is 4%, because people will
see that and raise their inflation expectation to 7%.
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The rational expectationists tend to think the best thing to do is for the
government to let them market work and let people correct their mistakes
on their own.
So how did the rational expectationists of the 1960’s explain
the almost perfect slanted “C” curve?
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Trick question. There were none until Lucas wrote a couple of
articles famous articles about it in the 1970’s. It is not an accident
that rational expectations “happened” in the 70’s and not the 60’s, as people were more
concerned with it then.
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This illustrates one reason that macroeconomics is hard. People can behave differently in different times, and a theory that explains
correctly in one age may not work in another.
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Winners and Losers From Inflation
Losers WinnersPeople holding cash Borrowers may win Savers may lose
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If you have $100 dollars in the cookie jar during the year and there is 10% inflation, the money loses 10% of its value.
$100 10% π $90
The 100 dollars on Dec. 31 will only buy what 90 dollars would have bought on Jan. 1
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Saving with 5% interest rate and 10% inflation
$100 5% i $105$105 10% π $95
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Why write that savers may lose rather than savers do
lose?
Because savers won’t keep their money in the bank in these conditions. Why not buy stock, land, or gold (or
even baseball cards)?
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To keep their customers, the banks have to raise the interest rate to compensate depositors for the inflation, and then give them
interest on top of that.
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If you have to pay people a 5% return to get their money, during
times of 10% inflation, you will have to pay them 15%.
The nominal interest rate is the written rate you pay them. The real rate of interest is the real rate their deposit is gaining value after taking
into account inflation.
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i = nominal interest rater = real interest rate
π = inflation rate
r = i - π
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r = i – π
First Case-5% = 5% - 10%
Second Case5% = 15% - 10%
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So savers lose to an unexpected inflation, but once it becomes
expected, it should be factored into the interest rate and they
don’t lose.
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By the same token, borrowers can win when there is inflation. They get to pay back with less valuable
money.
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Borrowing at 5% interest rate and 10% inflation
$100 5% i $105$105 10% π $95
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One of the longest running American
political battles and one of America’s
most famous political speeches (the “cross of gold” speech) is
about this.
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The farmers have always owed money to the bankers … and so the farmers have always liked
inflation compared to the bankers.
This was true at the 1896 Democratic Convention.
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So why was it called the cross of gold speech?
This was the time of the gold standard, so we had paper money backed by gold,
which put a limit on how much money could be created. The farmers wanted
more money made, but weren’t ready for fiat money.
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So they had an idea. Why should only gold back our money, why not
silver too? So the government should also print money based on
the amount of silver it owned. This is called a bimetal standard. And if this caused inflation, so much the
better.
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William Jennings Bryan gave a speech supporting this idea. He ended by saying, “You shall not crucify mankind on a cross of
gold.” The Democrats liked it so well they nominated him for
President 3 times. He lost all 3 times.
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In fact, there is a theory that “The Wizard of Oz” is an allegory
for this.
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Dorothy = Average American Citizen/VoterScarecrow = Farmers
Tin man = Industrial WorkersCowardly Lion = Populist Party
Yellow Brick Road = Gold StandardEmerald City = Money/Financial System
Wizard = Bankers
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Now we can see the story we have told so far about creating money and interest rates, that creating money always lowers interest
rates, is too simple.
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Because creating money can create inflation and/or the expectation of
inflation, which raises interest rates.
When the fed created money to lower interest rates in the 1970’s, it ended up creating higher rates as
inflation grew.
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Creating money may lower interest rates in the short-run, but if it
causes inflation, it will raise them in the long-run. And if people see
the inflation coming (rational expectations), it will raise them in
the short-run too.
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During the Great Depression, interest rates were low. People argued this showed the fed was
being expansionary (creating money) and so they could not do
anything more.
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Milton Friedman pointed out this was wrong. If the fed had really created a
lot of money, they would have reversed the deflation into inflation and the interest rates would have rose. The low interest rates in the depression were not a sign the fed
was being expansionary …
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They were a sign the fed was not being expansionary enough, it was not printing up enough money to cause inflation and increase AD by
increasing both M and V.
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Amazingly enough, the same mistaken idea has gone around
during this recession. The fed has increased the monetary base, the interest rates are driven to zero,
and some economists say, see, the fed is being expansionary and
there is nothing else they can do.
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This time it is left to Scott Sumner of market monetarism fame to play the Milton Friedman role of pointing out that low interest rates mean the fed has not created enough money to create expectations of inflation, so they are not doing everything they
could do.
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If they printed out enough money to cause people to expect 4% inflation, both velocity would increase and the zero bound
problem would go away. AD would increase and we would get back to
Qn.
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Why hasn’t the fed done so? Well, one reason is that the
macroeconomics profession has seemingly forgotten what
Friedman taught us about fighting the Great Depression and wants to go back to the old mistake of low interest rates mean easy money.
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But another reason is the politics of it. Nobody is pushing for it in the way that William Jennings
Bryan pushed for easier money back in 1896.
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Instead of pushing the fed to do more, one party has pushed for them to do less, while the other
has just been clueless.
Handout.
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At least one thing you can say for the fed is that they have not been
as bad as the European Central Bank.
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Unemployment in Jan 2014Greece = 26.7%
Spain = 26%Euro area = 12%Germany = 5.1%
U.S.A = 6.6%
In Jan 2013Euro area = 12%
U.S.A = 7.9%
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Did any western economies avoid the Great Recession of 2009?
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Chapters 12 and 13
Keynesian Economics
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John Maynard Keynes is an English
economics who blamed the
depression in the 1930’s not on a lack
of money, like Friedman, but on a lack of spending the money we did have.
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Why would this happen?
Keynes said our income goes up and down, we spend more or less
on consumption goods. How much more we spend with each
additional dollar is our marginal propensity to consume = MPC.
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If you get a $100 dollar raise, spend $70 at the store, and put
$30 in the cookie jar, your MPC = .70
Your marginal propensity to save = MPS = .30
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Imagine that the President of Ford comes to work in the morning
and is feeling good about things. Maybe he had a good dream or a
great breakfast. Keynes used the term “animal
spirits”.
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For whatever reason, the President of Ford thinks next year is going to be
better than this year. He orders a tool shed built behind the main factory to hold the tools of the
overtime workers he anticipates hiring next
year.
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Start with an increase of $100 in investment and MPC = 0.8
I C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $100 $400 $500
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Someone is hired to build the tool shed and is paid the $100. He spends $80, and remember, what is expense for someone is income for someone else. That
person has an income of $80 and spends $64, and so on.
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This process is called the Keynesian multiplier. An initial increase in spending of $100 causes GDP to go up $500.
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What if the President of Ford’s animal spirits are low, so he thinks next year will be worse than this year. Last year they build a tool
shed, this year they don’t.
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Everything is the same but with negative signs
I C GDPRound 1 -$100 -$0 -$100Round 2 -$0 -$80 -$80 Round 3 -$0 -$64 -$64Round 4 -$0 -$52 -$52More Rounds … … …Total -$100 -$400 -$500
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Now the economy is going down as the multiplier causes a cascade of
lay-offs. Keynes was a great believer in the self-fulfilling
prophecy. When people thought things would be good, they would be good … and when they thought
things would be bad, they would go bad.
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How do you now how much to multiply the initial change in spending
to get the end change in GDP?
m = 1/(1-MPC)m = 5 when mpc = 0.8
The $100 change in investment causes a $100 x 5 = $500 change in GDP.
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Keynes believed the main cause of the Great Depression was the simultaneous end of a lot of
investment projects at the end of the 1920’s and drop in confidence that the 1930’s would be as good
as the roaring 20’s.
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Let’s translate the table to the AD/AS diagram.
SRASAD0
AD1AD2ADF
QF Q2 Q1 Q0
$80 $100
$500
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And viola, we are into the recessionary gap.
In terms of M x V = P x Q We have a drop in V.
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Friedman’s story of the depression.1) A few banks fail.
2) People pull their money from the banks.
3) Money supply falls.4) Less money = less buying and AD
decreases.5) As the economy tanks, V falls
which further lowers AD.
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His solution is for the fed to not let the money supply fall, or at least pump it up again as ASAP when it
does.
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Keynes’ story of the depression.1) Business’s lose confidence in the future (their animal spirits droop).
2) They cut investment.3) Laid off workers cut their buying.
4) The multiplier plays out.5) Velocity drops, taking M with it.
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Increasing M won’t help because it is an effect, not the cause. Also the zero bound. The phrase Keynesians
use is “the fed is pushing on a string.”
So what is Keynes solution to the Great Depression? I’m glad you
asked.
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Let’s do the Keynesian table again, but with a change in G.
G C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $100 $400 $500
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And thus AD moves to the right. The recessionary effect of a drop in investment can be undone by the
inflationary effect of a rise in government spending.
If the government cuts spending, then the table has negative signs
and AD moves left.
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What if there is a $100 tax cut?
G C GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $0 $400 $400
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Expansionary Fiscal PolicyMove AD right to fight recessions.
1) Increase G2) Cut Taxes
So the government is running a deficit.
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Contractionary Fiscal PolicyMove AD left to fight inflation.
1) Decrease G2) Increase Taxes
So the government is running a surplus.
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The Obama stimulus program of 2009.
Spending - $550 BillionTax Cuts - $290 Billion
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Problems with Fiscal Policy.1) The Lag Problem – the same lags
as monetary policy, but with the time it takes congress to do things thrown in. Also it can take awhile for spending voted by congress to
actually be spent by the government.
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2) Political ProblemsKeynes says to run deficits when
recession is the problem and surpluses when inflation is the
problem. From 1969 to 2014, the federal
government has run deficits every year.
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Politicians love to spend on their
favored programs and cut taxes. Some times
the only hope for good government is politicians who are
good liars.
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But if the practical problems of lags and politics are solved, is fiscal
policy guaranteed to work?
No, there is an other problem called crowding out.
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Here is a graph of the credit market where saving does not depend on the
interest rate.
Interest rate
Loanable Funds
Supply (savings)
Demand (borrowing)
5%
$10 Billion
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Now the government borrows $5 billion. Demand moves $5 billion to the right. Has overall borrowing increased by $5 billion?
Interest rate
Loanable Funds
Supply (savings)
D1
5%
$10 Billion
D2
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Equilibrium borrowing remains at $10 billion. How is this possible?
i
Loanable Funds
Supply (savings)
D1
5%
$10 Billion
D2
7%
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The government borrowing has “crowded out” private borrowing
and spending through a higher interest rate. The government borrows $5 billion more. Ford,
IBM, etc. borrow $5 billion.
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Private companies and individuals are dropping spending as fast as
the government increases it.
GDP = C + I + G
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Keynesian table with crowding out.
G I C GDPRound 1 $100 -$100 $0 $0Round 2 $0 $0 $0 $0 Round 3 $0 $0 $0 $0Round 4 $0 $0 $0 $0And so on … … … …Total $100 -$100 $0 $0
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Let’s translate the table to the AD/AS diagram.
SRAS
AD0,1,2,…,F
Q0,1,2,…F
P
Q
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When does does crowding out occur? When the money the
government borrows and spends would have been spent by
someone else if the government had not borrowed it.
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This happens when:1) The government borrows money someone else was going to borrow
and spend, and now they don’t.2) The person who lends the
money to the government was going to spend it but lent it to the
government instead.
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Crowding out does not occur when people lend the government
“cookie jar” money, or money they were not going to spend on either
goods or bonds.
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So if you think of the Great Depression as being caused by low
AD because of people sitting on large cash stashes they are afraid
to spend or lend to private companies, the government can
borrow it from them and spend it for them, increasing AD
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People (usually conservatives) opposed to the Obama stimulus package point out “the money
must have come from somewhere”. Shouldn’t spending
drop wherever it came from?
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Keynesians point out that even if it came from somewhere, as long as
it wasn’t being spent in that somewhere, spending will rise.
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M x V = P x Q
Pure Keynesianism can be done without an increase in M. By
borrowing V=0 money and spending it, V is increased and AD
goes up.
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If crowding out is true, then V will not increase. Monetarists, in
general, believe in crowding out. That is why they say there must be
an increase in M to increase AD.
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Republican’s Favorite Graph