Introduction to Economics

1. Introduction to Economics Macroeconomics The US Economy

2. Economics in the News • President Bush approves the biggest increase in the defense budget since President Reagan • an issue: will this be inflationary? • An issue: what is the opportunity cost?

3. Percentage of Government Spending on Various Programs

4. GDP Deflator: History • early thirties: deflation • World War II: inflation • Korean War: inflation • fifties and sixties: price stability • Vietnam War: inflation • Lyndon Johnson: “guns and butter” • seventies: inflation • OPEC: energy prices • nineties: price stability

5. GDP Deflator: Percentage Change Source: http://www.yardeni.com

6. Guns or Butter Home Front “Butter” Last Year This year Production Possibility Frontier Govt.: Tax it away or borrow to buy it away War Front “Guns”

7. Concepts • The real or physical economy • mystery: competitive markets transform individual greed into social welfare • measure of the physical economy: index of industrial production • the money economy • is money a veil? • Mystery: money creation

8. Index of Industrial Production Source: http://www.yardeni.com

9. The Creation and Destruction of Value • Stock Market • Then:100 shares@$20 per share = $2000 • Now: 100 shares@$10 per share = $1000 • Where did the value go? • In the long run: the value of a share of stock is equal to the present value of future earnings (profits) per share • In the short run: irrational exuberance or excessive pessimism

10. The Creation of Money • Governments • Pay for wars or economic development by printing money • use money to buy goods for the government • the government can put a lot of money in circulation by printing it

11. Money Supply and Inflation • GDP (real) x GDP Deflator = Money Supply x velocity of circulation • Q x P = M x V • Q x P = M x V • If money supply increases more rapidly than output then prices go up • Who keeps an eye on the government?

13. In Last Year’s Local NewsSanta Barbara News Press

14. How Does Bank Failure Affect the Economy?

15. Is a wave of bank failures on the way? • Source of instability in the capitalist system

16. The Creation and Destruction of Money • Banks • Make loans and create deposits • Call loans and decrease deposits

17. Outline: Lecture Eight • The Banking System • The Federal Reserve

18. Why are Banking Systems Unstable? • Illiquid • Insufficient cash on hand • Insolvent • Liabilities exceed assets • Bad loans

19. Full Reserve Banking • Dates to the Middle Ages • goldsmiths • accept customer deposits of gold • issue certificates of deposit to customer • customer can use certificates as a medium of exchange • paper money substitutes for gold money • no money creation

20. Assets-Liabilities Statement

21. Full Reserve Banking Goldsmith Assets Liabilities customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins Note: The goldsmith is perfectly liquid. If a customer comes in with a certificate of deposit, the goldsmith has the reserves of gold to exchange for the certificate. Note: The goldsmith is perfectly solvent. The value of the gold reserves held as assets equals the value of the certificates issued, i.e assets equal liabilities.

22. Banking as a Business • Goldsmiths note that only about 25% of customers want to exchange certificates for gold on a given day • This creates an incentive for the goldsmiths to use some of the remaining gold reserves to make loans and earn interest

23. Fractional Reserve Banking Goldsmith Assets Liabilities customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins loans of 500 Florins certificates of deposit, 500 Florins (money creation) Note: The goldsmith is no longer perfectly liquid. If all the customers come in with certificates of deposit and demand 1,500 Florins, the goldsmith only has reserves of 1,000 Florins in gold to exchange for the certificates. The customers panic! Note: The goldsmith may not remain solvent. If the goldsmith makes unwise loans, and the customer in debt defaults, then the value of assets, 1,000 Florins, is less than the value of liabilities, 1,500 Florins.

24. History of US Capitalism • Punctuated by a series of banking crises • for example: panic of 1907 • motivates the formation of the Federal Reserve, 1913

25. Banking Crises (continued) • widespread bank failures in 1932 • depositors lose money • Roosevelt declares a bank holiday upon assuming office • Federal Deposit Insurance Corporation , FDIC, created in 1934 • insures accounts up to $100,000

26. Banking Crises (continued) • Savings and Loans failures in the 1980’s • in 1989 & 1990, 100’s of insolvent thrifts taken over • bail out of depositors costs US taxpayers about $500 B

28. Liquidity Crisis rumors depositors lose confidence run on the banks to withdraw deposits not enough reserves to meet demands of depositors panic Bank Failures banks make unsound loans for example, make real estate loans and then the real estate market crashes debtors default on loans banks become insolvent depositors lose money Fractional Reserve Banking is subject to two threats

29. Economic Concept: Moral Hazard • The creation of the Federal Deposit Insurance Corporation, FDIC, and the Federal Savings and Loan Insurance Corporation, FSLIC, did not prevent the failure of S&L’s in the 80’s • with an account insured up to $100,000, a depositor then takes less care to check out the policies and practices of an S&L before depositing cash • this effect of insurance making one feel “safe” and hence taking less care to avoid loss is called moral hazard

31. Source: http://www.fdic.gov/

32. Source: http://www.fdic.gov/

33. Source: http://www.fdic.gov/

34. The Federal Reserve • Objectives • Tools • Organization and Structure

35. The Federal Reserve • Objectives • prevent liquidity crises • prevent solvency crises • control inflation and money stock growth • stabilize short term interest rates

36. Tools lender of last resort to private banks sets required ratio of reserves to deposits establishes sound banking practices manipulates bank reserves affects federal funds rate and sets the discount rate Federal Reserve as Central Bank

37. Fed: Lender of Last Resort to Banks at Discount Rate, 99-01 Source: Federal Reserve Bank of Minneapolis

38. Fed: Lender of Last Resort to Banks at Discount Rate, 00-02 Source: Federal Reserve Bank of Minneapolis

39. % Year and Month

40. Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits • Helps Prevent Liquidity Crises • For Example: Dec 1992 • deposits of 0-$42.2M (small banks) • required minimum reserve ratio: 3% • deposits of $42.2+M- (large banks) • required minimum reserve ratio: 10%

41. Reserve Ratios (Continued) • For Example 1994 • deposits of 0-$4M: 0% reserve ratio • deposits of $4+M-$51.9M: 3% reserve ratio • deposits of $51.9M- :10% • Infrequent Changes in Reserve Ratios

42. Fed: Establish Sound Banking Practices Source: http://www.frbch.org/

43. Federal Reserve: Organization and Structure

44. Vice Chair: Board of Governors Members replacing Kelley and Meyers : Susan ScmidtBies, Mark W. Olson, Ben S. Bernanke, Donald L. Kohn

45. Federal Open Market Committee Meetings 2002: November 6, December 10

46. Federal Open Market Committee • Federal Open Market Committee: 12 Members • Seven Board Governors • President of New York Fed • Four other presidents

47. Federal Reserve Open Market Operations • Tight Money Policy • Fed sells securities in secondary market • decreases bank reserves • decreases excess reserves • decreases banking system capacity to make loans • Easy Money Policy • Fed buys securities in secondary market • increases bank reserves • increases excess reserves • increases banking system capacity to make loans

48. FOMC Tries to Loosen CreditBuys Treasuries in Secondary Market FED Commercial Banks Net Result: changes asset mix of banks & increases total bank reserves

49. FOMC Tries to Tighten CreditSells Treasuries in Secondary Market FED Commercial Banks Net Result: changes asset mix of banks & decreases total bank reserves

50. Limitations to FOMC Efforts • FOMC can increase reserves by buying securities: this enables banks to make loans • Fed can not force banks to make loans • Fed can not force consumers or businesses to ask banks for loans • Metaphor: “you can lead a horse to water, but you can not make him drink” • Contractionary monetary policy is more direct than expansionary monetary policy • if Fed sells securities, this reduces reserves, and hence for a given level of bank deposits and required reserves, decreases excess reserves