Current Events:
Worries of a 'Double Dip'
Rohmer, Summers Possible Candidates for Kohn's Fed Seat
March 9 (Bloomberg) -- Bloomberg's Hans Nichols reports on possible successors to Fed Vice Chairman Donald Kohn, who announced earlier this month that he will resign his post on June 23. (Source: Bloomberg)
The Ch. 18 Test will be on Monday; be sure to consult the Ch. 18 Test Prep Page for details. There are 50 questions on the Test; the Test Prep Page provides 65 sample questions to assist your preparation for the Test.
We will pick up where we left off in Chapter 21.
Chapter 21 The Monetary System
Chapter Overview
This chapter covers the definition and functions of money (and the measurements M1 and M2), then turns to a discussion of the demand for and supply of money examining the market for money and the market for bonds. How banks create money is next, followed by material on the Federal Reserve System and an introduction to the tools of monetary policy (monetary policy is the subject of the next chapter). It should be noted that the chapter discusses monetary policy in terms of the Fed changing the supply of money to cause changes in interest rates.
Chapter Outline
What Is Money?
What is Money?, 4:29
The Functions of Money
Types and functions of money, 9:52.
Medium of Exchange
Unit of Account
Store of Value
Defining the Money Supply
Narrowly Defined Money: M1
A Broader Definition of Money: M2
Where Did All the One-Dollar Coins Go?
Checkpoint: What Is Money?
Money: Demand and Supply
The Market for Money and Bonds
The Demand for Money
Equilibrium in the Money Market
Bond Prices and Interest Rates
A look at what happens to bond prices when interest rates change, 3:23.
How Banks Create Money
How Banks Create Money Out Of Thin Air, 7:06
Find out how banks create money out of thin air by using Federal Reserve rules to make multiple loans on the same deposits.
Money - How it gets created out of thin air, 5:17
So, how does the Federal Reserve and the banks under it create money out of nothing thereby inflating the dollar? The document "Modern Money Mechanics," produced BY the Federal Reserve, lays it all out.
Functions of Financial Institutions
Fractional Reserve System
The Money Creation Process
Money Creation by Chris Martenson, 4:19
Understanding how money is created provides a foundation for appreciating the implications of our massive levels of debt, because it tells us how that debt came into being. As John Kenneth Galbraith once said, "The process by which money is created is so simple, the mind is repelled." Dr. Martenson walks us through this simple process of fractional reserve banking.
The Money Multiplier
Multiplier effect and the money supply, 11:06
How "money" is created in a fractional reserve banking system. M0 and M1 definitions of the money supply: the multiplier effect.
The Federal Reserve System
Federal Reserve, 7:07
PBS NewsHour economics correspondent Paul Solman explains the workings of the Federal Reserve, c. 5:00, up to the sail analogy.
The Structure of the Federal Reserve
The Board of Governors
Federal Reserve Banks
Federal Open Market Committee (FOMC)
The Tools of the Federal Reserve
Reserve Requirements
Discount Rate
Open Market Operations
Checkpoint: The Federal Reserve System
Ideas for Capturing Your Classroom Audience
■ Take a virtual field trip. Visit the online money museum at the Federal Reserve
Bank of Richmond, located on the Web at http://www.richmondfed.org/about_us/
our_tours/money_museum/index.cfm.
■ Other links to educational resources from the Federal Reserve can be found at
http://www.federalreserveeducation.org/FRED/?CFID=4256596&CFTOKEN=
49264752.
■ Illustrate changes in bond prices using a value calculator such as the one available on the Smart Money site on the Web at http://www.smartmoney.com/
onebond/index.cfm?story=bondcalculator. This allows you to change the bond
parameters and instantly see the effects on price.
■ Look at the historical and current values for M1 (including rate of change from
previous period) on the Web at http://www.economagic.com/em-cgi/data.exe/
fedstl/m1sl+1. Similar data for M2 is available at http://www.economagic.
com/em-cgi/data.exe/fedstl/m2sl+1.
Chapter Checkpoints
What Is Money?
Question: Gresham’s law says that bad money drives out the good money from the
marketplace. One example was the 1965 U.S. Coinage Act that replaced silver quarters with “sandwich” coins made of a cheaper silver-nickel alloy. The pre-1965 quarters quickly vanished from circulation. Where did all the pre-1965 quarters go? Is Gresham’s Law much of a problem in today’s economy with paper (fiat) money and credit cards?
The point is to check that students can: understand the difference between the
intrinsic value of something used as money and its face value.
Money: Demand and Supply
Question: If the Federal Reserve did not have any reserve requirements for member
banks, would those banks hold zero reserves? Why or why not?
The point is to check that students can: understand that reserve holdings are necessary because the demand for cash at any bank is uncertain.
The Federal Reserve System
Question: The reserve requirement sets the required percent of vault cash plus
deposits with the regional Federal Reserve Banks that banks must keep for their
deposits. Many banks have widespread branches and ATMs. Would the existence
of branches and ATMs affect the level of excess reserves (above those required)
that banks hold? Why or why not? What would be the effect on the actual money
multiplier?
The point is to check that students can: relate increased holding of excess reserves by banks to less lending and therefore a smaller money multiplier.
Extended Example in the Chapter
Where Did All the One-Dollar Coins Go?
The U.S. government continually tries issuing dollar coins, but they don’t seem to
catch on. Dollar coins don’t seem to circulate in the United States. The 1979 Susan B. Anthony dollar was not popular (many people said it was too close in size to a quarter) and neither was the Sacagawea dollar coin introduced in 1999. So why would the government try again now in 2007 with the Presidents series of dollar coins?
It may be that the purpose has changed. While the argument was saving on the cost
of producing money in earlier decades (a dollar coin lasts longer than a dollar bill) the attraction now may be for the coins NOT to circulate! See the article by Gordon T. Anderson titled “Congress Tries Again for a Dollar Coin: After Two Bellyflops, Congress Is Considering a Dollar Coin Again. This Time It Might Actually Work” (CNN Money, April 28, 2005: 5:35 PM EDT), available on the Web at http://money. cnn.com/2005/04/27/pf/new_dollar/). The author points out the seigniorage profits the government can earn if people hoard the coins instead of using them.
Examples Used in the End-of-Chapter Questions
Question 2 asks about barter and modern economies. It’s worth noting that an
increase in barter characterized the late 1990s in Russia, a situation unusual among nations in transition. There are numerous studies of barter in Russia, but an interesting perspective can be found in this piece by the president of the Ukraine talking about the “murky” bartering of resources with Russia. The article is “A Deal to End All Barter” by Victor Yushchenko (09:44 25 JANUARY 2006, The Wall Street Journal Europe). See the Web at http://www.president.gov.ua/en/news/data/26_5700.html.
Question 7 references the FDIC. To learn more about the agency visit its Web site at http://www.fdic.gov/.
Questions 11 and 15 concern the independence of the Federal Reserve System. For
more information see the Web site at http://www.federalreserve.gov/generalinfo/
faq/faqfrs.htm.
Question 12 asks about the membership of the FOMC. For more information see the
Web site at http://www.federalreserve.gov/generalinfo/faq/faqfomc.htm.
For Further Analysis
Required Reserves and the Money Multiplier
This example can be used as a small group exercise or as an individual exercise.
The exercise provides an opportunity for students to apply the material in the chapter on reserve requirements and the money multiplier to work through some of the calculations. Setting the required reserve ratio equal to zero allows students to see that the amount of money in circulation would grow by an infinite amount. You may also consider having students construct the same example as an Excel spreadsheet.
Web-Based Exercise
Learn more about the people who make up the Federal Reserve Board of
Governors. You can find links to their biographies from the site at http://www.
federalreserve.gov/bios/.
Note to instructors: In the summer of 2007 there were two vacancies on the Board.
In a May 15, 2007, story from Market Watch (Dow Jones), Greg Robb reported
that President George W. Bush had nominated Elizabeth Duke, the chief operating
officer of TowneBank of Portsmouth, Virginia, and Larry Klane, a senior official
at Capital One Financial Corp., to fill the positions. See the article at
http://www.marketwatch.com/news/story/bush-picks-two-bankers-fed/story.
aspx?guid=%7BAE3A0592-80B2-477C-8C4B-89719F6E51F1%7. Depending on the
time at which you cover this material, it might be of interest to learn more about
the confirmation hearings for new appointees.
After reading the biographies, answer the following:
1) Discuss the backgrounds of the people who make up the Board. Are they all
economists?
2) How long has each person served?
3) Has the fact that President Bush has appointed all of the current members
affected the Fed’s independence?
Tips from a Colleague
The topic of “how banks create money” always stumps students because they don’t
completely understand that the loan checks issued by banks result in transfers of
deposit funds. Emphasize what is and what is not money; for example, it is not the
check that is money but the funds on deposit. Even more important, debit cards are
money but credit cards are not.
Chapter 20 Material
Where's the pork? Visit the Web site of Citizens Against Government Waste at
http://www.cagw.org/site/PageServer?pagename=reports_pigbook2007. This self described taxpayer watchdog organization has developed criteria by which to
identify wasteful projects. Relate this to the text material about politics and government spending.
Chapter Checkpoints
Demand-Side Fiscal Policy
Question: Explain why cutting taxes represents expansionary fiscal policy.
The point is to check that students can: apply their knowledge of the determinants
of aggregate demand to help evaluate the effect of cutting taxes (the key link is less taxes to more income to more spending).
Supply-Side Fiscal Policy
Question: In 1962 at a speech before the Economic Club of New York, President
John F. Kennedy argued that "it is a paradoxical truth that taxes are too high
today and tax revenues are too low.and the soundest way to raise taxes in the long
run is to cut rates now. Is President Kennedy's argument consistent with supply side economics? Why or why not?
The point is to check that students can: apply their comprehension of the material
on supply-side economics and evaluate the quote from President Kennedy.
Implementing Fiscal Policy
Question: Unless the economy enters a deep recession, we rarely hear Congress
discuss the budget in terms of fiscal policy: passing a spending and taxing package for macroeconomic purposes. Most of the discussion is on particular spending priorities for specific programs and bringing home projects for an individual politician's district. Has Congress essentially abandoned fiscal policy and left macroeconomic stabilization to the Federal Reserve and the setting of monetary policy?
The point is to check that students can: understand how changes in the price of oil affect the economy. It might be useful to point out that the initial effect is a decrease in aggregate supply against an unchanging aggregate demand.
Extended Example in the Chapter
The Size of Government Debate
Fiscal policy debates may have as much (if not more) to do with the philosophical
debate about the proper size of government as about the state of the macroeconomy.
In general, those on the left of the political spectrum favor a larger and more
active government while those on the right are constantly looking for ways to limit the size and power of the government. Examining federal receipts and expenditures as a percentage of GDP reveals the federal government’s tendency to spend more and more. The reason for this seems obvious: to cut spending Congress must cut programs, and whose programs would be cut? (In a later chapter, Chapter 23, the question of the budget deficit will be considered in more detail.)
Examples Used in the End-of-Chapter Questions
Question 2 references an article by Robert Dunn, titled “Let the Surplus Go” (The
New York Times, August 19, 2001) regarding the declining budget surplus. A summary
of the article in outline form (with key words noted) appears on the Web site
of Truth and Politics at http://www.truthandpolitics.org/html_gen.php?entryId=55.
Question 4 references The Power of Productivity by William Lewis (Chicago:
University of Chicago Press, 2004). An interview with William Lewis (by Nick
Schultz) is available on the Web site of TCS Daily: Technology, Commerce, Society,
at http://www.techcentralstation.com/061705A.html. Among the points elaborated
in the interview are Lewis’s views about the combination of big government and
underdeveloped economies.
The pieces are “Remember Fiscal Policy?” in the “Economics Focus” section and
“The Case for Using Fiscal Policy” in the “Economic Policy Section.” The first piece presents the arguments that fiscal policy may have less of an effect on the economy than its proponents contend and moreover, that for political reasons, policymakers are “incapable of designing the right measures or enacting them at the right time.” The second piece contends that Keynesian measures to counteract a recession (particularly deficit spending) went “out of fashion years ago.” It goes on to suggest that such methods had been misapplied, meaning that they were being used to promote growth as opposed to counteracting recession.
For Further Analysis
Using the AS/AD Model to Explore the Impacts of Demand-Side Fiscal Policy
This example can be used as an in-class small group exercise or as an individual in class exercise. It is designed to complement the text’s material by employing the graphical analysis of the AS/AD model to illustrate the effects of demand-side fiscal policy when the economy is below full employment and when it is above full employment. It would not be difficult to adapt the handout to have students consider contractionary policy as well.
Note that for the second question students will have to show a shift in aggregate
demand and then a resulting shift in aggregate supply in order for the economy to
return to long-run equilibrium. You may also wish to summarize the assignment,
pointing out how important it is for the government to assess how close GDP is to
full employment and that regardless of the current level of output (compared to Qf), expansionary fiscal policy seems to always result in higher prices.
Web-Based Exercise
Listen to the Candidates Debate
This example can be used as a small group exercise or as an individual exercise.
The exercise provides an opportunity for students to apply the material in the chapter to positions of political candidates. This also allows students to appreciate the political spectrum, particularly in terms of the “middle” where positions are not so clearly “left” or “right.” You can make the assignment more or less extensive by choosing a number of candidates for students to consider, including local or state candidates as well as presidential and congressional candidates. Alternatively, you can also have students learn more about the positions of their already-elected state (or local) representatives; for example, what are their voting records?
Listen to the Candidates Debate
Visit the Web sites of political candidates and learn more about their positions with regard to the economy, particularly in terms of taxes and spending. Remember that government spending is associated with funding particular programs.
Tips from a Colleague
Students may not appreciate that the size of government is an ongoing matter of
debate in the United States and other countries. You may wish to review the material from Chapter 1 regarding the role of government in the economy and discuss the normative aspects of economics. Students may not fully appreciate the role of Congress and the interaction between Congress and the Executive Branch in terms of fiscal policy, so the process may be worth a brief review, particularly in the discussion of lags.
References
The Ch. 18 Test will be on Monday; be sure to consult the Ch. 18 Test Prep Page for details. There are 50 questions on the Test; the Test Prep Page provides 65 sample questions to assist your preparation for the Test.
1. Be sure to review Chapters 18-19 (we will have Quizzes and Tests on this material as well, TBA). Some students have asked to be tested as close as possible after covering the material. To this end, we can have a Ch. 18 Test before students forget the material; since, we have already started Ch. 21.
2. Now that we finished Ch. 20, we will have Quizzes and a Test too on this material.
3. ■ Links to educational resources from the Federal Reserve can be found at
http://www.federalreserveeducation.org/FRED/?CFID=4256596&CFTOKEN=
49264752.
Pick one of the publications listed on the site below and summarize the contents of an article in a short paragraph: Cf. http://www.frbsf.org/publications/education/newsletter/
For the bond prices below try three changes in bond parameters and report your results:
■ Illustrate changes in bond prices using a value calculator such as the one available on the Smart Money site on the Web at http://www.smartmoney.com/
onebond/index.cfm?story=bondcalculator. This allows you to change the bond
parameters and instantly see the effects on price.
Based on your understanding of Ch. 21: what do you notice about the historical and current values for M1 and M2 based on these sources?
■ Look at the historical and current values for M1 (including rate of change from
previous period) on the Web at http://www.economagic.com/em-cgi/data.exe/
fedstl/m1sl+1. Similar data for M2 is available at http://www.economagic.
com/em-cgi/data.exe/fedstl/m2sl+1.
4. As review for HW, typical questions that you may encounter on the actual AP Economics Macro Test are included daily:
National Income and Price Determination, Review Questions
5. Which one of the following would shift the aggregate demand curve to the right?
a) A higher price level
b) An increase in investment spending
c) An increase in the interest rate at each possible price level
d) An increase in the personal income tax rates
e) A decrease in government spending directed to education
6. Assuming that other factors are held constant, nationwide improvements in productivity will
a) shift the aggregate demand curve to the left
b) shift the aggregate demand curve to the right
c) shift the aggregate supply curve to the right
d) shift the aggregate supply curve to the left
e) increase the price level
