Money, Trade, and Policy: Key Economic Concepts
Money, Trade, and Economic Policy
The Role of Money in Trade and Living Standards
The existence of money simplifies trade by eliminating the need for barter. This allows for specialization in production, leading to increased productivity and a higher standard of living as people can purchase more goods and services.
Liquidity
The ease with which an asset can be converted into the economy’s medium of exchange is known as liquidity.
Money Supply and Savings
If you withdraw $500 from your savings account and deposit it in your checking account, then M1 will change by $500, and M2 will remain unchanged.
The Fed as Lender of Last Resort
Being the “lender of last resort” means that in case of bankruptcy, the firm will respond to its debts.
Fed’s Open Market Operations
The Fed Open Market Committee can increase the money supply by lowering the reserve requirement for banks and by purchasing government securities (particularly bonds) on the open market.
Open Market Purchases and Money Supply
The Fed buys bonds when it conducts an open-market purchase. This action increases the money supply.
Primary Tool for Changing Money Supply
The primary tool used by the Federal Reserve to change the money supply is bonds (open-market purchase).
Reserve Ratio Calculation
A bank has $30,000 in deposits and $5,400 in reserves. Its reserve ratio is calculated as follows: 5400 / 30000 * 100 = 18% → 1 / r (0.18) = 5.56
Money Multiplier
The money multiplier is 8 when the reserve ratio is 12.5 percent. Calculation: 1 / 0.125 = 8
Excess Reserves
Suppose a bank has $3,000 in reserves, $25,000 of deposits, and a 10 percent reserve requirement. The amount of excess reserves is $500. Calculation: 0.10 * 25,000 = $2,500; $3,000 – $2,500 = $500
Reserves and Reserve Ratio
A bank has $1000 in deposits and maintains a 12 percent reserve ratio. Its reserves are $120.
First National Bank Example
The reserve ratio for this bank is 12%. If the required reserve ratio is 10 percent, then this bank has excess reserves of 2%.
Bank Reserves and Money Supply
When banks decide to increase their reserves, the money supply will decrease (holding all else constant).
Fed Bond Purchases and Federal Funds Rate
When the Fed purchases government bonds, the money supply increases and the federal funds rate decreases.
Change in Money Supply
What is the change in the money supply when the Fed purchases $700 worth of bonds and the required reserve ratio is 14 percent, assuming banks hold no excess reserves? Calculation: 1 / 0.14 = 7.14; 7.14 * 700 = $5000
Effects of Decreasing the Discount Rate
When the Fed decreases the discount rate, which represents the cost of bank borrowing from the FED, banks will increase their borrowing. This creates additional reserves, allowing banks to make more loans. These new loans end as deposits, increasing the amount of money in the economy through the multiplier effect.
Federal Funds Rate and Bond Sales
When the federal funds rate is below the target rate, the Fed will sell bonds. This action will decrease the money supply.
Trade Balance and Exchange Rates
Trade Surplus
Last month, a country sold more goods and services to residents of foreign countries than it purchased from them. This implies a trade surplus.
Calculating Imports with a Trade Deficit
Last year, a country sold $500 billion euros worth of goods to foreigners and had a trade deficit of $100 billion euros. The value of its imports was $400 billion euros. Calculation: Imports = Total value of goods sold to foreigners – Trade deficit; Imports = $500 billion euros – $100 billion euros; Imports = $400 billion euros.
Net Exports
In the first quarter of 2015, the U.S. had a trade deficit. In the first quarter of 2016, exports fell and imports rose. According to these numbers, net exports decreased.
Trade Balance Calculation
If a country’s exports were 500 billion pesos and its imports were 300 billion pesos, its trade balance would be a surplus of 200 billion pesos. Calculation: 500 – 300 = 200.
Foreign Direct Investment
A U.S. mutual fund buys stock issued by a corporation in Colombia. A U.S. grocery store chain builds and manages a new warehouse in Honduras. The latter is considered foreign direct investment. Both investments would be taken into account when computing U.S. net capital outflows.
Foreign Asset Purchases
A country recently had a trade deficit of $2.5 trillion and purchased $3 trillion of foreign assets. Foreigners purchased $5.5 trillion of its assets. Calculation: 5.5 trillion – 3 trillion = -0.5 trillion.
Exchange Rate Calculations
While vacationing in Italy, you see an interesting meal on a menu. The price is 24 euros.
Euro to Dollar Conversion
If the exchange rate is .80 euros per dollar, you would have to give up $30 to buy the meal. Calculation: 24 / 0.8 = 30 DOLLARS.
Dollar Appreciation Impact
If the dollar appreciated against the euro, but the price of the meal remained 24 euros, the meal would cost fewer dollars. Appreciation of the dollar means that the exchange rate between the euro and the dollar becomes more favorable for the dollar, making each euro worth fewer dollars.
Purchasing with Turkish Lira
While vacationing in Turkey, you see a rug you consider purchasing. The seller tells you the rug costs 1,200 Turkish lire.
Lira to Dollar Conversion
If the exchange rate is .60 lira per dollar, the rug costs $2000. Calculation: 1200 / 0.60 = 2000.
Dollar Depreciation Impact
If the dollar depreciates against the lira, it will take more dollars to buy the rug. Depreciation means that the exchange rate between the lira and the dollar becomes less favorable for the dollar, making each lira worth more dollars.
Fiscal and Monetary Policy
Stabilizing Prices and Output
Policymakers use fiscal policy and monetary policy to stabilize prices and output in the short run.
Aggregate Demand Fluctuations
Changes in aggregate demand can cause fluctuations in price employment and output in the short run, and only price inflation in the long run.
Wealth Effect
The wealth-effect notes that a decrease in price level increases the real value of households’ wealth. The larger real wealth increases the quantity of goods and services demanded.
Income Effect
The income effect states that a lower price level reduces the amount of money people wish to hold. When they lend out their excess savings, the interest rate falls, causing investment spending to rise and increasing the quantity of goods and services demanded.
Money Holding and Interest Rates
An increase in households’ desired money holding causes an increase in interest rates. This causes a decrease in investment spending and aggregate demand.
Theory of Liquidity Preference
According to the Theory of Liquidity Preference, a fall in the interest rate reduces the amount of money that people wish to hold. As a result, falling interest rates stimulate investment spending and aggregate demand.
Liquidity Theory
The theory of liquidity states that the interest rate adjusts to bring money supply and money demand into balance.
Excess Demand for Money
When there is an excess demand for money, households will increase interest-bearing bonds, causing interest rates to increase.
Figure 34-14 Analysis
Refer to Figure 34-14. Initial equilibrium exists at point A. A decline in prices will cause households to decrease their desired money holdings, moving the interest rate to decrease.
Excess Aggregate Demand
Refer to Figure 34-14. Households’ desired money holdings are given by MD1. If the current rate of interest is r3, then there is excess aggregate demand. Households will sell interest-earning assets, which causes the interest rate to fall.
Money Supply Increase
When the money supply increases, there is an excess supply of money. As a result, interest rates decrease and aggregate demand increases.
Open-Market Purchases
Open-market purchases cause a fall in interest rates and an increase in real GDP in the short run.
Federal Reserve Actions
Suppose the Federal Reserve lowers the target on the interest rate in the Federal Funds market. The Federal Reserve will increase the money supply, and aggregate demand will increase.
Interest Rate Above Equilibrium
When the interest rate is above equilibrium, there is excess supply of money. Households will sell interest-earning assets, which decreases the interest rate.
Federal Funds Rate Target
When the Federal Funds rate is above the Federal Reserve’s target, it will buy bonds to increase the money supply.
Stabilizing Aggregate Demand
If the Federal Reserve’s goal is to stabilize aggregate demand, then it will reduce the money supply in response to a stock market boom. This causes interest rates to increase.
Open-Market Purchase Effects
When the Federal Reserve conducts an open-market purchase, the money supply increases and aggregate demand increases.
Money Demand Increase
If the Federal Reserve’s goal is to stabilize aggregate demand, then in response to an increase in money demand, the Federal Reserve will increase the money supply.
Stabilizing Output
To stabilize output, the Federal Reserve will increase the money supply when aggregate demand falls.
Fiscal Policy Definition
The government’s choices regarding the overall level of government purchases and taxes is known as fiscal policy.
Reducing Aggregate Demand
To reduce aggregate demand, the government may reduce government spending or increase taxes.
Multiplier Effect
The additional shifts in aggregate demand that result when there is an increase in government spending is known as the multiplier effect.
Multiplier Value Calculation
What is the value of the multiplier if the marginal propensity to consume is 0.5? Calculation: 1 / (1 – 0.5) = 2
European Recession Impact
A European recession that reduces U.S. net exports by $50 billion may ultimately lead to a $200 billion reduction in aggregate demand if the MPC is 0.75.
Income and Consumption Increase
Last year, total income increased $1,000 and consumption increased $800. An increase in government spending equal to $10 would cause output to increase by $12.50 because the multiplier is 1.25. MULTIPLIER = 1000/800 = 1.25; INCREASE IN OUTPUT = 1.25 * 10 = 12.50
Figure 34-10 Analysis
Refer to Figure 34-10. Suppose the multiplier is 4 and the economy is currently at point A. An increase in government purchases of $10 will increase aggregate demand to $_____ if there is no crowding-out. If crowding-out exists, then aggregate demand will likely to increase to $_____.
Accelerator Effect
Refer to Figure 34-10. Suppose the multiplier is 2 and there is no crowding-out, but there is an accelerator effect. If the economy is currently at point A, then an increase in government purchases of $10 will likely increase aggregate demand to point _____ where output is $_____.
Tax Increase Impact
An increase in taxes shifts the aggregate demand curve to the left.
Crowding-Out Effect
The crowding-out effect occurs because an increase in government spending increases interest rates, causing investment to fall.
Tax Decrease Impact
A decrease in taxes increases aggregate demand through larger consumption by households.
Offsetting Pessimism
To offset increased pessimism by households, the government may increase government spending and/or decrease taxes.
Goal of Stabilization Policy
The goal of stabilization policy is to stabilize aggregate demand. As a result, stabilization policy will also stabilize output and employment.
Increasing Output
To increase output, policymakers can increase the money supply, decrease taxes, and/or increase government purchases.
Stabilizing Output and Employment
Suppose households attempt to increase money holdings. To stabilize output and employment, the Federal Reserve will increase the money supply.
Wave of Optimism
Suppose a wave of optimism causes firms to increase investment. To stabilize output and employment, the Federal Reserve will decrease the money supply.
Monetary vs. Fiscal Policy
What is the difference between monetary policy and fiscal policy? Monetary policy refers to actions taken by a central bank to influence the money supply, interest rates, and credit conditions in the economy. The goal of monetary policy is to stabilize the economy, control inflation, and promote economic growth. Fiscal policy, on the other hand, involves government decisions regarding its spending and taxation. It is implemented through changes in government spending and tax rates. The objective of fiscal policy is to stabilize the economy, address unemployment, and promote economic growth.