Llad Phillips1 Introduction to Economics Macroeconomics The US Economy

Llad Phillips2 Economics in the News President Bush approves the biggest increase in the defense budget since President Reagan 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?

Llad Phillips3 Percentage of Government Spending on Various Programs

Llad Phillips4 GDP Deflator: History early thirties: deflation early thirties: deflation World War II: inflation World War II: inflation Korean War: inflation Korean War: inflation fifties and sixties: price stability fifties and sixties: price stability Vietnam War: inflation Vietnam War: inflation  Lyndon Johnson: “guns and butter” seventies: inflation seventies: inflation  OPEC: energy prices nineties: price stability nineties: price stability

Llad Phillips5 GDP Deflator: Percentage Change Source:

Llad Phillips6 Guns or Butter Home Front “Butter” War Front “Guns” Production Possibility Frontier Govt.: Tax it away or borrow to buy it away Last Year This year

Llad Phillips7 Concepts The real or physical economy 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 the money economy  is money a veil?  Mystery: money creation

Llad Phillips8 Index of Industrial Production Source:

Llad Phillips9 The Creation and Destruction of Value Stock Market Stock Market  Then:100 per share = $2000  Now: 100 per share = $1000 Where did the value go? 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 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 In the short run: irrational exuberance or excessive pessimism

Llad Phillips10 The Creation of Money Governments 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

Llad Phillips11 Money Supply and Inflation GDP (real) x GDP Deflator = Money Supply x velocity of circulation GDP (real) x GDP Deflator = Money Supply x velocity of circulation  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? Who keeps an eye on the government?

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Llad Phillips13 In Last Year’s Local News Santa Barbara News Press

Llad Phillips14 How Does Bank Failure Affect the Economy?

Llad Phillips15 Is a wave of bank failures on the way? Source of instability in the capitalist system Source of instability in the capitalist system

Llad Phillips16 The Creation and Destruction of Money Banks Banks  Make loans and create deposits  Call loans and decrease deposits

Llad Phillips17 Outline: Lecture Eight The Banking System The Banking System The Federal Reserve The Federal Reserve

Llad Phillips18 Why are Banking Systems Unstable? Illiquid Illiquid  Insufficient cash on hand Insolvent Insolvent  Liabilities exceed assets  Bad loans

Llad Phillips19 Full Reserve Banking Dates to the Middle Ages 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 exchangecustomer can use certificates as a medium of exchange paper money substitutes for gold moneypaper money substitutes for gold money no money creationno money creation

Llad Phillips20 Assets-Liabilities Statement

Llad Phillips21 Full Reserve Banking AssetsLiabilities Goldsmith 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.

Llad Phillips22 Banking as a Business Goldsmiths note that only about 25% of customers want to exchange certificates for gold on a given day 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 This creates an incentive for the goldsmiths to use some of the remaining gold reserves to make loans and earn interest

Llad Phillips23 Fractional Reserve Banking AssetsLiabilities Goldsmith customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins 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. loans of 500 Florinscertificates of deposit, 500 Florins (money creation)

Llad Phillips24 History of US Capitalism Punctuated by a series of banking crises Punctuated by a series of banking crises  for example: panic of 1907  motivates the formation of the Federal Reserve, 1913

Llad Phillips25 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 $100,000insures accounts up to $100,000

Llad Phillips26 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 Bbail out of depositors costs US taxpayers about $500 B

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Llad Phillips28 Fractional Reserve Banking is subject to two threats Liquidity Crisis Liquidity Crisis  rumors  depositors lose confidence  run on the banks to withdraw deposits  not enough reserves to meet demands of depositors  panic Bank Failures 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

Llad Phillips29 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 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

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Llad Phillips34 The Federal Reserve Objectives Objectives Tools Tools Organization and Structure Organization and Structure

Llad Phillips35 The Federal Reserve Objectives Objectives  prevent liquidity crises  prevent solvency crises  control inflation and money stock growth  stabilize short term interest rates

Federal Reserve as Central Bank Tools 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

Llad Phillips37 Fed: Lender of Last Resort to Banks at Discount Rate, Source: Federal Reserve Bank of Minneapolis

Llad Phillips38 Fed: Lender of Last Resort to Banks at Discount Rate, Source: Federal Reserve Bank of Minneapolis

Year and Month %

Llad Phillips40 Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits Helps Prevent Liquidity Crises Helps Prevent Liquidity Crises For Example: Dec 1992 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%

Llad Phillips41 Reserve Ratios (Continued) For Example 1994 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 Infrequent Changes in Reserve Ratios

Llad Phillips42 Source: Fed: Establish Sound Banking Practices

Llad Phillips43 Federal Reserve: Organization and Structure

Llad Phillips44 Vice Chair: Board of Governors Members replacing Kelley and Meyers : Susan Scmidt Bies, Mark W. Olson, Ben S. Bernanke, Donald L. Kohn

Llad Phillips45 Federal Open Market Committee Meetings 2002: November 6, December 10

Llad Phillips46 Federal Open Market Committee Federal Open Market Committee: 12 Members Federal Open Market Committee: 12 Members  Seven Board Governors  President of New York Fed  Four other presidents

Llad Phillips47 Federal Reserve Open Market Operations Tight Money Policy 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 Easy Money Policy  Fed buys securities in secondary market  increases bank reserves  increases excess reserves  increases banking system capacity to make loans

Llad Phillips48 FOMC Tries to Loosen Credit Buys Treasuries in Secondary Market FEDCommercial Banks Net Result: changes asset mix of banks & increases total bank reserves

Llad Phillips49 FOMC Tries to Tighten Credit Sells Treasuries in Secondary Market FEDCommercial Banks Net Result: changes asset mix of banks & decreases total bank reserves

Llad Phillips50 Limitations to FOMC Efforts FOMC can increase reserves by buying securities: this enables banks to make loans 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” 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 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

Llad Phillips51 Understanding Open Market Operations Familiarity with the Fed’s balance sheet Familiarity with the Fed’s balance sheet Definitions of Banking Reserve Aggregates Definitions of Banking Reserve Aggregates Fed is a corporation Fed is a corporation  national banks are chartered by the US Comptroller of Currency  national banks must be members and buy stock; this provides Fed with working capital  state banks can be members if they choose  Fed’s profits, above a given level, are given to US Treasury

Llad Phillips52 Federal Reserve System Balance Sheet, August 13, 1997 Source: TheWall Street Journal, Friday , p.C 18

Llad Phillips53 Bank Reserve Aggregates, * Excess Reserves = Total Reserves - Required Reserves ** Free Reserves = Excess Reserves - Borrowed Reserves Source: The Wall Street Journal, Friday , p.C 18

Llad Phillips54 How Effective Has the Fed Been? Fed Goals Fed Goals  maximum employment  stable prices  moderate long-term interest rates Fed Objectives or Targets Fed Objectives or Targets  quantity of reserves  price of reserves  federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks

HooverRooseveltTrumanIke JFK LBJNixon/ Ford Carter ReaganBush Clinton Misery Index = Unemployment Rate + Inflation Rate

Llad Phillips56 The Federal Reserve System: Purposes & Functions format: Adobe Acrobat

Llad Phillips57 The Federal Reserve System: Purposes & Functions format: Adobe Acrobat

Llad Phillips58 Summary-Vocabulary-Concepts full reserve banking full reserve banking fractional reserve banking fractional reserve banking banking system crisis banking system crisis  illiquid bank  insolvent bank FDIC, FSLIC FDIC, FSLIC lender of last resort lender of last resort discount rate discount rate ratio of required reserves to deposits ratio of required reserves to deposits Federal Funds Rate Federal Funds Rate Federal Reserve (FR) Federal Reserve (FR)  District  Board of Governors  Open Market Committee  open market operations  policy goals  policy targets Reserve Aggregates Reserve Aggregates  total reserves  nonborrowed reserves  required reserves  excess reserves  free reserves secondary Treasuries market secondary Treasuries market

Llad Phillips59 GDP: Nominal and Real Source:

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