Enu macroecon policy 040812
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Go Global !Global Economic Environment :Global Economic Environment :The Effect of Government Macroeconomic Policy on Business
By
Stephen OngStephen OngEdinburgh Napier University Business School
[email protected] Professor, College of Management, Shenzhen
University4 August 2012
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Learning Objectives
To identify the fiscal policy instruments of Government to manage the economy
To critically assess the effectiveness of fiscal policy
To identify the principal instruments of monetary policy
To evaluate the nature and effectiveness of monetary policy
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AgendaAgenda
1.1.Fiscal PolicyFiscal Policy2.2.Monetary Monetary
PolicyPolicy
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Fiscal PolicyFiscal Policy
Government Policy Government Policy DilemmaDilemma
Aggregate DemandAggregate Demand
Fiscal PolicyFiscal Policy
IssuesIssues
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1. Impact of Government Economic Policy
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2. Aggregate Demand
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2.1 Movements vs Shifts
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2.2 Economic Downturn
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2.3 National Income & Consumption
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2.4 National Output (GDP)
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2.5 GDP=C+I
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2.6 Multiplier Model
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2.7 Taxes (-T)
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2.8 Government Spending (+G)
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2.9 GDP=C+I+G
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2.9.1 GDP=C+I+G
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2.10 Economic Boom & Defence Spending
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3. Fiscal Policy3. Fiscal Policy
• Council of Economic Advisers Council of Economic Advisers (CEA)(CEA)• Discretionary fiscal policyDiscretionary fiscal policy• Eliminate recessionary or Eliminate recessionary or
inflationary gapinflationary gap• Countercyclical Countercyclical
• Nondiscretionary fiscal policyNondiscretionary fiscal policy• Passive or automaticPassive or automatic
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• Expansionary fiscal policyExpansionary fiscal policy• Increased spending and/or Increased spending and/or
lower taxeslower taxes• Budget deficitBudget deficit
• Contractionary fiscal policyContractionary fiscal policy• Lower spending and/or higher Lower spending and/or higher
taxestaxes• Budget surplusBudget surplus
• Policy options?Policy options?
3.1 Fiscal Policy
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3.2 Expansionary Fiscal 3.2 Expansionary Fiscal PolicyPolicy
Real Domestic Output, GDP
Pri
ce L
evel
AD2
RecessionsDecreaseAggregateDemand
AD1
$5 Billion AdditionalSpending
Full $20 Billion Increase in
Aggregate Demand
AS
$490 $510
P1
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3.3 Contractionary Fiscal 3.3 Contractionary Fiscal PolicyPolicy
Real Domestic Output, GDP
Pri
ce L
evel
AD3
Reduce Demand Pull
Inflation
AD4
$5 Billion Initial Decrease
In Spending
Full $20 Billion Decrease in
Aggregate Demand
AS
$510 $522
P1
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3.4 Built-In Stability3.4 Built-In Stability
• Automatic Automatic stabilizersstabilizers• Taxes and transfersTaxes and transfers
• Economic importanceEconomic importance• Tax progressivityTax progressivity• Progressive tax systemProgressive tax system• Proportional tax systemProportional tax system• Regressive tax systemRegressive tax system
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3.5 Built-In Stability3.5 Built-In Stability
G
T
Deficit
Surplus
GDP1 GDP2 GDP3
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
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3.6 Evaluating Fiscal Policy3.6 Evaluating Fiscal Policy
• Standardized budget Standardized budget • Full-employment budgetFull-employment budget
• Cyclical deficitCyclical deficit• Recent U.S. fiscal policyRecent U.S. fiscal policy• Budget deficits and Budget deficits and
projectionsprojections• Social security considerationsSocial security considerations
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3.6.1 Evaluating Fiscal Policy3.6.1 Evaluating Fiscal Policy
G
T
GDP2 GDP1
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
(Year 2) (Year 1)
$500
$450
ab
c
Cyclical deficitFiscal policy neutral
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3.6.2 Evaluating Fiscal Policy3.6.2 Evaluating Fiscal Policy
G
T1
GDP4 GDP3
Real Domestic Output, GDP
Go
vern
men
t E
xpen
ses,
Gan
d T
ax R
even
ues
, T
(Year 4) (Year 3)
$500
$450
de
f
$475
$425 g
T2
h
Standardized deficitExpansionary fiscal policy
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• Problems of timingProblems of timing• Recognition lagRecognition lag• Administrative lagAdministrative lag• Operational lagOperational lag
• Political considerationsPolitical considerations• Future policy reversalsFuture policy reversals• Offsetting state and local financeOffsetting state and local finance• Crowding-out effectCrowding-out effect• Current thinking on fiscal policyCurrent thinking on fiscal policy
Problems, Criticisms, and Complications4. Fiscal Policy Issues4. Fiscal Policy Issues
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(1)Year
(2)Actual
Deficit (-) orSurplus (+)
(3)StandardizedDeficit (-) orSurplus (+)
4.1 Budget Balances as % of 4.1 Budget Balances as % of GDPGDP
1992199319941995199619971998199920002001200220032004200520062007
-4.5%-3.8%-2.9%-2.2%-1.4%-0.3%+0.8%+1.4%+2.5%+1.3%-1.5%-3.4%-3.5%-2.6%-1.9%-1.3%
-2.9%-2.9%-2.1%-2.0%-1.2%-1.0%-0.4%+0.1%+1.1%+1.0%-1.2%-2.5%-2.4%-1.9%-1.8%-1.4%
Source: Congressional Budget Office
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4.2 Standardized Budget 4.2 Standardized Budget BalanceBalance
Percentage of Potential GDP, 2007
Source: Organization for Economic Cooperation and Development
Denmark
New Zealand
Ireland
Canada
Norway
France
United States
United Kingdom
Japan
-6 -4 -2 0 2 4 6Deficits Surpluses
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4.3 Federal Budget Balance4.3 Federal Budget BalanceActual and Projected, Fiscal 1994-2014
Source: Congressional Budget Office
$300
200
100
0
-100
-200
-300
-400
-500
Bu
dg
et D
efic
it (
-) o
r S
urp
lus,
Bill
ion
s
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Actual Projected (as of March 2008)
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4.4 The Public Debt4.4 The Public Debt
• National or public debt $9.01 National or public debt $9.01 trilliontrillion• OwnershipOwnership
• U.S. securitiesU.S. securities• 53% owned by federal 53% owned by federal
government and Federal Reservegovernment and Federal Reserve• 47% held outside the federal 47% held outside the federal
government and Federal Reservegovernment and Federal Reserve
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Debt Held by theFederal Government
and FederalReserve (53%)
Debt Held OutsideThe FederalGovernmentand Federal
Reserve (47%)
FederalReserve
U.S.Government
AgenciesU.S.Individuals
ForeignOwnership
U.S. BanksAnd otherFinancial
Institutions
Other, IncludingState and LocalGovernments
Source: U.S. Treasury
9%
7%
25%
8% 7%
44%
4.5 The Public Debt
Total Debt: $9.01 trillion
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4.6 Debt and GDP4.6 Debt and GDP
Federal debt held by the public, percentage of GDP
Source: Economic Report of the President, 2006
Per
cen
t o
f G
DP
Year
50
45
40
35
30
25
20
15
10
5
01970 1975 1980 1985 1990 1995 2000 2005
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4.7 Debt and GDP4.7 Debt and GDPPublicly Held Debt: International Comparisons
As a Percentage of GDP, 2007
ItalyJapan
BelgiumHungaryGermany
United StatesUnited Kingdom
FranceNetherlands
CanadaSpain
Poland
0 20 40 60 80 100
Source: Organization for Economic Cooperation and Development
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4.8 Debt and GDP4.8 Debt and GDP
• Interest chargesInterest charges• Primary burdenPrimary burden• 1.7% of GDP 20071.7% of GDP 2007
• False concernsFalse concerns• BankruptcyBankruptcy• RefinancingRefinancing• TaxationTaxation• Burdening future Burdening future
generationsgenerations
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4.9 Debt and GDP4.9 Debt and GDP
• Substantive issuesSubstantive issues• Income distributionIncome distribution• IncentivesIncentives• Foreign-owned public debtForeign-owned public debt
• Crowding-out effect revisitedCrowding-out effect revisited• Burden on future generationsBurden on future generations• Public investment as an offsetPublic investment as an offset
• Graphically Graphically
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4.10 Crowding Out4.10 Crowding Out
5 10 15 20 25 30 35 400
2
4
6
8
10
12
14
16
Rea
l In
tere
st R
ate
(P
erce
nt)
Investment (Billions of Dollars)
ID1
ID2
a
b c
Interest RateRise WillDecrease
Investmenta to b
Crowding-Out Effect
A Large Public Debt to Finance Public Investment Will Cause…
If Public SpendingSpurs More Private
Investment WillIncrease to ID2
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4.11 The Leading Indicators4.11 The Leading Indicators1.1. Average workweekAverage workweek2.2. Initial claims for Initial claims for
unemployment insuranceunemployment insurance3.3. New orders for consumer New orders for consumer
goodsgoods4.4. Vendor performanceVendor performance5.5. New orders for capital goodsNew orders for capital goods6.6. Building permits for housesBuilding permits for houses7.7. Stock pricesStock prices8.8. Money supplyMoney supply9.9. Interest-rate spreadInterest-rate spread10.10.Consumer expectationsConsumer expectations Source: The Conference Board
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Monetary PolicyMonetary Policy
MoneyMoney
The Central Banker : FRS The Central Banker : FRS
The Banking SystemThe Banking System
Monetary PolicyMonetary Policy
The US Subprime CrisisThe US Subprime Crisis
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1. Functions of Money 1. Functions of Money
• Medium of exchangeMedium of exchange• Used to buy/sell goodsUsed to buy/sell goods
• Unit of accountUnit of account• Goods valued in dollarsGoods valued in dollars
• Store of valueStore of value• Hold some wealth in money Hold some wealth in money
formform• Money is liquidMoney is liquid
31-40
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1.1 Money Defined1.1 Money Defined
• MM11• CurrencyCurrency• Checkable depositsCheckable deposits
• Institutions offering checkable Institutions offering checkable depositsdeposits• Commercial banksCommercial banks• Savings and loan associationsSavings and loan associations• Mutual savings banksMutual savings banks• Credit unionsCredit unions
31-41
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1.2 Money Defined1.2 Money Defined
• MM22• M1 plus near-moniesM1 plus near-monies• Savings deposits including Savings deposits including
money market deposit money market deposit accounts (MMDA)accounts (MMDA)• Small time depositsSmall time deposits• Money market mutual funds Money market mutual funds
(MMMF)(MMMF)
31-42
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1.3 Money Defined1.3 Money DefinedM1 M256%
44%M118%
Savings Deposits,Including Money Market
Deposit Accounts
Small Time Deposits
Money Market MutualFunds Held By Individuals
Currency
Checkable Deposits
16%
14%
52%
$1,365Billion
$7,499Billion
January 2008
Totals
++
+
+
+
Source: Federal Reserve System31-43
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1.4 Money Supply1.4 Money Supply
• Are credit cards money?Are credit cards money?• What “backs” the money What “backs” the money
supply?supply?• Nothing!Nothing!
• Why is money valuable?Why is money valuable?• AcceptabilityAcceptability• Legal tenderLegal tender• Relative scarcityRelative scarcity 31-44
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1.5 Money and Prices1.5 Money and Prices
• Prices affect purchasing power Prices affect purchasing power of moneyof money• Hyperinflation renders money Hyperinflation renders money
unacceptableunacceptable• Stabilizing money’s purchasing Stabilizing money’s purchasing
powerpower• Intelligent management of the Intelligent management of the
money supply – monetary policymoney supply – monetary policy• Appropriate fiscal policyAppropriate fiscal policy 31-45
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2. Federal Reserve System2. Federal Reserve System
• Historical backgroundHistorical background
• Board of GovernorsBoard of Governors
• 12 Federal Reserve Banks 12 Federal Reserve Banks
• Serve as the central bankServe as the central bank
• Quasi-public banksQuasi-public banks
• Banker’s bankBanker’s bank
31-46
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2.1 Federal Reserve System2.1 Federal Reserve System
Commercial BanksThrift Institutions
(Savings and Loan Associations,Mutual Savings Banks,
Credit Unions)
The Public(Households and
Businesses)
12 Federal Reserve Banks
Board of Governors
Federal Open Market Committee
31-47
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2.2 Federal Reserve System2.2 Federal Reserve System
The 12 Federal Reserve Banks
Source: Federal Reserve Bulletin
31-48
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2.3 Federal Reserve System2.3 Federal Reserve System
• Federal Open Market CommitteeFederal Open Market Committee• Aids Board of Governors in setting Aids Board of Governors in setting
monetary policymonetary policy• Conducts open market operationsConducts open market operations
• Commercial banks and thriftsCommercial banks and thrifts• 7,300 commercial banks7,300 commercial banks• 11,000 thrifts11,000 thrifts
31-49
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2.4 Federal Reserve Functions2.4 Federal Reserve Functions
• Issue currencyIssue currency• Set reserve requirementsSet reserve requirements• Lend money to banks Lend money to banks • Set discount rateSet discount rate• Check collectionCheck collection• Fiscal agent for U.S. governmentFiscal agent for U.S. government• Supervise banksSupervise banks• Control the money supplyControl the money supply
31-50
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2.5 Federal Reserve System2.5 Federal Reserve System
• Federal Reserve independenceFederal Reserve independence• Recent developmentsRecent developments• Relative decline of banks and Relative decline of banks and
thriftsthrifts• Consolidation Consolidation • Convergence of services provided Convergence of services provided
by financial institutionsby financial institutions• Globalization of financial marketsGlobalization of financial markets• Electronic paymentsElectronic payments
31-51
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2.6 Financial Institutions2.6 Financial Institutions
World’s 12 Largest Financial Institutions, 2007
Barclays (UK)BNP Paribas (France
Citigroup (USA)HSBC Group (UK)UBS (Switzerland)
Royal Bank of Scotland (UK)ING Group (Netherlands)
Mitsubishi UFJ (Japan)Deutsche Bank Group (Ger)
Bank of America (US)Allianz Worldwide (Ger)JPMorgan Chase (USA)
0 1,300,000 1,600,000 1,900,000
Source: Organization for Economic Cooperation and Development
Assets (Billions of U.S. Dollars)
31-52
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2.7 U.S. Financial Institutions2.7 U.S. Financial Institutions
• Commercial banksCommercial banks• ThriftsThrifts• Insurance companiesInsurance companies• Mutual fund companiesMutual fund companies• Pension fundsPension funds• Securities firmsSecurities firms• Investment banksInvestment banks
31-53
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2.8 The Global Greenback2.8 The Global Greenback
• U.S. currency circulating abroadU.S. currency circulating abroad• Russia $80 billionRussia $80 billion• Argentina $50 billionArgentina $50 billion• $450 billion total$450 billion total• 60% of total US currency 60% of total US currency
• U.S. profits from dollars leavingU.S. profits from dollars leaving• Black markets and illegal activitiesBlack markets and illegal activities• Dollar offers stable purchasing powerDollar offers stable purchasing power• Exchange rate riskExchange rate risk
31-54
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3. Fractional Reserve Banking3. Fractional Reserve Banking
• The GoldsmithsThe Goldsmiths• Stored gold and gave a receiptStored gold and gave a receipt• Receipts used as money by publicReceipts used as money by public• Made loans by issuing receiptsMade loans by issuing receipts
• CharacteristicsCharacteristics• Banks create money through Banks create money through
lendinglending• Banks are subject to “panics” Banks are subject to “panics”
32-55
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3.1 Fractional Reserve System3.1 Fractional Reserve System
• Balance sheetBalance sheet• Assets = Liabilities + Net Assets = Liabilities + Net
WorthWorth• Both sides balanceBoth sides balance
• Necessary transactionsNecessary transactions• Create a bankCreate a bank• Accept deposits Accept deposits • Lend excess reservesLend excess reserves
32-56
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Assets Liabilities and Net Worth
3.2 Creating a Bank3.2 Creating a Bank
• Transaction #1Transaction #1• Vault cash: cash held by the Vault cash: cash held by the
bankbankCreating a Bank
Balance Sheet 1: Wahoo Bank
Cash $250,000 Stock Shares $250,000
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Assets Liabilities and Net Worth
3.2.1 Creating a Bank3.2.1 Creating a Bank
• Transaction #2Transaction #2• Acquiring property & equipmentAcquiring property & equipment
Acquiring Property and EquipmentBalance Sheet 2: Wahoo Bank
Cash $10,000 Stock Shares $250,000Property 240,000
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Assets Liabilities and Net Worth
3.2.2 Creating a Bank3.2.2 Creating a Bank
• Transaction #3Transaction #3• Commercial bank Commercial bank
functionsfunctions• Accepting depositsAccepting deposits• Making loans Making loans Accepting Deposits
Balance Sheet 3: Wahoo Bank
Cash $110,000 Checkable Deposits $100,000Property 240,000Stock Shares 250,000
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3.2.3 Creating a Bank3.2.3 Creating a Bank
• Transaction #4Transaction #4• Depositing reserves in a Depositing reserves in a
Federal Reserve bankFederal Reserve bank• Required reservesRequired reserves• Reserve ratioReserve ratio
Reserveratio =
Commercial bank’sRequired reserves
Commercial bank’sCheckable-deposit liabilities
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3.2.4 Reserve Requirements3.2.4 Reserve Requirements
Type of DepositCurrent
RequirementStatutory
Limits
Checkable deposits:
$0-$9.8 Million$9.3-$43.9 MillionOver $43.9 Million
Noncheckable nonpersonalsavings and time deposits
0% 310
3% 38-14
0 0-9
• Fed can establish and vary reserve ratio within limits set by Congress
• Required reserves help Fed control lending abilities of commercial banks
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Assets Liabilities and Net Worth
3.2.5 Creating a Bank3.2.5 Creating a Bank
Depositing Reserves at the FedBalance Sheet 4: Wahoo Bank
Cash $0 Checkable Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves 110,000
• Transaction #4• Assume the bank deposits all
cash on reserve at the Fed
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3.2.6 Reserve Requirements3.2.6 Reserve Requirements
• Excess reservesExcess reserves• Actual reserves - required Actual reserves - required
reservesreserves
• Required reservesRequired reserves• Checkable deposits x reserve ratioCheckable deposits x reserve ratio
• Example:Example:• Checkable deposits $100,000Checkable deposits $100,000• Reserve ratio 20%Reserve ratio 20% 32-63
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Assets Liabilities and Net Worth
3.2.7 Creating a Bank3.2.7 Creating a Bank
• Transaction #5Transaction #5• Clearing a checkClearing a check• $50,000 check reduces reserves $50,000 check reduces reserves
and checkable deposits and checkable deposits Clearing a Check
Balance Sheet 5: Wahoo Bank
Checkable Deposits $50,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
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Assets Liabilities and Net Worth
3.3 Money Creating Transactions3.3 Money Creating Transactions
• Transaction #6aTransaction #6a• Granting a loanGranting a loan• $50,000 loan deposited to $50,000 loan deposited to
checkingcheckingWhen a Loan is NegotiatedBalance Sheet 6a: Wahoo Bank
Checkable Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
Loans 50,000
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Assets Liabilities and Net Worth
3.3.1 Money Creating Transactions3.3.1 Money Creating Transactions
• Transaction #6bTransaction #6b• Using the loanUsing the loan• $50,000 loan cashed $50,000 loan cashed
After a Check is Drawn on the Loan Balance Sheet 6b: Wahoo Bank
Checkable Deposits $50,000
Property 240,000 Stock Shares 250,000
Reserves $10,000
Loans 50,000
A single bank can only lend an amountequal to their preloan excess reserves
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Assets Liabilities and Net Worth
3.3.2 Money Creating Transactions3.3.2 Money Creating Transactions
• Transaction #7Transaction #7• Bank buys government Bank buys government
securities from dealersecurities from dealer• Deposits payment into Deposits payment into
checking checking Buying Government SecuritiesBalance Sheet 7: Wahoo Bank
Checkable Deposits $100,000
Property 240,000 Stock Shares 250,000
Reserves $60,000
Securities 50,000
New money is created 32-67
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3.4 Commercial Banks3.4 Commercial Banks
• Conflicting goalsConflicting goals• Earn profitEarn profit• Make loans to earn interestMake loans to earn interest• Buy securities to earn interestBuy securities to earn interest
• Maintain liquidityMaintain liquidity• Alternative?Alternative?• Overnight bank loansOvernight bank loans• Federal funds rateFederal funds rate
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3.5 The Banking S3.5 The Banking Systemystem
• Multiple-deposit expansionMultiple-deposit expansion• Assumptions:Assumptions:• 20% required reserves20% required reserves• All banks “loaned up”All banks “loaned up”• Banks lend all of excess reservesBanks lend all of excess reserves
• A $100 bill is found and A $100 bill is found and depositeddeposited• Multiple deposits can be createdMultiple deposits can be created
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Bank
(1)AcquiredReserves
and Deposits
(2)RequiredReserves
(3)Excess
Reserves(1)-(2)
(4)Amount Bank CanLend; New Money
Created = (3)
Bank A $100 $20 $80 $80
Bank B $80 $16 $64 $64
Bank C $64 $12.80 $51.20 $51.20
Bank D $51.20 $10.24 $40.96 $40.96
The process will continue…
3.6 The Banking System
32-70
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Bank ABank BBank CBank DBank EBank FBank GBank HBank IBank JBank KBank LBank MBank NOther Banks
Bank
(1)AcquiredReserves
and Deposits
(2)RequiredReserves(Reserve
Ratio = .2)
(3)Excess
Reserves(1)-(2)
(4)Amount Bank CanLend; New Money
Created = (3)
$100.0080.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.50
21.99
$20.0016.0012.8010.248.196.555.244.203.362.682.151.721.371.104.40
$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40
17.59
$80.0064.0051.2040.9632.7726.2120.9716.7813.4210.748.596.875.504.40
17.59$400.00
3.6.1 The Banking System
32-71
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3.7 The Monetary Multiplier3.7 The Monetary Multiplier
Monetarymultiplier =
1
required reserve ratio
New Reserves$100
$20RequiredReserves
$80Excess
Reserves
$100Initial
Deposit
$400Bank System Lending
Money Created
GraphicExample
=1
R
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3.7.1 The Monetary Multiplier3.7.1 The Monetary Multiplier
• Maximum amount of new Maximum amount of new money created by single money created by single dollar of excess reservesdollar of excess reserves• Higher R, lower mHigher R, lower m• ReversibilityReversibility• Making loans creates moneyMaking loans creates money• Loan repayment destroys Loan repayment destroys
moneymoney 32-73
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3.8 Bank Panics of 1930-19333.8 Bank Panics of 1930-1933
• Before deposit insuranceBefore deposit insurance• Bank failure led to mass withdrawals Bank failure led to mass withdrawals • Forced loan reductionForced loan reduction• 25-33% decline in money supply25-33% decline in money supply• 1933 national bank holiday to 1933 national bank holiday to
evaluate all banksevaluate all banks• Contributed to the Great DepressionContributed to the Great Depression• Regulation protects the system Regulation protects the system
todaytoday 32-74
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4. Interest Rates4. Interest Rates
• Price paid for the use of Price paid for the use of moneymoney• Many different interest ratesMany different interest rates• Speak as if only one interest Speak as if only one interest
raterate• Determined by money supply Determined by money supply
and money demandand money demand
33-75
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4.1 Demand for Money4.1 Demand for Money• Why hold money?Why hold money?• Transactions demand, Transactions demand, DD11
• Determined by nominal GDPDetermined by nominal GDP• Independent of the interest rateIndependent of the interest rate
• Asset demand, Asset demand, DD22
• Money as a store of valueMoney as a store of value• Varies inversely with the interest Varies inversely with the interest
raterate
• Total money demand,Total money demand, D Dmm33-76
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4.1.1Demand for Money4.1.1Demand for MoneyR
ate
of
inte
rest
, i p
erce
nt
10
7.5
5
2.5
0
50 100 150 200 50 100 150 200 50 100 150 200 250 300
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded
(billions of dollars)
Amount of moneydemanded and supplied
(billions of dollars)
=+
(a)Transactionsdemand formoney, Dt
(b)Asset
demand formoney, Da
(c)Total
demand formoney, Dm
and supply
Dt Da Dm
Sm
5
33-77
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4.2 Interest Rates4.2 Interest Rates
• Equilibrium interest rateEquilibrium interest rate• Changes with shifts in money Changes with shifts in money
supply and money demandsupply and money demand• Interest rates and bond Interest rates and bond
pricesprices• Inversely relatedInversely related• Bond pays fixed annual Bond pays fixed annual
interest paymentinterest payment• Lower bond price will raise the Lower bond price will raise the
interest rateinterest rate 33-78
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4.3 Federal Reserve Balance Sheet4.3 Federal Reserve Balance Sheet
• AssetsAssets• SecuritiesSecurities• Loans to commercial banksLoans to commercial banks
• LiabilitiesLiabilities• Reserves of commercial banksReserves of commercial banks• Treasury depositsTreasury deposits• Federal Reserve Notes Federal Reserve Notes
outstandingoutstanding33-79
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SecuritiesLoans to Commercial BanksAll Other Assets
Total
Reserves of Commercial BanksTreasury DepositsFederal Reserve Notes (Outstanding)All Other Liabilities and Net WorthTotal
February 14, 2008 (in Millions)
Assets Liabilities and Net Worth
Source: Federal Reserve Statistical Release, H.4.1, February 14, 2008
$713,369
60,039111,689
$885,097
$ 11,3124,979
778,93789,869
$885,097
4.3.1 Federal Reserve Balance Sheet
33-80
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4.4 Central Banks4.4 Central Banks
Reserve Bank of Australia (RBA)
Bank of Canada
European Central Bank (ECB)
Bank of Japan (BOJ)
Banco de Mexico (Mex Bank)
Central Bank of Russia
Sveriges Riksbank
Bank of England
Federal Reserve System (the “Fed”)
(12 Regional Federal Reserve Banks)
Bank Negara Malaysia
Australia:
Canada:
Euro Zone:
Japan:
Mexico:
Russia
Sweden:
United Kingdom:
United States:
Malaysia :
Selected Nations
33-81
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4.5 Tools of Monetary Policy4.5 Tools of Monetary Policy
• Open market operationsOpen market operations• Buying and selling of government Buying and selling of government
securities (or bonds)securities (or bonds)• Commercial banks and the Commercial banks and the
general publicgeneral public• Used to influence the money Used to influence the money
supplysupply• When the Fed sells securities, When the Fed sells securities,
commercial bank reserves are commercial bank reserves are reducedreduced
33-82
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4.5.1 Open Market Operations4.5.1 Open Market Operations
New Reserves$1000
$5000Bank System Lending
Total Increase in the Money Supply, ($5,000)
Fed buys $1,000 bond from a commercial bank
$1000Excess
Reserves
33-83
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4.5.2 Open Market Operations4.5.2 Open Market Operations
Check is DepositedNew Reserves
$1000
Total Increase in the Money Supply, ($5000)
Fed buys $1,000 bond from the public
$200RequiredReserves
$800Excess
Reserves
$1000Initial
CheckableDeposit
$4000Bank System Lending
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4.6 Tools of Monetary Policy4.6 Tools of Monetary Policy
• The reserve ratioThe reserve ratio• Changes the money multiplierChanges the money multiplier
• The discount rateThe discount rate• The Fed as lender of last resortThe Fed as lender of last resort• Short term loansShort term loans
• Term auction facilityTerm auction facility• Introduced December 2007Introduced December 2007• Banks bid for the right to borrow Banks bid for the right to borrow
reservesreserves 33-85
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4.6.1 Tools of Monetary Policy4.6.1 Tools of Monetary Policy
• Open market operations most Open market operations most importantimportant• Reserve ratio last changed 1992Reserve ratio last changed 1992• Discount rate was a passive toolDiscount rate was a passive tool• Term auction facility is newTerm auction facility is new• Guaranteed amount lent by the Guaranteed amount lent by the
FedFed• Anonymous Anonymous 33-86
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4.7 The Federal Funds Rate4.7 The Federal Funds Rate
• Rate charged by banks on Rate charged by banks on overnight loansovernight loans• Targeted by the Federal ReserveTargeted by the Federal Reserve• FOMC conducts open market FOMC conducts open market
operations to achieve the targetoperations to achieve the target• Demand curve for Federal fundsDemand curve for Federal funds• Supply curve for Federal fundsSupply curve for Federal funds
33-87
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4.7.1 The Federal Funds Rate4.7.1 The Federal Funds Rate
Fed
eral
Fu
nd
s R
ate,
Per
cen
t
3.5
Quantity of Reserves
Df
Sf3
4.0
4.5
Sf1
Sf2
Qf3 Qf1 Qf2
Using Open Market Operations
33-88
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4.8 Monetary Policy4.8 Monetary Policy
• Expansionary monetary Expansionary monetary policypolicy• Economy faces a recessionEconomy faces a recession
• Lower target for federal funds rateLower target for federal funds rate
• Fed buys securities Fed buys securities
• Expanded money supplyExpanded money supply
• Downward pressure on other interest ratesDownward pressure on other interest rates
• Contractionary monetary Contractionary monetary policypolicy
33-89
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4.9 Taylor Rule4.9 Taylor Rule
• Rule of thumb for tracking actual Rule of thumb for tracking actual monetary policymonetary policy• Fed has 2% target inflation rateFed has 2% target inflation rate• If real GDP = potential GDP and If real GDP = potential GDP and
inflation is 2% then target inflation is 2% then target federal funds rate is 4%federal funds rate is 4%• Target varies as inflation and Target varies as inflation and
real GDP varyreal GDP vary 33-90
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4.10 Monetary Policy4.10 Monetary Policy
• Affect on real GDP and price Affect on real GDP and price levellevel• Cause-effect chainCause-effect chain
• Market for moneyMarket for money
• Investment and the interest rateInvestment and the interest rate
• Investment and aggregate demandInvestment and aggregate demand
• Real GDP and pricesReal GDP and prices
• Expansionary monetary policy Expansionary monetary policy • Restrictive monetary policyRestrictive monetary policy 33-91
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4.11 Monetary Policy and GDP4.11 Monetary Policy and GDP
10
8
6
0
Rat
e o
f In
tere
st, i
(P
erce
nt)
Amount of moneydemanded and
supplied(billions of dollars)
Amount of investment (billions of dollars)
Pri
ce
Le
ve
l
Real GDP(billions of dollars)
Q1 Qf Q3$125 $150 $175 $15 $20 $25
P2
P3
Sm1 Sm2 Sm3
Dm
IDAD1
I=$15
AD2
I=$20
AD3
I=$25
(a)The marketfor money
(b)Investment
demand
(c)Equilibrium real
GDP and thePrice level
AS
33-92
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4.12 Expansionary Monetary Policy4.12 Expansionary Monetary Policy
Problem: unemployment and recession
Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises
CA
US
E-E
FFEC
T C
HA
IN
33-93
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4.13 Restrictive Monetary Policy4.13 Restrictive Monetary PolicyProblem: inflation
Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines
CA
US
E-E
FFEC
T C
HA
IN
33-94
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4.14 Monetary Policy4.14 Monetary Policy
• Advantages over fiscal policyAdvantages over fiscal policy• Speed and flexibilitySpeed and flexibility• Isolation from political pressureIsolation from political pressure
• Recent U.S. monetary policyRecent U.S. monetary policy• Problems and complicationsProblems and complications• Recognition lagRecognition lag• Operational lag Operational lag • Cyclical asymmetry Cyclical asymmetry
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4.15 The Big Picture4.15 The Big Picture
Levels ofOutput,
Employment,Income, and
Prices
AggregateDemand
AggregateSupply
InputResourcesWith Prices
ProductivitySources
Legal-InstitutionalEnvironment
Consumption(Ca)
Investment(Ig)
Net ExportSpending
(Xn)
GovernmentSpending
(G)
33-96
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4.16 The Mortgage Debt Crisis4.16 The Mortgage Debt Crisis
• Home mortgage default 2007Home mortgage default 2007• Banks write off bad loansBanks write off bad loans• Reserves reducedReserves reduced• Fed as lender of last resortFed as lender of last resort• Term auction facilityTerm auction facility• Fed lowered federal funds rateFed lowered federal funds rate• Mortgage backed securities as a Mortgage backed securities as a
new innovationnew innovation• Bad incentivesBad incentives
33-97
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5. The US Subprime Crisis
Video : Capitalism : A Love Video : Capitalism : A Love StoryStory
““Over all history, money has Over all history, money has oppressed people in one of oppressed people in one of two ways: either it has been two ways: either it has been abundant and very unreliable, abundant and very unreliable, or reliable and very scarce.”or reliable and very scarce.”
John Kenneth GalbraithJohn Kenneth Galbraith, The Age of Uncertainty , The Age of Uncertainty (1977)(1977)
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ConclusionConclusion
““Understanding the forces that Understanding the forces that affect aggregate demand, including affect aggregate demand, including government fiscal and monetary government fiscal and monetary policies, can help economists and policies, can help economists and policymakers smooth out the cycle policymakers smooth out the cycle of boom and bust.” of boom and bust.”
Paul Samuelson
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Casestudy : IKEACasestudy : IKEA
1.1. Read and prepare the Read and prepare the Casestudy on IKEA Casestudy on IKEA (Johnson, Whittington & (Johnson, Whittington & Scholes (2011)) for Scholes (2011)) for discussion and discussion and presentation next week. presentation next week.
2.2. Identify and evaluate the Identify and evaluate the challenges facing IKEA challenges facing IKEA during the global recession, during the global recession, by conducting External by conducting External Environment, Industry, Environment, Industry, Competitor analysis and Competitor analysis and SWOT.SWOT.
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Core ReadingCore Reading
Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Environment, Napier University EdinburghEnvironment, Napier University Edinburgh
Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Business: Environments and Operations. 14Business: Environments and Operations. 14thth edition, Pearson edition, Pearson
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Questions?Questions?