36.1: Introduction to Natural Resource Economics

36.1.1: Types of Natural Resources

Learning Objective

Analyze natural resource economics and explain the types of natural resources that exist.

Key Points

• Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources.
• Every man-made product in an economy is composed of natural resources to some degree.
• Natural resources can be classified as potential, actual, reserve, or stock resources based on their stage of development.
• Natural resources are either renewable or non-renewable depending on whether or not they replenish naturally.
• Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources.

Key Terms

Renewable

Sustainable; able to be regrown or renewed; having an ongoing or continuous source of supply; not finite.

natural resource

Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.

depletion

The consumption of a resource faster than it can be replenished.

Natural Resource Economics

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. It’s goal is to gain a better understanding of the role of natural resources in the economy. Learning about the role of natural resources allows for the development of more sustainable methods to manage resources and make sure that they are maintained for future generations.The goal of natural resource economics is to develop an efficient economy that is sustainable in the long-run .

Importance of the Environment

This diagram illustrates how society and the economy are subsets of the environment. It is not possible for societal and economic systems to exist independently from the environment. For this reason, natural resource economics focuses on understanding the role of natural resources in the economy in order to develop a sufficient and sustainable economy that protects natural resources.

Types of Natural Resources

Natural resources are derived from the environment. Some of the resources are essential to survival, while others merely satisfy societal wants. Every man-made product in an economy is composed of natural resources to some degree.

There are numerous ways to classify the types of natural resources, they include the source of origin, the state of development, and the renewability of the resources.

In terms of the source of origin, natural resources can be divided into the following types:

• Biotic: these resources come from living and organic material, such as forests and animals, and include the materials that can be obtained them. Biotic natural resources also include fossil fuels such as coal and petroleum which are formed from organic matter that has decayed.
• Abiotic: these resources come from non-living and non-organic material. Examples of these resources include land, fresh water, air, and heavy metals (gold, iron, copper, silver, etc.).

Natural resources can also be categorized based on their stage of development including:

• Potential resources: these are resources that exist in a region and may be used in the future. For example, if a country has petroleum in sedimentary rocks, it is a potential resource until it is actually drilled out of the rock and put to use.
• Actual resources: these are resources that have been surveyed, their quantity and quality has been determined, and they are currently being used. The development of actual resources is dependent on technology.
• Reserve resources: this is the part of an actual resource that can be developed profitably in the future.
• Stock resources: these are resources that have been surveyed, but cannot be used due a lack of technology. An example of a stock resource is hydrogen.

Natural resources are also classified based on their renewability:

• Renewable natural resources: these are resources that can be replenished. Examples of renewable resources include sunlight, air, and wind . They are available continuously and their quantity is not noticeably affected by human consumption. However, renewable resources do not have a rapid recovery rate and are susceptible to depletion if they are overused.
• Non-renewable natural resources: these resources form extremely slow and do not naturally form in the environment. A resource is considered to be non-renewable when their rate of consumption exceeds the rate of recovery. Examples of non-renewable natural resources are minerals and fossil fuels.

There is constant worldwide debate regarding the allocation of natural resources. The discussions are centered around the issues of increased scarcity (resource depletion) and the exportation of natural resources as a basis for many economies (especially developed nations). The vast majority of natural resources are exhaustible which means they are available in a limited quantity and can be used up if they are not managed correctly. Natural resource economics aims to study resources in order to prevent depletion.

Natural resource utilization is regulated through the use of taxes and permits. The government and individual states determine how resources must be used and they monitor the availability and status of the resources. An example of natural resource protection is the Clean Air Act. The act was designed in 1963 to control air pollution on a national level. Regulations were established to protect the public from airborne contaminants that are hazardous to human health. The act has been revised over the years to continue to protect the quality of the air and health of the public in the United States.

Wind

Wind is an example of a renewable natural resource. It occurs naturally in the environment and has the ability to replenish itself. It has also been used as a form of energy development through wind turbines.

36.1.2: Basic Economics of Natural Resources

Learning Objective

Explain basic natural resource economics

Key Points

• As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems.
• By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations.
• Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues. These issues include resource extraction, depletion, protection, and management.
• Natural resource economics findings impact policies for environmental work including issues such as extraction, depletion, protection, and management.

Key Terms

natural resource

Any source of wealth that occurs naturally, especially minerals, fossil fuels, timber, etc.

sustainable

Able to be sustained for an indefinite period without damaging the environment, or without depleting a resource.

Natural Resource Economics

Natural resource economics focuses on the supply, demand, and allocation of the Earth’s natural resources. The main objective of natural resource economics is to gain a better understanding of the role of natural resources in the economy. By studying natural resources, economists learn how to develop more sustainable methods of managing resources to ensure that they are maintained for future generations. Economists study how economic and natural systems interact in order to develop an efficient economy.

As a field of academic research, natural resource economics addresses the connections and interdependence between human economies and natural ecosystems. The focus is how to operate an economy within the ecological constraints of the earth’s natural resources .

Natural Resource Economics

This diagram illustrates that society and the economy are subsets of the environment. It is not possible for social and economic systems to exist independently from the environment. Natural resource economics focuses on the demand, supply, and allocation of natural resources to increase sustainability.

Areas of Study

Economists study the commercial and recreational use and exploitation of resources. Traditionally, natural resource economics focused on fishery, forestry, and mineral models. However, in recent years many more topics have become increasingly important, including air, water, and the global climate. Natural resource economics is studied on an academic level, and the findings are used to shape and direct policy-making for environmental issues.

Examples of areas of study in natural resource economics include:

• welfare theory
• pollution control
• resource exhaustibility
• environmental management
• resource extraction
• non-market valuation
• environmental policy

Additionally, research topics of natural resource economists can include topics such as the environmental impacts of agriculture, transportation and urbanization, land use in poor and industrialized countries, international trade and the environment, and climate change.

Impact of Natural Resource Economics

The findings of natural resource economists are used by governments and organizations to better understand how to efficiently use and sustain natural resources. The findings are used to gain insight into the following environmental areas:

• Extraction: the process of withdrawing resources from nature. Extractive industries are a basis for the primary sector of the economy. The extraction of natural resources substantially increases a country’s wealth. Economists study extraction rates to make sure that resources are not depleted. Also, if resources are extracted too quickly, the sudden inflow of money can cause inflation. Economists seek to maintain a sense of balance within extraction industries.
• Depletion: the using up of natural resources, which is considered to be a global sustainable development issue. Many governments and organizations have become increasingly involved in preserving natural resources. Economists provide data to determine how to balance the needs of societies now and preserve resources for the future.
• Protection: the preservation of natural resources for the future. The findings of economists help governments and organization develop measures of protection to sustain natural resources. Protection policies state the necessary actions internationally, nationally, and individually that must take place to control natural resource depletion that is a result of human activity.
• Management: the use of natural resources taking into account economic, environmental, and social concerns. This process deals with managing natural resources such as land, water, soil, plants, and animals. Particular focus is placed on how the preservation of natural resources impacts the quality of life now and for future generations.

36.1.3: Externalities and Impacts on Resource Allocation

Learning Objective

Examine externalities and how they the impact resource allocation of natural resources.

Key Points

• An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit.
• A negative externality, also called the external cost, imposes a negative effect on a third party.
• When external costs are present, the market equilibrium use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society would have been better off if fewer natural resources had been used.
• Positive externalities, also referred to as external benefits, imposes a positive effect on a third party.
• Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.

Key Term

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Resource Allocation

Resource allocation is division of goods for the use of production within the economy. The needs and wants of society as well as industries impact what is produced. Suppliers focus on producing the varieties of goods and services that will yield the greatest satisfaction to consumers. In the long run, externalities directly impact resource allocation. It must be determined whether the production, as well as the process of production, creates more benefits that costs for the producers, consumers, and society as a whole.

Externalities

An externality is a cost or benefit that affects a party who did not choose to incur the cost or benefit. In regards to natural resources, production and use of resources can have a positive or negative effect on the allocation of the resources.

External Costs

A negative externality, also called the external cost, imposes a negative effect on a third party to an economic transaction. Many negative externalities impact natural resources negatively because of the environmental consequences of production and use. For example, air pollution from factories and vehicles can cause damage to crops . Likewise, water pollution has a negative impact of plants and animals.

Negative externality

Air pollution from vehicles is an example of a negative externality. It affects other than those who drive the vehicle and those who sell the gas.

In the case of negative externalities, the marginal private cost of consuming a good is less than the marginal social or public cost. The marginal social benefit should equal the marginal social cost (i.e. production should only be increased when the marginal social benefit exceeds the marginal social cost). When external costs are present, the use of natural resources is inefficient because the social benefit is less than the social cost. In other words, society and the natural resources involved would have been better off if the natural resources had not been used at all.

Developed countries use more natural resources and must enact sustainable development plan for the use of resources. Human needs must be met, but the environment and natural resources must be preserved. Examples of resource depletion include mining, petroleum extraction, fishing, forestry, and agriculture.

External Benefits

Positive externalities, also referred to as external benefits, impose a positive effect on a third party. An example of a positive externality is when crops are pollinated by bees from a neighboring bee farm. In order to achieve the socially optimal equilibrium, the marginal social benefit should equal the marginal social cost (i.e. production should be increased as long as the marginal social benefit exceeds the marginal social cost). Assuming that natural resources are used and also sustained, the external benefits of goods produced by natural resources impacts the majority of the public in a positive way.

35.1: Introducing Health Care Economics

35.1.1: Defining Health, Health Care, and Medical Care

Learning Objective

List the parties involved in the healthcare system in the United States

Key Points

• Kenneth Arrow, in 1963, differentiated health care economics from other economics due to the wide range of unique considerations involved (i.e. infinite demand, wide range of stakeholders, etc. ).
• Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. These parties determine the supply, demand, oversight, and externalities of the system.
• Currently, U.S. health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. This is unlike many developed nations, who have socialized support in place.
• The insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices.
• Overall, this system of health care in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high.

Key Term

Health care

The prevention, treatment, and management of illness or the preservation of mental and physical well-being through the services offered by the medical, nursing, and allied health professions.

Health care economics is a segment of economic study pertaining to the value, effectiveness, and efficiency in medical care and health care services and issues. The study of health care, from an economic perspective, requires taking a broad lens on a complex system with a wide variety of stakeholders. In 1963, Kenneth Arrow differentiated health care economics from other economics due to the wide range of unique considerations involved. Health care, due to the severity of the need/demand, wide variety of externalities, government intervention, and role of doctors as third-parties (making critical purchasing decisions for other people), cannot be considered from the same perspective as other industries.

Defining Health Care

Health care is a significant concern for patients, insurance companies, governments, businesses, health care providers, researchers, and non-profits. It is a vast economic system with many internal players and externalities. Understanding the basic factors involved, both logistically and economically, will provide useful context in defining health care and the medical care services.

outlines who is involved, and in what fashion.

Health Care System Flow Chart

This flow chart does an excellent job of outlining the various stakeholders and influences in the broader health care system context.

• Health (Box B): Health metrics for health attributes from a value of life and overall utility-based perspective.
• Demand for Health Care (Box C): The overall health care demand, which is a complex array of inputs that can be summarized as health care seeking behaviors, and what factors influence them (i.e. externalities, price, time, perspectives, etc.).
• Supply of Health Care Costs (Box D):The supply of health care in most systems is quite complex, inclusive of direct inputs such as drugs, medical suppliers, and diagnostics to insurance companies (third parties) to health care professionals (doctors, nurses, etc.) to research.
• Evaluation of the Whole System (Box F): This is where the government factors in, particularly in countries with a more socialized system for health care, alongside the comparisons both internally and externally.

This process flow is what defines health care and the medical industry from an economic standpoint, and the relative influence of each of these components, and the interdependence between them, is worth studying to determine where higher degrees of efficiency and efficacy can be found.

Health Care System in the U.S.

With this in mind, it is useful to also outline the inputs and outputs of the U.S. health care system, particularly during this transitional time. At the time of this writing (2013), the Affordable Care Act (often referred to as ‘Obamacare’) will be coming into play shortly. While the details and implications of this are beyond the scope of this discussion, it is useful to understand what the basic construct that exists in the United States currently.

At the moment, health care is largely privatized with the exception of medicaid and medicare, the former being for low income groups and the latter for retirees. For most of us, health care insurance is generally purchased on a capital market by a policy-holder (who may be a company the beneficiary works for or the beneficiary themselves, depending upon the profession and contractual obligations of an employer). This health insurance plan offers a construct for what will be covered under an umbrella of monthly health care payments, and what is considered outside of the plan. There are many large health care insurance providers out there, offering this service to prospective beneficiaries.

Now, either the insurance company, the government (medicaid and medicare), or the individual (if they are not covered or if their particular procedure is not covered) is the direct client of the hospitals, pharmacies, and doctor’s offices. These institutions are also quite complicated, and require their own insurances against liability due to the high consequences in the field. Doctors and nurses provide a service, either actively performing a recommended approach (e.g. surgery) or recommending a treatment (e.g drugs). These medical professionals are largely overseen by the government from a quality control perspective (various standardized test and degree requirements), adding an additional line of complexity to the operation.

Overall, this system of healthcare in the U.S. is quite convoluted. There are many players involved and the stakes are extremely high. Picture a demand curve for a treatment for a deadly disease, what would the price point be? Considering the consequences, healthcare services often fall outside of standard macroeconomic concepts, defying supply and demand frameworks due to the nature of the business (i.e. life and death, the well-being of people). This underlines a social issue: how can we improve healthcare economics to maximize value and minimize costs?

35.1.2: Where a Dollar Spent on Health Care Goes: Introducing the Inputs to Health Care

Learning Objective

Discuss the factors that affect the cost of and access to healthcare

Key Points

• While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price.
• In short, the dollar value of health care is largely provided by beneficiaries to insurance companies (or governments), and paid out to administrative systems who employ and pay health care providers.
• One of the most discussed topics in health care is accessibility. Governments and insurers provide economics means for this in developed nations.
• One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required.

Key Terms

Medicaid

U.S. government system for providing medical assistance to persons unable to afford medical treatments.

Medicare

The system of government subsidies for health care for the elderly and disabled.

Beneficiary

One who benefits or receives an advantage.

Healthcare has many inputs and a wide variety of interested parties profiteering. Understanding what drives the need for health care (and what prevents it), what is included in the cost, and the overall accessibility of this essential service is critical to understanding economics issues in healthcare. A dollar spent on health care can find it’s way to insurance providers, medical service providers, pharmaceutical companies, governments, administrative bodies (managing these businesses), and laboratories. Understanding what individuals pay for and why, alongside what is available, is important data for navigating this market.

Where the Money Goes

While a percentage breakdown of who procures the largest capital gains from health care is difficult to ascertain across such a complex system, it is safe to say that quite a few players contribute to the constantly rising price of even simple procedures and doctor’s visits. A breakdown of the critical players illuminates this further:

• Health Care Providers: On the surface, this is who a beneficiary feels like they are paying. This is their doctors, nurses, psychologists, dietitians, technologists, chiropractors, surgeons, and a wide range of other hands on and customer facing roles. These individuals are further differentiated by the fact that they often act as references as opposed to direct suppliers, making them both a direct to consumer provider and a third party provider.
• Pharmaceutical Companies: Drugs are playing an increasingly large role in health care, and likely will continue to do so in the future. The constant development of new drugs, alongside the distribution of established medications, is an enormous part of the market.
• Insurance Providers: There is a divider between most medical service consumers and their providers, and this is the insurance company. For those who are covered by their full-time jobs (or dependents of these individuals), this is largely a matter of who their business purchases from. For others not covered, insurance issues are a complex and highly expensive issue, and getting coverage is quite difficult (this is being addressed in the U.S. by new legislation, and is not an issue in most other developed nations). The insurance companies command a huge profit and represent a substantial part of the medical price tag.
• Government: The role of government in health care is fiercely debated in the United States, but in most of the developed world the government is essentially the provider of health care plans (using social services models to consolidate tax revenues to be allocated for this service). In the U.S., this is only done for medicaid and medicare. The government also takes tax revenues from involved parties in this industry, driving prices up further.
• Administration: This is the hospital itself, or the doctors office, where the management team attempts to run a largely profitable business in the medical industry. Administration pays the health care providers and the government, taking income from direct consumers, the government, and the insurance companies to cover the cost of business (and often turn substantial profits).

With these group of incumbents in mind, it becomes quite clear why the costs are rising exponentially and are so unsustainable. The constant struggle between these large and powerful players coupled with an essentially infinite demand has left the consumer as an extremely weak player in the market. Indeed, with this in mind, the graph displays the trajectory of health care spending due to excess costs in the long term .

Health Care Costs

This graph illustrates the danger of continuing down path of using the excessively high cost-structure U.S. health care incumbents have dictated in the context of spending as a % of GDP.

Accessibility

One of the most discussed topics in health care is accessibility. Due to the fact that health care represents the ability for an individual to maintain a healthy and happy life, it seems intuitive that accessibility must as unlimited as possible. Of course, in a capitalistic system, this will not be the case. Economics dictates that price points will be determined based on supply and demand, and the demand in this industry is often essentially infinite. As a result, accessibility and profitability do not always align from an economic perspective. The U.S. employs medicaid and medicare to provide for low-income and elderly citizens that would otherwise be excluded from the market, while other countries have healthcare systems with more government intervention to address market failure.

One of the larger issues in accessibility is nations without the infrastructure required to support health care industries. Developing nations often do not have access to the skills or suppliers required to run modern hospitals and doctors offices, nor the ability to act preventatively (i.e. eating healthy, getting exercise, check ups, etc.). This creates enormous inefficiency in the system and reduces the economic viability of operating in these countries for insurance providers. Addressing this concern is one of the central issues for the United Nations (UN) and other nongovernmental organizations.

35.1.3: Different Health Care Systems Around the World

Learning Objective

Identify different types of healthcare systems

Key Points

• A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities.
• The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale.
• The countries which perform the highest on these metrics are primarily located in Europe, where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available.
• The U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels.
• Developing nations struggle to compete and compare apples to apples to developed nations, primarily due to the required infrastructure and capital requirements.

Key Terms

Universal healthcare

A system where every citizen is guaranteed access to a certain basic level of health services.

World Health Organization

The World Health Organization (WHO) is a specialized agency of the United Nations (UN) that is concerned with international public health.

Determinants

A determining factor; an element that determines the nature of something

Health care differs from nation to nation, sometimes substantially depending upon the level of economic development and the political system in place. Health care systems, on the global scale, is best defined via the World Health Organization’s definition: “A health system consists of all organizations, people and actions whose primary intent is to promote, restore or maintain health. This includes efforts to influence determinants of health as well as more direct health-improving activities. A health system is therefore more than the pyramid of publicly owned facilities that deliver personal health services. ” This definition is important when observing international health care systems, as it captures both developed and developing nations within this context.

Comparisons: Developed Nations

The World Health Organization has been actively measuring a variety of performance indicators to determine an overall ranking system for health care on a global scale. While this has seen some objections, primarily due to the selection of attributes which weigh into this ranking, it is designed to measure critical success factors which are easily comparably across borders (apples to apples). These measured attributes include health of the population, fair financial contributions, responsiveness of the system, preventable deaths, affordability and a range of other considerations.

The countries which perform the highest on these metrics are primarily located in Europe (generally northern Europe, see ), where social systems are well designed at a governmental level to ensure prices remain accessible and care remain available. Interestingly, the U.S. has consistently ranked poorly and continues to perform substantially below European counterparts deemed developed at similar economic levels. Two good examples are provided in the media relative to the overall capital costs and the subsequent returns on these costs, on being costs to hospital beds per capita and the other costs to physicians per capita . By these measures, European nations capture more value and efficiency within their systems. The most notable difference between these systems is that the US is that, of these countries, the US is the only country without universal healthcare.

Capital Costs and Physicians

Similar to the graph representing costs vs. beds, this chart illustrates the number of physicians available (relative to the population) in the context of capital expenditures. Once again the United States is a clear outlier, where the number of physicians is low and the cost quite high.

Capital Costs and Hospital Beds

This graph demonstrates the apparent correlation between beds (per 1000 people) and the costs involved in healthcare overall. This demonstrates that, on a per capita basis, the U.S. is spending a great deal without capturing much in return relative to available space for patients.

Economic Efficiency of Global Health Care Systems

Healthcare spending per capita is on the left y-axis and life expectancy is on the right. Country differences are apparent, especially when comparing the US to others.

Let us explore further through an example of health care in German (though not all European countries are the same). Germany has consistently demonstrated reductions in cost of health care per capita relative to GDP growth. German health care is regulated by the Federal Joint Commission, a public health organization which leverages governmental health reform bills to generate new regulations. This system also includes a total of 85% of the population on the government offered standardized health care plan, which covers a variety of health care needs across the board. The remaining 15% of the population has opted for private health insurance options, which provide unique niche benefits for specific groups. This system has been highly effective and affordable in providing health care to German citizens.

Developing Nations

With fewer resources, developing nations struggle to compete provide the same access to health care as do developed nations.

China is an interesting case study. China has a great deal of variance in quality and accessibility, with hospital wait times for the poor (depending on severity) taking many hours (sometimes days) compared to the rich, who are admitted immediately. Transitioning towards a system that provides care to the rich and the poor alike is the primary challenge in these developing regions.

35.1.4: Externalities in the Health Care Market

Learning Objective

Describe externalities in the healthcare market

Key Points

• An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction.
• Negative externalities include tax costs, infectious disease, anti-biotic resistance and environmental degradation. The negative components impact others despite their participation in the system.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.
• Positive externalities include increases in wealth due to increased health, vaccinations to limit disease exposures and increases in technology and knowledge.

Key Terms

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

Vaccinations

Inoculation with a vaccine in order to protect a particular disease or strain of disease

Defining Externalities

An externality is any impact, be it positive or negative, on individuals or groups not involved in a given economic transaction . That is to say, an externality is something that affects other people outside of the particular parties involved in an exchange.

Externalities

The basic premise of an externality is captured in this diagram, where external factors affect the internal economic system for a product or service.

A classic example of externalities is the automobile. Cars consistently produce air pollution whenever they are driven, slowly eroding the health of our ecosystem. This cost is shouldered not only by the driver of the vehicle, but also by every living thing on the planet. This is an example of parties not involved in the transaction (selling or buying the vehicle) being impacted, in this case negatively.

Health Care Externalities

In health care, the critical externality in most systems is the care provided to others. You benefit from others being healthy because it reduces the likelihood of you catching their illness (assuming it’s contagious). You benefit from a positive externality of others receiving health care.

Your health care costs are also affected by others choosing to purchase health care. The healthy pay more to the insurance company than they receive in treatment, while the opposite is true for the sick. Insurance fundamentally operates by taking the money from healthy people to pay for the procedures required by sick people.

Taxpayers should also be concerned with the state of the healthcare system not only because they pay for Medicare and Medicaid, but also because healthcare is a huge part of the US economy. In 2011, the US spent 17.2% of GDP on healthcare, more than any other country. Reducing the cost of health care can clearly increase the amount that the US can consume or invest.

Other negative externalities include:

• Infectious Disease: One of the largest reasons why health care is so critical is the fact that disease are infectious. Untreated disease will result higher population vulnerability to that disease due to increased exposure.
• Environmental Degradation:Health care produces a great deal of chemical waste, requires a great deal of emissions (ambulances, etc.) and alters the natural ecological environment of bacteria.
• Antibiotic Resistance: An interesting byproduct of the newer solutions to medical dilemmas is the slowly growing resistance of antibiotics in bacteria. Due to the way in which the health care industry has been operating, bacteria are dramatically altering to resist our solutions.

Positive externalities include:

• Health Affects Wealth: Healthy workers are absent from work less and are more productive workers. A health care market that effectively helps workers can lead to positive economic gains.
• Technology and Information: The study of health care, and the research involved in generating new solutions, has dramatically increased the knowledge and technological capacity of society in general. This has affected other industries, as research and development in health care affects the technological efficacy in other markets.
• Vaccinations: An interesting new development in health care is the advent of vaccines. Vaccination results in herd immunity, or essentially the fact that many individuals will become immune and thus reduce the likelihood that everyone in the population will contract certain diseases.

35.1.5: Current Issues in Health Care

Learning Objective

Explain the main parts of the Affordable Care Act and the current American healthcare system

Key Points

• U.S. citizens pay substantially more per capita for health care than do residents of other countries, and many people lack access to affordable health care.
• Patients have procedures performed by doctors, by the actual exchange of money occurs between the patient’s insurance provider and the doctor’s employer.
• The Affordable Care Act addresses issues like pre-existing conditions, anti-trust, unfair rates based on gender, universal standards and a range of other considerations.
• Many individuals believe that this new legislation will increase costs for small businesses, and will motivate ‘freeloaders’, or individuals who take government handouts.

Key Terms

Affordable Care Act

The ACA was enacted with the goals of increasing the quality and affordability of health insurance.

Pre-existing Conditions

A pre-existing condition is a risk with extant causes that is not readily compensated by standard, affordable insurance premiums.

Current issues in the U.S. health care system largely revolve around the significant policy changes imposed by the Affordable Care Act (ACA, or Obamacare), which attempts to provide health insurance coverage for all citizens. This legislation was designed to respond to many flaws in the current U.S. system of healthcare. It is also important to understand the criticisms of this change, as many voters in the U.S. disagree with proposed changes to the system.

U.S. House Votes for the Affordable Health Care Act

This map outlines the voting distribution in 2009 when the Affordable Health Care Act was brought to the floor.

U.S. Health Care Currently

The U.S., despite having some of the greatest technological advances and medical professionals, has consistently struggled to provide affordable, effective health care to everyone. The costs alone, on a per capita basis, underline the way in which the U.S. system has struggled to meet international standards in providing affordable care. illustrates the costs incurred by each individual in the system based on a country to country comparison. As it illustrates, consumers in the U.S. are faced with much higher (and growing) costs than international counterparts.

Health Costs Per Capita

This chart illustrates the costs incurred by each individual in the system based on a country to country comparison. As is demonstrated, consumers in the U.S. are faced with much higher costs (and consistently growing higher) than international counterparts.

Most Americans with private health insurance have it provided by their employers. There are also social welfare programs such as Medicaid and Medicare. The insurers negotiate rates with hospitals for different procedures. Patients then go into the hospital and get procedures recommended by doctors. The doctors are then paid by hospitals. This is a classic case of moral hazard: the two parties deciding for the transaction to occur- patients and doctors- are not the same two exchanging money.

Healthcare has a demand curve that fluctuates wildly based upon the extent of the issue – consumers who are facing serious health problems will likely demand healthcare at almost any price, allowing medical providers to take advantage of the inelastic demand. Further issues include the fact that doctors represent a third party (recommending drugs and procedures) and that insurance companies have the power to deny coverage to individuals who need it most.

The Affordable Health Care Act

In December of 2009, the Senate passing a bill called Patient Protection and Affordable Care Act. The Affordable Care Act is a complex piece of legislation, but a number of bullets from the bill are highly useful to understand:

• Pre-existing Conditions: Individuals with pre-existing conditions are much more likely to be expensive clients, and thus are not profitable to insure. This results in insurers refusing to insure these patients. The Affordable Care Act addresses this through legislation, saying providers cannot refuse coverage.
• Changing Insurance Rates: As a complement to the analysis above, insurance agencies also cannot alter rates based on pre-existing conditions or gender. This levels the playing field for the consumer, who historically had limited buyer power.
• Antitrust: Previously, insurance companies were immune to antitrust laws. This means they could generate monopolies geographically and exploit consumers. This immunity has been repealed.
• Standards: Obamacare also closes loopholes regarding to quality standards, ensuring that insurance providers do not reduce what is provided to clients in an effort to cut costs.
• Healthcare.gov: This is a way to enable consumers in finding health care insurers in a way that promotes capitalistic competition between providers. Previously, discussing pricing and plans with insurers was highly complex for many individuals (designed for businesses, not individual consumers).
• Medicaid and Medicare: Overall, medicare has been reduced while medicaid has been expanded. Medicare spending has been increasing dramatically. This has been cut by $400 billion, which is a source of discontent for many individuals. Medicaid has been expanded to 133% of the poverty level, covering more people.

Criticisms

The ACA will only work if both healthy and sick people alike buy insurance: if the healthy choose to pay the fine for not having insurance and only the sick buy insurance, then costs will increase. There is also a political critique of the ACA. Some feel that the government should not mandate that private citizens purchase insurance in the first place. They feel that the government is overstepping its bounds.

Many individuals also believe that this new legislation will increase costs for small businesses that are now required to buy insurance for their employees, and will motivate ‘freeloaders’, or individuals who take government handouts. Overall, while the goal is to enable more people to health care more affordably, many people believe this new approach will do not accomplish that.

34.1: Interest

34.1.1: Defining Capital

Learning Objective

Define and explain capital.

Key Points

• Fundamentally, capital is any product that is produced and has the ability to enhance the power of an individual to perform economically useful work.
• Capital is directly impacted by both interest and profit. Interest allows capital to be obtained, while profit is the accumulation of the capital.
• Features that determine whether a good is capital include: 1) the good can be used in the production of other goods (this makes it a factor of production), 2) the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and 3) the good was produced.
• Types of capital include: physical, financial, natural, social, instructional, and human.
• Types of capital include: physical, financial, natural, social, instructional, and human.

Key Terms

capital

Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).

depreciate

To reduce in value over time.

Capital

In economics, capital (also referred to as capital goods, real capital, or capital assets) references non-financial assets used in the production of goods and services. Capital is important because it is a significant factor in the creation of wealth.

Capital goods are used in the production process and may depreciated through accounting practice to incorporate utilization, though they are not consumed. It is possible for capital goods to be maintained or regenerated depending on the type of capital.

Classifications of Capital

In a broad sense, capital can be divided into two categories:

• Physical Capital: capital that must be produced by human labor before it can become a factor of production (also referred to as manufactured capital). Examples include machinery and buildings .
• Natural Capital: a factor of production that occurs naturally in the environment; for example, land or minerals.

Fundamentally, capital is any product that is produced and has the ability to enhance a person’s power to perform work that is economically useful. For example, roads are capital for individuals who live in a city.

Capital is directly impacted by both interest and profit. Interest is a fee that is paid by a borrower of assets. It is a form of compensation for the use of the assets. Commonly, it is the price that is paid for the use of borrowed money. Profit is the accumulation of capital, which is the driving force behind economic activity. Interest allows capital to be obtained, while profit is the accumulation of the capital.

Features of Capital

There are certain features that determine whether a good is considered capital. These features include:

1. the good can be used in the production of other goods (this makes it a factor of production),
2. the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and
3. the good was produced.

Modern Types of Capital

There are detailed classifications of capital which include the following types:

• Financial Capital is capital that is liquidated as money for trade, and owned by legal entities. It is a form of capital assets that is traded in financial markets. The value of financial capital is based on the market perception of expected revenues and risk.
• Natural Capital is capital that occurs naturally in the environment and is protected because it supports human life. Examples of natural capital include land and water .
• Social Capital is capital that is captured as goodwill or brand value. It is the general concept of inter-relationships between humans have money-like value that motivates actions.
• Instructional Capital is capital that is defines as the aspect of teaching knowledge and transferring knowledge that is not inherent in individual or social relationships.
• Human Capital is capital that includes social, instructional, and individual human talent combined together. As a term, it is used to define balanced growth where the goal is to improve human capital and economic capital equally.

34.1.2: Interest Rates and Economic Rationale

Learning Objective

Define and explain the relationship between interest rates and economic rationale.

Key Points

• The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
• The interest rate guides economic rationale because it is a vital tool of monetary policy.
• The interest rate directly impacts economic choices such as spending, investment, and consumption.
• When interest rates decrease, investment and spending increase. When interest rates increase, investments decrease which causes the national income to fall.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

inflation

An increase in the general level of prices or in the cost of living.

Economic Rationale

Rationale is defined as an explanation of the basis or fundamental reasons for something. In economics, rationale are the reasons or thought processes that impact economic decisions. The interest rate is one of the primary influences on economic rationale.

Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor). It is the percent of principal paid a certain amount of times per period.

Impact of the Interest Rate

The interest rate guides economic rationale because it is a vital tool of monetary policy. The interest rate is taken into account when dealing with economic variables such as investment, inflation, and unemployment. Central banks usually reduce the interest rate to increase investment and consumption in the country’s economy. The interest rate directly impacts economic choices such as spending, investment, and consumption .

Interest Rates

This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. The interest rates reached 14% in 1969 and lowered to 2% by 2003. The interest rate in an economy directly impacts economic choices including spending, investment, and consumption.

Interest rates also influence inflationary expectations. People form an expectation of what will happen to inflation in the future. The current and projected interest rates are influential in these economic expectations. Investments are made based on the nominal interest rate and the degree of risk involved. Low interest rates are enticing, but can be problematic if an economic bubble forms. For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market. When these bubbles pop, the investments fail, resulting in large unpaid debts and financial bankruptcy for individuals and banking institutions.

When interest rates increase, investments decrease, which causes the national income to fall. High interest rates do encourage more savings, which over time leads to more investment and higher levels of employment to meet production needs. Higher rates discourage economically unproductive lending such as consumer credit and mortgage lending.

The interest rate also directly impacts money and inflation because the government can affect the markets and alter the total of loans, bonds, and shares that are issued. When the interest rate is lower, it usually increases the broad supply of money. An increase in the money supply leads to inflation.

33.1: Fundamentals of Banking Crises

33.1.1: Causes of Banking Crises

Learning Objective

Describe some common causes of a banking crisis, Explain a bank run

Key Points

• A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand.
• Due to the mass interdependence of economies across the globe, a banking crisis in one nation is likely to dramatically affect other international economies.
• The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.

Key Terms

Bank Run

A large number of customers withdraw their deposits from a financial institution at the same time due to a loss of confidence in the banks.

leverage

The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return, but usually at high risk.

In light of recent market and banking failures, the economic analysis of banking crises both historically and presently is a constant source of interest and speculation. Banking crises are when there are widespread bank runs: an abnormal number depositors try to withdraw their deposits because they don’t trust that the bank will have the deposits for withdrawal in the future.

Banking crises are not a new economic phenomenon, and similarly are not the only source of financial crises. Over the course of the past two centuries there have been a surprisingly large number of financial crises, as demonstrated in the attached figure . In understanding banking crises over time, it is useful to identify the causes in context with historic examples of banking collapses.

Financial Crises Globally since 1800

This chart is an interesting take on the relatively consistent frequency in which financial crises occur across the globe. It is interesting to note both the efficacy of Bretton Woods alongside the increasing risk of financial collapse in modern times.

Causes of Banking Crises

Banks can fail for several different reasons:

• Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand. This can quickly induce panic in the public, driving up withdrawals as everyone tries to get their money back from a system that they are increasingly skeptical of. This leads to a bank panic which can result in a systemic banking crisis, which simply means that all of the free capital in the banking system is withdrawn.
• Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a similar positive feedback loop effect in the stock markets, which was a much more dynamic factor in more recent banking crises (i.e. 2007-2009 sub-prime mortgage disaster). John Maynard Keynes once compared financial markets to a beauty contest, where investors are merely trying to pick what is attractive to other investors. There is a profound truth to this, creating an interdependent and potentially self-fulfilling investment thought process. This can create dramatic rises and falls (bubbles and crashes), which in turn can throw banks with poorly designed leverage into huge losses.
• Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of governmental oversight. As noted above, banks often leverage themselves to capture gains despite extremely high risks (such as over-dependence on derivatives).
• Contagion: Due to globalization and international interdependence, the failure of one economy can create something of a domino effect. In 2008, when the U.S. economy collapses, the reduced buying power and economic output from that economy dramatically damaged all economies dependent upon it (which includes most of the world). This is called contagion.

The Great Depression

The Great Depression highlights how bank runs caused a banking crisis, which ultimately became a global economic crisis.The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs. As fear began to grip consumers across the United States, people became protective of their assets (including their cash). This caused a large number of people to the banks to withdraw, which in turn motivated others to go to the banks and get their capital out also. Since banks lend out some of their deposits, they did not have enough cash on hand to meet the immediate withdrawal requests (they became illiquid) and therefore went bankrupt. Within a few weeks this resulted in a systemic banking crisis (see ).

1929 Stock Market Crash

As the market falls, investors create a positive feedback loop and self-fulfilling prophecy due to a lack of confidence that drives it down even further.

33.1.2: Consequences of Banking Crises

Learning Objective

Explain consequences of banking crises on the broader economy

Key Points

• Banks play a critical role in economic growth, primarily through investment and lending.
• After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle to raise the capital required to execute upon their operations.
• The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence.
• Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

Key Terms

liquidity

The degree to which an asset can be easily converted into cash.

Economic crisis

A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.

Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily through investment and lending.

Domestic Consequences

Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate and economy’s savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse individual and economic consequences within the system.

First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally, sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact that they have less capital to invest and returns to acquire.

This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.

Global Consequences

While these domestic consequences are expected and, in many ways, intuitive, the global dependency upon foreign trade in modern markets has exacerbated these effects. Imports and exports play an increasingly large role in the health of most developed economies, and as a result the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

A good example of this is to look at the way in which the U.S. (and to some extent, European) banking disasters in 2008 and 2009 led to a complete global financial meltdown, destroying economies not involved in the irresponsible investing practices executed by banks in these specific regions. identifies the critical importance of economic well-being in trading partners, as the U.S. banking and financial crises spread rapidly (within the course of just one year) across a substantial portion of the globe (though there are certainly other factors that contributed to the financial crisis and its consequences). The domestic reduction of capital for businesses, income for consumers and tax revenue for governments ultimately results in a reduction of trade and economic activity for other economies.

2009 GDP Growth Rates

This figure shows the growth in GDP for world economies in 2009. The slow and negative growth demonstrates all of the economic losses that resulted in part from the U.S. financial crisis, highlighting the dependency of global economies.

33.2: The 2007-2009 Crisis

33.2.1: Causes and Immediate Impacts of the Crisis

Banks, consumers, and the government all contributed to improper borrowing and lending, which in turn created a downward spiraling economy.

Learning Objective

Summarize the causes that led to the 2007 banking crisis

Key Points

• The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, began with the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to home-owners into a falsely ‘safe’ investment.
• Banks offered loans to debtors that couldn’t afford them, and then bundles these debt instruments and sold them.
• The banking crisis spread into a broader financial crisis as companies were negatively affected by the crisis in financial institutions to which they were connected.
• The government did not regulate the housing market at all, as a result of the elimination of two critical clauses: verification of income and a 20% down payment.
• The U.S. stock market, realizing the scale of errors of the banks, lost all investment confidence. This cut the NYSE in half, drastically reducing the value of the U.S. economy.

Key Terms

CDO

A type of asset-backed security and structured credit product constructed from a portfolio of fixed-income assets.

Sub-prime

Designating a loan (typically at a greater than usual rate of interest) offered to a borrower who is not qualified for other loans (e.g. because of poor credit history).

The recent financial crisis, commonly referred to as the sub-prime mortgage crisis of 2007-2008, was borne of the failure of a series of derivative-based consolidation of mortgage-backed securities that encapsulated extremely high risk loans to homeowners into a falsely ‘safe’ investment. To simplify this, banks pushed mortgages on prospective home owners who could not afford to repay them. Then they combined and packaged varying mortgage-backed securities based off of these loans and sold them as highly dependable and safe investments, either through a lack of due diligence (negligence) or lack of ethical consideration. This created an economic meltdown, starting with the United States, that spread across the global markets.

The inherent complexity of the causes and dramatic repercussions (most of which are still ongoing) require a great deal of context. It is a fiercely debated and widely discussed issue in the field of economics (and in mainstream media), providing a real-life case study for many of the critical concepts of economic theory.

How Did This Happen?

The inputs to the 2007-2008 economic collapse, briefly touched upon above, are complex and still evolving. That being said, there are a few key talking points from an economic perspective that should be discussed. A useful perspective to take is the various stakeholders and their contributions :

Inputs to the Mortgage Crisis

This graph outlines two of the three parties in the collapse (excludes government), as the banks and the buyers both took on ridiculous amounts of risk.

• Banks: Simply put, the banks made two critical errors. First, they lent money to people who could not pay it back (to buy homes). They pursued what is referred to as ‘predatory lending,’ or lending to individuals they knew could never pay it back. Secondly, banks knowingly grouped these loans into bundles called collateralized debt obligations (CDOs) and sold them as extremely safe derivative investments. They were not safe.
• Consumers: Consumers played their role as well, acting as easy prey for the banks predatory practices. Individuals bought homes they could not afford utilizing loans they could not pay back. This drove them into debt, to the extent at which they had to default. This meant that the capital banks expected to get back did not arrive, it simply was not there.
• Government: The government did not regulate the housing market, as a result of the elimination of two critical legal clauses that required the verification of income and a 20% down payment. In short, the U.S. government used to ensure that prospective home buyers could put down 20% of the their borrowing in addition to verify that their income could cover their mortgage payments. Without such verification, it became easier for people to get mortgages they could not afford.

Combining these factors, the problem largely revolved around irresponsible lending and borrowing which was then turned into derivatives that were labeled safe despite their massive risks. This resulted in an economic realization of loans that could not be repaid, which spread through the banking system and turned into large scale obligations that could not be met.

Economic Impact

What happened next is well captured in the . In short, the banks eventually failed due to their investments. In order to prevent the entire financial system from collapsing, some of the banks (and other financial institutions) were bailed out.

2008 Crisis Flow Chart

This chart embodies critical checkpoints in the economic decline reactions to poor mortgage management by the banks. Understanding the implications of each point on this diagram will greatly enhance the larger understanding of the short term effects of this economic collapse.

Of course the negative effects did not stop there. The U.S. stock market lost confidence in financial institutions and some of the companies connected to them and subsequently crashed. The NYSE fell by half, drastically reducing the value of the U.S. economy. This was then telegraphed into a loss of consumer confidence and business access to investment. Within a few months, there were job cuts, bankruptcies, and reduced spending, as the crisis spread throughout the economy (both domestically and globally).

33.2.2: Recovery

The objective of economic recovery when in crisis is to stabilize the economy and recapture the value lost using economic stimulus strategies.

Learning Objective

Discuss the characteristics of the recovery from the 2007 crisis

Key Points

• One of the key components to the crisis recovery in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA). It invests money in the economy to drive spending and recovery.
• ARRA is largely based on the Keynesian macro-environmental concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further.
• The Troubled Asset Relief Program (TARP) was another recovery strategy, buying toxic assets off the banks to prevent them from failing.
• TARP was criticized for protecting banks who behaved unethically and with a lack of strategic intelligence as businesses, essentially implying that they should have failed.
• While the stock market has recovered and the banks are in better shape now than before the collapse, the average American is still less likely to have a job or to be underemployed.

Key Terms

Economic crises

A period of economic slowdown characterized by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.

stimulus

Anything that may have an impact or influence on a system. In 2009, it is the monetary investments in the economy to recover from the collapse.

The 2007-2009 economic crisis has had far-reaching and profound effects on both the domestic and global markets, primarily as a result of the sub-prime mortgage disaster originating in the United States. Addressing these economic ramifications to induce recovery has been the focal point of global governments and global agencies such as the International Monetary Fund (IMF). The objective of economic recovery when in crisis is to stabilize the economy, and from there recapture the value lost through economic stimulus strategies while addressing the factors which contributed to the collapse in the first place.

Stimulus Package

One of the key components to the crisis recover in the United States is an act called the American Recovery and Reinvestment Act of 2009 (ARRA), put into place by the Obama administration just as the first days of his term were beginning. This act has seen substantial debate, both positively and negatively, as to the efficacy and overall implementation of the program. Understanding the inputs, and expected outcomes, is critical to understanding the economics behind reacting to economic crises (particularly from a Keynesian perspective).

The stimulus package can be broken down via the attached figure in regards to monetary investment in specific places , totaling $831 billion (USD) between 2009 and 2019. The goal of investing or providing tax relief and subsidies for individuals and companies is to drive up purchasing behavior and offset the positive feedback loop attributed to economic crises. This is largely based on the Keynesian concept of driving spending through enabling spending, in turn driving up demand, creating jobs, and driving spending up further. President Obama’s administration was criticized by classical economists for employing this as well as Keynesian economists (such as Paul Krugman) for not employing it enough. That being said, the efficacy in the attached figure demonstrates that it was likely a strategic reaction to the economic crisis .

ARRA Efficacy Projections

This graph points out the economic opportunity cost of not utilizing the ARRA, which would likely have left the U.S. (and subsequently, the global) economy in significantly worse shape than it is now.

Stimulus Investments (U.S.) of ARRA

This graphic demonstrates the different silos receiving government aid within the domestic economy, as a direct result of the American Recover and Reinvestment Act (ARRA).

Troubled Asset Relief Program (TARP)

Perhaps more debatable still, is the reaction to the inevitable and deserved bankruptcy of the banks and insurers involved in the toxic mortgage-backed securities (i.e. CDO’s) that drove the economy into disaster were bailed out by the government. These companies, such as AIG, Bank of America, Citigroup, and other distributors of toxic investments were handed the required capital by the government to offset their massive losses due to undue risk and poor leveraging. This was in the form of the government utilizing tax money to purchase these securities, removing the toxic assets from the books of the companies involved (who were deemed ‘too big to fail’). This move saved the economic decline and restored consumer confidence through direct government intervention.

TARP was also largely criticized, with a high number of seemingly reasonable objections. The first, and most intuitive, is that these businesses deserved to go under. Bad business practice, poor investment, and grossly unethical behavior deserves bankruptcy. Instead, the government demonstrated that, as long as certain fiscal influence is achieved, these competitive rules are negligible. Secondly, and slightly more complex, is the implementation of the TARP act (which necessitated SIG-TARP, an oversight group ensuring that TARP money went out to those who it was intended for). It was noted on many occasions that TARP money was ill-used.

Outcomes

While the long-term outcomes of these practices cannot yet be predicted, the progress made so far is worth analyzing economically. First and foremost, job numbers have improved, although not as much as had been hoped or expected (see ). While this is positive, it does not capture the large number of people who are underemployed or the individuals who have abandoned the search for employment. GDP growth has inched along to positive numbers, as has the profitability of many businesses and industries. Interestingly enough, as of the end of 2013, the stock market has not only recovered but expanded beyond 2007 levels.

U.S. Job Gains and Losses

This graph demonstrates the negative affect that the collapse had on jobs as well as the pacing of economic recovery in the short-term.

33.2.3: Global Impacts

The 2007-2009 economic collapse was damaging not only to the U.S. but also global markets, driving the global economy into recession.

Learning Objective

Analyze the extent to which the 2007 crisis was global

Key Points

• Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa.
• In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth, which This spread rapidly around the map to create a global recession in Q3 and Q4 in 2008 and Q1 of 2009.
• Another indirect global impact that occurred as a result of the economic collapse was political instability, primarily due to the inability of developed nations to pursue altruistic investments and global poverty reduction processes during recessionary times.
• On the upside, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future.

Key Term

recession

A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, and industrial production.

Modern markets are dependent upon one another across national borders, where global trends in economic growth and well-being will have a dramatic impact on national economic well-being and vice versa. As a result, the 2007-2009 economic collapse had large effects not only at the origin (in the United States), but also on a global scale. The speed in which the market decline spread across the globe underlines just how far globalization and international interdependence has come, with GDP growth numbers in 2009 already demonstrating substantial losses across the map (see ).

2009 Global GDP Growth and Decline)

As this map illustrates, many international markets fell rapidly into decline as a direct result of the U.S. sub-prime mortgage disaster.

Recession: Domestic to Global

In December 2007, the U.S. officially fell into an 18-month long recessionary period of negative GDP growth (over two consecutive quarters). This recessionary period spread rapidly around the map, creating a global recession in Q3 and Q4 in 2008 and Q1 of 2009 (defined as a contraction in global GDP growth during that time) as is represented in this figure . To provide additional context to the global adverse effects of the sub-prime mortgage crisis, of 65 countries that record and report GDP only 11 escaped a recessionary period between 2006 and today.

World GDP Growth

It is quite clear in this graphic, the global GDP growth dropped dramatically following the U.S. crisis, pitching the entire global economy into a recession.

Even countries where double-digit economic growth had been a consistent trend going into 2008, such as China, began to experience growth reductions due to reduced consumer purchasing power on a global scale. China has seen reductions towards the 7%-8% economic GDP growth (year on year), from clear double-digits in previous years.

Political Instability

Another indirect global impact that occurred as a result of the economic collapse is political instability, primarily due to the inability of developed nations to pursue social welfare investments and global poverty reduction processes during recessionary times. Indeed, these instabilities are not only isolated to developing nations. Countries in the EU, such as Greece, Spain and Italy, have seen dramatic GDP decreases and unemployment numbers reaching or exceeding 20% in some cases. This instability has placed a great deal of pressure on government officials to solve these huge economic problems in the short-term. The United States has also seen an incredible reduction in governmental efficacy with the least effective house of representatives for nearly a century alongside dramatic polarization of public opinion towards left-wing and right-wing ideas.

Global Responses

Positively, many global organizations and countries are actively employing policies to minimize the likelihood of a re-occurrence in the future. Reducing interest rates to drive up borrowing and investment, providing tax benefits to the unemployed and underemployed, and subsidizing new business have created positive steps towards meaningful recovery globally.

There have also been a series of banking and financial regulatory changes across the world.These global safety nets and prevention policies are setting the tone for future strategies to avoid economic crises and minimize the prospective damage that occurs as a result of these unethical practices.

32.1: Capital Flows

32.1.1: The Balance of Payments

Learning Objective

Explain the components and importance of the balance of payments

Key Points

• Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Whenever a country has an outflow of funds, it is recorded as a debit on the balance of payments.
• When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit.
• BOP=Current Account+Financial Account+Capital Account+Balancing Item.
• The current account records the flow of income from one country to another.
• The financial account records the flow of assets from one country to another.
• The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income.

Key Term

balance of payments

A record of all monetary transactions between a country and the rest of the world

The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. This includes payments for the country’s exports and imports, the sale and purchase of assets, and financial transfers. The BOP is given for a specific period of time (usually a year) and in terms of the domestic currency.

Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Sources of funds include exports, the receipt of loans or investment, and income from foreign assets. Whenever a country has an outflow of funds, such as when the country imports goods and services or when it invests in foreign assets, it is recorded as a debit on the balance of payments.

When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries .

U.S. Current Account

The chart shows the current account deficit of the U.S., both in dollars and as a percent of GDP. Deficits in the current account must be offset by surpluses in the financial and capital accounts.

Components of the Balance of Payments

The BOP can be expressed as:

The current account records the flow of income from one country to another. It includes the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers.

The financial account records the flow of assets from one country to another. It is composed of foreign direct investment, portfolio investment, other investment, and reserve account flows.

The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not affect national income. Debt forgiveness would affect the capital account, as would the purchase of non-financial and non-produced assets such as the rights to natural resources or patents.

The balancing item is simply an amount that accounts for any statistical errors and ensures that the total balance of payments is zero.

32.1.2: The Current Account

Learning Objective

Calculate the current account

Key Points

• The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceeds its exports.
• The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad but also to remittances.
• Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return.
• A country’s current account can by calculated by the following formula: CA = (X-M)+NY+NCT.

Key Terms

credit

An addition to certain accounts.

balance of trade

The difference between the monetary value of exports and imports in an economy over a certain period of time.

debit

A sum of money taken out of an account.

The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as it covers transactions in the “here and now” – those that don’t give rise to future claims.

The balance of trade is the difference between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade deficit if its imports exceed its exports. Because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case. Secluded economies like Australia are more likely to feature income deficits larger than their trade surplus.

The net factor income records a country’s inflow of income and outflow of payments. Income refers not only to the money received from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc.

Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or official assistance.

Calculating the Current Account

Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income and cash transfers.

Goods are traded by countries all over the world. When ownership of a good is transferred from a local country to a foreign country, this is called an export. When a good’s ownership is transferred from a foreign country to a local country, this is called an import. In calculating the current account, exports are marked as a credit (inflow of money) and imports are marked as a debit (outflow of money).

Services can also be traded by countries. This happens frequently in the case of tourism. When a tourist from a local country visits a foreign country, the local country is consuming the foreign services and this is counted as an import. Likewise, when a foreign tourist comes and enjoys the services of a local country, this is counted as an export. Other services can also be transferred between countries, such as when a financial adviser in one country assists clients in another.

A credit of income happens when a domestic individual or company receives money from a foreign individual or company. This would typically take place when a domestic investor receives dividends from an investment made in a foreign country, or when a worker abroad sends remittances back to the local country. Likewise, a debit in the income account takes place when a foreign entity receives money from an investment in the local economy.

Finally, a credit in the cash transfers column would be a gift of aid from a foreign country to the domestic country. Similarly, a debit in the cash transfers column might be the provision of official assistance by the local economy to a foreign economy.

Thus, a country’s current account can by calculated by the following formula:

CA = (X-M)+NY+NCT

Where CA is the current account, X and M and the export and import of goods and services respectively, NY is net income from abroad, and NCT is the net current transfers. When the sum of these four components is positive, the current account has a surplus.

Global Current Accounts

The map shows the per capita current accounts surpluses and deficits of countries around the world from 1980 to 2008. Deeper red implies a higher per capita deficit, while deeper green implies a higher per capita surplus.

32.1.3: The Financial Account

Learning Objective

Calculate the financial account

Key Points

• A financial account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in the domestic economy are spending on rest-of-world assets.
• The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.
• Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants.
• Portfolio investment refers to the purchase of shares and bonds.
• Other investment includes capital flows into bank accounts or provided as loans.
• The reserve account is operated by a nation’s central bank to buy and sell foreign currencies.

Key Terms

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

The financial account (also known as the capital account under some balance of payments systems) measures the net change in ownership of national assets. When financial account has a positive balance, we say that there is a financial account surplus. A financial account surplus means that the net ownership of a country’s assets is flowing out of a country – that is, foreign buyers are purchasing more domestic assets than domestic buyers are purchasing of assets from the rest of the world. Likewise, we say that there is a financial account deficit when the financial account has a negative balance. This occurs when domestic buyers are purchasing more foreign assets than foreign buyers are purchasing of domestic assets. For example, a financial accounts deficit would exist when County A’s citizens buy $200 million worth of real estate overseas, while overseas investors purchase only $100 million worth of real estate within Country A.

Calculating the Financial Account

The financial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account flows.

Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound flow and counts as a surplus item on the financial account. If a nation’s citizens are investing in foreign countries, there is an outbound flow that will count as a deficit. After the initial investment, any yearly profits not re-invested will flow in the opposite direction, but will be recorded in the current account rather than the financial account .

FDI in Austria

Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than Austrian investors do in the rest of the world. This contributes to a financial account surplus.

Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as short term investment. As with FDI, the income derived from these assets is recorded in the current account; the financial account entry will just be for any buying or selling of the portfolio assets in the international financial markets.

Other investment includes capital flows into bank accounts or provided as loans. Large short term flows between accounts in different nations are commonly seen when the market is able to take advantage of fluctuations in interest rates and/or the exchange rate between currencies. Sometimes this category can include the reserve account.

The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital flows to counteract those originating from the market. Inbound capital flows (from sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound flows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. Such intervention affects the financial account. Purchases of foreign currencies, for example, will increase the deficit and vis versa.

To calculate the total surplus or deficit in the financial account, sum the net change in FDI, portfolio investment, other investment, and the reserve account.

Interest Rates and the Financial Account

The outflow or inflow of assets in the financial account depends in large part on the domestic interest rate and how it compares to interest rates in other countries. A higher central bank interest rate will tend to increase the interest rate on all domestic financial assets, such as bonds, loans, and government securities. In general, if interest rates are higher in one country than another, an investor would prefer to purchase financial assets in the country with the higher interest rate.

An increase in the domestic interest rate will therefore cause foreign investors to purchase more domestic assets, creating a financial account surplus. Likewise, a fall in the domestic interest rate will cause domestic investors to purchase foreign assets in place of domestic assets, and will cause a financial account deficit.

32.1.4: The Capital Account

Learning Objective

Calculate the Capital Account

Key Points

• A deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets.
• The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers.
• Non-produced and non-financial assets include things like drilling rights, patents, and trademarks.
• Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, and the transfer of ownership on fixed assets.

Key Term

debt forgiveness

The partial or total writing down of debt owed by individuals, corporations, or nations.

There are two common definitions of the capital account in economics. The first is a broad interpretation that reflects the net change in ownership of national assets. Under the International Monetary Fund (IMF) definition, however, most of these asset flows are captured in the financial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-produced and non-financial assets, as well as capital transfers. The capital account is normally much smaller than the financial and current accounts.

Like the financial account, a deficit in the capital account means that money is flowing out of a country and the country is accumulating foreign assets. Likewise, a surplus in the capital account means that a money is flowing into a country and the country is selling (or otherwise disposing of) non-produced, non-financial assets.

Calculating the Capital Account

The capital account can be split into two categories: non-produced and non-financial assets, and capital transfers. Non-produced and non-financial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires the rights to mineral resources in a foreign country, there is an outflow of money and the domestic country acquires an asset, creating a capital account deficit .

Natural Gas Rights

If a U.S. company sold its rights to drill for natural gas off the southern coast of the U.S., it would be recorded as a credit in the capital account.

Capital transfers include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, and uninsured damage to fixed asset. For example, if the domestic country forgives a loan made to a foreign country, this transfer creates a deficit in the capital account.

Thus, the balance of the capital account is calculated as the sum of the surpluses or deficits of net non-produced, non-financial assets, and net capital transfers.

32.1.5: Reason for a Zero Balance

Learning Objective

Discuss the long term equilibrium of a country’s balance of payments

Key Points

• Equilibrium in the foreign exchange market implies that the quantity of currency demanded = quantity of currency supplied .
• The quantity of a currency demanded is from two sources: exports and rest-of-world purchases of domestic assets. The quantity supplied of a currency is also from two sources: imports and domestic purchases of rest-of-world assets.
• Therefore, exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases or rest-of-world assets).
• Finally, this means that exports – imports = (domestic purchases of rest-of-world assets) – (rest-of-world purchases of domestic assets).
• In other words, the current account balances out the financial account and the balance of payments is zero.

Key Terms

foreign exchange

The changing of currency from one country for currency from another country.

net exports

The difference between the monetary value of exports and imports.

Capital Flows

Trade within a country differs in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the firms exchange euros for pesos.

In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods or services from other countries.

Imaging that we are analyzing Italy’s economy and its currency transactions with the rest of the world. If an American buyer wishes to purchase bonds issued by an Italian corporation, she becomes part of the world demand for euros to buy Italian assets. Adding the demand for exports to the demand for assets outside of a country, we get the total demand for a country’s currency.

Likewise, a country’s currency is supplied when it is used to purchase currencies in the rest of the world. Italian euros, for eample, are supplied when Italian consumers or firms import goods and services from the rest of the world. Italian euros are also supplied when Italian purchasers acquire assets from other countries.

Equilibrium and Zero Balance

When a country’s balance of payments is equal to zero, there is equilibrium in the market for that country’s currency. Equilibrium occurs when:

Quantity of currency demanded = quantity of currency supplied

We have already seen that the quantity of currency demanded is equal to the demand for exports and demand for domestic assets. The quantity of currency supplied is equal to the demand for imports and the domestic demand for foreign assets. Thus, we can rewrite the relationship:

Exports + (foreign purchases of domestic assets) = imports + (domestic purchases of foreign assets)

Finally, we can rearrange the above formula as:

Exports – imports = (domestic purchases of foreign assets) – (foreign purchases of domestic assets)

The left-hand term is net exports – the difference between the amount of goods and services a country exports and the amount that it imports. We refer to this difference as the current account. When a country exports more goods than it imports, this number is positive and we say that the country has a current accounts surplus. When a country imports more than it exports this number is negative and we say that the country has a current accounts deficit.

The right-hand term is the difference between the foreign assets that people within the country purchase and the domestic assets that are purchased by foreigners. This is called the financial account. These assets include the reserve account (the foreign exchange market operations of a nation’s central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The financial account is also sometimes used in a narrower sense that excludes the foreign exchange operation of the central bank. When a country buys more foreign assets that other countries buy of its assets, this balance is positive and there is a financial account surplus.

If the above equation holds true, then any current account surplus must be matched by a financial account deficit, and vice versa. This holds true when a country’s currency market is in equilibrium and there are no external currency controls.

Exchange Rates

Exchange rates are constantly fluctuating to ensure that the quantity of currency supplied equals the quantity demanded. Because of this, the inflows and outflows of money are equal, creating a balance of payments equal to zero.

32.2: Exchange Rates

32.2.1: Introducing Exchange Rates

In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another.

Learning Objective

Explain the concept of a foreign exchange market and an exchange rate

Key Points

• Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous.
• In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.
• The foreign exchange rate is also regarded as the value of one country’s currency in terms of another currency.

Key Term

exchange rate

The amount of one currency that a person or institution defines as equivalent to another when either buying or selling it at any particular moment.

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency . For example, an inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.

Exchange Rates

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers.

Exchange rates are determined in the foreign exchange market, which is open to a wide range of buyers and sellers where currency trading is continuous. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date.

How the Foreign Exchange Market Works

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

32.2.2: Finding an Equilibrium Exchange Rate

There are two methods to find the equilibrium exchange rate between currencies; the balance of payment method and the asset market model.

Learning Objective

Differentiate between the Balance of Payment and Asset Market Models

Key Points

• The balance of payment model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance.
• The balance of payments model focuses largely on tradeable goods and services, ignoring the increasing role of global capital flows.
• The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. This includes financial assets.

Key Terms

depreciate

To reduce in value over time.

purchasing power parity

A theory of long-term equilibrium exchange rates based on relative price levels of two countries.

Countries have a vested interest in the exchange rate of their currency to their trading partner’s currency because it affects trade flows. When the domestic currency has a high value, its exports are expensive. This leads to a trade deficit, decreased production, and unemployment. If the currency’s value is low, imports can be too expensive though exports are expected to rise.

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows . In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Share of Stock

The key difference between the balance of payments and asset market models is that the former includes financial assets, such as stock, in its calculation.

The asset market model views currencies as an important element in finding the equilibrium exchange rate. Asset prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of the assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies. These assets are not limited to consumables, such as groceries or cars. They include investments, such as shares of stock that is denominated in the currency, and debt denominated in the currency.

32.2.3: Real Versus Nominal Rates

Real exchange rates are nominal rates adjusted for differences in price levels.

Learning Objective

Calculate the nominal and real exchange rates for a set of currencies

Key Points

• The measure of the differences in price levels is Purchasing Power Parity. The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies.
• If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1.
• When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms.
• Changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.
• To calculate the nominal exchange rate, simply measure how much of one currency is necessary to acquire one unit of another. The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries.

Key Terms

nominal exchange rate

The amount of currency you can receive in exchange for another currency.

real exchange rate

The purchasing power of a currency relative to another at current exchange rates and prices.

Currency is complicated and its value can be measured in several different ways. For example, a currency can be measured in terms of other currencies, or it can be measured in terms of the goods and services it can buy. An exchange rate between two currencies is defined as the rate at which one currency will be exchanged for another. However, that rate can be interpreted through different perspectives. Below are descriptions of the two most common means of describing exchange rates.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

When you go online to find the current exchange rate of a currency, it is generally expressed in nominal terms. The nominal rate is set on the open market and is based on how much of one currency another currency can buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP) . The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.

Groceries

Purchasing Power Parity evaluates and compares the prices of goods in different countries, such as groceries. PPP is then used to help determine real exchange rates.

If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two countries, and the real exchange rate would always equal 1. However, since these assumptions are almost never met in the real world, the real exchange rate will never equal 1.

Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.

The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.

32.2.4: Exchange Rate Policy Choices

A government should consider its economic standing, trade balance, and how it wants to use its policy tools when choosing an exchange rate regime.

Learning Objective

Explain the factors countries consider when choosing an exchange rate policy

Key Points

• A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies since most of their liabilities are denominated in other currencies.
• Floating exchange rates automatically adjust to trade imbalances while fixed rates do not.
• A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. Because these tools are reserved for preserving the fixed rate, countries can’t use its monetary or fiscal policies to address other economic issues.

Key Terms

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

When a country decides on an exchange rate regime, it needs to take several important things in account. Unfortunately, there is no system that can achieve every possible beneficial outcome; there is a trade-off no matter what regime a nation picks. Below are a few considerations a country needs to make when choosing a regime.

Stage of Economic Development

A free floating exchange rate increases foreign exchange volatility, which can be a significant issue for developing economies . Developing economies often have the majority of their liabilities denominated in other currencies instead of the local currency. Businesses and banks in these types of economies earn their revenue in the local currency but have to convert it to another currency to pay their debts. If there is an unexpected depreciation in the local currency’s value, businesses and banks will find it much more difficult to settle their debts. This puts the entire economy’s financial sector stability in danger.

Developing Countries

The developing countries, marked in light blue, may prefer a fixed or managed exchange rate to a floating exchange rate. This is because sudden depreciation in their currency value poses a significant threat to the stability of their economies.

Balance of Payments

Flexible exchange rates serve to adjust the balance of trade. When a trade deficit occurs in an economy with a floating exchange rate, there will be increased demand for the foreign (rather than domestic) currency which will increase the price of the foreign currency in terms of the domestic currency. That in turn makes the price of foreign goods less attractive to the domestic market and decreases the trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur.

Monetary and Fiscal Policy

A big drawback of adopting a fixed-rate regime is that the country cannot use its monetary or fiscal policies with a free hand. In general, fixed-rates are not established by law, but are instead maintained through government intervention in the market. The government does this through the buying and selling of its reserves, adjusting its interest rates, and altering its fiscal policies. Because the government must commit its monetary and fiscal tools to maintaining the fixed rate of exchange, it cannot use these tools to address other macroeconomics conditions such as price level, employment, and recessions resulting from the business cycle.

32.2.5: Exchange Rate Systems

The three major types of exchange rate systems are the float, the fixed rate, and the pegged float.

Learning Objective

Differentiate common exchange rate systems

Key Points

• A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to freely fluctuate according to the foreign exchange market.
• A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against a specific currency or good.
• Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes.

Key Terms

pegged float exchange rate

A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values, to occur.

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

floating exchange rate

A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.

exchange rate regime

The way in which an authority manages its currency in relation to other currencies and the foreign exchange market.

Example

• Examples of floating currencies include the US dollar, the European Union euro, the Japanese yen, and the British pound. Examples of fixed currencies include the Hong Kong dollar, the Danish krone, and the Bermudian dollar.

One of the key economic decisions a nation must make is how it will value its currency in comparison to other currencies. An exchange rate regime is how a nation manages its currency in the foreign exchange market. An exchange rate regime is closely related to that country’s monetary policy. There are three basic types of exchange regimes: floating exchange, fixed exchange, and pegged float exchange .

Foreign Exchange Regimes

The above map shows which countries have adopted which exchange rate regime. Dark green is for free float, neon green is for managed float, blue is for currency peg, and red is for countries that use another country’s currency.

The Floating Exchange Rate

A floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.

Many economists believe floating exchange rates are the best possible exchange rate regime because these regimes automatically adjust to economic circumstances. These regimes enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.

The Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good. In a fixed exchange-rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.

To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country’s currency.

The most famous fixed rate system is the gold standard, where a unit of currency is pegged to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading partners.

The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or value, which is either fixed or periodically adjusted. These are a hybrid of fixed and floating regimes. There are three types of pegged float regimes:

• Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by a central bank. The bands are adjusted periodically by the country’s central bank. Generally the bands are adjusted in response to economic circumstances and indicators.
• Crawling pegs:A crawling peg is an exchange rate regime, usually seen as a part of fixed exchange rate regimes, that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilize the peg under the fixed exchange regimes, as well as the flexibility under the floating exchange rate regime. The system is designed to peg at a certain value but, at the same time, to “glide” in response to external market uncertainties. In dealing with external pressure to appreciate or depreciate the exchange rate (such as interest rate differentials or changes in foreign exchange reserves), the system can meet frequent but moderate exchange rate changes to ensure that the economic dislocation is minimized.
• Pegged with horizontal bands:This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency’s value.

32.2.6: Fixed Exchange Rates

A fixed exchange rate is a type of exchange rate regime where a currency’s value is fixed to a measure of value, such as gold or another currency.

Learning Objective

Explain the mechanisms by which a country maintains a fixed exchange rate

Key Points

• A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to.
• A fixed exchange rate regime should be viewed as a tool in capital control. As a result, a fixed exchange rate can be viewed as a means to regulate flows from capital markets into and out of the country’s capital account.
• Typically, a government maintains a fixed exchange rate by either buying or selling its own currency on the open market.
• Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate.

Key Term

fixed exchange rate

A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

Reasons for Fixed Exchange Rate Regimes

A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable and is especially useful for small economies in which external trade forms a large part of their GDP.

This belief that fixed rates lead to stability is only partly true, since speculative attacks tend to target currencies with fixed exchange rate regimes, and in fact, the stability of the economic system is maintained mainly through capital control. Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation’s government can use to regulate flows from capital markets into and out of the country’s capital account. A fixed exchange rate regime should be viewed as a tool in capital control.

How a Fixed Exchange Regime Works

Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. This is one reason governments maintain reserves of foreign currencies. If the exchange rate drifts too far below the desired rate, the government buys its own currency in the market using its reserves. This places greater demand on the market and pushes up the price of the currency. If the exchange rate drifts too far above the desired rate, the government sells its own currency, thus increasing its foreign reserves.

Another, method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate. This method is rarely used because it is difficult to enforce and often leads to a black market in foreign currency. Some countries, such as China in the 1990s, are highly successful at using this method due to government monopolies over all money conversion. China used this method against the U.S. dollar .

PRC Flag

China is well-known for its fixed exchange rate. It was one of the few countries that could impose a fixed rate by making it illegal to trade its currency at any other rate.

32.2.7: Managed Float

Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.

Learning Objective

Describe a managed float exchange rate and explain why countries choose managed floats

Key Points

• Generally the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.
• Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance.
• A managed float regime is a hybrid of fixed and floating regimes. A managed float captures the benefits of floating regimes while allowing central banks to intervene and minimize the risk of harmful effects due to radical currency fluctuations that are a characteristic of floating regimes.

Key Term

Managed Float Regime

A system where exchange rates are allowed fluctuate from day to day within a range before the central bank will intervene to adjust it.

Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries’ exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.

How a Managed Float Exchange Rate Works

Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range .

India

India has a managed float exchange regime. The rupee is allowed to fluctuate with the market within a set range before the central bank will intervene.

Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.

Why Do Countries Choose a Managed Float

Some economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country’s monetary policy to be freed up to pursue other goals, such as stabilizing the country’s employment or prices.

However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country’s imports and exports. If the currency’s value increases too drastically, the country’s exports could become too costly which would harm the country’s employment rates. If the currency’s value decreases too drastically, the country may not be able to afford crucial imports.

This is why a managed float is so appealing. A country can obtain the benefits of a free floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency’s value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.

32.3: Equilibrium

32.3.1: Open Economy Equilibrium

In an open economy, equilibrium is achieved when no external influences are present; the state of equilibrium between the variables will not change.

Learning Objective

Summarize the factors that determine the macroeconomic equilibrium state

Key Points

• In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition.
• The trade balance is a function of savings and investment. Since actors can save or invest domestically or internationally relative changes can have large effects on the trade balance and the health of the economy as a whole.
• There are three properties of equilibrium: the behavior of agents is consistent, no agent has an incentive to change its behavior, and equilibrium is the outcome of some dynamic process (stability).

Key Terms

output

Production; quantity produced, created, or completed.

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

trade

Buying and selling of goods and services on a market.

Open Economy

In an open economy there there is a flow of funds across borders due to the exchange of goods and services. An open economy can import and export without any barriers to trade, such as quotas and tariffs. Citizens in a country with an open economy typically have access to a larger variety of goods and services. They also have the ability to invest savings outside of the country.

An open economy allows a country to spend more or less than what it earns through the output of goods and services every year. When a country spends more than it make, it borrows money from abroad. If a country saves more money than it makes, it can lend the difference to foreigners.

The equation used to determine the economic output of a country is

The economy’s output (Y) equals the sum of the consumption of domestic goods (C_d), the investment in domestic goods and services (I_d), the government purchase of domestic goods and services (G_d), and the net exports of domestic goods and services (NX). The sum of C, I, and G provides the domestic spending of a country, while X provides the foreign sources of spending.

The amount that a country saves is total of investment and net exports:

NX can also be considered the trade balance of a country. Therefore

Consider, for example, what happens if domestic interest rates rise relative to foreign interest rates. Savings will increase and investment will drop as investors borrow and invest abroad instead. The balance of trade will increase, affecting the health of the economy. In an open economy, market actors can choose to save, spend, and invest either domestically or internationally, so relative changes affect not only the flow of capital, but also the health of the economy as a whole.

Economic Equilibrium

In an open economy, equilibrium is achieved when supply and demand are balanced . When no external influences are present, the state of equilibrium between the variables will not change. In the case of market equilibrium in an open economy, equilibrium occurs when a market price is established through competition. For example, when the amount of goods and services sought by buyers is equal to the amount of goods and services produced by sellers. When equilibrium is reached and the market price is established in an open economy, the price of the goods or service will remain the same unless the supply or demand changes.

Equilibrium

The graph shows that the point of equilibrium is where the supply and demand are equal. In an open economy, equilibrium is achieved when the amount demanded by consumers is equal to the amount of a goods or service provided by producers.

There are three properties of equilibrium:

1. The behavior of agents is consistent,
2. No agent has an incentive to change its behavior, and
3. Equilibrium is the outcome of some dynamic process (stability).

In an open economy, equilibrium is reached through the price mechanism. For example, if there is excess supply (market surplus), this would lead to prices cuts which would decrease the quantity supplied (reduces the incentive to produce and sell the product) and increase the quantity demanded (by offering bargains), which would eliminate the original excess of supply. The interest rates also adjust to reach equilibrium. Although consumption does not always equal production, the net capital outflow does equal the balance of trade. The capital flows, which depend on interest rates and savings rates, also adjust to reach equilibrium.

32.3.2: Impacts of Policies and Events on Equilibrium

Government policies and outside events may affect the macroeconomic equilibrium by shifting aggregate supply or aggregate demand.

Learning Objective

Analyze the effects that events and policies can have on economic equilibrium

Key Points

• One type of event that can shift the equilibrium is a supply shock – an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
• An increase in the price level can lower aggregate demand as a result of the wealth effect, the interest rate effect, and the exchange rate effect.
• By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand.
• Capital flight occurs when assets or money rapidly flow out of a country. This leads to an increase in the supply of the local currency and a drop in the exchange rate. Net exports rise as a component of aggregate demand.

Key Terms

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

nominal

Without adjustment to remove the effects of inflation (in contrast to real).

stagflation

Inflation accompanied by stagnant growth, unemployment, or recession.

The macroeconomic equilibrium is determined by aggregate supply and aggregate demand. Much of economics focuses on the determinants of aggregate supply and demand that are endogenous – that is, internal to the economic system. These include factors such as consumer preferences, the price of inputs, and the level of technology. However, there are many factors that affect the macroeconomic equilibrium that are exogenous to the economic system – that is, external to the economic model.

Supply Shock

One type of event that can shift the equilibrium is a supply shock. This is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good, which in turn affects the equilibrium price. A negative supply shock (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output . A positive supply shock (an increase in supply) will lower the price of said good by shifting the aggregate supply curve to the right. A positive supply shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output.

Supply Shock and Equilibrium

A supply shock shifts the aggregate supply curve. In this case, a negative supply shock raises prices and lowers output in equilibrium.

One extreme case of a supply shock is the 1973 Oil Crisis. When the U.S. chose to support Israel during the Yom Kippur War, the Organization of Arab Petroleum Exporting Countries (OAPEC) responded with an oil embargo, which increased the market price of a barrel of oil by 400%. This supply shock in turn contributed to stagflation and persistent economic disarray.

Inflation

Inflation can result from increased aggregate demand, but can also be caused by expansionary monetary policy or supply shocks that cause large price changes. Changes in prices can shift aggregate demand, and therefore the macroeconomic equilibrium, as a result of three different effects:

• The wealth effect refers to the change in demand that results from changes in consumers’ perceived wealth. When individuals feel (or are) wealthier, they spend more and aggregate demand increases. Since inflation causes real wealth to shrink and deflation causes real wealth to increase, the wealth effect of inflation will cause lower demand and the wealth effect of deflation will cause higher demand.
• The interest rate effect refers to the way in which a change in the interest rate affects consumer spending. When prices rise, a nominal amount of money becomes a smaller real amount of money, which means that the real value of money in the economy falls and the interest rate (i.e. the price of money) rises. A higher interest rate means that fewer people borrow and consumer spending (aggregate demand) falls.
• Finally, the exchange rate effectrelates changes in the exchange rate to changes in aggregate demand. As above, inflation typically causes the interest rate to rise. When the domestic interest rate is high compared to that in other countries, capital flows into the country, the international supply of the domestic currency falls, and the price (i.e. exchange rate) of the domestic currency rises. An increase in the exchange rate has the effect of increasing imports and decreasing exports, since domestic goods are relatively more expensive. A decrease in net exports leads to a decrease in aggregate demand, since net exports is one of the components of aggregate demand.

Trade Policies

Trade policies can shift aggregate demand. Protectionism, for example, is a policy that interferes with the free workings of the international marketplace. By implementing protectionism policies such as tariffs and quotas, a government can make foreign goods relatively more expensive and domestic goods relatively cheaper, increasing net exports and therefore aggregate demand. Since the world demands more goods produced in the home country, the demand for the domestic currency increases and the exchange rate rises.

Capital Flight

Capital flight occurs when assets or money rapidly flow out of a country due to an event of economic consequence. Such events could be an increase in taxes on capital or capital holders, or the government of the country defaulting on its debt that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength.

This leads to an increase in the supply of the local currency and is usually accompanied by a sharp drop in the exchange rate of the affected country. This leads to dramatic decreases in the purchasing power of the country’s assets and makes it increasingly expensive to import goods. Net exports rise as a component of aggregate demand.

32.3.3: Effect of a Government Budget Deficit on Investment and Equilibrium

A budget deficit will typically increase the equilibrium output and prices, but this may be offset by crowding out.

Learning Objective

Evaluate the consequences of imbalances in the government budget

Key Points

• A government’s budget balance is the difference in government revenues (primarily from taxes) and spending. If spending is greater than revenue, there is a deficit. If revenue is greater than spending, there is a surplus.
• A government deficit can be thought of as consisting of two elements, structural and cyclical. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures are high, leading naturally to a budget deficit.
• The additional borrowing required at the low point of the cycle is the cyclical deficit. The cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle. This type of deficit serves as an automatic stabilizer.
• The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are the result of discretionary fiscal policy and can shift the aggregate demand curve to the right.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.
• Crowding out is a negative consequence of budget deficits in which higher interest rates lead to less private investment, higher exchange rates, and fewer exports.

Key Terms

cyclical deficit

The deficit experienced at the low point of the business cycle when there are lower levels of business activity and higher levels of unemployment.

structural deficit

The portion of the public sector deficit which exists even when the economy is at potential; government spending beyond government revenues at times of normal, predictable economic activity.

business cycle

A fluctuation in economic activity between growth and recession.

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

A government’s budget balance is determined by the difference in revenues (primarily taxes) and spending. A positive balance is a surplus, and a negative balance is a deficit. The consequences of a budget deficit depend on the type of deficit .

U.S. Budget Deficits

The graph shows the budget deficits and surpluses incurred by the U.S. government between 1901 and 2006. Although deficits may have an expansionary effect, this is not the primary purpose of running a deficit.

Cyclical Deficits

A cyclical deficit is a deficit incurred due to the ups and downs of a business cycle. At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditures (e.g., on social security and unemployment benefits) are high, naturally leading to a budget deficit. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing spending, which leads to a budget surplus. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.

This type of budget deficit serves as a stabilizer, insulating individuals from the effects of the business cycle without any specific legislation or other intervention. This is because budget deficits can have stimulative effects on the economy, increasing demand, spending, and investment. Higher spending on transfer payments puts more money into the economy, supporting demand and investment. Furthermore, lower revenues mean that more money is left in the hands of individuals and businesses, encouraging spending. As the economy grows more quickly, the budget deficit falls and the fiscal stimulus is slowly removed.

Structural Deficits

The structural deficit is the deficit that remains across the business cycle because the general level of government spending exceeds prevailing tax levels. Structural deficits are permanent, and occur when there is an underlying imbalance between revenues and expenses.

This is the budget gap still exists when the economy is at full employment and producing at full potential output levels. It can only be closed by increasing revenues or cutting spending. Unlike the cyclical budget deficit, a structural deficit is the result of discretionary, not automatic, fiscal policy. While automatic stabilizers don’t actually shift the aggregate demand curve (because transfer payments and taxes are already built into aggregate demand), discretionary fiscal policy can shift the aggregate demand curve. For example, if the government decides to implement a new program to build military aircraft without adjusting any sources of revenue, aggregate demand will shift to the right, raising prices and output.

Although both types of government budget deficits are typically expansionary during a recession, a structural deficit may not always be expansionary when the economy is at full employment. This is due to a phenomenon called crowding out. When an increase in government expenditure or a decrease in government revenue increases the budget deficit, the Treasury must issue more bonds. This reduces the price of bonds, raising the interest rate. The increase in the interest rate reduces the quantity of private investment demanded (crowding out private investment). The higher interest rate increases the demand for and reduces the supply of dollars in the foreign exchange market, raising the exchange rate. A higher exchange rate reduces net exports. All of these effects work to offset the increase in aggregate demand that would normally accompany an increase in the budget deficit.

31.1: Introduction to International Trade

31.1.1: Reasons for Trade

Learning Objective

Discuss the reasons that international trade may take place

Key Points

• International trade is the exchange of capital, goods, and services across international borders or territories.
• Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
• Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency gains for domestic producers.

Key Term

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations .

International Trade

Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage.

In addition to comparative advantage, other reasons for trade include:

• Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
• Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost declines as output increases.
• Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to international problems.
• Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
• Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater responsiveness to consumer wants and needs, and a wider variety of products.

To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.

31.1.2: Understanding Production Possibilities

Learning Objective

Explain the benefits of trade and exchange using the production possibilities frontier (PPF)

Key Points

• The production possibilities curve shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
• Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer.
• Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency.

Key Terms

Autarky

National economic self-sufficiency.

Production possibilities frontier

A graph that shows the combinations of two commodities that could be produced using the same total amount of each of the factors of production.

In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.

PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line . An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter . If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required.

Production Possibilities Frontier

If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur.

If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer.

The PPF will shift outwards if more inputs (such as capital or labor) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.

Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.

31.1.3: Defining Absolute Advantage

Learning Objective

Relate absolute advantage, productivity, and marginal cost

Key Points

• A country that has an absolute advantage can produce a good at lower marginal cost.
• A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
• Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.

Key Term

Absolute advantage

The capability to produce more of a given product using less of a given resource than a competing entity.

Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.

A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs .

China and Consumer Electronics

Many consumer electronics are manufactured in China. China can produce such goods more efficiently, which gives it an absolute advantage relative to many countries.

Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers . Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers.

Absolute Advantage

Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A.

If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.

31.1.4: Defining Comparative Advantage

Learning Objective

Analyze the relationship between opportunity cost and comparative advantage

Key Points

• Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
• Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
• Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of outputs becomes available to the trading nations.
• Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not necessarily related to a lower opportunity cost.

Key Terms

Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

competitive advantage

Something that places a company or a person above the competition

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Comparative Advantage

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.

Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.

Determining Comparative Advantage

Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players . Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.

Comparative Advantage

Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a comparative advantage in producing CD players. Both nations can benefit from trade.

For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).

Comparative vs Competitive Advantage

It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we more often discuss comparative advantage.

31.1.5: Absolute Advantage Versus Comparative Advantage

Learning Objective

Differentiate between absolute advantage and comparative advantage

Key Points

• The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.
• Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another.
• The existence of a comparative advantage allows both parties to benefit from trading, because each party will receive a good at a price that is lower than its opportunity cost of producing that good.

Key Terms

Absolute advantage

The capability to produce more of a given product using less of a given resource than a competing entity.

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good.

The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time . Country A uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit, and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in making both food and clothing.

Absolute Advantage

Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in food.

Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

For example, consider again Country A and Country B in . The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.

Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.

Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.

31.1.6: Benefits of Specialization

Learning Objective

Discuss the effects of specialization on production

Key Points

• Whenever countries have different opportunity costs in production they can benefit from specialization and trade.
• Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors.
• The disadvantages of specialization include threats to uncompetitive sectors, the risk of over-specialization, and strategic vulnerability.

Key Term

comparative advantage

The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:

• Greater efficiency: Countries specialize in areas that they are naturally good at and also benefit from increasing returns to scale for the production of these goods. They benefit from economies of scale, which means that the average cost of producing the good falls (to a certain point) because more goods are being produced . Similarly, countries can benefit from increased learning. They simply are more skilled at making the product because they have specialized in it. These effects both contribute to increased overall efficiency for countries. Countries become better at making the product they specialize in.
• Consumer benefits: Specialization means that the opportunity cost of production is lower, which means that globally more goods are produced and prices are lower. Consumers benefit from these lower prices and greater quantity of goods.
• Opportunities for competitive sectors: Firms gain access to the whole world market, which allows them to grow bigger and to benefit further from economies of scale.
• Gains from trade: Suppose that Britain and Portugal each produce wine and cloth. Britain has a comparative advantage in cloth and Portugal in wine . By specializing and then trading, Britain can get a unit of wine for only 100 units of labor by trading cloth for labor instead of taking 110 units of labor to produce the wine itself (assuming the price of Cloth to Wine is 1). Similarly, Portugal can specialize in wine and get a unit of cloth for only 80 units of labor by trading, instead of the 90 units of labor it would take to produce the cloth domestically. Each country will continue to trade until the price equals the opportunity cost, at which point it will decide to just produce the other good domestically instead of trading. Thus (in this example with no trade costs) both countries benefit from specializing and then trading.

Of course, there are also some potential downsides to specialization:

• Threats to uncompetitive sectors: Some parts of the economy may not be able to compete with cheaper or better imports. For example, firms in United States may see demand for their products fall due to cheaper imports from China. This may lead to structural unemployment.
• Risk of over-specialization: Global demand may shift, so that there is no longer demand for the good or service produced by a country . For example, the global demand for rubber has fallen due the the availability of synthetic substitutes. Countries may experience high levels of persistent structural unemployment and low GPD because demand for their products has fallen.
• Strategic vulnerability: Relying on another country for vital resources makes a country dependent on that country. Political or economic changes in the second country may impact the supply of goods or services available to the first.

As a whole, economists generally support specialization and trade between nations.

31.1.7: Relationship Between Specialization and Trade

Learning Objective

Discuss how countries determine which goods to produce and trade

Key Points

• Nations decide whether they should export or import goods based on comparative advantages.
• Generally, nations can consume more by specializing in a good and trading it for other goods.
• When countries decide which country will specialize in which product, the essential question becomes who could produce the product at a lower opportunity cost.

Key Term

Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good of another country. The traders decide on whether they should export or import goods depending on comparative advantages.

Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient, because they have the ability to produce both products. However, specializing in the product for which they have a comparative advantage and then trading would allow both countries to consume more than they would on their own.

One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When countries decide what products to specialize in, the essential question becomes who could produce the product at a lower opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one could have gotten if one produced another product instead of one unit of the given product.

For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard . This means that in the same amount of time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3 bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard.

Comparative Advantage

Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in producing mustard.

There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other – but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of consumption as producing all goods domestically.

31.2: Gains from Trade

31.2.1: Exports: The Economic Impacts of Selling Goods to Other Countries

Exporting is a form of international trade which allows for specialization, but can be difficult depending on the transaction.

Learning Objective

Evaluate the effects of international trade on exporting countries

Key Points

• Export is defined as the act of shipping goods and services out of the port of a country.
• Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported.
• When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported from the country.
• Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products.
• Due to an extra layer in the chain of distribution which squeezes the margins, exporters may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

Key Terms

export

Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

trade

Buying and selling of goods and services on a market.

Exports

Export is defined as the act of a country shipping goods and services out of the port of a country. In international trade, an export refers to the selling of goods and services produced in the home country to other markets (other countries) . The seller of the goods and services is referred to as the “exporter. “

Exports

The map shows the primary exporters for countries around the globe. The colors indicate the leading merchandise export destination for the indicated country (the United States main export destination is the European Union). Exporting is the act of shipping goods and services to other countries.

Protecting Exports

In order to protect exports, commercial goods are subject to customs authorities for both the exporting and importing countries. Legal restrictions and trade barriers are in place internationally to control trade, whether goods are being exported or imported. When legal restrictions and trade barriers are lessened or lifted the producer surplus increases and so does the amount of the goods and services that are exported to other countries.

Impact of Exports

Exporting goods and services has both advantages and disadvantages for countries involved in international trade.

Exporting allows a country’s producers to gain ownership advantages and develop low-cost and differentiated products. It is viewed as a low-risk mode of production and trade. Exporters also experience internationalization advantages which are the benefits of retaining a core competence within a company and threading it through the value chain instead of obtaining a license to outsource or sell the goods or services.

Disadvantages of exporting are mainly the result of manufacturers having to sell their goods to importers. In domestic sales, manufacturers sell directly to wholesalers or even directly to the retailer or customer. For exports, manufacturers face and extra layer in the chain of distribution which squeezes the margins. As a result, manufacturers may have to offer lower prices to the importers than to domestic wholesalers in order to move their product and generate business.

31.2.2: Imports: The Economics Impacts of Buying Goods from Other Countries

Imports are critical for many economies; they are the defining financial transactions of international trade and account for a large portion of the GDP.

Learning Objective

Evaluate the effects of international trade on an importing country

Key Points

• Imports are defined as purchases of good or services by a domestic economy from a foreign economy.
• Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations.
• In most countries, international trade and importing goods represents a significant share of the gross domestic product (GDP).
• International trade is generally more expensive than domestic trade due to additionally imposed costs, taxes, and tariffs.
• On a business level, companies take part in direct-imports; a major retailer imports goods from an overseas manufacturer in order to save money.

Key Terms

protectionism

A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.

trade

Buying and selling of goods and services on a market.

import

To bring (something) in from a foreign country, especially for sale or trade.

Imports

Imports are defined as purchases of good or services by a domestic economy from a foreign economy. The domestic purchaser of the good or service is called an importer. Imports and exports are critical for many economies and they are the defining financial transactions of international trade.

Protecting Imports

Due to the economic importance of imports, countries enact specific laws, barriers, and policies in order to regulate international trade. Protectionism is the economic policy of restraining trade between countries through tariffs on imported goods, restrictive quotas, and government regulations. When trade barriers and policies of protectionism are eliminated, consumer surplus increases. The price of a good or service will decrease while the quantity consumed will increase.

Impacts of Buying Imported Goods

On a national level, in most countries international trade and importing goods represents a significant share of the gross domestic product (GDP). International trade has a significant economic, social, and political importance in many countries. Imports provide countries with access to goods and services from other nations. Without imports, a country would be limited to the goods and services within its own borders .

Imports

The map shows the largest importers on an international scale. The color indicates the leading source of merchandise imports for the indicated country (the United States’ imports the largest percentage of its goods from China). Imports account for a significant share in the gross domestic product (GDP) of a country.

International trade is generally less expensive than domestic trade despite additionally imposed costs, taxes, and tariffs. However, the factors of production are usually more mobile domestically than internationally (capital and labor). It is common for countries to import goods rather than a factor of production. For example, the U.S. imports labor-intensive goods from China. Instead of importing Chinese labor, the U.S. imports goods that were produced in China by Chinese labor.

On a business level, companies take part in direct-imports, which occur when a major retailer imports goods that are designed locally from an overseas manufacturer. The direct-import program allows the retailer to bypass the local supplier and purchase the final product directly from the manufacturer. Direct imports save retailers money by eliminating the local supplier.

31.2.3: Costs of Trade

Free trade is a policy where governments do not discriminate against imports and exports; creates a large net gain for society.

Learning Objective

Identify the groups that benefit and the groups that are harmed by free trade policies

Key Points

• Free trade eliminates export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country.
• With free trade in place the producers in exporting countries and the consumers in importing countries all benefit.
• One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion.
• Trade restricts displaces workers, makes overcoming unemployment challenging, increases economic inequality, and can lower wages.
• When free trade is applied to only the high cost producer it can lead to trade diversion and a net economic loss.
• Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage.

Key Terms

welfare

Health, safety, happiness and prosperity; well-being in any respect.

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

free trade

International trade free from government interference, especially trade free from tariffs or duties on imports.

Free Trade

Free trade is a policy where governments do not discriminate against exports and imports. There are few or no restrictions on trade and markets are open to both foreign and domestic supply and demand.

Advantages

Free trade is beneficial to society because it eliminates import and export tariffs. Restricted trade affects the welfare of society because although producers experience increases in surplus and additional revenue, the loss faced by consumers is greater than any benefit obtained . When a country trades freely with the rest of the world, it should theoretically produce a net gain for society and increases social welfare. Free trade policies consist of eliminating export tariffs, import quotas, and export quotas; all of which cause more losses than benefits for a country. With free trade in place, the producers of the exported good in exporting countries and the consumers in importing countries all benefit.

Tariffs

This image shows what happens to societal welfare when free trade is not enacted. Tariffs cause the consumer surplus (green area) to decrease, while the producer surplus (yellow area) and government tax revenue (blue area) increase. The amount of societal loss (pink area) is larger than any benefits experienced by the producers and government. Free trade does not have tariffs and results in net gain for society.

Disadvantages

One of the main disadvantages is the selective application of free trade. Economic inefficiency can be created through trade diversion. It is economically efficient for a good to be produced in the country with the lowest production costs. However, this does not always occur if a high cost producer has a free trade agreement and the low cost producer does not. When free trade is applied to only the high cost producer it can lead to trade diversion to not the most efficient producer, but the one facing the lowest trade barriers, and a net economic loss. Free trade is highly effective and provides society with a net gain, but only if it is applied.

Due to industry specializations, many workers are displaced and do not receive retraining or assistance finding jobs in other sectors. The nature of industries and trade increases economic inequality. As a result of unskilled workers the wages within the various industries may decline.

Another disadvantage is that by increasing returns to scale, can cause certain industries to settle in an geographically area where there is not comparative advantage. Despite this disadvantage, the level of output that is generated by free trade for both the “winner” and the “loser” is increased substantially.

The Results of Free Trade

Economists have studied free trade extensively and although it creates winners and losers, the main consensus is that free trade generates a large net gain for society. In a 2006 survey of American economists, it was found that 85.7% believed that the U.S. should eliminate any remaining tariffs and trade barriers. Economists professor N. Gregory Mankiw explained that, “few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. “

31.3: The United States in the Global Economy

31.3.1: The Importance of Trade

International trade is an integral part of the modern world economy.

Learning Objective

Discuss the reasons of the U.S. increase in international trade participation after World War II

Key Points

• The international market serves as an important place for the exchange of goods and services.
• Economic theory shows that there are gains from trade for both countries involved.
• Advances in transportation has dramatically reduced the costs of moving goods around the globe.
• Technological advances have made international production and trade easier to coordinate.
• Trade barriers between countries have fallen and are likely to continue to fall.

Key Terms

production possibilities curve

The various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production

comparative advantage

The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.

Economists generally support trade because it allows for increased overall utility for both countries . Gains from trade are commonly described as resulting from:

Silk Road Trade

Even in ancient times, people benefited from widespread international trade. The benefits from international trade have increased as costs decline and the international system becomes better integrated.

• specialization in production from division of labor (according to one’s comparative advantage), economies of scale, scope, and agglomeration and relative availability of factor resources in types of output by farms, businesses, location and economies
• a resulting increase in total output possibilities
• trade through markets from sale of one type of output for other, more highly valued goods.

The Rise of International Trade

International trade is important, and, over time, has become more important. There have been three primary reasons for this increase in importance.

First, there have been large reductions in the cost of transportation and communication. It is now much cheaper to not only operate internationally and trade with foreign partners, but also to exchange information between potential buys and sellers.

Second, technological advances have made international production and trade easier to coordinate. More efficient telecommunications, from the first transatlantic telephone cable in 1956 to the popularization of the internet in the 1980s and 1990s, have allowed companies to exchange goods more efficiently and lowered the costs of international integration. Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also contributed to the rise in international trade.

Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of international monetary management has shaped the relationship between the world’s major industrial states and has resulted in a much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after World War II, the Bretton Woods Conference set up regulations for production of their individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade.This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed exchange rates, the goal of more open economies and free international trade remained.

31.3.2: The Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period.

Learning Objective

Explain the relationship between the trade balance of a nation and its economic well-being

Key Points

• A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
• Factors that can affect the balance of trade include the currency exchange rate, cost of inputs, barriers to trade such as tariffs and regulations, and the prices of domestic goods.
• The twin deficits hypothesis contends that there is a strong positive relationship between a national economy’s current account balance and its government budget balance.

Key Terms

net capital outflow

The net flow of funds being invested abroad by a country during a certain period of time.

net exports

The difference between the monetary value of exports and imports.

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation’s imports and exports. It is measured by finding the country’s net exports. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.

Factors that can affect the balance of trade include:

• The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing economy
• The cost and availability of raw materials, intermediate goods, and other inputs
• Currency exchange rate
• Multilateral, bilateral, and unilateral taxes or restrictions on trade
• Non-tariff barriers such as environmental, health, or safety standards
• The availability of adequate foreign exchange with which to pay for imports
• Prices of goods manufactured at home

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

Twin Deficits Hypothesis

The twin deficits hypothesis is a concept from macroeconomics that contends that there is a strong link between a national economy’s current account balance and its government budget balance. This link can be seen from considering the national accounting model of the economy:

Y=C+I+G+(NX

Y represents national income or GDP, C is consumption, I is investment, G is government spending, and NX stands for net exports (exports minus imports). This represents GDP because all the production in an economy (the left hand side of the equation) is used as consumption (C), investment (I), or government spending (G), and the leftover production is exported (NX).

Another equation defining GDP using alternative terms (which in theory results in the same value) is:

Y=C+S+T

Y is again GDP, C is consumption, S is savings, and T is taxes. This is because national income is also equal to output, and all individual income either goes to pay for consumption (C), to pay taxes (T), or becomes savings (S).

Since Y=C+I+G+NX, and Y-C-T=S, then S=G-T+NX+I, which simplifies to:

(S-I)+(T-G)=(NX)

If (T-G) is negative, we have a budget deficit. Assuming that the economy is at potential output (meaning Y is fixed), if the budget deficit increases and savings and investment remain the same, then net exports must fall, causing a trade deficit. Thus, budget deficits and trade deficits go hand-in-hand .

Twin Deficits in the US

In the U.S., net borrowing has tended to have a direct relationship with net imports. The red line represents net imports, which is equivalent to the negative balance of trade, and the black line represents net borrowing, which is equivalent to the government budget deficit. Although the two are not identical, a rise in one tends to accompany a rise in the other, and vice versa.

The twin deficits hypothesis implies that as the budget deficit grows, net capital outflow from a country falls. This is because the nation is financing its spending by selling assets to foreigners. The total rate of national savings falls, which may lead to an increase in the interest rate as lending to the country (i.e. buying bonds and other financial assets) becomes more risky.

31.4: Barriers to Trade

31.4.1: Tariffs

Tariffs are taxes levied on goods entering or exiting a country, and have consequences for both domestic consumers and producers.

Learning Objective

Discuss the consequences of a tariff for a domestic economy

Key Points

• Tariffs can be levied on goods being imported in a country (import tariff), or exported from a country (export tariff). They may be levied in order to protect domestic producers (protective tariff), or to raise revenue for the government (revenue tariff).
• Specific tariffs levy a fixed duty on a good. Ad valorem tariffs are based on a percentage of the good’s value. Compound tariffs are a combination of specific and ad valorem tariffs.
• Tariffs often increase domestic producer surplus and the quantity of a good supplied domestically, but hurt domestic consumer surplus.

Key Term

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

One barrier to international trade is a tariff. A tariff is a tax that is imposed by a government on imported or exported goods. They are also known as customs duties.

Types of Tariffs

Tariffs can be classified based on what is being taxed:

• Import tariffs: Taxes on goods that are imported into a country. They are more common than export tariffs.
• Export tariffs:Taxes on goods that are leaving a country. This may be done to raise tariff revenue or to restrict world supply of a good.

Tariffs may also be classified by their purpose:

• Protective tariffs: Tariffs levied in order to reduce foreign imports of a product and to protect domestic industries.
• Revenue tariffs: Tariffs levied in order to raise revenue for the government.

Tariffs can also be classified on how the duty amount is valued:

• Specific tariffs: Tariffs that levy a flat rate on each item that is imported. For example, a specific tariff would be a fixed $1,000 duty on every car that is imported into a country, regardless of how much the car costs.
• Ad valorem tariffs: Tariffs based on a percentage of the value of each item. For example, an ad valorem tariff would be a 20% tax on the value of every car imported into a country.
• Compound tariffs: Tariffs that are a combination of specific tariffs and ad valorem tariffs. For example, a compound tariff might consist of a fixed $100 duty plus 10% of the value of every imported car.

Consequences of Levying a Tariff

To see the effects of levying an import tariff, consider the example shown in . Assume that there is an import tax levied on a good in a domestic country, Home. The domestic supply of the good is represented by the diagonal supply curve, and world supply is perfectly elastic and represented by the horizontal line at P_w. Before a tariff is levied, the domestic price is at P_w, and the quantity demanded is at D (with quantity S provided domestically, and quantity D-S imported).

Effects of a Tariff

When a tariff is levied on imported goods, the domestic price of the good rises. This benefits domestic producers by increasing producer surplus, but domestic consumers see a small consumer surplus.

When the tariff is imposed, the domestic price of the good rises to P_t. Now, more of the good is provided domestically; instead of producing S, it now produces S*. Imports of the good fall, from the quantity D-S to the new quantity D*-S*. With the higher prices, domestic producers experience a gain in producer surplus (shown as area A). In contrast, because of the higher prices, domestic consumers experience a loss in consumer surplus; consumer surplus shrinks from the area above P_w to the area above P_t (it shrinks by the areas A, B, C, and D).

Because the tariff is a tax, the government gains some revenue. The government charges a tariff amount of P_t-P_w on every imported good. The amount of revenue is equal to the tariff amount times the number of imported goods, or (P_t-P_w)(D*-S*). This results in a governmental gain of area C.

In this example, domestic producers and the government both gain from the import tariff, and domestic consumers lose. However, if the world price is higher than the domestic price, a tariff will not change the price or quantity consumed of a good.

31.4.2: Quotas

Quotas are limitations on imported goods, come in an absolute or tariff-rate varieties, and affect supply in the domestic economy.

Learning Objective

Discuss the economic consequences of different kinds of quotas

Key Points

• There are two types of quotas: absolute and tariff-rate. Absolute quotas are quotas that limit the amount of a specific good that may enter a country. Tariff-rate quotas allow a quantity of a good to be imported under a lower duty rate; any amount above this is subject to a higher duty.
• Justifications for the use of quotas include protection for domestic employment and infant industries, protection against unfair foreign trade practices, and protection of national security.
• Quotas often hurt domestic consumers and benefit domestic producers. Quotas may also provide incentives for administrative corruption and smuggling.

Key Terms

quota

A restriction on the import of something to a specific quantity.

absolute quota

A limitation of the quantity of certain goods that may enter commerce during a specific period.

tariff-rate quota

Allows a specified quantity of imported goods to be entered at a reduced rate of duty during the quota period, with quantities entered in excess of the quota limit subject to a higher duty rate.

Barriers to trade exist in many forms. A tariff is a barrier to trade that taxes imports or exports, thus increasing the cost of a good. Another barrier to trade is an import quota, which places a limit on the amount of a good that may enter a country.

Types of Quotas

There are two main types of import quota: the absolute quota and the tariff-rate quota.

An absolute quota is a limit on the quantity of specific goods that may enter a country during a certain time period. Once the quota has been fulfilled, no other goods may be imported into the country. An absolute quota may be set globally, in which case goods may be imported from any country until the goal has been reached. An absolute quota may also be set selectively for certain countries. As an example, suppose an absolute, global quota for pens is set at 50 million. The government is setting a limit that, in total, only 50 million pens can be imported. If there were a selective, absolute quota, only 50 million pens would be able to be imported, but this total would be divided among exporting countries. Country A might only be able to export 10 million pens, Country B might be able to export 25 million pens, and Country C might be able to export 15 million pens. Collectively, the total imports equal 50 million pens, but the proportions of pens from each country are set.

A tariff-rate quota is a two-tier quota system that combines characteristics of tariffs and quotas. Under a tariff-rate quota system, an initial quota of a good is allowed to enter the country at a lower duty rate. Once the initial quota is surpassed, imports are not stopped; instead, more of the good may be imported, but at a higher tariff rate . For example, under a tariff-rate quota system, a country may allow 50 million pens to be imported at the low tariff rate of $1 each. Any pen that is imported after this first-tier quota has been reached would be charged a higher tariff, say $3 each.

Sugar: Tariff-Rate Barriers

In the US, the import of sugar is regulated by tariff-rate barriers. In 2012, the US allowed over 150,000 tons of raw cane sugar to be imported from Brazil at a reduced tariff rate.

Reasons to Implement Quotas

Quotas are often implemented for similar reasons as other trade barriers. Often, quotas are instituted to:

• Protect domestic industries and employment: By reducing the number of foreign imports, domestic suppliers must produce more to meet domestic demand. By producing more, the suppliers must hire more domestic workers, increasing employment. Additionally, setting quotas to reduce foreign competition allows domestic “infant industries,” or young, small industries, to grow and mature to a competitive level.
• Protect against unfair trade practices: Setting a quota helps protect a domestic economy from unfair trade practices such as dumping, the pricing of imports below production cost. By restricting imports, quotas minimize the impact of such activities.
• Protect national security: Import quotas discourage imports and encourage domestic production of goods that may be necessary to the security of the country. By protecting and encouraging the growth of these defense-related industries, a country will not have to be dependent on foreign imports in the event of a war.

Consequences of Quotas

Like other trade barriers, quotas restrict international trade, and thus, have consequences for the domestic market. In particular, quotas restrict competition for domestic commodities, which raises prices and reduces selection. This hurts the domestic consumer, who experiences a loss in consumer surplus. On the other hand, this very action benefits the domestic producer, who sees an increase in producer surplus. Often, the increase in producer surplus is not enough to offset the loss in consumer surplus, so the economy experiences a loss in total surplus.

Quotas may also foster negative economic activities. Import quotas may promote administrative corruption, especially in countries where import quotas are given to selected importers. There are incentives to give the quotas to importers who can provide the most favors or the largest bribes to officials. Quotas may also encourage smuggling. As quotas raise the price of domestic goods, it becomes profitable to try and circumvent the quota by bringing in goods illegally, or in excess of the quota.

31.4.3: Other Barriers

Barriers to trade include specific limitations to trade, customs procedures, governmental participation, and technical barriers to trade.

Learning Objective

Distinguish different barriers to trade

Key Points

• Specific limitations to trade barriers include local content requirements and embargoes. This category of barriers comes from trade regulations.
• Customs and administrative procedure barriers include bureaucratic red tape and anti-dumping practices. This category of barriers comes from government procedures.
• Governmental participation barriers include government procurement programs, export subsidies, and countervailing duties. This category of barriers involves the direct participation of government in trade.
• Technical barriers to trade include sanitary regulations, measurement and labeling standards, and ingredient standards. This category of barriers involves health, safety, and measurement standards.

Key Terms

countervailing duty

A tax levied on an imported article to offset the unfair price advantage it holds due to a subsidy paid to producers or exporters by the government of the exporting country if such imports cause or threaten injury to a domestic industry.

embargo

A ban on trade with another country.

Dumping

Selling goods at less than their normal price, especially in the export market.

In addition to tariffs and quotas, other barriers to trade exist. They can be divided into four separate categories: specific limitations to trade, customs and administrative procedures, government participation, and technical barriers to trade.

Specific Limitations to Trade

This category of trade barriers stems from regulations on international trade. Some examples include:

• Local content requirements, or domestic content requirements, are rules that mandate how much of a product must be produced domestically in order to qualify for lowered tariffs or other preferential treatment.
• Embargoes are prohibitions on trade ban imports or exports, and may apply to certain categories of products, or strictly to goods supplied by certain countries .

Customs and Administrative Procedures

This category of trade barriers refers to trade impediments that stem from governmental procedures and controls. Some examples include:

• Bureaucratic delays: Delays at ports or other country entrances caused by administrative or bureaucratic red-tape increase uncertainty and the cost of maintaining inventory.
• Anti-dumping duties: In international trade, dumping refers to a form of predatory pricing in which exported products are priced below the cost of production or below the price charged in the home market. Anti-dumping duties are usually extra taxes levied on the product to neutralize the predatory pricing and bring the price closer to the “normal value. “

Government Participation

This category of trade barriers represents direct governmental involvement in international trade. Some examples include:

• Government procurement programs: Public authorities, such as government agencies, are much like private interests in that they must also buy goods and services. Unlike private interests, governments are more likely to buy domestically produced goods and services, rather than the lowest-cost commodities. Because government procurement often represent a significant portion of a country’s GDP, foreign suppliers are at a disadvantage to domestic ones when it comes to these programs.
• Export subsidies: Export subsidies are production subsidies granted to exported products, usually by a government. With export subsidies, domestic producers can sell their commodities in foreign markets below cost, which makes them more competitive.
• Countervailing duties: Countervailing duties, or anti-subsidy duties, are extra duties levied on imports in order to neutralize an export subsidy. If a country discovers that a foreign country subsidizes its exports, and domestic producers are injured as a result, a countervailing duty can be imposed in order to reduce the export subsidy advantage. In that respect, countervailing duties are similar to anti-dumping duties in that they both bring a imported product’s value closer to the “normal value. “

Technical Barriers to Trade

Technical barriers to trade are non-tariff barriers to trade that refer to standards implemented by countries. Because these standards must be met before goods are allowed to enter or leave a country, they represent international trade barriers. Some examples include:

• Sanitary and phytosanitary measures: These are health standards for plants, animals, and other products, and are designed to protect humans, animals, and plants from pests or diseases.
• Rules for product weights, sizes, or packaging.
• Standards for labeling and testing products.
• Ingredient or identity standards.

31.5: Arguments for and Against Protectionist Policy

31.5.1: National Security Argument

National security protectionist arguments pertain to the risk of dependency upon other nations for economic sustainability.

Learning Objective

Evaluate the arguments in favor of the use of trade protectionism in the security industry

Key Points

• Economic interdependence and globalization has resulted in a unique capitalistic system, where each country is largely dependent upon other countries for economic sustainability.
• It has been noted, somewhat intuitively and empirically, that conflict reduces trade. This highlights the risk of conflict harming an economy.
• A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation, as economic levers such as sanctions can be utilized.
• Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. All of these economies struggle(d) against harsh economic sanctions.
• Combining these ideas, it is clear that there is substantial national security value to trade protectionism.

Key Terms

Self-sufficiency

Able to provide for oneself independently of others.

sanction

A penalty, or some coercive measure, intended to ensure compliance; especially one adopted by several nations, or by an international body.

Economic interdependence and globalization has resulted in a system, where each country is largely dependent upon other countries for economic sustainability (though to varying degrees). This results in a substantial national security threat in the form of conflicting or offensive trade strategies between countries. Indeed, economics is often used directly as a weapon of war and conflict via trade sanctions. This highlights a critical protectionist argument pertaining to the very real risk of dependency upon other nations for economic sustainability.

Trade and Conflict

An interesting discussion in economics is the relationship between trade and conflict. It has been noted, somewhat intuitively and empirically, that conflict reduces trade. However, is it also the case that trade reduces conflict? This question is largely unanswered, although the stances are becoming more highly developed. It is hypothesized that trade does not necessarily reduce conflict, but instead changes the nature of the conflict. Economic levers are much more practical than military levers, and are often used for similar reasons. For this reason, it is difficult to separate trade and conflict completely because there is some critical overlap between the two. This is a fundamental foundation for the trade protectionism logic from a national security perspective.

Trade During Conflict

A more specific context for trade and conflict can be the way in which trade is complicated during wartime. Indeed, trade during wartime can be a substantial threat to a nation depending on the scale and scope of the conflict (most notably who is involved). For example, consider World War II. In this scenario Germany was largely isolated in the conflict, and therefore had extremely limited trade partners. Direct conflict will almost always result in a complete cease in trading not only between the country in which the war is occurring, but also any of that country’s allies (who may or may not be directly involved). However, some argue self-sufficiency (via protectionism) in war is not necessary, as friendly nations will still provide trade and economic support.

Sanctions also play a dramatic role as an offensive militaristic maneuver. Iran and North Korea are strong modern examples as well as the recent history of the U.S.-Iraq war. In all of these circumstances, either the U.S. alone or along with a number of allies (representing substantial consumption percentages) actively limited the ability for these countries to trade and generate economic value for their nations (and subsequently their people). While this looks purely economic, it has important social and humanitarian implications as well. The chart makes this case quite clearly, pointing out the death toll in wartime if economic levers are utilized.

Infant Mortality in Iraq During Sactions

This graphic underlines the indirect consequences of employing economic levers (i.e. sanctions) in a militaristic fashion during a conflict. While the justification for these figures is complex, including other war-related factors, the correlation is quite clear. Diminishing a country’s economic prospects will in turn result in loss of life, particularly in developing nations.

Protectionism

Combining these ideas, it is clear that there is substantial national security value to trade protectionism. However, the opportunity cost of leveraging the ever-growing global markets make this an unattractive prospect if taken to any extreme, as the benefits of global trade rapidly offset the risk of economic dependency upon hostile nations.

31.5.2: Infant Industry Argument

Economic markets are inherently competitive and newer economies are vulnerable to their more developed counterparts in other countries.

Learning Objective

Discuss the use of trade protectionism to promote new industries

Key Points

• Trade protectionism is national policies restricting international economic trade to alter the balance between imports and goods manufactured domestically through import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.
• The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale, which infant industries in developing countries often protect against.
• The United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule, which proved effective.
• From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The argument is that free markets add value on a global level, while protectionism confines economic value to the nation employing it.

Key Terms

Dumping

Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.

Nascent

Emerging; just coming into existence.

Trade protectionism is defined as national policy restricting international economic trade to alter the balance between imports and goods manufactured domestically, usually executed via policies and governmental regulations such as import quotas, tariffs, taxes, anti-dumping legislation, and other limitations.

Arguments for Protecting Infant Industry

The primary purpose for this system is as the name implies: protection. Economic markets are inherently competitive, and newer economies are highly vulnerable to their more developed counterparts in other countries for a variety of reasons. The infant industry argument is that new industries need protection until they have become efficient enough to compete in the world market.

Despite the standard argument from mainstream economists postulating that free trade and open markets is the ideal system to allow for capitalistic development, there are many economists who believe that some degree of protectionism is the only way to minimize income gaps and substantial inequity from economy to economy (see ). The primary advantage to countries with higher economic power and bigger corporations is simply economies of scale and economies of scope, in addition to being further along the experience curve.

Economies of Scale

The basic premise behind economies of scale is that higher production quantity reduces cost per unit, ultimately allowing for the derivation of economic advantage in the market. Infant industries generally do not have the capacity to do this.

GDP by Country

This map demonstrates the vast difference in overall economic power across the globe, underlining the inequities that need to be addressed in economic policy formulation.

History has proven the value of protection for the countries employing tariff-based international trade policies. Alexander Hamilton first pointed out the inequities of developing economies with young industry in 1790, which was later picked up and developed by Daniel Raymond and Friedrich List in the 19th century. Around this time frame, the United States was employing heavy tariffs to protect their fragile economic system as the economy began to achieve autonomy after British rule. Indeed, Britain employed similarly protectionist policies during this time frame, setting the tone for large economic expansion in the longer term.

Criticism

Of course, protective policy while industry develops domestically is not a cure all. In Brazil in the 1980’s there were heavy protective policies in place to defend Brazil’s nascent computer industry from highly evolved competitors internationally. While this seemed practical, what ended up happening was quite damaging for Brazil. Technology advanced rapidly, and without strategic alliances on a global scale, Brazil largely missed out on these advances. This protectionism seems to have damaged industry prospects on a global level for Brazil in this scenario.

From a broader and more far-reaching perspective, protectionism as a general principle has been heavily criticized (even in infant industry situations). The reason for this is quite simply the significant jump in prosperity as international trade expanded, and the huge capacity for specialization, economies of scale, technology sharing, and a host of other advantages that have been a direct result of free global markets. The problem still remains, however, that this prosperity is often unregulated and of the greatest benefit to the influential players in established economies, sometimes at the expense of exploitation of developing nations (cheaper labor, reduced governmental oversight, etc.). As a result of this, protecting infant industries can benefit the nation employing them, but generally with the opportunity cost of global value.

31.5.3: Unfair Competition Argument

One of the strongest arguments for trade protectionism is unfair competition emerging due to differences in policy and enforcement ability.

Learning Objective

Examine the use of protectionism as a way of addressing unfair competitive practices

Key Points

• Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value.
• A recent topic is anti-dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices.
• Another critical risk in the global market is intellectual property (IP) protection as patents are often ignored globally, particularly by countries which lack the infrastructure to enforce IP laws.
• Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic anti-trust laws.

Key Terms

Subsidies

Financial support or assistance, such as a grant.

Reverse engineering

The process of analyzing the construction and operation of a product in order to manufacture a similar one.

Dumping

Selling goods at less than their normal price, especially in the export market as a means of securing a monopoly.

Protectionist policies are a highly charged topic in economic debates, as economies work to attain the optimal balance of free trade and trade protectionism to capture the most value. In many ways, the global markets are torn between pursuing what is best on the global level and what is best at the domestic level, and there is sometimes dissonance between the two. One of the strongest arguments for some degree of trade protectionism is the tendency for unfair competition to emerge, particularly in developing markets without the infrastructure to monitor their businesses and enforce penalties. This is called the unfair competition argument.

Dumping

A popular recent topic is anti-dumping policies directed at international players looking to undercut domestic business through selling at dramatically reduced prices. This can be a substantial threat, particularly from economies where labor laws are lax and workers are exploited to create extremely low cost goods. This is also a risk when governments get too involved in business, a criticism often pointed out in China. Governments can provide subsidies to reduce costs for domestic companies. This can also be a threat in infant industries, where larger and more established players can push out smaller players via undercutting prices, absorbing losses until the competition goes bankrupt.

Offsetting this threat has been an ongoing struggle, with the emergence of international trade agreements and organizations like the World Trade Organization (WTO) playing an increasingly large role. One of the struggles with international trade is the difficulty of enforcement between nations, and the WTO plays a critical role in identifying malpractice and addressing it.

Intellectual Property

Another critical risk in the global market is intellectual property (IP) protection. Patents, in a domestic system, protect the innovator to allow them to generate returns on the substantial time investment required to invent or innovate new products or technologies. On a global scale, however, it is quite common for developing nations to copy new technologies via reverse engineering. This results in copycats violating the patents in an environment where the infrastructure domestically will probably not take legal action. This reduces the desire for innovation and places large economic risks on countries dependent upon this for growth.

This is addressed through international patent laws and trade agreements as well, alongside political pressures such as raising tariffs and placing import quotas on countries suspected to be in violation of patents. The downside to this is that utilizing these measures creates political unrest, global factions, and strained business relationships.

Mergers, Acquisitions, and Market Dominance

Another unfair competition threat is the emergence of global monopolies. Some of the larger ones attain enough global power and geographic diversification to be difficult to break up via domestic antitrust laws. demonstrates the substantial threat of deadweight losses being incurred in economies where consolidation results in a lack of competitive forces to drive down price.

Economic Losses in a Monopoly

This chart highlights the very real risk of lost economic value in a monopolistic situation (deadweight loss in yellow).

On the domestic level monopolies are widely seen as being addressed (though this is hotly debated by many economists in light of the ‘too big to fail’ and ‘too big to jail’ banks). On a global scale it is even more difficult to regulate, as the size and scale of these companies often extends beyond the power of the governments where these companies are located. This is addressed through international standards and trade agreements, standardizing governmental policy on a global level to reduce the risk of monopoly and unfair consolidation towards market dominance.

31.5.4: Jobs Argument

Many policy makers who are proponents of trade protectionism argue that limiting imports will create or save more jobs at home.

Learning Objective

Analyze the use of trade restrictions for strategic purposes

Key Points

• This argument is predicated on the simply fact that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market.
• Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity domestically, thus creating jobs.
• A sentiment towards protectionism has developed in the U.S. due to the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) is required to sustain the ongoing consumption of imports.
• Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations (outsourcing), motivating governments to bring these jobs back home.
• Local governments leverage subsidies, tariffs, import quotas, and anti-dumping policies to maximize strategic capacity domestically, thus creating jobs.

Key Terms

Import Quota

A restriction on the import of something to a specific quantity.

Trade Balance

The difference between the monetary value of exports and imports in an economy over a certain period of time.

Many policy makers who are proponents of trade protectionism make the argument that limiting imports will create more jobs at home. This argument is predicated on the idea that buying more domestically will drive up national production, and that this increased production will in turn result in a healthier domestic job market. Domestic industries will not have to compete with foreign producers, and are therefore protected from losing marketshare to cheaper imports.

Trade Balance

It is useful to consider the concept of a trade balance, or net exports, in the context of the jobs argument. It is interesting to look at to assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations’. The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavy on one side of the spectrum.

Trade Balances on a Global Scale

It is interesting to look at this graph and assess the extremity to which some nations are ‘consumer nations’ and others are ‘producer nations. ‘ The U.S. and China are a great example of opposite sides of the spectrum, where the trade balance is heavily on one side of the spectrum.

In the U.S. this has created a dramatic push for trade protectionism policies; something the United States has not actively pursued in quite some time. The disastrous 2008 economic collapse via the clear-cut abuses by the banks, and the resulting drop in employment rates, has created an incredibly tangible social and political agenda to bring production back to domestic jobs from overseas. This sentiment towards protectionism is a direct result of the jobs argument in view of an imbalanced trade ratio, where more exports (production and jobs at home) are required to sustain the ongoing consumption of imports.

Outsourcing

Along similar lines, it is common practice for companies to identify strategic alliances abroad and send much of the production work to these locations. This is often a result of cheaper labor and easier systems of governance in those regions. The obvious perspective, from a policy making context, is that these are jobs lost to overseas competitors. While this perspective is often criticized for being short-sighted and against the modern economic view of free markets, it has resulted in policy makers providing incentives to ‘bring jobs back home. ‘

This idea of limiting outsourcing in light of the protectionist jobs argument has resulted in governmental subsidies that work to offset the costs of manufacturing domestically (in the U.S. particularly). These subsidies are essentially grants or tax breaks for companies operating domestically and creating jobs, driving up employment rates via protectionist strategies.

Trade Restriction Strategies

Offsetting the threats of outsourcing and trade imbalances and driving domestic purchasing, and thus domestic production, is done through a variety of political vehicles. Most notable among them are:

• Import Quotas: This is the act of limiting the number of a certain good that can be purchasing from a given country, ensuring that domestic producers maintain a portion of the market share.
• Tariffs: Tariffs are fairly straight-forward, essentially taxes to bring goods into a given country. High tariffs will raise the cost for foreign producers to sell their goods in a domestic system, providing strategic advantages for local producers. One of the pitfalls of tariffs is the likelihood of retaliation, where the foreign government returns with similar tariffs. This will in turn damage global prospects for domestic suppliers.
• Anti-dumping:Anti-dumping legislation actively offsets the ability of low cost or highly subsidized producers in foreign countries to undercut prices in a domestic system. Dumping is the process of selling goods far below market value to drive out competition, often in pursuit of creating a monopoly.
• Subsidies: On the other end of the spectrum, and as noted above, governments can provide subsidies to domestic producers to lower their costs and drive up competitive ability. This can in turn create jobs.

31.5.5: A Summary of International Trade Agreements

International trade agreements are agreements across national borders that reduce or eliminate trade barriers to promote economic exchange.

Learning Objective

Identify at least three main international trade agreements

Key Points

• International trade encounters a variety of obstacles which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions.
• The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices.
• NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs).
• The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE).

Key Terms

Foreign direct investment

Investment into production or business in a country by an individual or company of another country.

tariff

A system of government-imposed duties levied on imported or exported goods; a list of such duties, or the duties themselves.

International trade agreements are trade agreements across national borders intended to reduce or eliminate trade barriers to promote economic exchange. International trade encounters a variety of obstacles, some of which pertain to the protectionism identified in other atoms, which reduce trade incentives. This is usually through tariffs, quotas, taxes, and other trade restrictions. It is also useful to create standards and norms across different countries, particularly for things like intellectual property law recognition, which enables businesses to operate across borders.

There are quite a few international trade agreements, some of which are more formal than others. The trade agreements below provide a fairly comprehensive overview of the current international trade environment:

World Trade Organization (WTO)

The WTO is the largest international trade organization, replacing the General Agreement on Tariffs and Trade (GATT) in 1995, designed to enable international trade while reducing unfair practices. In many ways, the WTO is more complex than other international trade agreements because it incorporates a variety of smaller agreements into a larger framework. The WTO includes upwards of 60 different agreements alongside 159 official members and 25 observers. underlines how effective and universal international trade agreements are becoming. The WTO performs several objective functions as well if trade disputes arise, acting as a framework for assessing appropriate international trade practices.

WTO Members

The World Trade Organization (WTO) is an organization designed to oversee and enable international trade. This map shows how successful this has been on a global scale.

The core of the WTO is the most-favored nation (MFN) rule, which states that each WTO member must be charged the lowest tariffs that an importer places on any country. For example, if the US charges Brazil a 5% tariff on imported clothes, and this is the lowest tariff it has placed on any country in the WTO, all other WTO members must also be charged a 5% tariff. Every WTO member gets charged the lowest tariff that an importer charges any other member.

North American Free Trade Agreement (NAFTA)

Unlike the WTO, which is an entirely global approach, most international agreements stem from geographic proximity. NAFTA is a trilateral agreement between the United States, Canada and Mexico designed to minimize any trade or investment barriers between any of these countries (primarily in the form of tariffs). Generally speaking, the United States demonstrates a trade deficit with these countries relative to goods and a surplus relative to services. The United States also demonstrates high and fast-growing foreign direct investment (FDI) in both regions.

NAFTA Participants

This map outlines each of the countries involved in the North American Free Trade Agreement, an international trade agreement focused on a geographic proximity.

There has been a great deal of controversy surrounding this trade agreement. Agriculture is not included in this agreement, and is often a tough point of discussion for the WTO as well. Mexico is also a point tension due to the fact that it is developing economically (compared to the U.S. and Canada who are considered already developed). Finally, Canadians have often objected to the NAFTA agreements due to the way in which the United States FDI employs hostile takeovers. These agreements demonstrate some of the validity behind trade protectionism and isolationism (as discussed in other atoms in this chapter).

Asia-Pacific Economic Cooperation (APEC)

The APEC forum is particularly interesting in the context of the above agreements, as it is slightly less formal than the above two (it is referred to as a ‘forum’). The APEC forum is a cooperative discussion between 21 countries in the Pacific Rim region promoting free trade, with a focus on newly industrialized economies (NIE). Developing nations gaining access to capital investment and export agreements is the central outcome of APEC, driving economic growth through controlled global expansion. This region represents over half of the world’s GDP and 40% of the overall world population, making this a critical region of the world economy.

APEC Participants

The Asia-Pacific Economic Cooperation (APEC) is a forum of 21 countries in the Pacific Rim region, focusing on free trade and economic cooperation.

30.1: Questions for Debate

30.1.1: Arguments For and Against Discretionary Monetary Policy

Learning Objective

Contrast discretionary and rules-based monetary policy.

Key Points

• A discretionary policy allows policymakers to respond quickly to events.
• A rule-based policy can be more credible because it is more transparent and easier to anticipate, unlike discretionary policy.
• A strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances, creating a need for a compromise between discretionary and rules-based policy.

Key Term

discretionary policy

Actions taken in response to changes in the economy. These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner.

Discretionary policies refer to actions taken in response to changes in the economy, but they do not follow a strict set of rules; instead, they use subjective judgment to treat each situation in a unique manner. For much of the 20th century, governments adopted discretionary policies to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output, and unemployment. However, following the stagflation of the 1970s, policymakers were attracted to policy rules.

Discretionary Policy

A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under control, but then relax its stance later. This could make the policy noncredible and ultimately ineffective.

Rules-based Policy

A rule-based policy can be more credible, because it is more transparent and easier to anticipate, unlike discretionary policy. Policy is implemented based on indicator events in the economy and the policy is expected and carried out in a timely manner. Further, as commented by Milton Friedman who argued in favor of a rules-based approach, the dynamics of discretionary policy present a lag between observation and implementation. This can create compounding issues related to the discretionary policy enacted. However, a strict rules-based approach does not allow for flexibility and as a result may limit choices or be inapplicable in certain circumstances.

Milton Friedman

Milton Friedman was a Nobel Prize (1976) recipient in the field of Economics and was a supporter of rules-based monetary policy.

Compromise

A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For instance, the Federal Reserve Bank, European Central Bank, Bank of England, and Reserve Bank of Australia all set interest rates without government interference, but do not adopt a strict rules-based policy stance. In this case the central banking authorities have autonomy and are able to use monetary policy to enable their mandate of economic growth and full employment. The policies they enact cannot be destabilized by government fiscal policy.

30.1.2: Arguments For and Against Fighting Recession with Expansionary Monetary Policy

Learning Objective

Assess the value of discretionary expansionary monetary policy and the associated shortcomings.

Key Points

• The success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general.
• Without central bank credibility with respect to low interest rate targets, economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.
• Announcements can be made credible in various ways. One method would be to establish an independent central bank with low inflation targets (but no output targets).

Key Terms

discretionary

Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or judgment.

expansionary monetary policy

Traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

Expansionary monetary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into investing, leading to overall economic growth. Monetary policy, to a great extent, is the management of expectations between interest rates, the price of the use of money, and the total supply of money. Monetary policy uses a variety of discretionary tools to control one or both of these to influence outcomes like economic growth, inflation, exchange rates with other currencies, and unemployment. When the central bank is in complete control of the money supply, the monetary authority has the ability to alter the money supply and influence the interest rate to achieve policy goals .

Money supply

The increase in the money supply is the primary conduit for expansionary monetary policy.

However, the success of monetary policy intervention rests on the credibility of the central bank on one hand and the understanding of central bank operations related to interest rates and money supply effects on the part of the public, in general. For example, if the central bank is implementing expansionary policy but is committed to keeping interest rates low, the central bank needs to convey this policy with credibility, otherwise economic agents may assume that expansionary policy will lead to inflation and begin augmenting behavior to initiate the outcome expected, higher inflation.

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body.

30.1.3: Arguments For and Against Fighting Recession with Expansionary Fiscal Policy

Learning Objective

Evaluate the pros and cons of fiscal policy intervention during recession

Key Points

• Government can enact changes in fiscal policy by changing taxes and government spending levels in various sectors.
• Fiscal stimulus through the debt creation channel, may result in reducing the availability of loanable funds, increasing interest rate which may in turn cause a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus.
• Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP.

Key Terms

crowding out

A drop in private investment caused by increase in government investment.

fiscal stimulus

Involves government spending exceeding tax revenue, and is usually undertaken during recessions.

Fiscal policy is a broad term, describing the policies enacted around government revenue and expenditure in order to influence the economy. Governments can increase their revenue by increasing taxes, or increase their expenditure by spending money on programs.

Expansionary fiscal policies are usually implemented during recessions because they attempt to increase economic demand, and as a result, increase economic output which is reduced during a recession. Expansionary fiscal policies involve reducing taxes or increasing government expenditure.

Remember that government revenue is based on collected taxes. When taxes exceed government spending, the government is characterized as having a surplus. When taxes equal government expenditures, the government has a balanced budget. When the government spends more than the revenue it collects, it has a deficit. Increasing government spending, creating a budget deficit, and financing the shortfall through debt issuance are typical policy actions in an expansionary fiscal policy scenario.

Due to the funding process of expansionary policy, there is a lack of consensus among economists with respect to the merits of fiscal stimulus. The discord mostly centers on crowding out, defined as government borrowing leading to higher interest rates that in turn may offset the stimulative impact of government spending. When the government runs a budget deficit, funds will need to come from public or foreign borrowing. As a result, the government issues bonds. This raises interest rates across the economy because government borrowing increases demand for credit in the financial markets. This may in turn reduce aggregate demand for goods and services, which defeats the purpose of a fiscal stimulus.

Fiscal stimulus is implemented with the view that tax relief through a reduction in tax rate and or direct government spending through investment (infrastructure, repair, construction) will provide stimulus to increase economic growth by directly influencing consumption or the government expenditure component of GDP .

Fiscal policy: Taxes

Taxes have not only been a way to initiate fiscal policy intervention, but have also been used to solidify popular approval. In the picture above former President George W. Bush is signing into effect the Tax Relief Reconciliation Act of 2001.

30.1.4: Arguments For and Against Inflation Targeting Policy Interventions

Learning Objective

Argue that central banks should maintain inflation targets, Argue that central banks should not maintain inflation targets

Key Points

• Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target.
• Inflation targeting has often been successful in keeping inflation levels low and avoiding many of its negative effects.
• Inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation.
• On the other hand, if the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions.
• Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target.

Key Terms

inflation

An increase in the general level of prices or in the cost of living.

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

Inflation targeting is an economic policy in which a central bank publicly determines a target inflation rate and then attempts to steer actual inflation towards the target. For example, in the United States, the Federal Reserve implicitly maintains a target inflation range of 1.7%-2.0%. When inflation falls below this range, the Fed would lower interest rates and raising the money supply in order to push inflation up. Likewise, when inflation rises above the target range, the Fed would raise interest rates and decrease the money supply in order to suppress the high level of inflation . While the inflation rate and the interest rate generally have an inverse relationship, these tools are not always successful in affecting inflation – for example, in response to the 2008 financial crisis and ensuing recession, the Fed raised its target inflation level to 2% and lowered interest rates to nearly zero. This did not, however, succeed in raising inflation to 2%.

Inflation Targeting

The relationship between the money supply and the inflation rate is not exact, but it suggests that a central bank can often affect inflation by adjusting the money supply through higher or lower interest rates.

Argument in Favor of Inflation Targeting

Proponents of inflation targeting argue that a volatile inflation rate has negative effects for an economy. High levels of inflation eat away at savings, increase menu costs and shoe-leather costs, discourage lending, and may create an inflationary spiral that leads to hyperinflation. Inflation targeting has been successful in keeping inflation levels low and avoiding many of these negative effects.

Further, inflation targeting is a transparent way to explain interest rate policy and to anchor consumers’ expectations about future inflation. When the central bank announces an inflation target of 2%, the public knows that if inflation goes too far above or below that level, the central bank will take action. This certainty stimulates economic activity. Further, the public’s expectations about inflation tend to be a self-fulfilling prophecy. When consumers expect high inflation they spend their money immediately, attempting to avoid higher future prices. This increase in demand leads to higher prices, causing more inflation. Likewise, when consumers expect deflation they tend to save their money, delaying consumption until prices fall. This decrease in demand causes producers to sell their goods at lower prices, and the cycle continues. Inflation targeting sets consumers’ expectations, making a certain inflation level easier to maintain.

Arguments Against Inflation Targeting

On the other hand, some argue that the costs of inflation targeting exceed the benefits. If the rule is implemented very strictly, an inflation target could severely limit the central bank’s flexibility in responding to changing economic conditions. During a recession, for example, central banks shouldn’t raise the interest rate even if inflation is above the target level. Further, sometimes higher inflation is a good thing because it stimulates spending. A central bank with a strict inflation targeting rule, however, would not allow that higher inflation rate even if it were otherwise beneficial.

Others argue that, since inflation isn’t necessarily coupled to any factor internal to a country’s economy, inflation isn’t the best variable to target. Adherents of market monetarism, for example, argue that targeting a nominal national income (nominal GDP) would be more effective than targeting inflation. Others suggest targeting long-run inflation, which takes the exchange rate into account, rather than the short-term inflation rate.

29.1: Introducing the Financial System

29.1.1: Institutions, Markets, and Intermediaries

Learning Objective

Review the purpose and types of financial intermediaries

Key Points

• Financial intermediaries provide access to capital.
• Banks convert short-term liabilities (demand deposits) into long-term assets by providing loans; thereby transforming maturities.
• Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles.

Key Terms

pooling

grouping together of various resources or assets

financial intermediary

A financial institution that connects surplus and deficit agents.

A financial intermediary is an institution that facilitates the flow of funds between individuals or other economic entities having a surplus of funds (savers) to those running a deficit of funds (borrowers). Banks are a classic example of financial institutions.

Banks provide a safe and accessible environment for individuals and economic entities to deposit excess funds Additionally, banks also provide a service by packaging deposits into loans that are made available to economic agents (individuals and entities) in need of funds.

Banks are the most common financial intermediaries

Banks convert deposits to loans and thereby increase access to capital by serving as a financial intermediary between savers and borrowers.

Though, perhaps the most well-known of financial intermediaries, banks represent only one intermediary within a larger group. Other financial intermediaries include: credit unions, private equity, venture capital funds, leasing companies, insurance and pension funds, and micro-credit providers.

Major functions of financial intermediaries

As noted, financial intermediaries provide access to capital. However, in conjunction with increasing access to funds, through their ability to aggregate funds, intermediaries also reduce the transaction and search costs between lenders and borrowers.

By repurposing funds from savers to borrowers financial intermediaries are able to promote economic growth by providing access to capital. Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles and through creating loans of varying lengths from investor monies or demand deposits, these intermediaries are able to convert short-term liabilities to assets of varying maturities.

Returning to the example of a bank used above, banks convert short-term liabilities (demand deposits) into long-term assets by providing loans; thereby transforming maturities. Additionally, through diversified lending practices, banks are able to lend monies to high-risk entities and by pooling with low-risk loans are able to gain in yield while implementing risk management.

29.1.2: Role in Matching Savings and Investment Spending

Learning Objective

Explain the connection between savers and investors

Key Points

• The marginal propensity to save (MPS), the percentage of after-tax income that an economic agent will choose to save.
• Savings marketed by financial intermediaries, all consist of stocks, bonds, and cash balances, which in turn pay for the investment capital that increases productivity, efficiency and output of goods and services.
• Financial intermediaries are a significant component to the transformation of savings into investment.

Key Term

real interest rates

The rate of interest an investor expects to receive after allowing for inflation.

A popular national income accounting framework for discussing the economy is the GDP expenditure equation:

Y = C + I + G + (X – M), where C refers to consumption spending, I references investment spending, G is government spending, and X – M is net imports (X, exports; M, imports). Savings is defined as income that is not consumed. C, is consumption. Investment, I, is made into capital (plant and machinery, also ‘human capital’ – training and education), with intent to increase productivity, efficiency and output of goods and services. I can be generally defined as purchases of good that will be used to produce more goods and services in the future. In national accounting terms, stocks, bonds, mutual funds, and other cash equivalents, are not classified as investments but rather are classified as savings. Savings from this perspective facilitates capital purchase which are included in investments

Saving is what households (participants in the consumption account) do. The level of saving in the economy depends on a number of factors:

• A higher real interest rates increases returns to saving.
• Poor expectations for future economic growth, increase households’ savings as a precaution.
• More disposable income after fixed expenditures (such as mortgage, heating bill, basic goods purchases) have been made increases saving.
• Perceived likelihood of reduced return through regulation or taxation on savings will make saving less attractive.

Marginal propensity to save

The factors as stated affect the marginal propensity to save (MPS), the percentage of after-tax income that an economic agent will choose to save. The greater the MPS, the more saving households will do as a proportion of each additional increment of income. Stocks and bonds are considered to be important intermediary forms of savings as these get transformed into a capital investment that produces value .

Bonds are a type of savings

Savings are used to fund investments, where investments are defined as expenditures on factory plants, equipment and homes.

Savings and Investment

Assuming a closed economy, one where there is no export or impart activity to interfere with the domestic savings level, on an aggregate basis individual savings creates the supply of loanable funds available for investment purposes. The amount of savings available in the economy is equal to the amount of funding available for investment activity. The higher the level of savings, typically the lower the relative interest rate, ceteris paribus. On a macroeconomic theory basis, a higher the savings rate promotes business activity my lessening the cost of money and increasing risk taking activities to facilitate growth or production of goods and services.

Financial intermediaries can assist with increasing the incentive to save through developing financial products that offer ease of liquidation but provide a higher return than a savings account. In this manner, financial intermediaries are a significant component to the transformation of savings into investment. Mutual funds, pension obligations, insurance annuities, and other forms of savings marketed by financial intermediaries all consist of stocks, bonds, and cash balances, which in turn pay for the investment capital that increases productivity, efficiency and output of goods and services.

29.1.3: Role in Providing a Market for Loanable Funds

Learning Objective

Summarize the mechanics of the loanable funds market.

Key Points

• In the loanable funds market, market clearing is defined as the interest rate/loanable funds quantity where savings equal investment (the amount of capital needed for property, plant, and equipment based investments).
• The interest rate is the cost of borrowing or demanding loanable funds and is the amount of money paid for the use of a dollar for a year.
• Loanable funds are often used to invest in new capital goods. Therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds.

Key Term

loanable funds

Money available to be issued as debt.

In economics, the loanable funds market is a conceptual market where savers (suppliers) and borrowers (demanders) are able to establish a market clearing quantity and price (interest rate). In the loanable funds market, market clearing is defined as the interest rate/loanable funds quantity where savings equal investment (the amount of capital needed for property, plant, and equipment based investments) . Loanable funds are typically cash, but can also include other financial assets to serve as an intermediary.

Equilibrium in the loanable funds market

When the supply and demand for loanable funds are equal, savings is equal to investment and the loanable funds market is in equilibrium at the prevailing interest rate.

For instance, buying bonds will transfer savers’ money to the institution issuing the bond, which can be a firm or government. In return, the borrower’s (institution issuing the bond) demand for loanable funds is satisfied when the institution receives cash in exchange for the bond.

Loanable funds are often used to invest in new capital goods. Therefore, the demand and supply of capital is usually discussed in terms of the demand and supply of loanable funds.

Interest rate

The interest rate is the cost of borrowing or demanding loanable funds and is the amount of money paid for the use of a dollar for a year. The interest rate can also describe the rate of return from supplying or lending loanable funds.

As an example, consider this: a firm that borrows $10,000 in funds for one year, at an annual interest rate of 10%, will have to pay the lender $11,000 at the end of the year. This amount includes the original $10,000 borrowed plus $1,000 in interest; in mathematical terms, this can be written as $10,000 × 1.10 = $11,000.

29.2: Tools of Finance

29.2.1: Present Value and the Time Value of Money

The time value of money is the principle that a certain amount of money today has a different buying power (value) than in the future.

Learning Objective

Calculate the present and future value of money

Key Points

• Time value of money: (1 + r)^t x (the value of the initial investment) = future value; where r is the annual interest rate and t is the number of years.
• The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.
• The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future.

Key Terms

time value of money

The principle that a certain currency amount of money today has a different buying power (value) than the same currency amount of money in the future.

present value

The value of an asset in today’s dollars after adjusting for an increase in the asset values as a result of interest earned during the period.

The time value of money is the principle that a certain amount of money today has a different buying power (value) than the same currency amount of money in the future. The value of money at a future point of time would take account of interest earned or inflation accrued over a given period of time. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up, thus changing the “value” of the money.

For example, assume that an investor has $100 today and can invest this money at a 5% return for one year. A year from now the original investment will equal $105, (100)*(1.05). The return of $5 represents the time value of money over the one year interval .

Money

Assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate.

Time value of money: (1 + r)^t x (the value of the initial investment) = future value; where r is the annual interest rate and t is the number of years.

Alternatively, if an investment is valued at $125 and this value includes the 7% return generated over a one year time horizon, the original value of the investment or its present value is equal to (125)/(1.07) or 117.

Present value: (the value of the investment at a future time)/(1 + r)ⁿ; where r is the annual interest rate and n is the number of years the investment has occurred.

The time value of money is the central concept in finance theory. However, the explanation of the concept typically looks at the impact of interest and assumes, for simplicity, that inflation is neutral.

29.2.2: Measuring and Managing Risk

Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.

Learning Objective

Explain the relationship between time, money, and risk

Key Points

• Investment returns compensate holders for the time to maturity via a risk premium.
• Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment.
• To compensate investors for taking on reinvestment risk, issuers will provide a risk premium to incentivize the investor to purchase the investment.

Key Terms

time horizon

A fixed point of time in the future where certain processes will be evaluated or assumed to end.

risk premium

The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

Assets can have varying maturity dates and potential for default, the attribution of time to maturity and timely payments involve an assessment of risk. Risk is pervasive in the economy and is an essential component in the derivation of an asset’s investment return.

Time and Risk

Time is a component of risk for varying reasons; however, the two most common are related to the increase in general uncertainty rising with the time horizon and reinvestment risk.

In our everyday lives, we are faced with momentary uncertainties that become increasingly harder to predict as we move from a five minute horizon to a five day, five month, or even five year period. This same phenomenon is true of financial assets. Though the attribution of acceptable inflation can be incorporated into an investment return, the actual pricing and resulting purchasing power of the investment at maturity is unknown and the uncertainty increases with time. Therefore, investment returns compensate holders for the time to maturity via a risk premium .

Return expectations are based on risk analysis

In finance and economics, as depicted in the graph above of the capital asset pricing model, risk is evaluated to set the boundary for acceptable return.

Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment. For example, if asset A and asset B both pay a 5% coupon on an annual basis, but asset B matures in 5 years and asset A matures in 1 year, all else equal (asset quality and issuer solvency), we would expect asset A to trade at a higher price than asset B. Remembering that yield and price are inversely related, the higher price on A implies that it has a lower yield than B. The differential in yield can be attributed to a risk premium for time to maturity.

Another aspect of time horizon is reinvestment risk. For some investments, there is a potential for an issuer to call or redeem a security prior to maturity. Given that at the time that the investment is called prevailing rates may be lower than at the purchase of the asset, the holder is taking a reinvestment risk at the time of purchase. To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.

29.2.3: The Value of Diversification

The compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.

Learning Objective

Explain the rationale for diversification

Key Points

• Diversification strategies can be as simple as not “placing all your eggs in one basket” or be as complex as routine evaluation of investment correlation and risk and dynamic rebalancing of investment holdings.
• Whether a common sense or highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return. A diversified portfolio will earn a return that is always higher than its lowest performing asset.
• Most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class.
• Investors may enter into hedging strategies in order to ensure a constant return over market volatility. For a fee, a hedging strategy offers a constant return on an investment. The party on the other side of the hedge absorbs the volatility of the investment and pays out a consistent return.

Key Terms

asset clas

A group of economic resources sharing similar characteristics, such as riskiness and return.

risk premium

The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

prospectus

A document, distributed to prospective members, investors, buyers, or participants, which describes an institution (such as a university), a publication, or a business and what it has to offer.

Each asset class has specific investment objectives; these are typically stated in a prospectus or investment description. However, all investments have some degree of risk in meeting the stated investment objectives or return.

The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset. However, the compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.

The Value of Diversification

Diversification strategies can be as simple as not “placing all your eggs in one basket. ” It can also be as complex as a routine evaluation of investment correlation and risk, and dynamic rebalancing of investment holdings. However, whether a common sense or a highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return.

By holding varying investments, even if they are within the same company or sector, an investor still has the benefit of reducing risk inherent from the default of one asset. For example, stock and bonds provide different returns; while a stock may exhibit no growth for a period of time, the bond may continue to pay its coupon and provide a return. Through diversification, an investor’s entire portfolio can perform better than its worst-performing asset.

In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class . In some cases where the return on investment needs to be met, managers may advocate for the use of hedging instruments to transfer risk of return objectives being met to another party in lieu of a consistent return.

Hedging strategies can be relatively complex but, in general, they serve the role of insuring that an investor is able to meet investment performance objectives. Typically, an investor pays a fee and enters into the hedging strategy, which transfer the risk inherent in an investment for a constant return. The party on the opposite side of the hedge absorbs both the upside and downside return potential of the asset, along with the fee for taking on the risk of uncertainty, and pays the first party a constant return as part of the agreement.

Systematic Risk

It’s important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market. For example, government policy, international economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how diversified it is.

29.2.4: The Relationship Between Risk and Return and the Security Market Line

The security market line is useful to determine if an asset being considered for a portfolio offers a reasonable expected return for risk.

Learning Objective

Explain how the security market line relates risk and return

Key Points

• In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk.
• The security market line essentially graphs the results from the capital asset pricing model formula. The intercept of the SML is the nominal risk-free rate available for the market, while the slope is the market premium.
• If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Key Terms

systematic risk

The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta.

non-systematic risk

Risk that is unique to a specific company; can be reduced through diversification.

capital asset pricing model

Used to determine the required rate of return of an asset taking into account an asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk).

security market line

A line representing the relationship between expected return and systematic risk; thus a graphical representation of the capital asset pricing model.

Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk. Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market. Non-systematic risk is unique to a specific company and can be reduced through diversification.

Capital Asset Pricing Model (CAPM)

In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset’s sensitivity to non-diversifiable or systematic risk. Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset’s price sensitivity is greater than the market; equal to one when the asset’s sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.

The CAPM is a model for pricing an individual security or portfolio. The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset’s overall sensitivity to market fluctuations or its beta. Mathematically, the capital asset pricing model can be written as: E(R_i) = R_f + β(E(R_m) – R_f), where R is the return, E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.

Security Market Line (SML)

For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class . The SML essentially graphs the results from the capital asset pricing model formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between β and required return is plotted on the SML, which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(R_m)− R_f.

Security market line

The security market line depicts the the return on a security relative to its own risk.

The SML is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security’s expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued since the investor would be accepting a smaller return for the amount of risk assumed.

28.1: Introduction to Monetary Policy

28.1.1: The Demand for Money

Learning Objective

Relate the level of the interest rate to the demand for money

Key Points

• Money provides liquidity which creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.
• The quantity of money demanded varies inversely with the interest rate.
• While the demand of money involves the desired holding of financial assets, the money supply is the total amount of monetary assets available in an economy at a specific time.
• In the United States, the Federal Reserve System controls the money supply. The Fed has the ability to increase the money supply by decreasing the reserve requirement.

Key Terms

money supply

The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.

asset

Something or someone of any value; any portion of one’s property or effects so considered.

The Demand for Money

In economics, the demand for money is generally equated with cash or bank demand deposits. Generally, the nominal demand for money increases with the level of nominal output and decreases with the nominal interest rate.

The equation for the demand for money is: M_d = P * L(R,Y). This is the equivalent of stating that the nominal amount of money demanded (M_d) equals the price level (P) times the liquidity preference function L(R,Y)–the amount of money held in easily convertible sources (cash, bank demand deposits). Specific to the liquidity function, L(R,Y), R is the nominal interest rate and Y is the real output.

Money is necessary in order to carry out transactions. However inherent to the holding of money is the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.

When the demand for money is stable, monetary policy can help to stabilize an economy. However, when the demand for money is not stable, real and nominal interest rates will change and there will be economic fluctuations.

Impact of the Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). It is viewed as a “cost” of borrowing money. Interest-rate targets are a tool of monetary policy. The quantity of money demanded varies inversely with the interest rate. Central banks in countries tend to reduce the interest rate when they want to increase investment and consumption in the economy. However, low interest rates can create an economic bubble where large amounts of investments are made, but result in large unpaid debts and economic crisis. The interest rate is adjusted to keep inflation, the demand for money, and the health of the economy in a certain range. Capping or adjusting the interest rate parallel with economic growth protects the momentum of the economy.

Control of the Money Supply

While the demand of money involves the desired holding of financial assets, the money supply is the total amount of monetary assets available in an economy at a specific time. Data regarding money supply is recorded and published because it affects the price level, inflation, the exchange rate, and the business cycle.

Monetary policy also impacts the money supply. Expansionary policy increases the total supply of money in the economy more rapidly than usual and contractionary policy expands the supply of money more slowly than normal. Expansionary policy is used to combat unemployment, while contractionary is used to slow inflation.

In the United States, the Federal Reserve System controls the money supply. The reserves of money are kept in Federal Reserve accounts and U.S. banks. Reserves come from any source including the federal funds market, deposits by the public, and borrowing from the Fed itself. The Fed can attempt to change the money supply by affecting the reserve requirement and through other monetary policy tools .

Federal Funds Rate

This graph shows the fluctuations in the federal funds rate from 1954-2009. The Federal Reserve implements monetary policy through the federal funds rate.

28.1.2: Shifts in the Money Demand Curve

Learning Objective

Explain factors that cause shifts in the money demand curve, Explain the implications of shifts in the money demand curve

Key Points

• The real demand for money is defined as the nominal amount of money demanded divided by the price level.
• The nominal demand for money generally increases with the level of nominal output (the price level multiplied by real output).
• The demand for money shifts out when the nominal level of output increases.
• The demand for money is a result of the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets.

Key Terms

asset

Something or someone of any value; any portion of one’s property or effects so considered.

nominal interest rate

The rate of interest before adjustment for inflation.

Demand for Money

In economics, the demand for money is the desired holding of financial assets in the form of money. The nominal demand for money generally increases with the level of nominal output (the price level multiplied by real output). The interest rate is the price of money. The quantity of money demanded increases and decreases with the fluctuation of the interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. A demand curve is used to graph and analyze the demand for money.

Factors that Cause Demand to Shift

A demand curve has the price on the vertical axis (y) and the quantity on the horizontal axis (x). The shift of the money demand curve occurs when there is a change in any non-price determinant of demand, resulting in a new demand curve. Non-price determinants are changes cause demand to change even if prices remain the same. Factors that influence prices include:

• Changes in disposable income
• Changes in tastes and preferences
• Changes in expectations
• Changes in price of related goods
• Population size

Factors that change the demand include:

• Decrease in the price of a substitute
• Increase in the price of a complement
• Decrease in consumer income if the good is a normal good
• Increase in consumer income if the good is an inferior good

The demand for money shifts out when the nominal level of output increases. It shifts in with the nominal interest rate.

Shift of the Demand Curve

The graph shows both the supply and demand curve, with quantity of money on the x-axis (Q) and the price of money as interest rates on the y-axis (P). When the quantity of money demanded increase, the price of money (interest rates) also increases, and causes the demand curve to increase and shift to the right. A decrease in demand would shift the curve to the left.

Implications of Demand Curve Shift

The demand for money is a result of the trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money determines how a person’s wealth should be held. When the demand curve shifts to the right and increases, the demand for money increases and individuals are more likely to hold on to money. The level of nominal output has increased and there is a liquidity advantage in holding on to money. Likewise, when the demand curve shifts to the left, it shows a decrease in the demand for money. The nominal interest rate declines and there is a greater interest advantage in holding other assets instead of money.

28.1.3: The Equilibrium Interest Rate

Learning Objective

Use the concept of market equilibrium to explain changes in the interest rate and money supply

Key Points

• The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor).
• Factors that contribute to the interest rate include: political gains, consumption, inflation expectations, investments and risks, liquidity, and taxes.
• In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced.
• The real interest rate measures the purchasing power of interest receipts. It is calculated by adjusting the nominal rate charge to take inflation into account.

Key Terms

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money that they borrow from a lender (creditor). Equilibrium is reached when the supply of money is equal to the demand for money. Interest rates can be affected by monetary and fiscal policy, but also by changes in the broader economy and the money supply.

Factors that Influence the Interest Rate

Interest rates fluctuate over time in the short-run and long-run . Within an economy, there are numerous factors that contribute to the level of the interest rate:

Fluctuation in Interest Rates

This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. Interest rates fluctuate over time as the result of numerous factors. In Germany, the interest rates dropped from 14% in 1967 to almost 2% in 2003. This graph illustrates the fluctuations that can occur in the short-run and long-run. Interest rates fluctuate based on certain economic factors.

• Political gain: both monetary and fiscal policies can affect the money supply and demand for money.
• Consumption: the level of consumption (and changes in that level) affect the demand for money.
• Inflation expectations: inflation expectations affect a the willingness of lenders and borrowers to transact at a given interest rate. Changes in expectations will therefore affect the equilibrium interest rate.
• Taxes: changes in the tax code affect the willingness of actors to invest or consume, which can therefore change the demand for money.

Market Equilibrium

In economics, equilibrium is a state where economic forces such as supply and demand are balanced and without external influences, the equilibrium will stay the same. Market equilibrium refers to a condition where a market price is established through competition where the amount of goods and services sought by buyers is equal to the amount of goods and services produced by the sellers. In the case of money supply, the market equilibrium exists where the interest rate and the money supply are balanced. The money supply is the total amount of monetary assets available in an economy at a specific time. Without external influences, the interest rate and the money supply will stay in balance.

28.2: Monetary Policy Tools

28.2.1: The Reserve Ratio

The reserve ratio is the percentage of deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned.

Learning Objective

Identify the effects of reserve requirements on monetary policy

Key Points

• The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impacts the amount of loanable funds available.
• Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio.
• The higher the reserve requirement is set, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.

Key Terms

loanable funds

Money available to be issued as debt.

money supply

The total amount of money (bills, coins, loans, credit, and other liquid instruments) in a particular economy.

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Banks assume responsibility for consumer deposits and make money by loaning out deposited finds. Therefore, banks with relatively higher deposits are able to supply a larger amount of loanable funds. The supply of loanable funds directly impacts growth and interest rates in an economy. Typically, an increase in the supply of loanable funds is associated with a decrease in interest rates. The greater the accessibility of loanable funds, as conferred by access and cost, the greater opportunity for businesses and consumers to make investment purchases and increase production and labor supply, respectively.

However, in economic downturns the amount of outstanding loans may be counter to a bank’s longevity, as depositors may seek to cash-out holdings. In order to reduce the risk of a panic or “run on bank” from the perception that a bank may not have adequate liquidity to meet depositor access to cash deposits, central banks have adopted policies to ensure that banks use prudent judgement when assessing the amount of deposits to loan.

Reserve Ratio

The reserve ratio is a central bank regulatory tool employed by most, but not all, of the world’s central banks. The ratio is a set percentage of customer deposits that a bank is required to hold in reserves, or funds that are not allowed to be loaned. Required reserves are normally in the form of cash stored physically in a bank vault (vault cash) or deposits made with a central bank. The required reserve ratio is a tool in monetary policy, given that changes in the reserve ratio directly impact the amount of loanable funds available .

Federal Reserve-US Central Bank

The Federal Reserve is charged with maintaining sustainable economic growth. To carry out its responsibilities, the “Fed” uses policies including the reserve ratio to adjust the money supply to either incentivize growth or slow down growth, as needed.

Monetary policy tool

Money growth in the economy can occur through the multiplier effect resulting from the reserve ratio. For example, a reserve ratio of 20% will result in 80% of any given initial deposit being loaned out and if the process of loaning is assumed to continue, the maximum increase in money expansion specific to an initial deposit at a 20% reserve ratio will be equal to the reserve multiplier 1/(reserve ratio) x the initial deposit.

For example, with the reserve ratio (RR) of 20 percent, the money multiplier, m, will be calculated as:

This then signifies that any initial deposit will contribute to an expansion in money supply up to 5 times its original value.

The conventional view in economic theory is that a reserve requirement can act as a tool of monetary policy. The higher the reserve requirement is set, the theory supposes, the less the amount of funds banks will have to loan out, leading to lower money creation. Alternatively, the higher the reserve requirement the, lower the supply of loanable funds, the higher the interest rate and the slower the resulting economic growth.

28.2.2: The Discount Rate

The rate that member banks charge each other is the federal funds rate and the rate the Fed charges is referred to as the discount rate.

Learning Objective

Illustrate the effects of the discount rate on monetary policy

Key Points

• The Fed targets the rate for federal funds via its open market operations.
• The Fed seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate.
• The discount rate difference over the fed funds rate can be varied by the Fed based on bank liquidity needs.

Key Terms

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

discount rate

An interest rate that a central bank charges to depository institutions that borrow reserves from it.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

The central bank of the United States is the Federal Reserve (the Fed). The Fed employs monetary policy through direct controls on the money supply through open market operations to achieve economic stability and growth.

Open market operations entail Fed intervention in the buying and selling of government bonds to achieve a change in the money supply and the corresponding change in the interest rate. The Fed sells bonds to reduce the money supply and increase the prevailing interest rate and buys bonds to increase the money supply and reduce the prevailing interest rate. The interest rate is an active target and is set as a target rate range by the Fed; it is conveyed to the public by the Federal Reserve Open Market Committee (FOMC) as the fed funds target rate (short for the Federal Funds rate).

Coincident with the Fed’s open market operations is the Fed’s selection of a reserve requirement which corresponds to a required percentage of deposits (reserves) that banks must keep on site or at the Fed on a daily basis. Given their daily activities, banks may fall short of their required daily reserve requirement. When this occurs, banks may either turn to the Fed or Fed member banks for overnight or short-term loans to satisfy their liquidity short-fall. The rate that member banks charge each other is referred to as the federal funds rate and the rate the Fed charges banks is referred to as the discount rate.

This distinction is particularly important. The discount rate is the rate that the central bank actual controls. It is the rate the central bank charges its member banks to borrow overnight. However, the rate that the central bank actually cares about is the fed funds rate. That is the rate banks charge each other, and is influenced by the discount rate.

The Fed targets the rate for federal funds via its open market operations and seeks to be the lender of last resort by charging banks a higher rate than the federal funds rate .

Historical discount and fed fund target rates

The discount rate is higher than the fed funds target rate and the variance serves as a disincentive for banks to seek funds or short-term borrowings from the Fed.

For example, the difference or spread of the primary credit rate (rate to member banks in solid financial standing) over the FOMC’s target federal funds rate was initially 1 percent. During the financial crisis, this spread was reduced to one-half of one percent on August 17, 2007, and was further reduced, to a quarter of 1 percent, on March 16, 2008.

Typically, the discount rate along with the fed funds target rate are mechanisms that the Fed uses to discourage banks from excess lending, as part of a contractionary or restrictive policy scheme. Given that lending has an expansionary effect, to the extent that the fed funds target rate and discount rate diminish the profitability of excess loaning, these parameters place limits to the expansion of the money supply via the loanable funds market. However, as noted in the aforementioned historical example, the discount rate, in conjunction with the fed funds target rate, may be purposely maintained at a lower interest level to encourage borrowing and increase growth when the economy is showing signs of either slowing or contracting. In this manner, the discount rate in tandem with the fed funds target rate are part of an expansionary policy mechanism.

28.2.3: The Federal Funds Rate

The Federal Funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve.

Learning Objective

Discuss the importance of the Federal Funds Rate as a monetary policy tool

Key Points

• Banks may borrow reserves from one another overnight in order to maintain their required reserve ratio. The rate of interest negotiated between banks for these loans is the Federal Funds rate.
• The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates. Thus, a high Federal Funds rate is contractionary, while a low federal funds rate is expansionary.
• The Federal Reserve doesn’t control the Federal Funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.
• The Fed doesn’t control the federal funds rate directly, but it does set a target interest rate and uses open market operations in order to achieve that rate.

Key Terms

reserve

Banks’ holdings of deposits in accounts with their central bank.

federal funds rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.

The Federal Funds rate (or fed funds rate) is the interest rate at which depository institutions (primarily banks) actively trade balances held at the Federal Reserve. In the US, banks are obligated to maintain certain levels of reserves, either in the form of reserves with the Fed or as vault cash. Each day, banks receive deposits, which contribute to a bank’s reserves, and issue loans, which are liabilities against the bank. These daily activities change their ratio of reserves to liabilities. If, by the end of the day, the bank’s reserve ratio has dropped below the legally required minimum, it must add to its reserves in order to remain compliant with the law. Banks do this by borrowing reserves from other banks with excess reserves, and the weighted average of these interest rates paid by borrowing banks determines the federal funds rate.

The Federal Funds rate is directly related to the interest rate paid by firms and individuals. If a bank can borrow reserves cheaply, it can afford to offer loans to the public at lower rates and still make a profit. On the other hand, if the Federal Funds rate is high, banks will not borrow reserves in order to issue low-interest loans to the public. In fact, many mortgages and credit card interest rates are indexed to the Federal Funds rate – a homeowner might pay an adjustable interest rate that is set at the level of the Federal Funds rate plus four percent, for example. A high Federal Funds rate, therefore, has a contractionary effect on economic activity, while a low Federal Funds rate has an expansionary effect.

The Fed doesn’t control the Federal Funds rate directly – it is negotiated between borrowing and lending banks – but it does set a target interest rate and uses open market operations in order to achieve that rate. The target Federal Funds rate is decided by the governors at the Federal Open Market Committee (FOMC) meetings, who will either increase, decrease, or leave the target rate unchanged based on the economic conditions within the country . Influencing the Federal Funds rate is the primary monetary policy tool that the Fed uses to achieve its dual mandate of stable prices and low unemployment.

Federal Funds Rate 1954-2009

The graph shows the federal funds rate for the past fifty years. The peak in the 1980s reflects the contractionary monetary policy the Fed instituted to combat high levels of inflation due to oil shocks, and the low rate in the late 2000s reflects expansionary monetary policy meant to combat the effects of recession.

28.2.4: Open Market Operations

Open market operations (OMOs) are the purchase and sale of securities in the open market by a central bank.

Learning Objective

Discuss the use of open market operations to implement monetary policy

Key Points

• In the United States, the Federal Reserve Bank of New York uses open market operations to implement monetary policy.
• This occurs under the oversight of the Federal Reserve Open Market Committee (FOMC).
• The short-term objective for open market operations is specified by the FOMC and is publicly communicated following the FOMC meeting.
• Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.

Key Terms

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds target rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

The Federal Reserve has several tools at its disposal to reach its monetary policy objectives. These include the discount rate, the fed funds target rate, and the reserve requirement, and open market operations (OMOs). OMOs are considered to be the most flexible option for the Federal Reserve out of all of these.

On a general level, OMO are the purchase and sale of securities in the open market by a central bank, as a means of controlling the money supply and the related prevailing interest rate.

US Treasury Bill Yields

By buying and selling US Treasury bills on the open market, the Federal Reserve hopes to change their yields, which will then affect the interest rates in the broader market.

In the United States, the Federal Reserve Bank of New York conducts open market operations. They are under the oversight of the Federal Reserve Open Market Committee (FOMC). The FOMC makes a plan for open market operations over the short term, and publicly announce it after their regularly scheduled meetings. 

Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the federal funds rate–the interest rate at which depository institutions lend reserve balances to other depository institutions overnight–around the target established by the FOMC.

OMO Mechanism

OMOs are typically either expansionary or contractionary in nature. In an expansionary platform, the OMO will seek to increase the money supply and reduce interest rates in order to promote economic growth. In a contractionary scheme, the OMO will seek to reduce the money supply and increase interest rates in an effort to deter economic growth. Therefore, the implementation of contractionary policy will result in the selling of bonds (cash in exchange for debt holding) and an expansionary policy (buy bonds in exchange for cash) will result in an increase in the money supply at a lower interest rate as a means to enhance growth opportunities and revitalize the economy.

The interest rate targeted through the OMO manipulation of the money supply is the fed funds target rate or the rate that member Fed banks charge one another for overnight loans. The target rate is important monetary tool from the perspective that the higher the fed funds rate relative to the return on loanable funds, the greater the incentive for banks to meet their reserve requirement (the bank will lose money) thereby placing limits on the growth of the money supply through the loanable funds market. In addition to this direct interest rate channel, the fed funds rate influences many other interest rates in the economy and by so doing contributed to either incentivizing borrowing for growth or disincentivizing the same.

28.2.5: Setting and Achieving the Interest Rate Target

The Federal Reserve (Fed) has an ability to directly influence economic growth and stability through the use of monetary policy.

Learning Objective

Describe the way in which the Federal Reserve targets the interest rate

Key Points

• Though the Fed can directly influence the money supply through open market operations, the majority of the Fed’s activities seek to target interest rates, the outcome of changes in money supply.
• Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it.
• The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the fed funds rate.

Key Terms

reserve ratio

A central bank regulation employed by most, but not all, of the world’s central banks, that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves (rather than lend out).

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

The Federal Reserve (Fed) has an ability to directly influence economic growth and stability through the use of monetary policy. Though the central bank can directly influence the money supply the majority of its activities center around interest rates, the outcome of changes to the money supply.

Interest Rate Mechanism

The Fed can set a reserve ratio, which is in effect the required reserves (percentage of deposits) that a bank must hold either on site or at the Fed. The requirement must be satisfied on a daily basis. However, given daily bank dynamics of withdrawals, deposits and loan of funds some banks may fall short of their daily reserve requirement. For banks in need of reserve funds, the overnight or short-term bank loan market is available.

Banks can seek to borrow from other banks holding funds at the Fed. The rate that Fed member banks charge one another is referred to as the Federal Funds rate, or Fed Funds rate for short (rate for funds held at the Fed). The rate is indirectly influenced and targeted by the Fed via a direct channel of open market operations and is communicated to the public as a Fed Funds target range as a standard part of the Fed Open Market Committee communications. It is important to note that the Fed does not set the fed funds target rate, it only issues a range that it targets through active management of the money supply.

Using its open market channel, the Fed buys government bonds to increase the money supply and sells the same bonds to reduce it. Adding to the money supply will typically lead to lower interest rates, while reducing the money supply will increase interest rates. The Fed actively adjusts the buying and selling of bonds to achieve the target interest rate. This in turn impacts the rate that Fed member banks are willing to charge each other for overnight loans, or the Fed Funds rate. The fed funds rate will be within the range of the target; if not the Fed will adjust its open market operations (buying and selling of bonds) to achieve the range .

Historical effective federal funds target rate

The graphic depicts the movement in the effective federal funds target rate. The target rate has historically been set in terms of a range; the current range as depicted in the graph is 0.00 to 0.25 percent.

28.2.6: Executing Expansionary Monetary Policy

Central banks initiate expansionary policy during periods of economic slowing, increasing the money supply and reducing interest rates.

Learning Objective

Explain common expansionary monetary policy tools

Key Points

• In an expansionary policy regime, the Fed would reduce the reserve requirement, thereby effectively increasing the amount of loans that a bank can issue.
• Expansionary monetary policy will seek to reduce the fed funds target rate (a range).
• In an expansionary policy regime, the Fed purchases government securities via open market operations from a bank in exchange for cash; the Fed’s purchase increases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

Key Terms

reserve requirement

The minimum amount of deposits each commercial bank must hold (rather than lend out).

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

fed funds rate

Short for Federal Funds rate. The interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.

Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is essentially the price of money. The two variables have an inverse relationship. As a result, as the money supply in an economy is increased, the interest rate will generally decrease and if the money supply is contracted, interest rates will generally increase .

Relationship between money supply and interest rates

As money supply increases, the interest rate decreases, as depicted in the graph above.

The money supply is a monetary policy mechanism available to a central bank as part of its mandate to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls the demand for funds increases, thereby expanding consumer and investment spending and promoting economic growth.

Expansionary policy

An active expansionary policy increases the size of the money supply, decreasing the interest rate. Central banks can increase the money supply through open market operations and changes in the reserve requirement.

Bank reserves

Banks and other depository institutions are required to keep a certain amount of funds in reserve in order to maintain enough liquidity to meet unexpected demand for deposits. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve (the Fed). By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.

In an expansionary policy regime, the Fed would reduce the reserve requirement. Banks would be able to issue more loans with the same reserves, thereby increasing the supply of money and the level of economic activity and investment.

Federal Funds market

From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the Federal Funds rate or simply the “fed funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is greater than the demand, then the funds rate falls, and if the supply of reserves is less than the demand, the funds rate rises.

At a lower fed funds rate, banks are more likely to increase loans, thereby expanding investment activity (in factories, for example, not financial instruments) and promoting economic growth.

Expansionary monetary policy will seek to reduce the fed funds target rate (a range). The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.

Open market operations

The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.

In an expansionary policy regime, the Fed purchases government securities from a bank in exchange for cash. Payment for the bonds increases the bank’s reserves. As a result, the bank may have more reserves than required. The bank can lend these unneeded reserves to another bank in the federal funds market. Thus, the Fed’s open market purchase increased the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) falls.

28.2.7: Executing Restrictive Monetary Policy

The central bank may initiate a contractionary or restrictive monetary policy to slow growth.

Learning Objective

Explain common restrictive monetary policy tools

Key Points

• In a contractionary policy regime, the Fed may increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.
• Restrictive monetary policy will seek to increase the fed funds rate, which is the interest banks charge on loans to other banks.
• In a contractionary policy regime, the Fed uses open market operations to sell government securities from a bank in exchange for cash and thereby reduce the money supply and increase interest rates.

Key Term

full employment

A state when an economy has no cyclical or deficient-demand unemployment.

Monetary policy is based on the relationship between money supply and interest rates, where the interest rate is the price of money. The interest rate, therefore, has an inverse relationship with the money supply. As a result, as the money supply in an economy is decreased, the interest rate is assumed to increase and if the money supply is increased, interest rates are typically assumed to decrease .

Contractionary monetary policy

Contractionary monetary policy results in a reduction in the money supply, depicted as a leftward shift, which results in an increase in interest rates as well as a decrease in the quantity of loanable funds.

The money supply is a monetary policy mechanism available to a central bank as part of its initiatives to promote economic growth and maintain full employment. Central banks use monetary policy to stabilize the economy; during periods of economic slowing central banks initiate expansionary policy, whereby the bank increases the money supply in order to lower prevailing interest rates. As the cost of money falls, economic theory assumes that the demand for funds will increase, thereby expanding consumer and investment spending and promoting economic growth. During periods where the economy is showing signs of growing too quickly or operating above full employment, the central bank may initiate a contractionary or restrictive monetary policy by reducing the money supply and allowing interest rates to increase and economic growth to slow.

Restrictive policy

An active contractionary policy restricts the size of the money supply, increasing the interest rate. Central banks can decrease the money supply through open market operations and changes in the reserve requirement.

Bank reserves

Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Fed. By adjusting the reserve requirement, the Fed can effectively change the availability of loanable funds.

In a contractionary policy regime, the Fed would increase the reserve requirement, thereby effectively restricting the funds that banks have available for loans.

Federal funds market

From day to day, the amount of reserves a bank wants to hold may change as its deposits and transactions change. When a bank needs additional reserves on a short-term basis, it can borrow them from other banks that happen to have more reserves than they need. These loans take place in a private financial market called the federal funds market.

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the “funds rate.” It adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the fed funds market is lower than the demand, then the funds rate increases.

At higher fed funds rates, banks are more likely to limit borrowing and their provision of loanable funds, thereby decreasing access to loanable funds and reducing economic growth.

Restrictive monetary policy will seek to increase the fed funds target rate. The Fed does not control this rate directly but does control the interest rate indirectly through open market operations.

Open market operations

The major tool the Fed uses to affect the supply of reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted by the Federal Reserve Bank of New York.

In a contractionary policy regime, the Fed sells government securities from a bank in exchange for cash. Payment for the bonds decreases the bank’s reserves, reducing the supply of funds that the bank has for loans. The Fed’s open market purchase decreases the supply of reserves (money) to the banking system, and the federal funds rate (interest rate) increases. In net, this reduces the financial resources available to stimulate growth and leads to a contraction in the economy.

28.2.8: The Taylor Rule

Taylor’s rule was designed to provide monetary policy guidance for how a central bank should set short-term interest rates.

Learning Objective

Explain the Taylor Rule and its use by central banks

Key Points

• The rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors.
• The rule recommends a relatively high interest rate (contractionary monetary policy) when inflation is above its target or when the economy is above its full employment level.
• The rule recommends a relatively low interest rate (expansionary monetary policy) when inflation is below its target or when the economy is below its full employment level.

Key Term

Taylor Rule

A way of determining the appropriate change in interest rates for a given change in inflation.

The Taylor rule is a formula developed by Stanford economist John Taylor. It was designed to provide monetary policy guidance for the Federal Reserve. The formula suggests short-term interest rates depending on changing economic conditions, in order to keep the economy stable in the short term, and minimize inflation over the long term.

The rule stipulates how much a central bank should change the nominal interest rate (real rate plus inflation) in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.

Professor John Taylor

Stanford University Professor John Taylor is the creator of the Taylor Rule, a monetary policy instrument developed to promote stable economic growth and limit short-run economic disruption related to inflation.

The factors that the Taylor rule suggests taking into account when setting inflation-adjusted short-term interest rates are:

1. the level of actual inflation relative to the target,
2. how far economic activity is above or below its “full employment” level, and
3. what the level of the short-term interest rate is that would be consistent with full employment.

The Taylor rule advocates setting interest rates relatively high (contractionary policy) when inflation is high or when the employment rate exceeds the economy’s full employment level. Expansionary policies with low interest rates are recommended by the Taylor rule in times when the economy is slow (i.e. unemployment is high, or inflation is low). 

The Taylor rule doesn’t always provide an easy answer. For example, in times of stagflation, inflation may be high while unemployment is also high. However, the Taylor rule can still provide a handy “rule of thumb” to policy makers on how to balance these conflicting issues when setting the interest rates.

The Taylor rule fairly accurately demonstrates how monetary policy has been conducted under recent leaders of the Federal Reserve, such as Volker and Greenspan. However, the Federal Reserve does not follow the Taylor rule as an explicit policy.

28.3: Impacts of Federal Reserve Policies

28.3.1: The Impact of Monetary Policy on Aggregate Demand, Prices, and Real GDP

Changes in a country’s money supply shifts the country’s aggregate demand curve.

Learning Objective

Recognize the impact of monetary policy on aggregate demand

Key Points

• Aggregate demand (AD) is the sum of consumer spending, government spending, investment, and net exports.
• The AD curve assumes that money supply is fixed.
• The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP).
• The decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the AD curve to the left.
• The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP).
• The increase in the money supply will lead to an increase in consumer spending. This increase will shift the AD curve to the right.
• Increased money supply causes reduction in interest rates and further spending and therefore an increase in AD.

Key Term

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It is the combination of consumer spending, investments, government spending, and net exports within a given economic system (often written out as AD = C + I + G + nX). As a result of this, increases in overall capital within an economy impacts the aggregate spending and/or investment. This creates a relationship between monetary policy and aggregate demand. 

This brings us to the aggregate demand  curve. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is also referred to as the effective demand.

The aggregate demand curve illustrates the relationship between two factors – the quantity of output that is demanded and the aggregated price level. Another way of defining aggregate demand is as the sum of consumer spending, government spending, investment, and net exports. The aggregate demand curve assumes that money supply is fixed. Altering the money supply impacts where the aggregate demand curve is plotted.

Contractionary Monetary Policy

Contractionary monetary policy decreases the money supply in an economy . The decrease in the money supply is mirrored by an equal decrease in the nominal output, otherwise known as Gross Domestic Product (GDP). In addition, the decrease in the money supply will lead to a decrease in consumer spending. This decrease will shift the aggregate demand curve to the left. This reduction in money supply reduces price levels and real output, as there is less capital available in the economic system.

Aggregate Demand Graph

This graph shows the effect of expansionary monetary policy, which shifts aggregate demand (AD) to the right.

Expansionary Monetary Policy

Expansionary monetary policy increases the money supply in an economy. The increase in the money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. This increase will shift the aggregate demand curve to the right.

In addition, the increase in money supply would lead to movement up along the aggregate supply curve. This would lead to a higher prices and more potential real output.

28.3.2: The Effect of Expansionary Monetary Policy

An expansionary monetary policy is used to increase economic growth, and generally decreases unemployment and increases inflation.

Learning Objective

Analyze the effects of expansionary monetary policy

Key Points

• The primary means a central bank uses to implement an expansionary monetary policy is through purchasing government bonds on the open market.
• Another way to enact an expansionary monetary policy is to increase the amount of discount window lending.
• A third method of enacting a expansionary monetary policy is by decreasing the reserve requirement.

Key Terms

unemployment

The state of being jobless and looking for work.

expansionary monetary policy

Traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

Monetary policy is referred to as either being expansionary or contractionary. Expansionary policy seeks to accelerate economic growth, while contractionary policy seeks to restrict it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. This is done by increasing the money supply available in the economy.

Expansionary policy attempts to promote aggregate demand growth. As you may remember, aggregate demand is the sum of private consumption, investment, government spending and imports. Monetary policy focuses on the first two elements. By increasing the amount of money in the economy, the central bank encourages private consumption. Increasing the money supply also decreases the interest rate, which encourages lending and investment. The increase in consumption and investment leads to a higher aggregate demand.

It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to growing the economy, the agents will anticipate future prices to be higher than they would be otherwise. The private agents will then adjust their long-term plans accordingly, such as by taking out loans to invest in their business. But if the agents believe that the central bank’s actions are short-term, they will not alter their actions and the effect of the expansionary policy will be minimized.

The Basic Mechanics of Expansionary Monetary Policy

A central bank can enact an expansionary monetary policy several ways. The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. Commonly, the central bank will purchase government bonds, which puts downward pressure on interest rates. The purchases not only increase the money supply, but also, through their effect on interest rates, promote investment.

Because the banks and institutions that sold the central bank the debt have more cash, it is easier for them to make loans to its customers. As a result, the interest rate for loans decrease. Businesses then, presumably, use the money it borrowed to expand its operations. This leads to an increase in jobs to build the new facilities and to staff the new positions.

The increase in the money supply is inflationary, though it is important to note that, in practice, different monetary policy tools have different effects on the level of inflation.

Other Methods of Enacting Expansionary Monetary Policy

Another way to enact an expansionary monetary policy is to increase the amount of discount window lending. The discount window allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. Decreasing the rate charged at the discount window, the discount rate, will not only encourage more discount window lending, but will put downward pressure on other interest rates. Low interest rates encourage investment .

Bank of England Interest Rates

The Bank of England (the central bank in England) undertook expansionary monetary policy and lowered interest rates, promoting investment.

Another method of enacting a expansionary monetary policy is by decreasing the reserve requirement. All banks are required to have a certain amount of cash on hand to cover withdrawals and other liquidity demands. By decreasing the reserve requirement, more money is made available to the economy at large.

28.3.3: The Effect of Restrictive Monetary Policy

A restrictive monetary policy will generally increase unemployment and decrease inflation.

Learning Objective

Analyze the effects of restrictive monetary policy

Key Points

• Another way to enact a restrictive monetary policy is to decrease the amount of discount window lending.
• A final method of enacting a restrictive monetary policy is by increasing the reserve requirement.
• The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. The central bank can issue or resell its debt in exchange for cash. It can also sell off some of its reserves in gold or foreign currencies.

Key Term

contractionary monetary policy

Central bank actions designed to slow economic growth.

Monetary policy is can be classified as expansionary or restrictive (also called contractionary). Restrictive monetary policy expands the money supply more slowly than usual or even shrinks it, while and expansionary policy increases the money supply. It is intended to slow economic growth and/or inflation in order to avoid the resulting distortions and deterioration of asset values

Business cycle

Restrictive monetary policy is used during expansion and boom periods in the business cycle to prevent the overheating of the economy.

Contractionary policy attempts to slow aggregate demand growth. As you may remember, aggregate demand is the sum of private consumption, investment, government spending and imports. Monetary policy focuses on the first two elements. By decreasing the amount of money in the economy, the central bank discourages private consumption. Increasing the money supply also increase the interest rate, which discourages lending and investment. The higher interest rate also promotes saving, which further discourages private consumption. The decrease in consumption and investment leads to a decrease in growth in aggregate demand.

It is important for policymakers to make credible announcements. If private agents (consumers and firms) believe that policymakers are committed to limiting inflation through restrictive monetary policy, the agents will anticipate future prices to be lower than they would be otherwise. The private agents will then adjust their long-term strategies accordingly, such as by putting plans to expand their operations on hold. But if the agents believe that the central bank’s actions will soon be reversed, they may not alter their actions and the effect of the contractionary policy will be minimized.

The Basic Mechanics of Expansionary Monetary Policy

A central bank can enact a contractionary monetary policy several ways. The primary means a central bank uses to implement an expansionary monetary policy is through open market operations. The central bank can issue debt in exchange for cash. This results in less cash being in the economy.

Because the banks and institutions that purchased the debt from the central bank have less cash, it is harder for them to make loans to its customers. As a result, the interest rate for loans increase. Businesses then, presumably, have less money to use to expand its operations or even maintain its current levels. This could lead to an increase in unemployment.

The higher interest rates also can slow inflation. Consumption and investment are discouraged, and market actors will choose to save instead of circulating their money in the economy. Effectively, the money supply is smaller, and there is reduced upward pressure on prices since demand for consumption goods and services has dropped.

Other Methods of Enacting Restrictive Monetary Policy

Another way to enact a contractionary monetary policy is to decrease the amount of discount window lending. The discount window allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions

A final method of enacting a contractionary monetary policy is by increasing the reserve requirement. All banks are required to have a certain amount of cash on hand to cover withdrawals and other liquidity demands. By increasing the reserve requirement, less money is made available to the economy at large.

28.3.4: Limitations of Monetary Policy

Limitations of monetary policy include liquidity traps, deflation, and being canceled out by other factors.

Learning Objective

Describe obstacles to the Federal Reserve’s monetary policy objectives

Key Points

• A liquidity trap is a situation where injections of cash into the private banking system by a central bank fail to lower interest rates and therefore fail to stimulate economic growth.
• Deflation is a decrease in the general price level of goods and services. Deflation is a problem in a modern economy because it increases the real value of debt and may aggravate recessions and lead to a deflationary spiral.
• Fiscal policy can also directly influence employment and economic growth. If these two policies do not work in concert, they can cancel each other out.

Key Term

deflation

A decrease in the general price level, that is, in the nominal cost of goods and services.

Monetary policy is the process by which the monetary authority of a country controls the supply of money with the purpose of promoting stable employment, prices, and economic growth. Monetary policy can influence an economy but it cannot control it directly. There are limits as to what monetary policy can accomplish. Below are some of the factors that can make monetary policy less effective.

Multiple Factors Influencing Economy

While monetary policy can influence the elements listed above, it is not the only thing that does. Fiscal policy can also directly influence employment and economic growth. If these two policies do not work in concert, they can cancel each other out. This is an especially significant problem when fiscal policy and monetary policy are controlled by two different parties. One party might believe that the economy is teetering on recession and may pursue an expansionary policy. The other group may believe the economy is booming and pursue a contractionary policy. The result is that the two would cancel each other, so that neither would influence the direction of the economy.

Liquidity Trap

A liquidity trap is a situation where injections of cash into the private banking system by a central bank fail to lower interest rates and therefore fail to stimulate economic growth . Usually central banks try to lower interest rates by buying bonds with newly created cash. In a liquidity trap, bonds pay little to no interest, which makes them nearly equivalent to cash. Under the narrow version of Keynesian theory in which this arises, it is specified that monetary policy affects the economy only through its effect on interest rates. Thus, if an economy enters a liquidity trap, further increases in the money stock will fail to further lower interest rates and, therefore, fail to stimulate.

Liquidity Trap

Sometimes, when the money supply is increased, as shown by the Liquidity Preference-Money Supply (LM) curve shift, it has no impact on output (GDP or Y) or on interest rates. This is a liquidity trap.

A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Deflation

Deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0%. This should not be confused with disinflation, a slowdown in the inflation rate. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money. This allows one to buy more goods with the same amount of money over time.

From a monetary policy perspective, deflation occurs when there is a reduction in the velocity of money and/or the amount of money supply per person. The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.

Deflation is a problem in a modern economy because it increases the real value of debt and may aggravate recessions and lead to a deflationary spiral. If monetary policy is too contractionary for too long, deflation could set in.

28.3.5: Using Monetary Policy to Target Inflation

Inflation targeting occurs when a central bank attempts to steer inflation towards a set number using monetary tools.

Learning Objective

Assess the use of inflation targets and goals in monetary policy

Key Points

• Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.
• If inflation appears to be above the target, the bank is likely to raise interest rates; if inflation appears to be below the target, the bank is likely to lower interest rates.
• Increases in inflation, measured by the consumer price index (CPI), are not necessarily coupled to any factor internal to country’s economy and strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.

Key Term

consumer price index

A statistical estimate of the level of prices of goods and services bought for consumption purposes by households.

Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or “target”, inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools .

Fed Reserve Seal

The United States Federal Reserve uses a form of inflation targeting when coordinating its monetary policy.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting. Examples include:

• if inflation appears to be above the target, the bank is likely to raise interest rates. This usually has the effect over time of cooling the economy and bringing down inflation;
• if inflation appears to be below the target, the bank is likely to lower interest rates. This usually has the effect over time of accelerating the economy and raising inflation.

Under the policy, investors know what the central bank considers the target inflation rate to be and therefore may more easily factor in likely interest rate changes in their investment choices. This is viewed by inflation targeters as leading to increased economic stability.

The United States Federal Reserve, the country’s central bank, practices a version of inflation targeting. Instead of setting a specific number, the Fed sets a target range.

Criticisms of Inflation Targeting

Increases in inflation, measured by changes in the consumer price index (CPI), are not necessarily coupled to any factor internal to country’s economy. Strictly or blindly adjusting interest rates will potentially be ineffectual and restrict economic growth when it was not necessary to do so.

It has been argued that focusing on inflation may inhibit stable employment and exchange rates. Supporters of a nominal income target also criticize the tendency of inflation targeting to ignore output shocks by focusing solely on the price level. They argue that a nominal income target is a better goal.

28.4: Historical Federal Reserve Policies

28.4.1: Volcker Disinflation

Paul Volcker, the 12th Chairman of the Federal Reserve, became known for lowering the inflation rate and achieving price stability.

Learning Objective

Evaluate the benefits and consequences of Paul Volcker’s actions as chairman of the Federal Reserve Board of Governors

Key Points

• During his time as the chairman of the Fed, Volcker is credited with ending the high levels of inflation that the United States experienced during the 1970s and early 1980s.
• When he became chairman in 1979, inflation was high and peaked in 1981 at 13.5%. However, due to the work of Volcker and the rest of the board, the inflation rate dropped to 3.2% by 1983.
• Volcker raised the federal funds rate from 11.2% in 1979 to 20% in June of 1981. The unemployment rate became higher than 10% during this time as well.
• Volcker chose to enact a policy of preemptive restraint during the economic upturn which increased the real interest rates.
• Despite his level of success, Volcker’s Federal Reserve board drew some of the strongest political attacks and protests in the history of the Federal Reserve. The protests were a result of the negative effects that the high interest rates had on the construction and farming industries.

Key Terms

stagflation

Inflation accompanied by stagnant growth, unemployment, or recession.

inflation

An increase in the general level of prices or in the cost of living.

Paul Volcker

Paul Volcker is an American economist who was appointed by President Carter in 1979 to be the 12th Chairman of the Federal Reserve of the United States (the Fed). He was reappointed by President Reagan and served as chairman until August of 1987. During his time as the Chairman of the Fed, Volcker is credited with ending the high levels of inflation that the United States experienced during the 1970s and early 1980s . Volcker was also appointed as the chairman of the Economic Recovery Advisory Board under President Obama from 2009 to 2011.

Paul Volcker

Paul Volcker was the 12th Chairman of the Federal Reserves. He became known for decreasing inflation during the early 1980s.

Benefits During Volcker’s Tenure

During his time as chairman, Paul Volcker led the Federal Reserve board and helped to end the stagflation crisis of the 1970s. The inflation rate had remained high throughout the 1970s, while the growth rate was slow and the unemployment was high. When he became chairman in 1979, inflation was high and peaked in 1981 at 13.5%. However, due to the work of Volcker and the rest of the board, the inflation rate dropped to 3.2% by 1983.

Volcker raised the federal funds target rate from 11.2% in 1979 to 20% in June of 1981. The unemployment rate became higher than 10% during this time as well. The economy was restored by 1982 as a result of the tight-money policy put in place by the Fed. Volcker chose to enact a policy of preemptive restraint during the economic upturn which increased the real interest rates. Volcker’s policy also pushed the President and Congress to adopt a plan to balance the budget. Volcker’s tenure as the chairman of the Federal Reserve resulted in sound monetary and fiscal integrity that achieved the goal of price stability.

Consequences From Volcker’s Tenure

Despite his level of success in certain areas, Volcker’s Federal Reserve board drew some of the strongest political attacks and protests in the history of the Federal Reserve. The protests were a result of the negative effects that the high interest rates had on the construction and farming industries. Nobel laureate Joseph Stiglitz explained “Paul Volcker, the previous Fed Chairman known for keeping inflation under control, was fired because the Reagan Administration didn’t believe he was an adequate deregulator. “

Despite the protests, Paul Volcker was respected for the work that he did while he was the chairman of the Federal Reserve. Congressman Ron Paul was a harsh critic of the Fed, but he commented about Volcker by saying, “If I had to name a Federal Reserve chairman that did a little bit of good, that would be Paul Volcker. ” Volcker received the U.S. Senator John Heinz Award for Greatest Public Service by an elected or Appointed Official in 1983.

28.4.2: Greenspan Era

Alan Greenspan was Chairman of the Federal Reserve from 1987 to 2006.

Learning Objective

Summarize the actions taken during Alan Greenspan’s tenure as chairman of the Federal Reserve Board of Governors

Key Points

• In 1987, Greenspan stated that the Fed was ready “to serve as a source of liquidity to support the economic and financial system” following the stock market crash.
• Greenspan influenced each presidency during his tenure as chairman. He provided economic consultation for President Clinton and assisted in the deficit reduction program in 1993.
• He raised interest rates several times in 2000 which was likely this cause of the bursting of the dot-com bubble. In 2001, Greenspan began to lower interest rates. By 2004, the Federal Funds rate was 1%.
• In 2004, Greenspan urged homeowners to take out ARMS. Over the next two years, the interest rates increased to 5.25% which contributed to the mortgage crisis in 2007.

Key Term

interest rate

The percentage of an amount of money charged for its use per some period of time (often a year).

Alan Greenspan

Alan Greenspan is an American economist who served as the Chairman of the Federal Reserve of the United States from 1987 to 2006. He had the second longest tenure in the position. He was appointed by Ronald Reagan in 1987 and reappointed in four-year intervals, finally retiring on January 31, 2006 .

Alan Greenspan

Alan Greenspan was the 13th Chairman of the Federal Reserve. He held the position from 1987 until 2006. His tenure as the chairman was marked by low interest rates which eventually were blamed for the 2007 mortgage crisis in the United States.

Chairman of the Federal Reserve

The stock market crashed in 1987 shortly after Greenspan became Chairman of the Federal Reserve (the Fed). He stated the the Fed was ready “to serve as a source of liquidity to support the economic and financial system. ” Throughout his early years as chairman, Greenspan impacted all the presidencies in various ways. President George H.W. Bush blamed federal policy when he was not reappointed for a second term.

During President Clinton’s terms in office, Greenspan was consulted regarding economic affairs and assisted in the 1993 deficit reduction program. As a whole, the 1990s saw healthy economic growth.

The most notable actions taken during Greenspan’s tenure as chairman began in 2000. He raised interest rates several times in 2000 which was likely this cause of the bursting of the dot-com bubble. In 2001, Greenspan and the Fed initiated a series of interest cuts that brought the Federal Funds rate down to 3% following the September 11, 2001 terror attacks. The Federal Funds rate continued to drop until it was 1% in 2004. Greenspan believed that a group in rates would lead to a surge in home sales and refinancing. In February of 2004, Greenspan suggested that homeowners should consider taking out adjustable-rate mortgages (ARMS) where the interest rate adjusts to the current interest rate in the market. A few months later, Greenspan began raising the interest rates. Interest rate funds increased to 5.25% about two years later.

The Housing Bubble

In 2007, only months after Greenspan retired, the subprime mortgage crisis occurred in the United States. It is suggested that Greenspan’s easy-money policies were the leading cause of the mortgage crisis. When homeowners took out subprime ARMS in 2004, the interest rates were set much higher than what the homeowners paid the first few years of the mortgages. In 2009, Robert Reich explained that the lower interest rates in 2004 allowed banks to borrow money for free. As a result, the banks borrowed large amounts of money, lent it out to borrowers, and earned substantial profits. Without government oversight for lending institutions, banks lent money to unfit borrowers. Greenspan did not think the oversight was necessary. He trusted that the market would weed out bad credit risks, but it did not. In 2008, Greenspan admitted during Congressional testimony that he had put too much faith in the self-correcting power of free markets. He had not anticipated the self-destructive power of irresponsible mortgage lending. Greenspan did not accept responsibility for creating the housing bubble that led to the mortgage crisis. He simply stated that he did not believe in deregulation as strongly following the crisis.

28.4.3: Bernanke Era

The Bernanke Era has included challenges faced by the Federal Reserve such as the financial crisis, strengthening federal policy, and reducing the deficit.

Learning Objective

Review the challenges faced by Ben Bernanke during his time as chairman of the Federal Reserve Board of Governors

Key Points

• During his tenure as chairman, Bernanke has been responsible for overseeing the Federal Reserve’s response to the financial crisis.
• Ben Bernanke was one of the first individuals to discuss “the Great Moderation” which is the theory that traditional business cycles have declined in volatility in recent decades because of structural changes that have occurred in the international economy.
• The financial crisis in the later-2000s brought the period of the Great Moderation to an end.
• The main controversies surrounding Bernanke’s terms as chairman include how he handled the financial crisis, particularly failing to see the crisis, for bailing out Wall Street, and for injecting $600 billion into the banking system to give the slow economic recovery a boost.
• Bernanke also focused on the importance of reducing the deficit and reforming entitlement programs in order to achieve financial stability and economic growth.

Key Terms

deflation

A decrease in the general price level, that is, in the nominal cost of goods and services.

inflation

An increase in the general level of prices or in the cost of living.

financial crisis

A period of serious economic slowdown characterized by devaluing of financial institutions often due to reckless and unsustainable money lending.

Ben Bernanke

Ben Bernanke is an American economist and chairman of the Federal Reserve (the Fed) through January 2014. He was appointed chairman by President Bush and reappointed by President Obama. During his tenure as chairman, Bernanke has been responsible for overseeing the Federal Reserve’s response to the financial crisis .

Ben Bernanke

Ben Bernanke (right) was appointed chairman of the Federal Reserve by President Bush and he was reappointed by President Obama. Throughout his time as chairman, Bernanke has influenced the financial crisis, the Wall Street bailout, and the economic stimulus.

The Great Moderation

Ben Bernanke was one of the first individuals to discuss “the Great Moderation” which is the theory that traditional business cycles have declined in volatility in recent decades because of structural changes that have occurred in the international economy. The primary structural changes include increases in the economic stability of developing nations and the diminished influence of monetary and fiscal policy.

The Great Moderation is important because while Bernanke was chairman of the Federal Reserve, it is speculated the the economic and financial crisis in the later-2000s brought the period of the Great Moderation to an end. The period was known for predictable policy, low inflation, and modest business cycles.

The Bernanke Doctrine

Ben Bernanke gave a speech in 2002, before he became chairman of the Federal Reserve. He emphasized that Congress gave the Fed responsibility for preserving price stability – avoiding inflation and deflation. He also identified seven specific measures for the Fed to reduced deflation. These seven measures were:

1. Increase the money supply
2. Ensure liquidity makes its way into the financial system
3. Lower interest rates all the way down to 0%
4. Control the yield on corporate bonds and other privately issued securities
5. Depreciate the U.S. dollar
6. Execute a de facto depreciation
7. Buy industries throughout the U.S. economy with “newly created money”

Chairman of the Federal Reserve

As Chairman of the Federal Reserve, Bernanke sits on the Financial Stability Oversight Board and is also Chairman of the Federal Open Market Committee, the Fed’s principal monetary policy making body. One of Bernanke’s first main challenges was balancing his comments and how they were influenced by the media. As an advocate for more transparent federal policy, Bernanke stated clearer inflation goals, but his public statements negatively impacted the stock market. As a result, he did not continue to make public statements about the direction of the Federal Reserve.

The main controversies surrounding Bernanke’s terms as chairman include how he handled the financial crisis, particularly failing to see the crisis, for bailing out Wall Street, and for injecting $600 billion into the banking system to give the slow economic recovery a boost.

Two areas that received prominent attention include:

• The Merrill Lynch merger with Bank of America: New York state Attorney General Andrew Cuomo wrote a letter to Congress in 2009 accusing Bernanke and the treasury secretary of fraud concerning the acquisition of Merrill Lynch by Bank of America. Cuomo stated that the extent of Merrill Lynch’s losses were not disclosed to Bank of America by Bernanke or the treasury secretary. Bernanke was questioned in Congressional hearings as to whether he bullied individuals when the merger was invoked. Bernanke stated that the Fed did nothing illegal when they tried to convince Bank of America to not end the merger.
• AIG bailout: It was stated that Bernanke had overruled recommendations from his staff regarding the AIG bailout. The question arose as to whether it had been necessary to bailout AIG. Senators from both parties supported Bernanke and said that the AIG bailout averted worse problems. They stated that act of averting worse problems outweighed any responsibility that he had for the financial crisis.

In 2010, Bernanke also expressed his views regarding deficit reduction and reforming Social Security/Medicare. He favored reducing the U.S. budget deficit. He stated that reforming Social Security and Medicare entitlement programs would help reduce the deficit. He believed that a credible plan needed to be developed in order to address the funding crisis that is pending. He explained that without reform, the U.S. will not have financial stability or healthy economic growth. His comments were directed at Congress and the President since reform in fiscal exercise is not in the power of the Federal Reserve. He emphasized that deficit reduction would need to consist of raising taxes, cutting entitlement payments, and reducing government spending.

27.1: Introducing Money

27.1.1: The Definition of Money

Learning Objective

Distinguish between the three main functions of money: a medium of exchange, a unit of account, and a store of value

Key Points

• Money comes in three forms: commodity money, fiat money, and fiduciary money. Most modern monetary systems are based on fiat money.
• Commodity money derives its value from the commodity of which it is made, while fiat money has value only by the order of the government.
• Money functions as a medium of exchange, a unit of account, and a store of value.

Key Term

Fiat money

Money that is given value because those who use it believe it has value; the value is not derived from any inherent characteristic.

Money is any object that is generally accepted as payment for goods and services and repayment of debts in a given socioeconomic context or country. Money comes in three forms: commodity money, fiat money, and fiduciary money.

Many items have been historically used as commodity money, including naturally scarce precious metals, conch shells, barley beads, and other things that were considered to have value . The value of commodity money comes from the commodity out of which it is made. The commodity itself constitutes the money, and the money is the commodity.

Commodity Money

Conch shells have been used as commodity money in the past. The value of commodity money is derived from the commodity out of which it is made.

Fiat money is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts. Paper money is an example of fiat money.

Fiduciary money includes demand deposits (such as checking accounts) of banks. Fiduciary money is accepted on the basis of the trust its issuer (the bank) commands.

Most modern monetary systems are based on fiat money. However, for most of history, almost all money was commodity money, such as gold and silver coins.

Functions of Money

Money has three primary functions. It is a medium of exchange, a unit of account, and a store of value:

1. Medium of Exchange: When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange.
2. Unit of Account: It is a standard numerical unit of measurement of market value of goods, services, and other transactions. It is a standard of relative worth and deferred payment, and as such is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a unit of account, money must be divisible into smaller units without loss of value, fungible (one unit or piece must be perceived as equivalent to any other), and a specific weight or size to be verifiably countable.
3. Store of Value: To act as a store of value, money must be reliably saved, stored, and retrieved. It must be predictably usable as a medium of exchange when it is retrieved. Additionally, the value of money must remain stable over time.

Economists sometimes note additional functions of money, such as that of a standard of deferred payment and that of a measure of value. A “standard of deferred payment” is an acceptable way to settle a debt–a unit in which debts are denominated. The status of money as legal tender means that money can be used for the discharge of debts. Money can also act a as a standard measure and common denomination of trade. It is thus a basis for quoting and bargaining prices. Its most important usage is as a method for comparing the values of dissimilar objects.

27.1.2: The Functions of Money

Learning Objective

Analyze how the characteristics of money make it an effective medium of exchange

Key Points

• The barter system has a number of limitations, including the double coincidence of wants, the absence of a common measure of value, indivisibility of certain goods, difficulty of deferred payments, and difficulty of storing wealth.
• Despite the numerous limitations, the barter system works well when currency is unstable or unavailable for conducting commerce.
• Money is durable, divisible, portable, liquid, and resistant to counterfeiting.
• Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment.

Key Term

barter

An exchange goods or services without involving money.

Barter is a system of exchange in which goods or services are directly exchanged for other goods or services without using a medium of exchange, such as money . The reciprocal exchange is immediate and not delayed in time. It is usually bilateral, though it can be multilateral, and usually exists parallel to monetary systems in most developed countries, though to a very limited extent. The barter system has a number of limitations which make transactions very inefficient, including:

Barter

In a barter system, individuals possessing something of value could exchange it for something else of similar or greater value.

• Double coincidence of wants: The needs of a seller of a commodity must match the needs of a buyer. If they do not, the transaction will not occur.
• Absence of common measure of value: In a monetary economy, money plays the role of a measure of value of all goods, making it possible to measure the values of goods against each other. This is not possible in a barter economy.
• Indivisibility of certain goods: If a person wants to buy a certain amount of another’s goods, but only has payment of one indivisible good which is worth more than what the person wants to obtain, a barter transaction cannot occur.
• Difficulty of deferred payments: It is impossible to make payments in installments and difficult to make payments at a later point in time.
• Difficulty storing wealth: If society relies exclusively on perishable goods, storing wealth for the future may be impractical.

Despite the long list of limitations, the barter system has some advantages. It can replace money as the method of exchange in times of monetary crisis, such as when a the currency is either unstable (e.g. hyperinflation or deflationary spiral) or simply unavailable for conducting commerce. It can also be useful when there is little information about the credit worthiness of trade partners or when there is a lack of trust.

The money system is a significant improvement over the barter system. It provides a way to quantify the value of goods and communicate it to others. Money has several defining characteristics. It is:

• Durable.
• Divisible.
• Portable.
• Liquid.
• A unit of account.
• Legal tender.
• Resistant to counterfeiting.

Money serves four primary purposes. It is:

• A medium of exchange: an object that is generally accepted as a form of payment.
• A unit of account: a means of keeping track of how much something is worth.
• A store of value: it can be held and exchanged later for goods and services at an approximate value.
• A standard of deferred payments (this is not considered a defining purpose of money by all economists).

The use of money as a medium of exchange has removed the major difficulty of double coincidence of wants in the barter system. It separates the act of sale and purchase of goods and services and helps both parties in obtaining maximum satisfaction and profits independently.

27.1.3: Measuring the Money Supply: M1

Learning Objective

Define M1

Key Points

• The Federal Reserve measures the money supply using three monetary aggregates: M1, M2, and M3.
• M1 is the narrowest measure of the money supply, including only money that can be spent directly.
• M2 is a broader measure, encompassing M1 and near monies.
• M3 includes M2 plus relatively less liquid near monies. However, this measure is no longer used in practice.

Key Term

M1

The amount of cash in circulation plus the amount in bank checking accounts.

The Federal Reserve measures the money supply using three main monetary aggregates: M1, M2, and M3.

M1 is the narrowest measure of the money supply, including only money that can be spent directly. More specifically, M1 includes currency and all checkable deposits . Currency refers to the coins and paper money in the hands of the public. Checkable deposits refer to all spendable deposits in commercial banks and thrifts.

M1

The M1 measure includes currency in the hands of the public and checkable deposits in commercial banks.

A broader measure of money than M1 includes not only all of the spendable balances in M1, but certain additional assets termed “near monies”. Near monies cannot be spent as readily as currency or checking account money, but they can be turned into spendable balances with very little effort or cost. Near monies include what is in savings accounts and money-market mutual funds. The broader category of money that embraces all of these assets is called M2. M3 encompassed M2 plus relatively less liquid near monies. In practice, the measure of M3 is no longer used by the Federal Reserve.

Imagine that Laura deposits $900 in her checking account in a world with no other money (M1=$900). The bank sets 10% of the amount aside for required reserves, while the remaining $810 can be lent out by the bank as credit. The M1 money supply increases by $810 when the loan is made (M1=$1,710). In the meantime, Laura writes a check for $400. The total M1 money supply didn’t change; it includes the $400 check and the $500 left in the checking account (M1=$1,710). Laura’s check is accidentally destroyed in the laundry. M1 and her checking account do not change, because the check is never cashed (M1=$1,710). Meanwhile, the bank lends Mandy the $810 credit that it has created. Mandy deposits the money in a checking account at another bank. The bank must keep 10% as reserves and has $729 available for loans. This creates promise-to-pay money from a previous promise-to-pay, inflating the M1 money supply (M1=$2,439). Mandy’s bank now lends the money to someone else who deposits it in a checking account at another bank, and the process repeats itself.

27.1.4: Measuring the Money Supply: M2

Learning Objective

Define M2

Key Points

• M2 consists of all the components of M1 plus near-monies.
• Near monies are relatively-liquid financial assets that can be quickly converted into M1 money.
• Near monies include savings deposits, small time deposits, and money market mutual funds.

Key Term

M2

The amount of cash in circulation plus bank accounts, savings accounts and small deposits.

There is no single “correct” measure of the money supply. Instead there are several measures, classified along a continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (for example, currency and checkable deposits). Broader measures add less liquid types of assets (certificates of deposit, etc.). The continuum corresponds to the way that different types of money are more or less controlled by monetary policy. Narrow measures include those more directly affected and controlled by monetary policy, whereas broader measures are less closely related to monetary policy actions.

The different types of money are typically classified as “M”s. Around the world, they range from M0 (the narrowest) to M3 (broadest), but which of the measures is actually the focus of policy formulation depends on a country’s central bank.

M2 is one of the aggregates by which the Federal Reserve measures the money supply . It is a broader classification of money than M1 and a key economic indicator used to forecast inflation. M2 consists of all the liquid components of M1 plus near-monies. Near monies are relatively liquid financial assets that may be readily converted into M1 money. More specifically, near monies include savings deposits, small time deposits (less than $100,000) that become readily available at maturity, and money market mutual funds.

Federal Reserve

Historically, the Federal Reserve has measured the money supply using the aggregates of M1, M2, and M3. The M2 aggregate includes M1 plus near-monies.

Imagine that Laura writes a check for $1,000 and brings it to the bank to start a money market account. This would cause M1 to decrease by $1,000, but M2 to stay the same. This is because M2 includes the money market account in addition to all the money counted in M1.

27.1.5: Other Measurements of the Money Supply

Learning Objective

Explain how the money supply is measured

Key Points

• M0 is a measure of all the physical currency and coinage in circulation in an economy.
• MB is a measure that captures all physical currency, coinage, and Federal Reserve deposits (special deposits that only banks can have at the Fed).
• The different forms of money in the government money supply statistics arise from the practice of fractional-reserve banking. Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created, which makes up the non-M0 components in the M1-M3 statistics.

Key Terms

M0

The amount of coin and banknotes in circulation.

MB

The portion of the commercial banks’ reserves that is maintained in accounts with their central bank plus the total currency circulating in the public.

In addition to the commonly used M1 and M2 aggregates, there are several other measurements of the money supply that are used as well . More specifically:

Euro Money Supply

The measures of the money supply are all related, but the use of different measures may lead economists to different conclusions.

• M0: The total of all physical currency including coinage. M0 = Federal Reserve Notes + US Notes + Coins .
• MB: Stands for “monetary base,” referring to the base from which all other forms of money are created. MB is the total of all physical currency plus Federal Reserve Deposits (special deposits that only banks can have at the Fed). MB = Coins + US Notes + Federal Reserve Notes + Federal Reserve Deposits.
• M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits.
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).
• M3: M2 + all other certificates of deposit (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.
• M4-: M3 + commercial paper.
• M4: M4- + treasury bills (or M3 + commercial paper + T-bills)
• MZM: “Money Zero Maturity” is one of the most popular aggregates in use by the Fed because its velocity has historically been the most accurate predictor of inflation. It is M2 – time deposits + money market funds.
• L: The broadest measure of liquidity that the Federal Reserve no longer tracks. M4 + Bankers’ Acceptance.

The different forms of money in the government money supply statistics arise from the practice of fractional-reserve banking. Fractional-reserve banking is the practice whereby a bank retains only a portion of its customers’ deposits as readily available reserves from which to satisfy demands for withdrawals. Whenever a bank gives out a loan in a fractional-reserve banking system, a new sum of money is created. This new type of money is what makes up the non-M0 components in the M1-M3 statistics.

27.2: Introducing the Federal Reserve

27.2.1: Introduction to Monetary Policy

Monetary policy is the process by which a monetary authority controls the money supply, often to produce stable prices and low unemployment.

Learning Objective

Justify expansionary and contractionary monetary policy.

Key Points

• Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the money supply more rapidly than usual, and contractionary policy expands the money supply more slowly than usual.
• Expansionary policy is traditionally used to try to combat unemployment by lowering interest rates. A monetary authority will typically pursue expansionary monetary policy when there is an output gap.
• Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Key Terms

inflation

An increase in the general level of prices or in the cost of living.

output gap

The difference between an economy’s actual GDP and its long-run potential GDP

Monetary policy is the process by which the monetary authority of a country, which could be a government agency or a central bank, controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by easing credit to entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values, or to cool an overheating economy. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Expansionary Monetary Policy

A monetary authority will typically pursue expansionary monetary policy when there is an output gap – that is, a country is producing output at a lower level than its potential output. Without a policy intervention the output gap may correct itself, if falling wages and prices shift the short-run aggregate supply curve to the right until the economy returns to the long-run equilibrium. Alternatively, the monetary authority could intervene in order to increase aggregate demand and close the output gap. Expansionary monetary policy consists of the tools that a central bank uses to achieve this increase in aggregate demand.

In practice, this means that a monetary authority will use the tools at its disposal in order to increase the money supply and decrease interest rates. Since interest rates represent the price of money, lower interest rates will cause the quantity of money demanded to increase, stimulating investment and spending. In addition, lower interest rates make a currency worth less in the currency exchange market. This reduces the demand for and increases the supply of dollars in the currency market, reducing the exchange rate (in foreign currency per dollar). A lower exchange rate makes a country’s goods relatively more affordable for the rest of the world, stimulating exports and further increasing output.

Contractionary Monetary Policy

By contrast, a monetary authority will pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that high short-run aggregate demand creates an equilibrium in which prices are higher than in the long-run equilibrium. This will cause high levels of inflation. In response, the monetary authority may reduce the money supply and thereby raise the interest rate. Investment falls as the interest rate rises. The higher interest rate also increases the demand for dollars as foreign investors shift their investments to the United States. Likewise, the supply of dollars declines. Consumers in the United States purchase domestic interest-bearing assets rather than purchasing assets abroad, taking advantage of the higher domestic interest rate. Increased demand and decreased supply cause an increase in the exchange rate, which boots imports while reducing exports. Thus, contractionary monetary policy causes aggregate demand to fall, thereby reducing the rate of inflation. .

Money Supply and Inflation

The graph shows the relationship between the money supply and the inflation rate. By controlling the money supply, monetary authorities hope to influence the rate of inflation.

27.2.2: The Creation of the Federal Reserve

The Federal Reserve was created to promote financial stability, provide regulation and banking services, and conduct monetary policy.

Learning Objective

Explain monetary policy as the main function of a central bank

Key Points

• The Federal Reserve (the Fed) was originally created in response to a series of bank panics. While its policy goals were originally unclear, today the Fed has a dual mandate: to achieve maximum employment and stable prices.
• The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.
• The Fed sets the required ratio of reserves that banks must hold relative to their deposit liabilities.
• The discount rate is the interest rate charged by the Fed when it lends reserves to banks.
• The buying and selling of federal government bonds by the Fed are called open-market operations.

Key Terms

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

reserve requirement

The minimum amount of deposits each commercial bank must hold (rather than lend out).

The Federal Reserve Act of 1913

Until 1913, the United States did not have a true central bank. The US suffered through a number of financial crises that eventually drove Congress to create the US central bank, the Federal Reserve (the Fed), through the Federal Reserve Act of 1913.

The Act established three key objectives for monetary policy: maximum employment, stable prices, and moderate long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate and are the most emphasized of the three.

Over the years, the Fed has expanded its duties to include conducting monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system, and providing financial services.

How the Fed Conducts Monetary Policy

The Fed has three main policy tools: setting reserve requirements, operating the discount window and other credit facilities, and conducting open-market operations.

Reserve Requirements

Commercial banks are required to hold a certain proportion of their deposits in reserves and not lend them out. This proportion is called the reserve requirement and is controlled by the Fed. By changing the reserve requirement, the Fed can impact the amount of money available for lending, and by extension, spending and investment.

Discount Window

Commercial banks are required to have a certain amount of reserves on hand at the end of each day. If they are going to come up short, they must borrow from other banks or the Fed. The Fed extends these loans through the discount window and charges what is called the discount rate. The discount rate is set by the Fed, and is important because it radiates throughout the economy: if it becomes more expensive to borrow at the discount window, interest rates will rise and borrowing will become more expensive economy-wide. In this way, the Fed can use the discount window to affect interest rates and the money supply .

Increasing the Money Supply

The diagram shows how the central bank can increase the money supply by lending money through the discount window or purchasing bonds (open market operations).

Open-Market Operations

The government borrows by issuing bonds. Recall that the interest rate that the government pays is determined by the price of the bond: the higher the price of the bond, the lower the interest rate. The Fed can affect the interest rate by conducting open-market operations (OMOs) in which it buys or sells bonds. Buying or selling bonds changes the demand or supply of the bonds, and therefore their price. By extension, OMOs change the interest rate, hopefully to achieve one of the Fed’s monetary goals.

27.2.3: Structure of the Federal Reserve

The Federal Reserve System (The Fed) was designed in order to maintain the central bank’s independence and promote decentralized power.

Learning Objective

Recall the structure of the Federal Reserve System of the United States

Key Points

• The Fed is a system of 12 regional banks, each of which has its own board of directors and rotating representative to the Federal Open Market Committee (FOMC).
• The Fed is run by a Board of Governors, the head of which is the Chairperson.
• The Federal Open Market Committee (FOMC) consists of the seven members of the Board of Governors and five rotating regional bank presidents. It is primarily responsible for buying and selling federal government bonds in order to conduct monetary policy.

Key Terms

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

The Federal Reserve (the Fed) was designed to be independent of the Congress and the government. The idea justification for independence is that it allows the Fed to operate without being put under political pressure to take actions that may not be in the best long-term economic interest of the country.

The Federal Reserve System is composed of five parts :

Structure of the Federal Reserve

The diagram shows the relationship between the different organizations that compose the Federal Reserve System

1. The presidentially appointed Board of Governors (or Federal Reserve Board), an independent federal government agency located in Washington, D.C. Each governor serves a 14 year term. As of February 2014, the Chair of the Board of Governors is Janet Yellen, who succeeded Ben Bernanke.
2. The Federal Open Market Committee (FOMC), composed of the seven members of the Federal Reserve Board and five of the 12 Federal Reserve Bank presidents, which oversees open market operations, the principal tool of U.S. monetary policy.
3. Twelve regional Federal Reserve Banks located in major cities throughout the nation, which divide the nation into twelve Federal Reserve districts. The Federal Reserve Banks act as fiscal agents for the U.S. Treasury, and each has its own nine-member board of directors.
4. Numerous other private U.S. member banks, which own required amounts of non-transferable stock in their regional Federal Reserve Banks.
5. Various advisory councils.

The Fed can be thought of as having both private and public organization characteristics, though it considers itself to be private. On one hand, the Fed works toward achieving public goals such as moderate inflation and low unemployment. It does not exist to make money. On the other hand, it is, by design, separate from the government. It operates independently, and is not subject to political pressures directly as is Congress or the President.

27.2.4: The Federal Open Market Committee and the Role of the Fed

The Federal Open Market Committee is responsible for conducting open market operations in order to achieve a target interest rate.

Learning Objective

Describe the structure and operations of the Federal Open Market Committee (FOMC)

Key Points

• Open market operations are the buying and selling of federal government bonds in order to influence the money supply and interest rate.
• The Fed sets targets for the federal funds rate and then conducts operations to maintain that rate. To achieve a lower federal funds rate, for example, the Fed goes into the open market to buy securities and thus increase the money supply.
• The FOMC decides on a target federal funds rate by looking at monetary targets such as inflation, interest rates, or exchange rates.

Key Terms

reserve

Banks’ holdings of deposits in accounts with their central bank.

federal funds rate

The interest rate at which depository institutions actively trade balances held at the Federal Reserve with each other.

One of the primary tools used by the Federal Reserve (the Fed) to conduct monetary policy is open market operations: the buying and selling of federal government bonds in order to influence the money supply and interest rate. These operations are the primary responsibility of the Federal Open Market Committee (FOMC). The FOMC is a twelve-person committee composed of the seven members of the Board of Governors, plus a rotating combination of five presidents of the Federal Reserve Regional Banks. The president of the New York regional bank is always a member of the FOMC; the other four seats are filled by four of the other eleven bank presidents.

When conducting monetary policy the Fed sets a target for the federal funds rate, which it attempts to achieve using open market operations. To lower the federal funds rate, for example, the Fed buys securities on the open market, increasing the money supply. In order to raise the federal funds rate, on the other hand, the Fed sells securities and thereby reduces the money supply.

Open Market Operations

As mentioned previously, the aim of open market operations is to manipulate the short term interest rate and the total money supply. This involves meeting the demand for money at the target interest rate by buying and selling government securities or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Imagine the Fed is targeting a federal funds rate of 3%. If there is an increased demand for money and the Fed takes no action, interest rates will rise. This may produce unintended contractionary effects in the economy. Instead, the FOMC responds to an increase in the demand for money by going to the open market to buy a financial asset, such as government bonds, foreign currency, or gold. To pay for these assets, the Fed transfers bank reserves to the seller’s bank and the seller’s account is credited. Since the bank now has more reserves than it had before, it can lend out more money and the money supply increases. Thus, the increase in demand for money is met with an increase in supply, and the interest rate remains unchanged.

Conversely, if the central bank sells its financial assets on the open market, reserves are transferred from the buyer’s bank back to the Fed. This reduces the amount of money that a bank may loan out and the total money supply falls. The process works because the central bank has the authority to bring money in and out of existence. They are the only point in the whole system with the unlimited ability to produce money.

FOMC Meeting

The members of the FOMC meet eight times a year in order to vote on current monetary policies.

27.2.5: The Federal Reserve and the Financial Crisis of 2008

The Fed responded to the financial crisis with conventional open market operations and unconventional credit facilities and bailouts.

Learning Objective

Summarize the monetary policy tools used by the Federal Reserve in response to the financial crisis of 2008.

Key Points

• In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s.
• The Fed cut the target federal funds rate and the discount lending rate seven times. Normally, a low federal funds rate would encourage banks to make loans, stimulating the economy, but this failed to work following the crisis.
• Unable to rely on conventional tools, the Fed created a variety of credit facilities to provide liquidity to the economy.
• The Fed also provided emergency funds to support financial institutions deemed “too big to fail”.

Key Terms

liquidity

The degree to which an asset can be easily converted into cash.

discount rate

An interest rate that a central bank charges to depository institutions that borrow reserves from it.

open market operations

An activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy.

In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s. It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis caused the failure of businesses, huge declines in consumer wealth, and a downturn in economic activity that lead to the 2008-2012 global recession.

The Federal Reserve’s response to the 2008 crisis saw the use of both conventional and new monetary tools in order to stabilize the economy, support market liquidity, and encourage economic activity. Conventional monetary policy suggests that in an economic downturn, a central bank should conduct open market operations in order to increase the money supply and lower interest rates. Lower interest rates stimulate loans, spending, and investment and help an economy escape from recession. Further, this type of financial crisis meant that banks’ assets were suddenly worth far less; open market operations can ensure that these banks have the liquidity they need to carry out their financial activities.

Conventional Monetary Tools

The Federal Reserve (the Fed) did engage in these types of conventional operations in 2007 and 2008, cutting the target federal funds rate and the discount rate seven times. Normally, a low federal funds rate would encourage banks to borrow money in order to lend it out to firms and individuals, stimulating the economy, but in the aftermath of the financial crisis the Fed was unable to lower interest rates enough to successfully induce banks to make loans. One reason why traditional monetary policies failed is due to the zero lower bound and the low levels of inflation that accompanied the crisis.

The zero lower bound refers to the fact that the central bank cannot push nominal interest rates below 0%. This is because any creditor can do better by keeping their money in cash than by loaning it out at an interest rate below 0%. When inflation is high, however, central banks may be able to push the real interest rate below 0%. Recall that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. If the nominal interest rate is 1% and inflation is 3%, the real interest rate is -2%. However, following the crisis, the U.S. experienced very low levels of inflation, and cutting the federal funds rate failed to provide enough economic stimulus to get the country out of the recession.

Unconventional Monetary Tools

Unable to create interest rates low enough to encourage banks to resume lending money, the Fed turned to other, untried policy tools to encourage economic activity. To deal with the shrinking credit markets, the Fed created a selection of new credit facilities. The Primary Dealer Credit Facility (PDCF) allows the banks that normally handle open market operations on behalf of the Fed to apply for overnight loans. The Term Asset-Backed Securities Loan Facility uses the primary dealers to give companies access to loans based on asset-backed securities, such as those related to credit card or small business debt. These new credit facilities were created based on the hope that increasing liquidity in the market would induce firms and consumers to borrow and spend.

The Fed also provided targeted assistance to bail out large financial institutions that would have otherwise collapsed. During the crisis, housing prices fell and the number of foreclosures increased dramatically. Investors, banks, and other financial institutions came under pressure as their mortgage-based assets lost value. The Fed provided credit to these institutions in an attempt to mitigate the effect of falling asset prices and stem the crisis. This included bailouts of two housing finance firms – Fannie Mae and Freddie Mac – which had been established by the government in order to encourage home ownership and stimulate the housing market.

The Fed also provided billions of dollars of assistance to AIG, an insurance firm that had invested heavily in mortgage loans . Without the assistance the firm would have collapsed, possibly causing a chain reaction of failing financial institutions. The Fed determined that these consequences were too severe to be allowed – that is, that AIG was “too big to fail. ” Many argue that when the Fed provided this type of emergency aid, it encouraged banks to take even more extreme risks, safe in the knowledge that they would be bailed out if their investments failed. Others praise the Fed for avoiding an even deeper financial crisis.

27.2.6: The Structure and Function of Other Banks

While central banks share responsibility for monetary policy, their structures, methods, and primary goals differ across countries.

Learning Objective

Summarize the structure of the ECB, the Bank of England, and the People’s Bank of China

Key Points

• The European Central Bank controls interest rates through auctions rather than the bond market, and is responsible for maintaining price stability over all other goals.
• The Bank of England is the second-oldest central bank in the world. Monetary policy is dictated by the Monetary Policy Committee, and recently the Financial Policy Committee was formed in order to regulate the UK’s financial sector.
• The People’s Bank of China conducts monetary policy and is the largest central bank in the world.

Key Terms

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

Eurozone

Those European Union member states whose official currency is the euro.

price stability

A state of economy characterized by low inflation, and thus a stable value of money.

The primary function of a central bank is to manage the nation’s money supply (monetary policy), through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. However, the structure, tools, and primary goals of these banks differ between countries.

European Central Bank

The European Central Bank (ECB) is the central bank for the euro and administers the monetary policy of the Eurozone, which consists of 17 EU member states and is one of the largest currency areas in the world. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt, Germany. In contrast with the Federal Reserve, the ECB has the primary objective of maintaining price stability within the Eurozone, but is not charged with regulating unemployment or economic output.

In the U.S., liquidity is furnished to the economy primarily through the purchase of Treasury bonds by the Federal Reserve (the Fed), but the European system uses a different method. Instead, there are about 1,500 eligible banks that can bid for short term repurchase contracts, or “repos”. The banks borrow cash, and when the repo notes come due the participating banks bid again. Because the loans have a short duration, the ECB can adjust interest rates and money supply by varying the quantity of notes offered at auction.

The ECB has three decision-making bodies: the Executive Board, the Governing Council, and the General Council. The Executive Board is responsible for implementing monetary policy and the day-to-day running of the bank. The Governing Council makes decisions about what monetary policies to implement. The General Council deals with the transitional issues that come about as new countries adopt the euro.

The Bank of England

The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world . It was established to act as the English Government’s banker, and was privately owned from its foundation in 1694 until it was nationalized in 1946. In 1998, it became an independent public organization, owned by the Treasury Solicitor on behalf of the government, with independence in setting monetary policy. The primary goals of the Bank of England are to maintain price stability and support the economic policies of the government.

Bank of England Charter

The illustration shows the sealing of the Bank of England Charter in 1694. The structure and function of the Bank of England served as a model for the central banks formed later.

The Monetary Policy Committee is responsible for formulating monetary policy and for setting interest rates in order to maintain a given inflation target. The recently-established Financial Policy Committee is responsible for regulating the UK’s financial sector in order to maintain financial stability.

The People’s Bank of China

The People’s Bank of China (PBC) is the central bank of the People’s Republic of China with the power to control monetary policy and regulate financial institutions in mainland China. The People’s Bank of China has the most financial assets of any single public finance institution. It is responsible for making and implementing monetary policy for safeguarding the overall financial stability and provision of financial services.

The PBC has nine regional branches, as well as many sub-branches and six overseas representative offices. It is divided into 18 functional departments that oversee such issues as monetary policy, financial stability, anti-money laundering, and legal affairs. The top management of the PBC is composed of the governor and a certain number of deputy governors. The PBC adopts a governor responsibility system under which the governor supervises the overall work of the PBC while the deputy governors provide assistance to the governor to fulfill his or her responsibility.

27.3: Creating Money

27.3.1: The Fractional Reserve System

A fractional reserve system is one in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.

Learning Objective

Examine the impact of fractional reserve banking on the money supply

Key Points

• The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected.
• The fraction of deposits that a bank keeps in cash or as a deposit with the central bank, rather than loaning out to the public, is called the reserve ratio.
• A minimum reserve ratio (or reserve requirement) is mandated by the Fed in order to ensure that banks are able to meet their obligations.
• Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money.
• A lower reserve requirement allows banks to issue more loans and increase the money supply, while a higher reserve requirement does the opposite.

Key Terms

deposit

Money placed in an account.

reserves

Banks’ holdings of deposits in accounts with their central bank, plus currency that is physically held in the bank’s vault.

Banks operate by taking in deposits and making loans to lenders. They are able to do this because not every depositor needs her money on the same day. Thus, banks can lend out some of their depositors’ money, while keeping some on hand to satisfy daily withdrawals by depositors. This is called the fractional-reserve banking system: banks only hold a fraction of total deposits as cash on hand.

Reserve Ratio

The fraction of deposits that a bank must hold as reserves rather than loan out is called the reserve ratio (or the reserve requirement) and is set by the Federal Reserve. If, for example, the reserve requirement is 1%, then a bank must hold reserves equal to 1% of their total customer deposits. These assets are typically held in the form of physical cash stored in a bank vault and in reserves deposited with the central bank.

Banks can also choose to hold reserves in excess of the required level. Any reserves beyond the required reserves are called excess reserves. Excess reserves plus required reserves equal total reserves. In general, since banks make less money from holding excess reserves than they would lending them out, economists assume that banks seek to hold no excess reserves.

Money Creation

Because banks are only required to keep a fraction of their deposits in reserve and may loan out the rest, banks are able to create money. To understand this, imagine that you deposit $100 at your bank. The bank is required to keep $10 as reserves but may lend out $90 to another individual or business. This loan is new money; the bank created it when it issued the loan. In fact, the vast majority of money in the economy today comes from these loans created by banks. Likewise when a loan is repaid, that money disappears from the economy until the bank issues another loan .

Money Creation in a Fractional Reserve System

The diagram shows the process through which commercial banks create money by issuing loans.

Thus, there are two ways that a central bank can use this process to increase or decrease the money supply. First, it can adjust the reserve ratio. A lower reserve ratio means that banks can issue more loans, increasing the money supply. Second, it can create or destroy reserves. Creating reserves means that commercial banks have more reserves with which they can satisfy the reserve ratio requirement, leading to more loans and an increase in the money supply.

Why Have Reserve Requirements?

Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. However, banks also have an incentive to loan out as much money as possible and keep only a minimum buffer of reserves, since they earn more on these loans than they do on the reserves. Mandating a reserve requirement helps to ensure that banks have the ability to meet their obligations.

27.3.2: Example Transactions Showing How a Bank Can Create Money

The amount of money created by banks depends on the size of the deposit and the money multiplier.

Learning Objective

Calculate the change in money supply given the money multiplier, an initial deposit and the reserve ratio

Key Points

• When a deposit is made at a bank, that bank must keep a portion the form of reserves. The proportion is called the required reserve ratio.
• Loans out a portion of its reserves to individuals or firms who will then deposit the money in other bank accounts.
• Theoretically, this process will until repeat until there are no excess reserves left.
• The total amount of money created with a new bank deposit can be found using the deposit multiplier, which is the reciprocal of the reserve requirement ratio. Multiplying the deposit multiplier by the amount of the new deposit gives the total amount of money that may be created.

Key Terms

deposit multiplier

The maximum amount of commercial bank money that can be created by a given unit of reserves.

currency

Paper money.

To understand the process of money creation, let us create a hypothetical system of banks. We will focus on two banks in this system: Anderson Bank and Brentwood Bank. Assume that all banks are required to hold reserves equal to 10% of their customer deposits. When a bank’s excess reserves equal zero, it is loaned up.

Anderson and Brentwood both operate in a financial system with a 10% reserve requirement. Each has $10,000 in deposits and no excess reserves, so each has $9,000 in loans outstanding, and $10,000 in deposit balances held by customers.

Suppose a customer now deposits $1,000 in Anderson Bank. Anderson will loan out the maximum amount (90%) and hold the required 10% as reserves. There are now $11,000 in deposits in Anderson with $9,900 in loans outstanding.

The debtor takes her $900 loan and deposits it in Brentwood bank. Brentwood’s deposits now total $10,900. Thus, you can see that total deposits were $20,000 before the initial $1,000 deposit, and are now $21,900 after. Even though only $1,000 were added to the system, the amount of money in the system increased by $1,900. The $900 in checkable deposits is new money; Anderson created it when it issued the $900 loan.

Mathematically, the relationship between reserve requirements (rr), deposits, and money creation is given by the deposit multiplier (m). The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves. When banks in the economy have made the maximum legal amount of loans (zero excess reserves), the deposit multiplier is equal to the reciprocal of the required reserve ratio (
).

In the above example the deposit multiplier is 1/0.1, or 10. Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to $10 .

Money Creation and Reserve Requirements

The graph shows the total amount of money that can be created with the addition of $100 in reserves, using different reserve requirements as examples.

27.3.3: The Money Multiplier in Theory

The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central bank money.

Learning Objective

Explain how the money multiplier works in theory

Key Points

• The total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio (the money multiplier).
• When banks have no excess reserves, the supply of total money is equal to reserves times the money multiplier. Theoretically, banks will never have excess reserves.
• According to the theory, a central bank can change the money supply in an economy by changing the reserve requirements.

Key Terms

money multiplier

The maximum amount of commercial bank money that can be created by a given unit of central bank money.

central bank

The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates.

commercial bank

A type of financial institution that provides services such as accepting deposits, making business loans, and offering basic investment products to the public.

In order to understand the money multiplier, it’s important to understand the difference between commercial bank money and central bank money. When you think of money, what you probably imagine is commercial bank money. This consists of the dollars in your bank account – the money that you use when you write a check or use a debit or credit card. This money is created when commercial banks make loans to companies or individuals. Central bank money, on the other hand, is the money created by the central bank and used within the banking system. It consists of bank reserves held in accounts with the central bank, as well as physical currency held in bank vaults.

The money multiplier measures the maximum amount of commercial bank money that can be created by a given unit of central bank money. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves; this multiple is the reciprocal of the reserve ratio. We can derive the money multiplier mathematically, writing M for commercial bank money (loans), R for reserves (central bank money), and RR for the reserve ratio. We start with the reserve ratio requirement that the the fraction of deposits that a bank keeps as reserves is at least the reserve ratio:

Taking the reciprocal:

Therefore:

The above equation states that the total supply of commercial bank money is, at most, the amount of reserves times the reciprocal of the reserve ratio (the money multiplier) .

Money Creation and the Money Multiplier

The graph shows the theoretical amount of money that can be created with different reserve requirements.

If banks lend out close to the maximum allowed by their reserves, then the inequality becomes an approximate equality, and commercial bank money is central bank money times the multiplier. If banks instead lend less than the maximum, accumulating excess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier. In theory banks should always lend out the maximum allowed by their reserves, since they can receive a higher interest rate on loans than they can on money held in reserves.

Theoretically, then, a central bank can change the money supply in an economy by changing the reserve requirements. A 10% reserve requirement creates a total money supply equal to 10 times the amount of reserves in the economy; a 20% reserve requirement creates a total money supply equal to five times the amount of reserves in the economy.

27.3.4: The Money Multiplier in Reality

In reality, it is very unlikely that the money supply will be exactly equal to reserves times the money multiplier.

Learning Objective

Explain factors that prevent the money multiplier from working empirically as it does theoretically

Key Points

• Some banks may choose to hold excess reserves, leading to a money supply that is less than that predicted by the money multiplier.
• Customers may withdraw cash, removing a source of reserves against which banks can create money.
• Individuals and businesses may not spend the entire proceeds of their loans, removing the multiplier effect on money creation.

Key Terms

money multiplier

The maximum amount of commercial bank money that can be created by a given unit of central bank money.

reserve requirement

The minimum amount of deposits each commercial bank must hold (rather than lend out).

The money multiplier in theory makes a number of assumptions that do not always necessarily hold in the real world. It assumes that people deposit all of their money and banks lend out all of the money they can (they hold no excess reserves). It also assumes that people instantaneously spend all of their loans. In reality, not all of these are true, meaning that the observed money multiplier rarely conforms to the theoretical money multiplier.

Excess Reserves

First, some banks may choose to hold excess reserves. In the decades prior to the financial crisis of 2007-2008, this was very rare – banks held next to no excess reserves, lending out the maximum amount possible. During this time, the relationship between reserves, reserve requirements, and the money supply was relatively close to that predicted by economic theory. After the crisis, however, banks increased their excess reserves dramatically, climbing above $900 billion in January of 2009 and reaching $2.3 trillion in October of 2013 . The presence of these excess reserves suggests that the reserve requirement ratio is not exerting an influence on the money supply.

U.S. Monetary Base

The monetary base is the sum of currency and reserves held in accounts at the central bank. After the financial crisis the monetary base increased dramatically: the result of banks starting to hold excess reserves as well as the central bank increasing the supply of reserves.

Cash

Second, customers may hold their savings in cash rather than in bank deposits. Recall that when cash is stored in a bank vault it is included in the bank’s supply of reserves. When it is withdrawn from the bank and held by consumers, however, it no longer serves as reserves and banks cannot use it to issue loans. When people hold more cash, the total supply of reserves available to banks goes down and the total money supply falls.

Loan Proceeds

Third, some loan proceeds may not be spent. Imagine that the reserve requirement ratio is 10% and a customer deposits $1,000 into a bank. The bank then uses this deposit to make a $900 loan to another one of its customers. If the customer fails to spend this money, it will simply sit in the bank account and the full multiplier effect will not apply. In this case, the $1,000 deposit allowed the bank to create $900 of new money, rather than the $10,000 of new money that would be created if the entire loan proceeds were spent.