1. UNIT #5: Managing the national economy

2. The Federal Reserve & Money Unit #5

3. Money $$$ Money: a substance that functions as a… medium of exchange standard of value store of value Money is… Acceptable Portable Durable Divisible Uniform Scarce

4. Types of Money We generally talk about two kinds of money: Commodity money – money that has some value in trade as a commodity Fiat money – money that gains value through government decree

5. Measuring the Money Supply The Money Supply is the total amount of money in the economy M1 – the money supply that can be used as cash or easily converted to cash– includes currency (coins & bills), checking accounts, and Traveler’s Checks M2 – broader measure of money supply and includes M1, savings accounts, and money market funds

6. So we have money, but how do we have that money transferred between people? = BANKS!!!

7. U.S. Banking System We use a Fractional Bank Reserve System: Requires banks to keep a fraction (called the Reserve Requirement) of their deposits on hand in the form of reserves The current Reserve Requirement is 10% Banks use the extra money as loans to consumers & businesses that they earn interest off of **In a sense, as banks continuously lend money that is not in reserves they are “creating money”. This lending is increasing the flow of money that ordinarily wouldn’t be able to happen!**

9. How much do banks need to keep on reserves? Reserves = Total Deposit X RR (in % form) -------------------------------------- 1000 x .20 = 200 1000 – 200 = 800 -------------------------------------- 800 x .20 = 160 800 – 160 = 640 LOAN Dave’s $640 LOAN Kim’s $800 Kim’s $800 Pat’s $1000 Pat’s $1000 Pat’s $1000

10. Examples – Calculating Reserves Use this formula: Amount of Reserves = Total Deposit X RR (in % form) Mr. Allgyer’s bank gets a deposit of $20,000. The reserve requirement is 20%. How much does he need to keep in reserves? Mr. Allgyer’s bank now gets a deposit of $10,000. The reserve requirement is 15%. How much does he have to lend out?

11. How much total money do banks create? Because each loan decreases in size, we will eventually run out of money to loan based on one initial deposit. We can figure out where it caps out by using the equation: Amount of Money Created = Total Deposit / RR (in % form) Ex) Total Deposit: $1000 Reserve Requirement: 20% Money Supply: $5000

12. Example – Money Creation Use this formula: Amount of Money Created = Total Deposit / RR (in % form) Mr. Allgyer’s bank gets a deposit of $3000 and the reserve requirement is 10%. How much money will be put into the money supply through loans/deposits?

13. The Federal Reserve System The Fed is the central bank of the U.S. Its goal is to keep the entire banking system stable and healthy Their responsibilities include: Holding reserves Providing cash & loans to banks Clearing checks Control the nation’s money supply (they set the Reserve Requirement!) Issues Federal Reserve Notes (our paper currency)

14. Controlling the Economy School of Thought #1: MONETARISM Belief that changes in the money supply can play an important role in controlling the economy Pushed by economist Milton Friedman He believed that it was the Fed’s job to control the money supply to influence the economy!

15. The Federal Reserve System Econ Alive pages 282-288 Complete Section III (A-E)

16. “The Fed” = CENTRAL BANK OF THE U.S. Primary method of managing the economy is through monetary policy central bank policy aimed at regulating the amount of money in circulation and interest rates Goal of policy is to allow the economy to grow, achieve full employment, and keep price stable Created in 1913 by Congress SLIDE 1

17. Structure of Fed Chairman of Board & FOMC – Ben S. Bernanke Board of Governors Board of 7 Governors appointed by President for 14-year terms (1 vacancy/2 years) Purpose is to supervise banking system & control direction of monetary policy Chairman is appointed by President for 4 year term & is spokesperson for Fed Federal Open Market Committee (FOMC) Made up of 7 members of Board of Gov., 5 district bank presidents (1 is always the Pres. Of NY Fed) Meets 8 times a year to determine changes to monetary policy Fed Reserve District Banks 12 Districts with a Federal Reserve Bank in each one

18. Policies followed by Fed Easy Money Policy (Expansionary) Fed expands the money supply trying to cause cheaper lending to stimulate economic growth Interest rates lower but too much easy money policy leads to INFLATION Tight Money Policy (Contractionary) Fed shrinks the money supply trying to cause lending to be more expensive to slow the economy Interest rates rise but too much tight money policy leads to a RECESSION

19. The Fed carries out monetary policy by using these 3 tools… 1. Reserve Requirement 2. Discount Rates 3. Open Market Operations

20. Tools of the Fed Open Market Operations DEFN: buying & selling of gov’t securities in bond market Buy Securities = More $ Sell Securities = Less $ Most-Used Tool Reserve Requirements DEFN: amount of deposit bank keeps in reserves High RR = Less $ Low RR = More $ Least-Used Tool Discount Rates DEFN: Interest Rates on loans the Fed gives to banks High DR = Less $ Low DR = More $ Rarely-Used Tool

21. Targeting the Federal Funds Rate Fed Funds Rate – interest rate that banks charge each other for short-term loans Banks set this rate, so this is NOT a monetary policy tool HOWEVER, the Fed sets a target rate based on its view of the economy & uses OMO to nudge the rate towards the target!

23. UNIT #5 Fed REVIEW: Define monetary policy in your own words. If the Fed wanted to increase the money supply using the discount rate, what would they do? Would the Fed be attempting to stimulate or slow down the economy? If the Fed wanted to decrease the money supply using reserve requirement, what would they do? What would happen to interest rates? If the Fed wanted to increase the money supply using open market operations, what would they do? Would this be considered easy or tight money policy? What is the relationship between interest rates and the amount of credit demanded?

24. Aggregate supply & demand AGGREGATE SUPPLY & DEMAND

25. Looks similar right?…

26. The basics… Aggregate supply = total supply of goods and services produced in the nation’s economy Aggregate demand = total demand for goods and services in the nation’s economy Macroeconomic Equilibrium = when aggregate demand equals aggregate supply

27. Review of Demand-Side vs. Supply Side What do demand-siders want? What do supply siders want? How do they want us to achieve those effects?

28. Supply & Demand’s Influence on Monetary Policy How does the Fed stimulate the economy?

29. CI’s & CO’s What is monetary policy? How would you stimulate the economy right now using ONE TOOL of monetary policy (discount rate, reserve requirement, or open market operations)? How could the government stimulate or slow down the economy? List anything you know about fiscal policy (their way of managing the economy). Describe a major similarity and difference between monetary & fiscal policy. How do demand-side and supply-side policies differ? How are aggregate supply & demand different from the supply & demand that we’ve already covered? Draw an aggregate supply & demand graph, show the effect of demand-side policies on the graph, and explain the two ways in which Keynes and demand-siders argued that they could achieve this effect (list the two tools!). Describe one economic cost & one social cost of economic instability. What is deficit spending, and why does the government do this? Define transfer payments in your own words. Also, provide an example of a transfer payment. Some costs of economic instability are stagflation, a high misery index, a large GDP gap, wasted resources, political instability, and increasing crime. Choose two of these & describe them! Scenario – Taxes on all businesses are increased. Draw what happens to aggregate supply. What are transfer payments? Describe the difference between the 3 major taxes: regressive, proportional, and progressive. Also, give a real life example of one of the taxes. By the government keeping both individual income taxes and business income taxes high, how will this impact the economy? Also, what type of fiscal policy is this: expansionary or contractionary?

30. Fiscal Policy Read pages 279-282 & complete Section on “Government Influence on Economy” (A – C)

31. What is fiscal policy? the use of government spending and taxing to influence economic activity Goals are economic growth, full employment, & stable prices Expansionary Fiscal Policy – Goal is to stimulate economic activity Increase spending & Lower taxes Contractionary Fiscal Policy Goal is to slow down economic activity Decrease spending & Increase taxes

32. Theories on the Government Role in the Economy DEMAND-SIDE Economics SUPPLY-SIDE Economics Policies designed to stimulate aggregate demand (nationwide consumption) by cutting individual income taxes and increasing government spending Put forth by Keynes in 1936 (called Keynesian economics) Idea that GOV’T HAS BIGGER ROLE IN ECONOMY policies designed to stimulate aggregate supply (nationwide production) by lowering corporate income taxes and the individual income tax on high-income taxpayers Idea that GOV’T HAS SMALLER ROLE IN ECONOMY

33. Impact of Government Spending The government’s spending has a magnified effect on the economy due to… the “multiplier effect” – each dollar spent encourages more spending Option 1 – spend more = stimulate the economy Option 2 – spend less = slow the economy Government uses “automatic stabilizers” to manage the economy These stabilizers counter the fluctuations of the business cycle Examples include: transfer payments (payments for which the government receives nothing in return) such as unemployment benefits, food stamps, welfare Tax brackets They work by increasing or decreasing aggregate demand

34. Taxes Taxes are mandatory payments to the government

35. Two Tax Principles Conditions: Those who benefit from gov’t services should be the ones who pay for them People should pay taxes in proportion to the amount of services or benefits they receive People should be taxed according to their ability to pay, regardless of the benefits they receive Benefit Principle Ability-to-Pay Principle

36. Three Types of Taxes Proportional –same % rate of taxation on everyone, regardless of income Progressive –higher % of taxation on persons with higher incomes Regressive –higher % of taxation on lower incomes than higher

37. Specific Taxes Sales Tax = taxes paid on purchases Varies by state by amount and which items are actually taxed Tend to be a Regressive tax FICA (Federal Insurance Contributions Act) = federal tax levied for SS & Medicare Medicare is federal healthcare program available to all senior citizens regardless of income Example of a Proportional Tax (1.45% of all earnings) Social Security is a federal retirement fund SS is capped tax that doesn’t exceed 6.2% of wages & salaries up to $106,800 Example of a Proportional tax (up to $106,800) but then Regressive afterwards Federal Individual Income Tax = tax on people’s earnings is paid through a payroll’s withholding system example of Progressive tax

38. Specific Taxes Excise Tax= taxes paid on products the government wants to regulate Examples include cigarettes, alcohol, & gasoline Tend to be a Regressive tax Property Tax= taxes for land & buildings Property taxes are a significant source of revenue for public schools Example of a Proportional Tax based on the assessed value of property Other Taxes – Luxury, Estate, Corporate Income, Unemployment

41. Impact of Government Spending & Deficit Spending

42. Government Spending Government revenues come from: Individual income tax, payroll taxes (ex. FICA), corporate income taxes, and excise taxes Government spends their money on: 1. Mandatory spending – Fixed by law must pay interest on national debt & on entitlements/transfer payments (ex. Social security, welfare, & medicare) 2. Discretionary spending – Can be raised or lowered as Congress sees fit Examples are education, defense, health care, foreign aid, etc.

43. Deficit Spending YOU MUST distinguish between debt & deficit! A deficit is not having enough revenues to meet gov’t spending in one year Deficit 2006 + Deficit 2007 + Deficit 2008 = DEBT So national debt is the accumulation of all deficits (total money owed from borrowing) over time! Deficit Spending is when the government spends more money than it collects in revenue

47. Deficit Spending THE AMERICAN GOV’T LOVES TO DEFICIT SPEND!! But why??? spending more may help to stimulate the economy we need to protect ourselves we have to do it (mandatory spending – baby boomers hitting the retirement age)

48. Effects of Deficit Spending Adds to national debt Inflation can occur! Unease about foreign-owned debt Citizens become discouraged Worried about the tax burden on future citizens Feel like their money is wasted Fear of Government Bankruptcy How does uncertainty hurt the economy? Purchasing power transfer from private sector (private individuals/businesses) to public sector (levels of government) because the government taxes us more so they can spend! CROWDING OUT EFFECT!! When the gov’t borrowing drives interest rates up so high that people are no longer willing to borrow money to invest in businesses, to buy products on credit, etc.